Advanced Contractual Risk Management

Reducing cost of capital needed to fund large capex projects.

Posted: October 24, 2017

Advanced Contractual Risk Management

Is there anything that can be done to renew confidence in complex capital projects?

We think there is, and it could be as simple as the way you interact with your contractors and the Advanced Contractual Risk Management solution(s) you select for your business.

Despite the current low confidence in large project investments, McKinsey estimates that more than US$60 trillion of complex projects will be sanctioned over the next 14 years to 2030—and even with the latest oil price forecasts factored in, more than half of these projects will be energy-related. In addition, almost 80% of these projects will be large complex projects, and if the past is our guide, almost two thirds of these will overrun, many hugely so.

The oil and gas industry’s relatively poor track record of completing complex capex projects on time and on budget has been testing the banking sector’s appetite for lending to it for some time. And when large projects are increasingly being hit with unforeseen claims, this just compounds the problem.

12% share price drop after project delay announcement

PwC’s analysis of 36 companies across multiple sectors has revealed that after a public announcement of a capital project delay or shutdown, a majority of companies experience a steady decline in share price. By the three-month mark following such an announcement, the decline in share price averages 12%. As a result, the organisations competing for these investment dollars, to finance their complex capital projects, often sensibly look for proven risk mitigation mechanisms such as advanced contractual risk management software to help them to generate the confidence required to secure these funds.

Compared with large infrastructure projects that provide more predictable future cash flows, upstream oil and gas projects are considered as sitting at the riskier end of the spectrum, due to challenges of project size, complexity, and the volatility of oil and gas revenue streams.  Technical, economic, commercial, organizational, and political risks are typically evaluated to determine the cost of capital for any of these large projects. 

Keeping public political stakeholders aligned

Recent research (*) from McKinsey identified that during project execution, the key risks for the sponsor or developer are related to contractual default, claims, keeping public political stakeholders aligned, and monitoring for any mismanagement by the contractor.  McKinsey research concluded that “the interface with the contractor is therefore the critical element.”

So, clearly there is a strong case for owner operators of capital projects to embed and enforce proven contractual risk-management discipline to mitigate these risks and better manage this essential interface with the contractor. And if implemented properly, then surely such ventures should command lower risk premiums and therefore lower cost of capital to fund their projects.

Sensible owner operators proactively manage the contractor and the contract risk using best-of-breed Contract Risk Management solutions with Early Warning Indicators (EWIs) that flag potential risks in time to take corrective action. As such, they truly merit a lower cost of capital than those that are negligent in this regard.

*Sources: McKinsey – Working Papers on Risk, Number 52

author
Written By
Clare Colhoun

VP Global Product Sales. Clare Colhoun has over 20 years of diverse experience in capital project intensive markets. Prior joining AVEVA, Clare held executive positions in strategic planning and finance in global blue chip businesses.

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