Volume: 4 | Issue: 2

Adapting to the New Normal in Oil and Gas Construction: How the Market Will Endure Growing Pressures

In February, President Obama vetoed legislation that would approve the construction of TransCanada’s Keystone XL Pipeline. The 7-year regulatory saga is emblematic of the regulatory and public relations burdens on US energy projects. With the rejection of the bill, the burden will grow.

However, the difficulties faced by the US energy infrastructure market do not end there. The tightening of trade labor markets and lower commodity prices have made funding and executing projects a struggle. These three factors—regulatory uncertainty, trade labor constraints, and commodity pricing volatility—represent a “new normal” for the energy infrastructure markets. They also present a unique opportunity for the contractor community to meet the challenges of a rapidly changing marketplace.

Growing Regulatory Burden

How does an oil pipeline (Fig. 1) that would represent less than 1% of the total oil pipeline infrastructure in the US draw such remarkable political opposition?

The answer is threefold. Firstly, like many political issues, the debate has become symbolic. In the case of the Keystone XL, the debate has transformed into one about climate change and environmentalism. It is also bearing the brunt of environmentalists’ objections to a US oil industry that has grown with remarkable speed since 2009.

Fig. 1—Although TransCanada’s proposed Keystone XL Pipeline would represent less than 1% of the total oil pipeline infrastructure in the US, it drew remarkable political opposition. The 7-year regulatory saga is emblematic of the regulatory and public relations burdens on US energy projects.

 

Secondly, political activism is changing. No longer does an activist need to go door to door to generate support for a cause. Facebook, Twitter, and the broader Internet have all changed the political discussion, as well as access to power in the US. As a result, constituencies can be built around tweets and blog posts with the ability to change rapidly the political debate in Washington, DC.

Thirdly, as the country becomes more politically polarized, politicians use these debates to their own advantage. According to the Pew Research Center, the most frequent voters and campaign contributors are also the most ideologically extreme (Fig. 2). In this self-perpetuating cycle, the Keystone XL became a debate about climate change and environmentalism, which invigorates both ends of the political spectrum. The fact that the pipeline would represent less than 1% of oil pipeline infrastructure in the US, with negligible effect on the environment, is lost in the noise.

Fig. 2—A survey of 10,000 people showed that the most frequent voters and campaign contributors in the US are also the most ideologically extreme. In this self-perpetuating cycle, the Keystone XL Pipeline project became a debate about climate change and environmentalism, which invigorated both ends of the political spectrum

 

Political polarization, the changing nature of political activism, and the growth of the US energy industry have collided over the Keystone XL. For TransCanada, the project has been an expensive effort. Last summer, Russ Girling, president and chief executive officer of TransCanada, told the Wall Street Journal that the USD 5.4 billion total cost of the Keystone XL would nearly double by the time the US government completed its review of the project.

With political activists emboldened in the wake of Obama’s veto, the energy industry will face greater regulatory burden and public scrutiny. This will result in greater compliance costs and project delays.

In this environment, project owners face a dilemma. There is no room for error in project quality or safety. At the same time, regulatory costs are increasing and project returns declining. How do owners construct a project at a lower cost using contractors with an excellent safety record and a strong reputation for quality? Moreover, how do contractors deal with a problem that may worsen during an extended market downturn: the availability of skilled labor?

Labor: A Not So Ancient History

From December 2007 to June 2009, the Great Recession resulted in more than 8.2 million job losses in the US. Construction put in place fell from a seasonally adjusted annual rate (SAAR) of USD 1.2 trillion in March 2006 to a low of USD 754 billion in February 2011. Approximately 2.3 million construction jobs were lost, or nearly 30% of the construction workforce.

Five years later, the construction industry has rebounded modestly. Construction put in place has yet to eclipse USD 1 trillion (SAAR), but it is improving steadily. The total construction employment has rebounded to just more than 6 million workers, a far cry from its peak of
8 million workers in 2006. Today, the industry is struggling to find qualified labor. Could 2 million workers have left the workforce for good?

The answer is an unequivocal yes. Some workers found new careers, while others left the workforce entirely. This issue has caused challenges in the industry: Nearly 83% of employers reported having trouble finding skilled labor in October 2014, according to the Associated General Contractors.

The oil and gas industry now finds itself in the same precarious position. As the economic downturn persists, employers lay off skilled labor. The workers then move to other sectors of the economy or leave the workforce entirely. As a result, when the market rebounds, laid off workers do not rush back into the market to fill the void.

If markets in North Dakota and west Texas struggled to find talent when the oil price was USD 100/bbl, how will they find it at USD 70/bbl? Firstly, only the most talented labor and field management will remain in the industry through the layoffs. When prices rebound, labor will move to the highest bidder. This will place pressure on already constrained contractor margins and will likely force some firms out of the market. Only the most efficient operators will survive and flourish.

Secondly, because of labor constraints, the US oil market may be unable to mobilize on new drilling and production as quickly once the prices rebound. The supply chain for remote infrastructure will be labor-constrained and delays will become even more prevalent than they were in early 2014. Ironically, this could affect oil prices and create a self-correcting price response.

Still an OPEC World

While most analysts predict the downturn in oil prices will last from 6 months to a few years, a political event in the Middle East or in another Organization of the Petroleum Exporting Countries (OPEC) state could cause prices to rebound rapidly. The rapid production decline rates of shale wells in the US could also cause supplies to fall quickly and prices to rebound more quickly than anticipated. The global demand growth remains the third major wild card, and forecasts vary.

While one debates the timing of a market rebound, one thing is certain: Commodity prices will be volatile as oil and gas from US shale continues to disrupt world energy markets. Because of hydraulic fracturing and horizontal drilling, US oil production has increased by more than 125% since September 2008, and natural gas production has grown by more than 35% during the same period. The country’s oil production now represents nearly 10% of global oil supply, and liquefied natural gas export facilities in the US will come on line this year. The US is now a leading global energy producer.

OPEC and other oil-rich nations are struggling with the new reality as lower prices put pressure on fiscal policy and political leadership. OPEC’s cohesiveness will continue to be tested. Combined with the political environment in the Middle East, changes in global demand, and improving hydraulic fracturing and horizontal drilling technologies, volatility is likely.

In an environment of volatility, regulatory burdens, and labor scarcity, the dilemma of infrastructure owners becomes even more acute. So how do owners construct a project quickly at lower cost with contractors that have an excellent safety record, a reputation for quality, and access to trade labor? In FMI’s discussions with a variety of industry participants, we found that many companies are already finding solutions to this question.

Integration of the Value Chain

The concept of vertical integration has been around since the 1970s, when companies such as Fluor and Bechtel began building their reputations for applying innovative methods and performing precise engineering and construction work in the petroleum industry. By adding turnkey solutions and offering a comprehensive suite of engineering, procurement, and construction (EPC) management services, these large vertical integrators have gained tighter controls over processes and positioned themselves closer to their end users.

Today, industry stakeholders are considering long-term strategic alliances to plan and execute complex projects using more integrated and collaborative delivery methods. In FMI’s discussions with industry leaders, we found that many contractors are already using this strategy to improve their services and capabilities.

Bruce Brown, general manager of oil, gas, and chemical at Cianbro, stated, “As the programs grow from the owner’s perspective, there will be an interest in more turnkey capabilities. On larger projects, I think labor constraints will drive partnerships to the medium-sized contractors—and more alliances between contractors and engineers—to help provide turnkey capabilities.”

Ronnie Wise, chief operating officer of Price Gregory, said, “Some of the larger contractors with the financial resources will attempt to provide services in addition to construction. They will be able to provide the additional resources to execute the major expansions planned in the shale plays. Some owner companies will try to take advantage of this type of arrangement to involve contractors in the development stage of the project or even going to an EPC approach during the peak construction years. These efforts could yield benefits in a safer, more efficient project with less budget and schedule risk for the client.”
Some companies are planning for future labor needs by looking at innovative contracting methods that help them get in on the “ground floor” with client projects. For example, instead of working in a subcontractor role, Kiewit operates in a direct-perform general contractor role as part of a large EPC team by getting involved involved with jobs several years before the projects break ground.

“That gives us the opportunity to plan for future labor needs well in advance,” said Dan Lumma, senior vice president of Kiewit Energy Group. For example, during the months or years leading up to a new project, Kiewit places qualified employees in the offices of its clients and engineering partners. Lumma said the new strategy is working out well for the company, particularly with progressive clients who have a long-term vision and strategy.

This approach to resource planning and activity scheduling is closely aligned with the clients’ functional planning and allows both engineering and construction firms to acquire and deploy the right resources to the right place at the right time. The “integrated planning” also establishes a clear line of sight between project strategy and execution while reducing the risk of cost overruns and schedule delays.

While long-term strategic alliances and partnerships are gaining traction in the oil and gas industry, some energy infrastructure construction firms are examining acquisitions aimed at diversifying and integrating their project portfolios. Through acquisition, firms are able to apply their knowledge and resources to different geographic areas and service lines, allowing them to serve clients more effectively and limiting risk.

Flatiron, one of the largest infrastructure contractors in the US and Canada, is a good example of a company that has used this growth strategy. Christian Büscher, vice president of corporate development and risk management at Flatiron, said, “Diversification means investing in areas you can control—the work types, the kind of business you do—but adding geographical areas to it. Say, ‘Let’s have a second leg to stand on.’”

While acquisitions are a vital driver of competition and growth among players in oil and gas engineering and construction, there is no magic formula for success in acquisition. As one industry executive put it, “It is more an art than a science.” The game is always changing and small or medium-size firms can capitalize on the existing market presence of an acquired firm to move into new markets or expand their service offerings.

Over the past few years, transactions that diversify capabilities and geographic coverage have been extensive. While large transactions such as AMEC/Foster Wheeler, AECOM/Kentz, and CB&I/Shaw garnered the headlines, many smaller, little noted transactions have given some contractors diversification that will provide them with a long-term advantage. For example, Wood Group’s acquisitions of Elkhorn Holdings, Sunstone Projects, and Swaggart Brothers provide the company an integrated presence in the US and Canada with a full complement of field services such as engineering, construction, maintenance, and fabrication. The company is now capable of providing a suite of service offerings of greater value to customers. 

Vertical integration will be a driving force in energy infrastructure construction markets over the next decade as owners and service providers react to greater regulatory burdens, labor risks, and pricing volatility. By improving customer service through integrated project delivery, client partnerships, and expanded capabilities, leading engineering and construction companies are providing solutions to a market with both substantial challenge and opportunity ahead. OGF


Scott Duncan is a vice president at FMI Capital Advisors, a registered investment banking subsidiary of FMI Corp. He works with construction industry firms on mergers and acquisitions, valuations, and ownership transfer matters. He may be reached at sduncan@fminet.com.
Sabine Hoover is a senior research consultant at FMI Corp. She has more than 10 years of experience in applied research with a specialty in market research on the construction industry. She may be reached at shoover@fminet.com.