Goodbye to risk?

Lump Sum Contracts Losing Devotees


By Lori Musser

Blaming not-fit-for-purpose lump sum contracts, rumor has it that some traditional engineering, procurement and construction companies are moving away from EPC work. Instead, advisory services are being offered up as EPCs take a cold, hard look at where their futures lie.

While some EPCs are outrightly spurning lump sum bids, others are negotiating modified fixed-price contracts, or simply adopting a more rigorous bid oversight strategy.

Along the project cargo supply chain, response to the trend is mixed. Forwarders are happy to be out of the risk management business that is part and parcel of fixed-price contracts, while carriers may be less pleased. Having the flexibility to optimize fleet utilization in a lump sum scenario can be a windfall.

EPCs use all sorts of contracts – unit price, cost plus, target cost and fixed price – with variations on each theme so that virtually every contract is unique. However, “they have traditionally favored lump sum contracts,” said Tim Walsh, a Norton Rose Fulbright partner in St. Louis who focuses on energy sector transactional and dispute work.

In a lump sum contract, most risks migrate to the contractor, and away from the owner. For that reason, they have been the darlings of governments and mega project owners. The contractor benefits too, with flexibility to innovate and finish early, and with a greater potential margin for profit than in a cost-reimbursable contract. “With the greater risk, comes the greater reward,” Walsh said.

While the use of lump sum deals has been widespread, industry developments have moderated their appeal. “We are seeing more creative, cost-reimbursable clauses being worked into the contracts. In a very tight market, I definitely see EPCs wanting to take less risk,” Walsh said to Breakbulk.

An Unlucky Streak

Upsized projects, cyclicality, labor shortages and weather all challenge EPC performance on fixed-price contracts.

Weather events are particularly harmful to construction projects, and an extraordinary series of hurricanes has made a mark on Gulf of Mexico projects since 2000. Also, projects have gotten bigger; even a minor problem on a billion-dollar development can erode an EPC’s cash flow, as can currency fluctuations, which have been particularly volatile since 2007. And, with bigger projects come longer timelines.

Walsh said that when the project market tightened after the global economic downturn, EPCs faced difficult decisions. Some had to cut staff. Many had to take on more risk to win awards. New risks emerged, such as a labor shortage in the Gulf caused by the outflow of skilled workers and an associated spike in costs when new projects began again, and unprecedented international trade and tariff issues that increased the cost of materials. “Repercussions from contracts negotiated before these risks became realities that are still being felt,” Walsh said.

Lessons were learned. “The newer EPC contracts deal with these possibilities,” Walsh said, and while that can give contractors some relief, the question remains of who takes the risk. “New contract clauses can substantially change the owner’s risk profile, along with the price of the commodity they are trying to move at the end of a project.”

High-Profile Exits

In the last two years, some leading EPCs have renounced lump sum contracts. Last July, SNC-Lavalin announced it would leave “lump-sum turnkey,” or LSTK, contracting in favor of more high-performing pursuits. That decision followed the firm’s pullout from several lump sum projects for which they were shortlisted, including Montreal’s LaFontaine Tunnel.

In a statement of clarification, the firm said they would consider bidding “if the contracting model changes to one with better risk profile than LSTK” or becoming a subcontractor with limited risks.

In September, SNC-Lavalin confirmed: “Our new strategic direction is well into the execution phase, we are completing those LSTK contracts already started and carefully managing the associated delivery and risks, and we have not taken any new work, and ceased all bidding, in these large construction scopes.”

Skanska, a multinational EPC based in Sweden, identified “restoring profitability and reducing risk within construction” as a priority in its annual report, adding that in the U.S. it would stop bidding for both mega design-build public-private partnership projects and engineer-procure-construct projects in the power sector. As of Jan. 1, 2019, it declared that infrastructure development was no longer one of its business stream.

It has since revised its bid strategy, advising that special focus is being placed on “improving construction project execution,” starting with a stricter bid strategy.

EPCs that undertake massive projects must focus on cash flow or face the consequences. Evan Armstrong, president of 3PL consulting firm Armstrong & Associates, said to Breakbulk: “It all has to do with how well the project scope is defined. If all of the project steps are planned and accounted for with some type of buffer built into the profit margin, they are fine. Scope creep can be a killer and turn a project upside down quickly.”

Although many other factors were at play, lump sum contract issues undoubtedly influenced restructuring decisions at Fluor and McDermott International.

At McDermott, President and CEO David Dickson reported a massive cash flow problem in 2019. In January 2020, McDermott filed for Chapter 11 protection. Dickson said many of McDermott’s balance sheet woes stemmed from “focus projects” that came with the CB&I merger of 2018. He called the bid on the Cameron LNG in Louisiana a “miss” (see related story, page 26).

For Fluor, a record drop in stock prices followed its second quarter 2019 earnings report. Chief Financial Officer Michael Steuert said on Fluor’s earnings call that cash flow problems stemmed from “troubled projects.”

Supply Chain Impacts

Utsav Mathur is a shipping, offshore energy, and global disputes lawyer based in Norton Rose Fulbright’s Houston office. He said the impact of EPC contracts permeates the supply chain. “If the project owner secures a flat fee, the EPC will try to push a similar structure downstream. They will go to forwarders, logistics providers and the carriers themselves and secure the lowest flat, capped, or limited fee contract of affreightment structure to give some protection vis-à-vis the flat structure they have upstream.”

EPCs under flat fee structures often take on a lot of risk. “They are usually challenged to pass it on to ocean carriers who are reluctant to give up the protections offered by COGSA, Hague-Visby and other cargo liability regimes. But, when the EPC engages a freight forwarder, the EPC is often able to contractually pass on significant transportation risk, including full value cargo liability, to the forwarder,” Mathur said. This leads to limited upside for the forwarder with significant liability and no ability to pass liability downstream to carriers. “Providers working with large EPCs on large contracts have become risk managers.”

While big EPC contracts provide an important market opportunity for logistics firms, they can bring trouble too. One concern is safety. Mathur said: “In one case, we had an EPC who made a decision late in the project to switch out a supplier of marine services [based on price considerations]. A casualty followed and several hundred million dollars of project cargo was lost. Even if the EPC’s decision to change providers wasn’t a breach of contract or breach of the standard of care, it created a lot of issues in the litigation that followed.”

On a more positive note, a lump sum carriage contract may be of great benefit to a carrier with access to a large owned or chartered fleet with varying degrees of utilization and the ability to optimize cargo movements.
“Although there is the risk of inefficient movements, there is also potential to find efficiencies and maximize net earnings,” Mathur said.

Walsh said, in a lump sum contract, cargo (or project) owners truly give up control. “The owner has very limited visibility on carriers selected, price, or ability to control, other than what they negotiate in the contract, such as general safety guidelines and vetting policies.”

Lump sum contracts anywhere along the supply chain offer incentives to reduce costs. Mathur said: “While every party involved in a large capital project will acknowledge that cost reduction should never compromise safety, the history of litigation suggests that cost-cutting can lead to incidents.”

Future Proofing EPCs

Once a contractor realizes they have a risk issue because of price and cost overruns, there is a disincentive to get the project under control. This then snowballs and problems deepen. “Contractors fail; they get in too deep,” Walsh said.

The nature of the contract itself can discourage resolution, but, Walsh said, EPC contracts have already started to incorporate clauses into lump sum contracts to deal with emerging issues. “So the fix is already here. The fortune of those companies with legacy contracts should improve. Even five years ago, EPC contract parties did not contemplate the types of cost escalations that have been experienced related to tariffs and other international change regimes. They do now.”

While the problems of lump sum contracts “are not insurmountable,” according to Mathur, vigilance is needed. “Every time there is a downturn, we can’t allow price to become the sole governing factor – safety should always remain the top priority.”

Over the long term, EPCs have been able to manage lump sum projects successfully, but growing project risk and aggressive bidding has created countless problems. The time for change is here. New types of contracts, new clauses and new approaches to bidding may offer relief not just to EPCs, but to project owners, carriers and project logistics providers all along the supply chain.  

Illustration by Mark Clubb after Banksy

Based in the U.S., Lori Musser is a veteran shipping industry writer.