Basis: The observations and opinions in this article are those of the author and reflect his best professional analytics from his knowledge and experience. Pathfinder, LLC makes no claim regarding the reported trends and this article should not be used as a basis for any decisions or actions that may affect any business. The author and Pathfinder shall not be responsible for any loss of any type sustained as a result of this article.
The engineering and construction (E&C) industry serves a broad spectrum of customers from oil/gas/chemical owners, pharmaceutical, power supply, mining, and automobile manufacturers, to residential homeowners, public infrastructure, and small businesses. Over the past three years, the E&C industry has been a roller-coaster of declines driven by the global pandemic to recent recovery and expansions ... and is now buffeted by severe inflationary pressures. The focus of this article is on the E&C process plant sector (primarily serving oil/gas/chemical/power/pharmaceutical businesses), but its observations and conclusions apply across other markets.
Despite Yogi Berra’s comment, “It’s tough to make predictions, especially about the future,” I will try to forecast some E&C trends, with comparisons to recent history and current circumstances.
Yesterday (2020 - 2021)
The pandemic caused a sharp drop in bookings and backlog from projects delayed or canceled, stemming from a global economic contraction ... as evidenced by the Association of Builders and Contractors (ABC) Backlog & Construction Confidence Index.
Widespread Covid-related health restrictions caused a new workforce landscape to emerge, with many services performed from individuals’ homes rather than offices, along with significant travel reductions and increased use of virtual meetings ... all of which hampered productivity.
Prior to 2020, lump sum contracting was available where the scope of work was adequately defined and in historical locations. Between 2002-2020, lump sum bookings accounted for an average of approximately 30% of all worldwide process plant bookings, dominated by the Asia Pacific region.
Today (2022)
While industry bookings and backlog have recently exceeded their pre-pandemic levels (US Census Bureau), energy prices and labor/material shortages have precipitated high international inflation. ABC’s Chief Economist Anirban Basu remarked: “It is simply remarkable that contractors continue to add to backlog amidst global strife, rising materials prices and ubiquitous labor force challenges” ... backlog is up in every segment. Contractors with more than $100M in annual revenue currently enjoy the highest backlog, with about 13 months’ work (ABC data). Recent third-quarter 2022 data indicate contractor backlogs slightly below 2Q 2022 but above the 2020-2021 level.
In the US, new projects resulting from the Infrastructure Investment and Jobs Act will begin in the second half of 2022 and continue throughout 2023, with expected growth rates of 20% and 11% for infrastructure work in 2022 and 2023, respectively, according to Oxford Economics.
In 2022, natural gas prices reached 13-year highs amid the Ukraine-Russia war, and gas shortages are expected to continue. Basic material prices (commodities such as iron, zinc, copper, steel, and cement) have risen 30-to-80% between May 2021 and May 2022 and are disrupting equipment supply chains for everything from automobiles to mining equipment. The St. Louis Federal Reserve Board’s index of all commodities over this same 12-month period indicated a 30% overall rise in prices.
The US and Middle East petrochemical industry has been advantaged by close access to plentiful natural gas feedstocks, along with elevated product prices. Oil/gas/chemical earnings will reach record levels in 2022, provoking louder calls within the US for a windfall profit tax ... which, if enacted, would put American-based companies at a distinct competitive disadvantage versus foreign firms.
Labor and energy volatility, as well as supply-chain shortages, are limiting lump sum turnkey contracting. Lump sum contracts, where available, often contain escalation provisions linked to market indices. Contract negotiations now favor the seller, not the buyer.
While merger and acquisition (M&A) activity of all types in 2021-2022 slowed significantly (PwC 2022 midyear outlook), E&C industry M&A activity in 2022 has already exceeded each of the two previous years. In addition, the number and value of divestitures by contractors of non-core businesses and marginal operations are at record levels.
Tomorrow (2023+) ... few certainties and many challenges in the future
Business Volume
- Over the next two years, E&C bookings volume will be only slightly higher than in 2022. Recessionary pressures in 2023, higher credit rates, as well as China’s sluggish economic growth, will hinder global economies and serve to restrain more aggressive growth in bookings. China, India, and the United States will account for nearly 50% of total process plant investments.
- Green energy investments (solar, wind, biomass) will triple by 2030 from 2022 levels. Moreover, according to Wells Fargo analysts, the global liquefied natural gas (LNG) market is poised to increase much faster than other energy types through the end of the decade ... not only new LNG production projects but also regasification facilities. Carbon capture and sequestration (CCS) projects to reduce emissions will accelerate in number and value, and by 2030 will represent a new E&C sector in the oil/gas market. Those owners investing in CCS technology and projects will outpace their competitors in public favor and possibly in revenue growth ... those contractors with CCS execution capability hold an advantage versus their counterparts.
- The US federal government’s 2022 reduction in oil drilling leases and first-ever increase in royalty rates (up 50% to 18.75%) will inhibit drilling in the US on new acreage, despite high crude prices.
- In the United States, no new refinery has been built since 1976 and more than 50 refineries (with 5M bbl/day capacity) have been shut down since 1991 (US EIA agency). Chevron CEO Michael Wirth said in June 2022: “I don’t think you are ever going to see a refinery built again in this country.” While refinery debottlenecking projects will modestly increase in the US and Canada, major investments in refinery and chemical capacity will continue to occur in Middle East countries, China, and India, driven by national companies such as SABIC, Sinopec, and Reliance.
Contracting
- The shift of project contract risk to owners will continue. Lump sum/fixed price contracting, with its inherent higher risk to contractors, will decline to historic lows in favor of reimbursable cost and unit rate agreements. More than ever before, E&C project contracts will contain monetary caps on contractors’ liabilities. Even in the Asia Pacific and the Middle East, where lump sum (LS) contracting has long been a mainstay, most LS project contracts will contain escalation clauses and higher contingencies. Liquidated damages for schedule delay, if agreed, will be difficult to enforce due to third-party supply problems impacting schedules.
Challenges
- A major E&C challenge will be delivering construction services, with serious risks to cost and schedule performance, given price volatility, talent shortages/turnover, and equipment delays. Prices and availability for essential construction materials like steel, lumber, and cement will continue to remain unreliable in the near term.
- The number of new engineering graduates in the United States has grown at a humble rate of +1.5% in recent years, which is barely balanced by attrition and less than the expected demand by 2030 (US Department of Labor). The number of engineering graduates in China and India are more than four times the USA’s annual rate, and technology capability and innovations will continue to steadily migrate to the Asia Pacific region over the next decade. Owner and Contactor ability to attract and retain technical talent in the US and Canada will be a critical business advantage in the region’s tight market for technical resources.
- Electricity supply in the US has not kept pace with demand. Summer electricity blackouts are likely to be more frequent and more widespread as grid operators struggle to meet increased demand, a problem that has plagued some states for years but could threaten much of the country. Besides those states that have experienced rolling blackouts in the past (eg., CA, NM, and NY), New England and mid-western states have seen similar summer electrical blackouts. In July 2022, Daniel Turner (Power the Future Director) said potential outages have come as many states have moved too quickly to take generation plants that rely on fossil fuels offline and attempt to switch production to renewable energy sources, which do not have the capacity to keep up with demand.
Power supply problems are not limited to the US. In September 2022, the Wall Street Journal reported “record drought across the globe this year dried up rivers and reservoirs and sapped the world’s largest source of renewable electricity: hydropower.” China’s industrial area of Sichuan ordered many factories in 19 cities to shut down or scale back production for one week due to electricity shortages from hydro-generated facilities stemming from a severe regional drought. Apple, Toyota, and Volkswagen were among the companies that reported their plants had temporarily suspended operations, causing product delivery delays.
Policy decisions and energy transition plans in the electricity generation arena will have direct knock-on effects for the E&C and other industries.
Other Key Factors
- As a result of supply-chain disruptions, increased labor costs, and inflation, contractors’ profit will struggle to retain its typical 4-to-6% net margin, and most likely will decline in the 2023-2024 period. Randall Forsyth (Barron’s Associate Editor) reported in July 2022: “Profits are in the early innings of a decline that potentially will be much worse than anticipated by corporate America.” Nancy Lazar (Piper Sandler’s Research Lead) recently warned: “Inflation is going to come back and hit them [corporate America] over the head.”
- While bookings will modestly increase despite short-term recessionary influences, margin and labor headwinds will further encourage mergers and acquisitions, particularly among smaller contractors, but M&A activity will be below pre-pandemic levels due to higher bank lending rates.
- Pre-fabrication/pre-assembly and strategic supplier relationships (both owner-contractor and contractor-vendor collaborations) will gain greater importance as means to diminish supply chain problems.
- Into this decade, the use of drones in construction will become routine for field surveys and security, as well as safety, emissions, and progress assessments.
- Safety will continue its 20-year improvement trend, with the ten largest E&C contractors consistently performing better (their TRIR is now < 0.2) than their smaller-sized counterparts.
More Unknowns
- Government climate change policies to reach net zero emissions could be a heavy influence on process plant capital spending and profitability ... and thereby E&C activity.
- As a result of recent health care/medical supply concerns, some governments may compel pharmaceutical companies to install more manufacturing capability in their domestic market, which would increase demand for E&C services.
- Interest rate changes, trade policies, currency exchange fluctuations, and geopolitical tensions are all unknown factors that could each have varied and substantial impacts on regional economies and thereby within the E&C industry.
ABOUT THE AUTHOR
Stephen Liccini has 40+ years of international experience in project management, primarily with ExxonMobil, and has been Pathfinder's Contract & Procurement Specialist since 2014, assisting numerous clients. He specializes in project planning, contracting, negotiations, claims and dispute resolution, project reviews/controls, training programs, and cost/schedule practices.
sliccini@pathfinderinc.com
856-424-7100
