1. Asset Performance Networks
MODELING INTERNATIONAL ESCALATION
FACTORS FOR UPSTREAM E+P PROJECTS
- AN ECONOMICS PERSPECTIVE -
By
Jan A. Jackson, MBA, MIB, PMP, CCC
(Senior Consultant – Project Consulting
Services (2007))
Washington D.C. Office
3 Bethesda Metro Center
Suite 925
Bethesda, MD 20814
Tel: +1 (240) 683-1001
Fax: +1 (240) 683-1009

2. Table of Contents
ABSTRACT
KEYWORDS
ABSTRACT
This paper is focused on establishing a method for a modified escalation model that
produces more specificity for project cost comparisons among certain types of upstream
projects. Many escalation models fail due to either lack of appropriate detail or
requirements to maintain too many complex routines. In short, any model needs to
deliver the appropriate amount of information without becoming a burden. This study
will also address the concept of location factors and the challenges in dealing with
sourcing issues for respective commodities. Within the last five years several major
commodities such as steel or cement have experienced exorbitant price increase on the
global markets due to increased demand from developing economies. The demand pull
exerted by China’s expanding economy has broken the continuity of slow but steady
project cost increases for global capital projects. This paper presents considerations
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regarding escalation indices for projects like pipelines, offshore, and onshore to enable
reasonable economic comparisons.
KEYWORDS
Escalation, inflation, producer price index, commodity, sourcing, location factor
1. INTRODUCTION
1.1 Background
Currently used escalation factors for comparisons of E+P (Exploration and
Production) projects often appear to produce disproportionate and questionable
results in comparison to project costs from different time periods. More
specifically, the driver behind this exercise is the apparent understatement of the
amount of cost escalation calculated based on the (Consumer Price Index) CPI
index used in many costing systems. This document recommends a more
accurate approach and set of indices to escalate costs and demonstrate the
differences to currently used models.
1.2 Objectives
Efforts here are focused on detailing a method or structure for a modified
escalation model that may produce more specificity for project cost comparisons.
Further, but to a lesser degree, this study will address the concept of location
factors and the challenges in determining sourcing issues for respective
commodities. Within the last five years several major commodities such as steel
or cement have experienced exorbitant price increase on the global exchanges
due to increased demand from developing economies in general and China in
specific. The demand pull exerted by China’s expanding economic activity has
broken the continuity of moderate but steady cost increases for capital projects
around the world.
This document presents a set of escalation indices for pipelines, offshore, and
onshore projects to allow for a reasonable project-to-project comparison and
account for the unusual escalation within the last several years.
2. THEORETICAL CONTEXT
2.1 Escalation defined
In recent years drastic price changes for certain commodities, such as steel
and cement have upset not only financial markets, but integrated economic
entities along the value chain as well. China’s appetite for resources to feed its
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4. rapidly expanding (and transitioning) economy is possibly the most dominant
factor in observed commodity price hikes and spikes of late. Escalation is a
pronounced and continued increase in the cost basis of certain, specific economic
production factors over time. It is frequently tied to one commodity or industrial
sector and initially impacts producers of goods whereas inflation represents a
general price increase across the broad spectrum of an economy.
In the long run however cost escalation is passed on to the end consumer in
form of higher prices and thus ultimately ‘bleed’ into inflation and the CPI. In
order to adequately capture project cost information over time and ensure
comparability among projects some E+P companies have established proprietary
projects systems to track costs according to an established Cost Breakdown
Structure (CBS) by ‘Project Type.’ The following simplified figure uses both of
these elements in developing appropriate indices to track escalation:
Figure (1) – Index Development Chart
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E+P projects systems may define several major project categories, such as
‘Pipelines’, ‘Offshore’, and ‘Onshore’ to capture type-specific information (see
above figure, Level 1). Currently, cost escalation is often accounted for in many
costing systems by applying a common, yearly inflation factor across all project
categories. However, each project category is characterized by a unique cost
composition, which therefore will produce different escalation profiles.
In the above figure, Level 2 depicts one possible distribution of common cost
types for each project category. Level 3 is a further refinement of the previous
level to break down broad cost types such as ‘material’ into distinct sub-
categories (steel, concrete, etc.). In order to present an alternative to currently
used CPI-based escalation models, this paper has defaulted to escalating only the
‘dominant’ sub-category for each cost type (e.g. steel pipe being the dominant
materials item for ‘pipelines’). Level 4 then assigns the appropriate (commodity
or producer) price index to each cost type.
The Bureau of Labor Statistics of the United States (BLS) compiles weekly,
monthly, and annual data on a wide variety of economic issues [1]. As an
additional feature, it is feasible to consider the impact of ‘local content’
procurement on project cost, as some commodities may show significant
differences in market price by locality if it is not traded globally as such. These
considerations must be balanced with potentially higher freight and delivery
costs when ordering from foreign markets. The model used in this document
does consider issues of domestic v. foreign sourcing as displayed on Level 4 in
Figure (1).
2.2 Definitions and Economics
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6. Producer Price Index (PPI) data are commonly used in escalating purchase
and sales contracts. These contracts typically denominate specify dollar amounts
to be paid at some point in the future. It is often desirable to include an escalation
clause that accounts for changes in input prices. For example, a long-term
contract for steel may be escalated for changes in scrap metal prices by applying
the percent change in the PPI for wheat to the contracted price for steel.
The PPI is a family of indexes that measures the average change over time in
selling prices received by domestic producers of goods and services. PPIs
measure price change from the perspective of the seller. This contrasts with other
indices that measure price change from the purchaser's perspective, such as the
Consumer Price Index (CPI). Sellers' and purchasers' prices may differ due to
government subsidies, sales and excise taxes, and distribution costs.
3. ESCALATION INDICES
3.1 Required Index Components
Many models fail due to either lack of appropriate detail and applicability to
the business case or too many complex routines for maintaining the escalation
model. In other words, the model needs to deliver the appropriate amount of
information without becoming a burden and outweighing its benefits. The
following chart is taken from several E+P projects studies on upstream projects to
show their relevant cost composition.
Figure (2) – Cost Composition by Project Type
100%
5.5%
11.7%
90% 20.7%
13.1% Other Indir ec t
10.2%
80% 2.6% Owner s
3.0% 7.6% 5.7%
4.9%
70% 1.5% PM
6.5% 6.2% 10.4%
60% 6.7%
Engineer ing
9.5%
Other Dir ects
50% 9.3%
Installation
40% 33.8% 43.5%
Const / Fab
25.0%
30%
Mater ials
20% Equipment
9.6%
10% 23.2% 20.1% Equip. & Mat. *
0.0966
0%
Pipeline Offshor e Onshor e
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The previous chart identifies about ten (10) distinct project cost types.
Clearly, each of these cost types could be broken down further into very specific
categories. However, the desire for specificity should be weight against the
perceived benefit that is gained from applying a more detailed set of escalation
indices to an increasing number of cost types. In fact, several main cost types
may actually be combined if the nature of their sub-costs suggests strong
congruency.
Figure (3) – Simplified Index Development Model
ESCALATION INDEX DEVELOPMENT
PROJECT TYPES COST TYPES INDEX WEIGHT FACTOR
PIPELINE (B1) EQUIP. MACH (a1) BLS INDEX a1 IN % B1
MATERIAL (a2) BLS INDEX a2 IN %
ONSHORE (B2) B2
LABOR/CONTRAC
BLS INDEX a3 IN %
T (a3)
OFFSHORE (B3)
ENGINEERING/IND. B3
BLS INDEX a4 IN %
(a4)
DETERMINE DETERMINE IDENTIFY BLS MULTIPLY BLS
COMBINE .
PROJECT APPLICABLE INDEX PER COST INDICES BY
WEIGHTS
CATEGORIES COST TYPES TYPE WEIGHT
For example, for our model we have combined ‘Installation’ with
‘Construction/Fabrication’ (labor possibly being the main common sub-cost
type). In the following figure the basic sources to arrive at escalation factors are
displayed. It is recommended however to consider adjustments to this model
based upon specific requirements.
Figure (4) – Tabular Index Weights and Source
COST PIPELINE ONSHORE OFFSHORE INDEX
50% MAT. IC 332312-5
EQUIP. MAT + O.D.C. 30% 30% 30% For pipeline (331210-0)
50% EQP. IC 333132
CONST.INST. BLS Index of hourly compensation
33% 42% 33%
FABRIC. costs for production workers
ENGINEERING 05% 06% 06% BLS IC 54133
INDIRECTS 32% 22% 31% Same as ‘ENGINEERING’
TOTAL 100% 100% 100%
The indices in the above table are displayed in the following chart. Clearly, a
significant directional change occurred in 2004 with cost increases in many major
cost components but most visibly in steel- or metals-related commodities. The
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8. CPI index does not display a considerable change in degree of escalation for that
particular time period, which may be the cause for disproportionate comparative
results when assessing multiple time periods.
Figure (5) – CPI v. Component PPI
The comparison of escalation factors according the weights determined per the
specific project type is displayed in the following chart:
Figure (6) – Project Types v. CPI
Despite the already significant disparity in escalation development between
the CPI and the above displayed project type indices, a comparison to the
overall BLS ‘Crude Petroleum + Natural Gas Extraction Index’ reveals a even
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.drastic differential and suggests significant overheating of this sector in the
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last few years. Consequently, even the factors calculated in this document may
understate the true extent of escalation.
Figure (7) – Comparison to Overall Industry Index
370.00
350.00
CRUDE PETROLEUM + NATURAL GAS EXTRACTION
330.00
310.00
290.00
270.00
250.00
230.00
ENGINEERING SERVICES
210.00
190.00
170.00
150.00
130.00
STEEL PIPE
110.00
90.00
70.00
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Y
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Y
Y
Y
3.2 Other (Industry) Escalation Indices
The following chart contrasts various commonly used industry indices for
comparison. The Nelson-Farrar Refinery Inflation Cost Index [2] is a composite
of three sub-components (Material, Labor, and Misc. Equipment).
Figure (8) – Common Industry Indices Comparison
Even though the Nelson-Farrar Index appears to be significantly lower than
the developed ‘Pipeline’ index as well as the CPI, it features however an up-tick
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10. in 2003-2004 similar in trending to the ‘Pipeline’ index, which corresponds with
cost escalations experienced in a variety of commodities during the same
timeframe.
Endnotes
[1] See www.bls.gov and www.fedstats.gov
[2] The Nelson-Farrar Series of Indices is published in the Oil & Gas Journal,
www.ogjonline.com
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