RISKS ASSOCIATED WITH MAJOR CONSTRUCTION PROJECTS DURING THE GREAT AMERICAN ENERGY BOOM

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1 CONSTRUCTION HAROLD DORBIN Managing Director navigant.com About Navigant Navigant Consulting, Inc. (NYSE: NCI) is a specialized, global professional services firm that helps clients take control of their future. Navigant s professionals apply deep industry knowledge, substantive technical expertise, and an enterprising approach to help clients build, manage and/or protect their business interests. With a focus on markets and clients facing transformational change and significant regulatory or legal pressures, the Firm primarily serves clients in the healthcare, energy and financial services industries. Across a range of advisory, consulting, outsourcing, and technology/analytics services, Navigant s practitioners bring sharp insight that pinpoints opportunities and delivers powerful results. More information about Navigant can be found at navigant.com. RISKS ASSOCIATED WITH MAJOR CONSTRUCTION PROJECTS DURING THE GREAT AMERICAN ENERGY BOOM OVERVIEW The recent growth in domestic oil and gas production through unconventional methods such as the high volume hydraulic fracking technology, can only been seen as an opportunity not only to those in the energy industry but others as well, including technology providers, design, construction and equipment suppliers. However, the recent and sudden drop in global oil pricing coupled with the increasing calls for greater regulation and/or changes to current regulations surrounding exportation and operational practices of domestic oil and gas production, present even more business uncertainty to the critical energy industry. While technological advancements have made it more economical for shale oil and gas extraction, the physical location of the shale formations and transportation of the product is the cause for one of the most recent trends in energy construction. Existing transmission network flows of natural gas, crude oil and natural gas liquids (NGLs) need to adapt to their new supply source locations, acquire greater operational flexibility to reverse flow of pipeline laterals if needed, and be nimble enough to route flows to meet demands influenced by regulation and regional pricing effects. The market shift to shale oil and gas extraction/production provides substantial opportunities for growth and expansion, but the path to achieving this resource s full production capability is ripe with uncertainty and risk which includes economic uncertainty, compliance with regulatory changes and new legislation, capital investment, new facility development, transportation, labor and resources, etc. These risks have the potential to not only affect the energy industry but can collaterally affect other industries trying to construct major capital projects during this Great American Energy Boom. As a result, every industry involved with constructing new facilities should be aware of what is happening in the market, future forecasts and trends, and should be focusing on what can be done to optimize management of their own project risk.

2 2 KEEPING PACE WITH SHALE PRODUCTION The Great American Energy Boom and its effect on natural gas production is recent and dramatic. In its 1999 Annual Energy Outlook, the Energy Information Administration (EIA) forecasted that net natural gas imports between 1997 and 2020 would grow from 12.9% of consumption to 15.5% (i.e. consumption was forecasted to grow more quickly than production). 1 During the latter half of the 2000s, five new liquefied natural gas (LNG) import terminals were built and some existing facilities expanded. 2 However, in its Annual Energy Outlook 2014, just 15 years later, the EIA projected that by 2016 the United States natural gas production would exceed domestic supply shifting the interest to building LNG (liquefaction) export terminals, as illustrated in Figure 1. 3 As of the beginning of 2015, there have been 48 permit applications either to construct liquefaction facilities at existing LNG import facilities (import facilities also known as regasification) or to construct new LNG export facilities with a total proposed capacity of 42 bcfd. 4 This represents about 63% Figure 1. U.S. Natural Gas Production, Consumption, and Trade (Trillion Cubic Feet) 1. U.S. Natural Gas Exports: New Opportunities, Uncertain Outcomes, Congressional Research Service, January 28, 2015; pg Ibid 3. Ibid, pg Ibid, pg 3

3 3 of current U.S. production, with eight of these projects requiring construction of liquefaction facilities at import terminals at a cost in the range of US$6-10 billion and the remaining 40 projects would be new liquefaction facilities costing in the range of US$20 billion each. 5 The EIA estimates that the overall U.S. natural gas production will grow 56% between 2012 and 2040 with shale gas comprising more than 50% of that eventual production, as shown in Figure 2. 6 In the case of oil, shale oil production in 2000 was approximately 250,000 bbl/d (barrels per day) and in 2013 it had grown to more than 3.5 million bbl/d a 14 fold increase. 7 The EIA projected in its 2014 Annual Energy Outlook that this growth would continue with light tight oil (LTO) production peaking at 4.8 million bbl/d in 2021 with most of this production coming from three formations, Eagle Ford in Texas, Permian Basin in Texas, and Bakken in North Dakoda. 8 Light tight oil is simply oil produced from oil bearing low permeability formations shale or tight sandstone. These EIA production projections were, of course, made during the significant drop in the crude oil prices globally in June 2014 through January 2015 and require some speculation on regulations and the availability to export U.S. domestic crude. In addition to the construction of new facilities to produce LTO, refineries will need to consider how best to configure themselves for the light and sweet (low sulfur) crude. Refineries will also need to evaluate whether the investment makes sense. The Petroleum Administration for Defense District (PADD) 9 located on the Gulf Coast of the U.S., comprised of New Mexico, Texas, Louisiana, Arkansas, Mississippi and Alabama (PADD 3) have collectively the largest amount of refining capacity in the United States. Most of these refineries have coking units which allow the purchase of heavier crudes at discounted prices. Coking units process the heavier residual streams from the heavy crude oil into more valuable and useful products. Coking units are expensive. For two of the three formations that are responsible for the growth in LTO production (the Eagle Ford and Permian Basins in Texas) the proximity of the LTO supply if the LTO is priced low enough, may drive some refinery reconfiguration projects in PADD 3. Figure 2. U.S. Projected Annual U.S. Natural Gas Production (Trillion Cubic Feet) 5. Ibid pg Ibid pg U.S. Crude Oil Export Policy: Background and Considerations, Congressional Research Service, December 31, 2014, pg ibid 9. The U.S. is divided into five Petroleum Administration for Defense Districts (PADDs). These were created during World War II under the Petroleum Administration for War to help organize the allocation of fuels derived from petroleum products, including gasoline and diesel (or distillate ) fuel. Today, these regions are still used for data collection purposes.

4 4 Pipelines are the primary means of crude oil transportation in the U.S. but it is also transported by rail, marine vessel, and truck. In general, the U.S. pipeline system was developed to move crude oil and petroleum products northward from the Gulf Coast. The geographic distribution of LTO production in North Dakoda and inland Texas, constrains the U.S. pipeline system and makes access challenging for some LTO producers. 10 Infrastructure and pipelines needed to transmit and transfer natural gas, LTO and NGL will need to keep pace with the growth expected from shale production. The U.S. has more miles of crude and product pipelines to be completed in 2015 than any other country/region and is second only to Asia-Pacific for miles of gas pipeline projects to be completed in Table 1 Pipeline Construction in 2015 was reproduced from the Oil & Gas Journal. 11 Table 1. Pipeline Construction in in in in. 32+ in. Total Area Miles GAS PIPELINE US Canada Latin America Asia-Pacific ,080 1,694 Europe Middle East Africa Total gas ,390 4,045 CRUDE PIPELINE US ,115 Canada Latin America Asia-Pacific Europe Middle East Africa Total crude ,886 PRODUCT PIPELINES US Canada Latin America Asia-Pacific Europe Middle East Africa Total product WORLD TOTALS Gas ,390 4,045 Crude ,886 Product Total 555 1,923 1,154 2,880 6,512 1 Projects planned to be completed in Regions east of the Ural Mountains and south of the Caucasus Montains, excluding the Middle East. 3 Regions west of the Ural Mountains and north of the Caucasus Mountains. 10. Ibid p Near term pipeline plans shrink, longer term growth returns, Oil & Gas Journal, February 2, 2015, Smith.

5 5 The U.S. also has significant growth (nearly 700 percent) in gas pipeline projects underway at the start of, or set to begin in 2015, and to be finished after 2015, as compared to projects planned to be completed in Perhaps even more significant is that the majority of the gas pipeline to be installed in these latter projects are very large diameter (i.e. high volume) gas pipe. For crude oil and product pipelines, the increase is more than 270 percent. Table 2 Pipeline Construction Beyond 2015 is reproduced from the Oil and Gas Journal. 12 But, major pipeline projects require long term commitments and take years to complete. The crude oil transportation network is evolving to address the challenges. A number of pipelines/laterals are reversing flow, rail shipments are increasing to deliver LTO from North Dakoda to east and west coasts as well as the Gulf Coast and new pipelines are being developed. 13 Valero, a large U.S. refiner, planned to spend US$750 million to buy more than 5,000 rail cars at the end of 2014 expanding its fleet to more than 12,300 cars. 14 Table 2. Pipeline Construction Beyond in in in. 32+ in. Total Area Miles GAS PIPELINE US ,434 3,719 5,290 Canada ,045 2,226 Latin America , ,205 Asia-Pacific ,782 8,969 12,596 Europe ,337 2,354 Middle East ,531 3,133 Africa Total gas 264 1,439 5,806 20,357 27,866 CRUDE PIPELINE US -- 1,490 1, ,885 Canada ,368 2,968 Latin America Asia-Pacific , ,589 Europe Middle East ,043 1,114 Africa Total crude 107 2,217 4,323 4,069 10,626 PRODUCT PIPELINES US 25 1, ,880 Canada Latin America Asia-Pacific Europe Middle East Africa Total product 447 1,595 1, ,247 WORLD TOTALS Gas 264 1,439 5,806 20,357 27,866 Crude 107 2,127 4,323 4,069 10,626 Product 447 1,595 1, ,247 Total 818 5,161 11,334 24,426 41,739 1 Projects under way at the start of or set to begin in 2015 and be completed after Includes some probable major projects whose installation will begin in 2015 or later. 2 Regions east of the Ural Mountains and south of the Caucasus Montains, excluding the Middle East. 3 Regions west of the Ural Mountains and north of the Caucasus Mountains. 12. Near term pipeline plans shrink, longer term growth returns, Oil & Gas Journal, February 2, 2015, Smith. 13. U.S. Crude Oil Export Policy: Background and Considerations, Congressional Research Service, December 31, 2014, p Amid U.S. Boom, Railroads are Beating Pipelines in Crude Transport, BloombergBusiness, June 13, 2013, Philips and Loder.

6 6 REGULATIONS AND IMPACTS As shale production increases, so does the interest in regulating it. Export Regulations Exporting of crude oil and LNG is a key driver to accelerating the expansion of shale formation development, domestic production in general and the infrastructure needed to get it to export. Legislation like the Energy Policy and Conservation Act (EPCA) of and the Short Supply Control Regulations 16 administered by the Bureau of Industry and Security (BIS) limit the export of crude oil and natural gas produced (in the case of EPCA) in the United States. Although there are a few smaller exceptions, it generally requires a license to export crude oil, including crude oil sent to Canada. 17 Some analysts estimate that pricing discounts on LTO production driven by high LTO production and export restrictions may occur as early as 2015/ While the export of crude oil and LNG has the focus of industry and federal politicians, the path forward is not resolved. By way of example, the U.S. House of Representatives recently approved HR 702, a bill to repeal the 40-year ban on exporting domestically produced crude oil by a 261 to 159 vote. Voting ran largely along party lines as 235 Republicans supported HR 702 and 153 Democrats opposed it. The vote came days after the White House announced that the measure would be vetoed if it arrived on President Barack Obama s desk. 19 Environmental Issues Raised It is well documented that environmental organizations, and concerned activists have pointed to a number of issues involving shale production that they believe the public should consider, including the use of water in hydraulic fracking operations in areas where water supply is not abundant, the use of chemicals in hydraulic fracking operations and even earthquakes potentially being caused by fracking operations. While there may be evidence on all sides of these issues, legislators are starting to promulgate regulations in some of these areas. In March of 2015, Federal rules were unveiled to require the disclosure of chemicals used in fracking operations, to set safety standards about how chemicals can be stored around fracking operation well sites, and to require the disclosure of well geology to the Bureau of Land Management. The Obama administration is also expected to develop rules to curb the release of methane, a greenhouse gas, at the well heads. 20 While these rules pertain to federally controlled land, and other wells are largely regulated by the states in which they reside, federal rules have in the past served as a guide for states to develop their own regulations and rules. States do have regulations associated with shale production operations, but the approaches vary in each state. Among its other regulations that address shale production operating sites, Texas has had rules in place since 2012 mandating the disclosure of chemicals used in hydraulic fracturing fluids. 21 In June of 2015, New York State announced that it would ban high volume fracking from taking place within the state. 22 Both the Marcellus Shale deposit (named after Marcellus, New York) and the Utica Shale deposit reside partly in New York State and are recognized as significant natural gas shale reserves. A number of issues likely play into each state s decision about how to regulate hydraulic fracking and oil and gas shale production. But the varying differences in approaches state-bystate may drive perceived financial risk to lenders, developers and operators of shale development operations. Unforeseen changes to regulations, concerns that rule development may occur in an unpredictable manner and that rules may be enforced at an unexpected rate, may all present risk to the industry. 15. P.L CFR U.S. Crude Oil Export Policy: Background and Considerations, Congressional Research Service, December 31, 2014, p Turner, Mason & Company, U.S. Crude Export Restrictions: Industry Response and Impacts, February 28, US House approves bill to repeal crude export ban, Oil & Gas Journal, October 19, 2015, Snow. 20. New Federal Rules are set for Fracking, NY Times, March 20, 2015, Davenport 21. Hydraulic Fracturing Disclosure Rule (Statewide Rule 29, Texas Administrative Code, Title 16, Part 1, 3.29) 22. New York Department of Environmental Conservation website,

7 7 INDUSTRY RISKS AND FUTURE CONSTRAINTS The demand for energy will continue to grow as the world s population increases and as developing nations continue to industrialize. In the United States, the recent Energy Boom due to shale gas and oil extraction technology developments, is calling for significant investments in production equipment, transmission (pipeline, rail, trucks, and marine vessels), and refineries to optimize their operations with LTO. Regulation at some level is necessary for the industry to succeed, but what level is appropriate for each state and each production location, currently varies. As well, production levels will depend in part on the level of export of LNG and crude oil allowed in the future and the permits granted for new facilities. The risks to be considered in shale oil and gas production are likely different from what has been considered in the past with more conventional development methods. Below are some risk observations and considerations for project developers, owners, designers, contractors, equipment suppliers and vendors. Getting to Market Logistics and transmission requirements are always a consideration when developing a new field or greatly expanding existing operations. The location of some of the new production sites, may require that either new pipelines be constructed, existing pipelines be used in a slightly different service or flow direction be reversed to meet market requirements. Production may even be a new phenomenon in the region. New Pipelines getting rights of way may take longer and be more difficult than perceived. Advance studies are likely required to ensure that needed flexibility in operations will be in place. Longer development of routing and longer design development will be necessary to address scenarios for reverse flow, future demand requirements, and environmental considerations. Commitments for a new pipeline developed by operating companies will typically require long term commitments from others who use the pipeline and years to construct once the commitments and funding are lined up. This can impact the timing of planned production. Alternative transport use of trucks and rail may come under further regulation if dependence on them rises, even in the short term. If regional roads are used significantly, public concerns may be expressed and public action taken. Additional investments in road and rail infrastructure and their maintenance will need to be considered in the overall ROI for the enterprise. Construction of infrastructure takes time and is already heavily guided by standards, permits and regulatory approval. Because production may depend on these alternative transport methods, the regulatory framework even at a local level - must be fully considered and incorporated into the project planning. Where is the market changes in export allowances and the pace of LNG facility permit approvals depend heavily on federal and state legislatures. Longer term planning must consider possible easing of the current export by license policy/legislation and its impact on demand and flow requirements (i.e., pipeline diameter and/or flow direction) during design. The appetite for LTO in existing Gulf Coast refineries my also require a steeper discount than anticipated for the refiners to adopt the lighter crudes and adjust their operations to produce it. Once major refiners had adjusted their operations and equipment to handle a larger blend of the lighter crude, LTO prices should be more predictable. Constraints on the Construction Industry If issues such as exporting, permit approvals, regulatory environment and refinery accommodation favor a high production scenario, there may be a large and relatively sudden demand for engineering and construction services to develop infrastructure, transmission, production facilities and ports/marine terminals. If all of these high production favorable events were to occur in a short period of time, the engineering and construction industry would need to respond quickly at a time when oil prices are relatively low. American companies have disclosed at least 86,405 job cuts directly attributed to falling oil prices since June Spears & Associates, a consulting firm for oil-service companies indicates that the amount of fracking work has dropped about 40% from a year ago and that the price of a fracking job has fallen by 35%. 24 Whatever the number, a lag in the ability for engineering firms to suddenly respond to a huge demand may be expected as resources to perform the work need to be gathered. 23. Oil crash cut my pay and killed over 86,000 jobs, CNN Money website citing outplacement firm Challenger, Gray & Christmas. 24. Fracking firms that drove oil boom struggle to survive, September 23, 2015, Snider and Dezember.

8 In LNG liquefaction, the pool of available contractors experienced with the technology chosen may be stretched. This may put more risk back onto the Owner in connection with wrap up guarantees and risk in contracting for the construction schedules that Owner s/lender s prefer. Contractor s may also seek contract carve outs for labor cost risk and even productivity due to the CONCLUSION As U.S. and global energy demands grow, oil and gas production from shale formations in the U.S. are poised to absorb that demand. Several possible national demand for labor and the lack of regional skilled labor. headwinds may delay the impact that Labor force shortages in construction will continue to be an on the energy industry and on U.S. energy issue. Several of the shale production locations are located independence. These headwinds include a the in areas where industrial construction has not been common recent drop in oil prices from June 2014 putting in the last several years and consequently a large percentage some fracking operations out of business, of the construction labor will need to relocate to the area. increasing regulations on to outright state bans on Displacement of skilled workers to perform construction comes hydraulic fracking, political disagreement on lifting at a cost. Housing/accommodation will need to be provided or reducing the ban on crude oil exports, to a lack or compensated for in hourly wages. Local acquisition of of necessary infrastructure in the geographic regions about anything will cost more as demands picks up on local where the shale formation production areas are. communities to supply the needs of regional construction. these technologies will eventually have The pace at which shale oil and gas production projects More problematic is that contractors will likely have to create occur have a tremendous effect on how large the impact the support needed for construction because it does not exist. will be to the engineering and construction community and Work camps, cafeterias, roads, bridges, construction marine on project execution in general. Somehow the energy industry terminals and off-loading cranes may all need to be added to and the engineering and construction industries have always address the project. This also means that project risk assessments risen to the challenge and overcome obstacles. There is no performed by bidding contractors will need to carefully address reason to believe that they will not again. available labor, housing, existing/needed infrastructure, logistics, and local community support for the project to accurately gauge the estimated cost and schedule. Projects not even associated with the energy industry may also be impacted in similar ways. Labor supply must carefully be considered by owners and contractors. Tracking regional projects planned and specialty craft availability to ensure that manloading peaks do not coincide with other regional projects should receive extra scrutiny. Availability of experienced contractors to perform planned projects may also be stretched due to the increase in shale development projects and due to the elevated needs that shale production projects have for additional infrastructure. This elevated need for additional infrastructure may demand design/ construction resources not customarily involved with energy projects to be in high demand. ABOUT THE AUTHOR Harold Dorbin is a Managing Director in Navigant s Global Construction Practice and is based in the Houston, TX office. Harold has more than 33 years of experience supporting owners, contractors, fabricators, and governments with the development and execution of complex construction projects and the resolution of construction disputes and insurable claims in seven continents and more than 20 countries. Harold has led project advisory service engagements for individual construction programs as large as US$30 billion, in a variety of industries including oil & gas, process, power generation, transmission, nuclear power, transportation, ports, mining and infrastructure. Harold s project advisory experience includes: project risk assessments, project governance assessments and evaluations, project RFP and bid optimization/development/analysis, procedure development and client instruction/training Navigant Consulting, Inc. All rights reserved Navigant Consulting is not a certified public accounting firm and does not provide audit, attest, or public accounting services. See navigant.com/licensing for a complete listing of private investigator licenses.