Pennies from Heaven - Rising Costs May Lead to Financing Issues

For energy infrastructure developers, especially those involved with contentious projects, the most pressing business concern is, in the words of Williams CEO, Alan Armstrong, "improving the predictability of pipeline permitting and project costs." Project costs for pipeline projects rose substantially from 2012 to 2015. This makes estimating future project costs, which some public companies do better than others, even more difficult. To do so, permitting expectations need to be run in concert with sensitivities around budgetary expectations. Why? As cost estimates become more uncertain, there is a greater likelihood that early stage projects will not be built. And those projects that are built may not give the pipelines the types of returns that they expect.

Recent examples of projects that have greatly exceeded their original budgets include Spectra's NJ-NY Project which was originally budgeted at $789M but came in at $1.167B, and Kinder Morgan's Northeast Upgrade Project , which was originally budgeted to cost $376M but ended up costing $504M. Each project did not receive its FERC approval until approximately six months after the date originally requested. As discussed in Ready, AIM, Fire!,  a late decision is associated with increases in costs. Typical drivers of cost overruns stem from standby payments to contractors, or more costly construction activities (generally, 30-50%) during the winter months.

A key determinant for whether a pipeline project gets built is the overall cost of the project compared to the capacity being created. The ultimate profitability of a project can be driven by the ability of the applicant to accurately forecast the total costs such that the rate charged provides an adequate return on the pipeline's investment. By analyzing our data for projects originally filed between October 1, 2007 and September 30, 2013 (which is the last year for which a majority of projects have filed a final cost report), we can spot trends that shippers, project developers and analysts should take note of, especially during early project negotiations.

A common industry metric used to compare one pipeline project to another, and to compare the increase of costs over time, is the cost per inch-mile of pipeline that is built. An inch-mile is simply the diameter of the pipeline in inches multiplied by the miles of pipeline being built. For example, a 10-mile long, 20-inch pipeline would have 200 inch-miles and a 10-mile long, 42-inch pipeline would have 420 inch-miles.

A review of the average cost of projects in our dataset indicates that costs held fairly steady and even trended down somewhat for in-service dates between 2009 and 2012. However, between 2012 and 2015, costs increased substantially. For those projects that went into service in 2016, the industry expectation is that the costs will continue to increase. As project costs increase and become more uncertain, pipelines will find it more difficult to find expansion shippers willing to pay the price to make a project viable. If this trend continues, financial backers may begin to view costs as a potential warning sign to reconsider whether to finance such projects.

Natural Gas Pipeline Project Cost per Inch-mile

While precedent agreements signed with expansion shippers are required to allocate the risk of cost overruns, the actual allocation between the shippers and the project sponsor is left to the negotiations between those parties. Given the increase in uncertainty caused by the increasing costs, pipeline developers are likely to try to shift the risk of cost overruns onto their shippers, which may cause a project to fail if the shippers are not willing to bear that risk.

Upon reviewing company budgeting performance from 2007 to 2013, it is apparent that some pipeline companies are clearly better than others at forecasting the costs of their projects. In the chart below, we set forth the range of cost underruns/overruns that four separate publicly traded companies experienced for projects originally filed from 2007 to 2013. To the extent that a company is actually more precise at forecasting costs, it should, generally, be expected to attract more shippers to its projects, because shippers will likely trust the pipeline company's estimates based on past performance. Unfortunately, considering pipeline performance alone doesn't eliminate the risk associated with the changing regulatory landscape. When FERC lost its quorum, a number of projects were caught up in the delay caused by the loss of the quorum, potentially leading to increased costs. These projects include Transcanada's WB Xpress Project , Enbridge's NEXUS and PennEast Projects.

Natural Gas Pipeline Project Cost Error