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Gas Pipeline Operators Deal with Labor Shortages, Escalating Costs

When the sponsors of the Rockies Express Pipeline (REX) began to lay out their plans for the landmark natural gas pipeline, they locked in certain costs, including steel and labor, for the first half of the project. However, "that type of hedging is not available in today's cost environment," Sempra Energy CEO Donald Felsinger said. "The key point is that the Rockies Express or any similar pipeline couldn't be duplicated at the same price."

Felsinger's comments, which were made Thursday during Sempra's quarterly earnings conference call (see related story), mirror similar statements by other energy company executives in recent days, who have explained that rising construction costs -- for both materials and labor -- are cutting into the bottom line.

REX is a prime example of what's happening in the industry. Last February Kinder Morgan Energy Partners LLC (KMP), which sponsors REX with Sempra and ConocoPhillips, said finding qualified workers to build the pipeline had pushed the original $4.4 billion cost of the eastern leg of the project up 11%, or $500 million, to $4.9 billion (see NGI, March 3). Now the sponsors estimate that REX will cost closer to $5.6 billion (see related story).

"I think one of the great challenges we and other builders and operators face today is obviously rising construction and material costs," said KMP CEO Rich Kinder, who addressed the issue during a quarterly conference call in July. "And these continue to create a challenging business environment for our whole industry...We're really focused on managing those increases, trying to identify ways to offset them where we can and bring in our projects as close to being on time and on budget as possible."

KMP's forecasted capital spending for its major projects increased "by a little less than 10%" since issuing some projections in January, Kinder noted.

"Most of the increase during the last quarter has been on our natural gas pipeline major project. There we have faced...market conditions that have driven higher prices for consumables, for labor and construction equipment. And then specific to our REX project, we did have certain provisions in the final EIS, the environmental impact statement, that have resulted in substantial increased costs on that project. While we'd rather obviously not see these increases, we remain confident that REX and all of our other projects will still deliver attractive returns to our investors."

To make capital investment decisions, Kinder said, "we conservatively estimate the cash flows, which leads us to opportunities to outperform..."

Kinder noted that "the cost of pipe on some of our earlier projects where we ordered a pipe upfront was in the $1,200 per ton range. Today the same pipe is going for in the range of $2,500 per ton. By locking in early, we save enormous amounts of money..."

So much pipeline construction is under way across the United States "that I think still the pressure is pretty great," for construction materials and labor, said Kinder. "Now there is some anecdotal evidence. We talked to contractors who say they are having the capabilities to do more spreads. They are training more welders. All those things are steps in the right direction. But so far, we haven't seen the corner being turned. So I think that the pipelines with similar construction [are] still pretty hot."

Speaking only for KMP, Kinder said, "Tariffs in general will be higher than they have been on prior projects. If you had to replicate REX today at today's steel prices, today's compression prices, no telling what the tariff would be. But it would sure be a lot higher than the roughly $1.10 across the whole system that is our present tariff. So, yes, tariffs are going to get higher, in general, to reflect the higher-cost construction.

"That said, I think that Kinder Morgan and other companies of this size may actually have an advantage because we're using a lot of the major contractors, particularly when you get to 42-inch [diameter] pipe, there are very few contractors who could really do this. We have good relationships. We know who's good and who's not. So I think we may have more insight into it than most."

To land new pipeline projects KMP "will make as certain as we possibly can that we have built in the current costs at that time of doing that project, including labor escalations and including pipe costs," Kinder said. "And the pipe costs are fairly easy to lock down and most of these, now they may not be at prices you would like, but you can ascertain what the prices are. And of course you do have some lead time in terms of getting in line at the mill because the permitting process on any of these projects is the most significant time consumer in the project...So we'll be happy to build more pipelines, but only obviously, if we can get a good return on those that we build."

Sempra's Felsinger said, "there is always the uncertainty" around a project's ultimate cost. And as the REX sponsors look at the environmental and routing decisions they face to complete the pipe, "there is always the chance that the cost could change. But we think the $5.6 billion with what we know today is a good number."

El Paso Corp., the largest natural gas transporter in the country, is under similar cost pressures for its pipelines, said pipeline chief Jim Yardley.

"Steel for pipe making has doubled since the beginning of the year," Yardley said during a conference call Wednesday (see related story). "And the cost of large diameter pipe has increased approximately 60%. For the most part we've minimized the impact of these increases by locking in our pipe at or near the time we committed to go forward with our customers under long-term transportation contracts.

"Having said that, since our New York analyst conference in April our expected total capital cost for the projects that were in the backlog at that time has increased by approximately 8%. This increase is due somewhat to higher-than-expected pipe but also increases in scope requested by customers. So, while costs have increased, our project returns have not materially changed due to risk mitigation plans we put in place with customers and better marketing results in general..."

El Paso CFO Mark Leland also pointed to labor-related issues for the spike in operating costs this year. El Paso has about $8 billion of pipeline projects in its backlog, and it is gearing up to build the projects over the next couple of years, he noted. Those projects take more than materials, he said. They take a lot of trained people.

"I think we've done a lot of increasing of our staffs in engineering and supply chain management," said Leland. "And so a lot of it is related to preparing for the growth mode that we're in. Also, some of the labor is related to demographics, and getting ready for people retiring in the field in particular. So, that -- and a lot of that I think is now behind us. We may have a little bit more, but we have moved to a little bit higher plateau, if you will, on the labor side."

AGL Resources Inc. also is faced with rising costs, said CEO John W. Somerhalder II. "Given the increases in labor and materials and commodity prices, particularly the cost of steel and higher costs for pad gas," he said that the cost of AGL's Golden Triangle Storage project will be 10-20% higher than a previous estimate of $265 million.

Boardwalk Pipeline Partners has the same issue.

"With all the pipeline projects currently under way across the country, we are competing for construction resources," said Boardwalk President H. Dean Jones II. "The industry has experienced cost pressures and delays, and we are no exception." Boardwalk's Gulf Crossing project was estimated to cost $3.4 billion in the first three months of the year; the cost now is estimated at $3.7 billion, he said. "The new capital cost estimate reflects the expanded pipeline facilities necessary to accommodate additional volumes from the assumed capacity options exercised and the...cost resulting from construction delays."

Oneok Inc. CEO John W. Gibson said his company's partnerships have made "good progress on its internally generated growth projects." However, Oneok, too, is experiencing cost increases and delays.

"More than two years ago, we purchased the pipe for our three announced NGL [natural gas liquid] pipeline projects, Overland Pass, the Piceance Lateral and the Arbuckle Pipeline," said Gibson. "This was a good decision for our company,as it enabled us to avoid the significant run-up in steel prices that the industry has experienced and is facing today. In fact we estimate this decision saved almost $100 million of additional capital. What we did not forecast correctly, however, was the increase in labor we have incurred since the Overland Pass and Arbuckle Pipeline projects were first planned and announced several years ago..."

Overland Pass experienced some regulatory delays, which "contributed to most, if not all, of the cost increases," Gibson noted.

"In hindsight, we should have reacted more quickly at the beginning of the project to resolve the regulatory delay that affected the receipt of our initial permit, a delay that resulted in our having to construct portions of the pipeline during one of Wyoming's harshest winters in the generation," said Gibson. "The delay in receiving our permit not only delayed our pipeline start-up, it also added the additional labor associated with winter construction. So on Overland Pass the lesson learned was to focus the necessary resources on the front end of the project to better understand both regulatory and wildlife issues."

Costs for the Arbuckle Pipeline were developed about 18 months ago, said Gibson. "We underestimated the magnitude of the labor cost increases we've experienced and the difficulty in cost of acquiring right-of-way in the Barnett Shale area, near Fort Worth, where we've been buying easement by the foot, rather than buy the rod. While the steel cost increase did not affect the cost of pipe for Arbuckle, these increases did have an effect on the cost of valves and fittings." However, he added, "both Overland Pass and Arbuckle are still economically attractive projects [that will provide] much needed service for producers and processors, and are key to our growth in the NGL sector."

For El Paso CEO Doug Foshee, the costs may be higher, but he said they come with a silver lining.

"It is a high-quality problem to have, one we have been dreaming about having for most of the last five years," Foshee said. "I think the real answer is, first off, we have a lot of lead time because remember that a lot of this [capital spending] gets spent over the next four years, particularly on the pipeline side. So we have an awful lot of leverage to withhold.

"In addition, to internal generated cash flow, we have got an MLP [master limited partnership] out there, which we expect to grow overtime," said Foshee. "We have lots of ability to flex back and forth in terms of the discretionary capital that we spend in [exploration and production]. We have the ability to take partners on almost any of the projects we have in the pipeline backlog if we choose to do that, and project finance alternatives. So it is a fun problem to have. We have got lots of lead time to get around it, and look forward to reporting that."

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