Increasing Material Prices Gouge Construction Industry
This year, exceptionally high construction material price increases have caused problems for the construction industry. A major factor is the current economic and construction boom occurring in China. China’s rapid growth and tremendous construction activity are creating shortages in the US and throughout the world.
Basic economics dictate that, in an open marketplace, prices will rise when demand increases or when supply decreases. Demand is increasing exponentially in China, which is affecting prices worldwide. The increased demand stems from a construction boom resulting from the country’s economic revolution. China is in the midst of the 10th phase of its 50 year plan, which specifies that the construction industry should be promoted, improved, and better managed. Other factors increasing China’s demand for materials include preparations for the 2008 Olympic Games, construction of the Three Gorges Dam, and the construction of thousands of highways throughout the country.
Demand is also significantly higher in the US due to a rise in construction activity, related in part to new home construction. Some of the highest price increases have occurred with steel, lumber and plywood, while cement has been in short supply. The following graph shows the extent of construction material price inflation over the past twelve months:
The construction industry has seen the demand for steel increase and the supply decrease simultaneously. All types of steel have increased in price over the past twelve months. For example, concrete reinforcing bar has risen by 45.2% and structural steel has risen by 25.7%.
Currently, China is consuming about 25% of the world’s steel supply. Since China is a major player in the steel production market, it can redirect previously exported steel to fill its own domestic demand for the material, but it reduces the material’s availability on the open market. A similar situation is occurring in India, where some suppliers have halted exports in order to meet their own domestic material demands.
While demand for steel has steeply risen, the shortage of coke, used in steel manufacturing, has reduced US steel production. Other factors such as high energy costs, high transportation costs resulting from increased fuel costs, the decreased value of the US dollar, and the consolidation of steel manufacturers are all contributing to the increased steel prices. In addition, delivery delays have resulted from international shipping lanes being stretched to capacity.
The federal government removed tariffs on imported steel earlier this year. While this action was expected to lower prices, the effect was negated by the rising demand.
Lumber and Plywood
The prices for lumber and plywood have also risen dramatically over the past twelve months, mainly due to increased residential construction activity in the US. Low interest rates have spurred much of this new residential construction. Lumber prices have increased an average of 25.8% while plywood prices have increased an average of 21.5%. Since the start of this year’s hurricane season, repair and reconstruction work necessitated by wind and water damage has further driven up lumber prices. These high prices will likely be sustained over the next year or two as the massive reconstruction efforts progress.
Some regions of the country have been hit with dramatic cement price increases, but on a national scale, the average price increase has only been 2.5%. The shortage of cement, however, has been widespread. In some cases concrete mixing companies, which rely on the steady supply of cement, cannot produce concrete fast enough to keep up with demand. The shortage has led to project delays and disruptions as well as increased costs.
In 2003, 20% of the US demand for cement was fulfilled by imports. The US has anti-dumping laws and very high tariffs against Mexico, making imports from that country cost prohibitive. The length of time to import materials from overseas, as opposed to receiving materials from Mexico, is longer, as it takes weeks rather than days to receive a shipment. The resulting delays can be hard on contractors who need to adhere to a tight schedule. In addition, because of high activity in Asian markets, particularly in China, freightliners are making the majority of shipments to that part of the world rather than to the US. China is currently consuming approximately 40% of the world’s cement supply. The country’s exceptionally high demand for concrete has allowed it to outbid US buyers on the world market, further reducing availability to the US.
Challenging Times for Contractors
Many of today’s construction contracts are lump sum or unit price contracts and can take a year or more to complete. Because these contracts are typically based on material prices estimated at the beginning of the project, the contractor can be adversely affected when material prices surge unexpectedly.
Depending on the contract, increases in the cost of construction materials can be transferred from the contractor to the owner. More often, however, the contractor absorbs the increased cost of construction materials. Considering the increased cost of materials and the fact that numerous projects today have slim profit margins, contractors are facing situations where they either make no profit or stand to lose money on a given project.
In addition to rising prices, another major problem is the delayed delivery of materials to contractors due to material shortages. Material delivery delays can be beyond the control of the contractors, and they can delay the entire project. Such delays put contractors at risk of liquidated damages and extended overhead and project costs due to missed project deadlines.
Impact on Public Projects
Public projects constitute a large portion of construction spending in the U.S. Many municipal projects are being delayed because bids are coming in much higher than the budgeted amount. This is a somewhat unique problem for cities and states, since bonds, which are usually for a specific amount, must often be approved by voters. In several recent cases, from the time when a bond was put to a vote and the time bids were requested, material costs increased dramatically. Thus, bids are coming back for much higher than the approved amounts. At that point, municipalities must determine how to make up the difference, which could mean going back to the voters for more money. This can put projects on hold if voters are unwilling to approve increases in the bond amounts, or if there is simply no additional money available. For example, in South Hackensack, New Jersey, bids for an elementary school renovation came in at approximately $2.5 million over the budgeted amount due, for the most part, to increased steel prices. Because voters were reluctant to approve the increase, the project was put on hold.
Extraordinary material price increases can, as they have in the past year, set in quickly and unexpectedly. In addition, some of these high prices may be here to stay, at least for the near future. Some possible solutions for dealing with increases and high prices include:
1. Incorporate price protection clauses into contracts (apply bid qualifications):
A contract clause can be the ideal way for a contractor to protect against material price increases. Typically, a price escalation clause will take effect with a price increase over a certain percentage, around 10%, and max out at a percentage of perhaps 80%. As a concession to the owner, the clause may also include provisions for reduced compensation should prices fall. Specific language for drafting a contract clause typically requires consulting an attorney; however, some elements to consider including in a price protection clause are as follows:
- A statement indicating that the contract amount is subject to change, depending on the price of certain materials
- A specified trigger percentage and maximum percentage
- A time extension due to material shortages and delays resulting from material shortages
- A notification requirement for the contractor to inform the owner of delays and requests for extensions or of significant price differences
- A specification that proof of price increases or material shortages will be provided in writing from various sources
2. Lock in Material Prices:
In the same way that owners secure the value of a contract with a contractor, a contractor should attempt to lock in construction material prices with its suppliers whenever possible. This is difficult to do for concrete, since suppliers have been reducing the time during which their price quotes are valid.
3. Buy Materials as Early as Possible:
On projects where it may not be standard practice, if site conditions allow, a contractor can purchase as much steel, or other materials, as early in the project as possible and then store the materials on site. Buying early is advantageous since the contractor can lock in on prices and ensure there is an adequate supply of materials for the project, even if a market shortage occurs later in the project.
4. Delay Construction:
Because of the volatility of material prices, it can occasionally benefit an owner to delay a project, when practicable, until prices come down. There is a certain amount of risk associated with this tactic, since prices could steadily increase.
5. Bulk Discounts:
If a contractor is purchasing material for multiple projects, it may be beneficial to purchase materials at the same time to receive bulk discounts. From an owner’s perspective, it can choose to utilize some of the same furnishings and finishes on similar projects in order to obtain better bulk discounts.
It is sometimes possible for builders and contractors to work together with other builders and contractors to obtain groups discounts on materials. This can be achieved by buying larger quantities at a bulk rate.
6. Employ Alternatives to Help Reduce Costs:
A contractor can have parts of a project redesigned with less costly materials in order to keep a project within budget. Value engineering involves reducing the scope of the project, delaying certain aspects of the project, or eliminating wish list items like skylights or elaborate landscaping.
In some situations, it may be advantageous to consider renovating an existing building as opposed to building a new structure. A cost comparison may reveal that a renovation is significantly less expensive than a new building. Alternatively, depending on the condition of the existing building, the renovation may be significantly more expensive (e.g., renovating a much older building requires bringing it up to code).
7. Renegotiate Contracts to Accommodate Price Increases and/or Industry Shortages:
There are certain realities the owner must acknowledge regarding material price increases, and it may be necessary and beneficial for the contractor to be proactive with the owner. It may be possible for a contractor to renegotiate a contract to accommodate price increases or industry shortages. In some situations, it may be in the best interest of the owner to renegotiate. For example, if the duration of the project as well as the price of the project increases significantly, the contractor may be put at financial risk. In this situation, the owner could make certain allowances for increases rather than risk the entire project.
8. Maintain a Good Relationship with Material Suppliers:
It is good business practice, and general common sense, for contractors to maintain a positive relationship with material suppliers. Part of building and maintaining this relationship is paying the suppliers’ invoices on time. Without the cooperation of the material suppliers, the project simply will not happen.
Looking to the Near Future
Increased material costs are already increasing the price of new homes and may eventually cause a decrease in residential construction. The increased material costs and potential schedule delays may also decrease the level of overall construction in other sectors as well.
The market may, however, experience some relief in the near future. The following factors may alleviate the current situation:
- Rising interest rates may slow construction enough for cement and steel production to catch up, thus stabilizing prices and supplies.
- Construction rates will decrease as winter approaches, allowing production rates to catch up and thus prices to stabilize.
- The Chinese government has taken measures to slow its economic growth, which may in turn reduce demand and prompt a decrease in material prices throughout the world.
- Potentially, new production and manufacturing facilities could increase supply.
Contractors should be careful to protect their own interests in a market that is shifting an increased amount of risk onto contractors. Protection from material price increases is just one of the considerations contractors should keep in mind. Owners should also be aware that current material shortages can delay projects and increase their costs.
Source: Interface Consulting International, Inc.
Released: July 30th, 2007 11:45 AM
Author: Interface Consulting International, Inc.
Phone: (713) 626-2525
Fax: (713) 626-2555