Back to clients sharing risk

Goldman Sachs has coined a new acronym to describe global markets - “The New Soviet Bloc” - and Building clients and contractors had better beware. While the BRIC countries will still gather the headlines, Goldman’s strategists see investment opportunities in CCCP: Crude Oil, Copper, Corn and Platinum. When an investment bank is advising its clients that a punt on copper is a better bet than on China, all those in construction have a good reason to take stock.

Copper is a particular case in point, as demand is growing but it is becoming harder to get the stuff out of the ground. Output from the world’s largest mines such as Escondida in Chile fell by over 5% last year because of declining ore quality. A shortfall in production during 2011 and 2012 is likely to keep pressure on the prices of pipes and wires.  Who would be a plumber or electrician in the current market?

During the noughties, globalisation was beneficial for almost every industry other than construction. Falling prices of consumer goods such as electronics and clothes kept the inflation rate down - while construction prices stubbornly grew. Since 2008, of course, the situation has been reversed and as global markets march on, clients and contractors need to consider how sustainable the current market is and how much rock-bottom tender prices can be relied on. After the NICE decade of non-inflationary constant expansion, there is a whiff of stagflation in the air, but increasing interest rates won’t help.

Movements in commodity and metals markets have been truly eye-watering.

Copper prices have risen by nearly 60% from a trough in 2010, and steel output increased by 15% to 1.4 billion tonnes during the year - leaving iron ore prices 20% higher than the 2010 average. And that’s before we even think about the implications of flooding on the Queensland coking coal supply chain, or the weak pound on the price the UK pays for dollar-denominated commodities. Some commentators believe that current prices mark the high point for this cycle - but there are plenty of forecasters who predict that commodity prices could rise much further.

Some commentators believe that current prices mark the high point, but there are also forecasters who predict commodity prices could rise much further

So that’s the bad news - but what should we be doing about it? My suspicion is that many contractors and clients are hoping that the problem will go away - or that someone else will hold the risk. A quick search on Google gives plenty of evidence that manufacturers and distributors are trying hard to pass prices up the supply chain. However, there is little evidence from recent tenders that these prices are being passed on to the client. Is this good news or bad? 

Commentators such as Goldman Sachs provide little comfort to suppliers caught between global demand on the one hand and deep uncertainty with regards to UK construction workload as public sector cuts take shape, on the other. The cautious contractor who builds commodity price inflation into a bid is likely to lose out to a competitor who is prepared to take the risk. Unfortunately, the prospects of deeper consolidation in the supply chain grow as contractors continue to submit low-margin, fixed-price bids. Should the rules of the game change while the risks are so high?

Clients need to secure optimum value in the current market, so we can expect to see continuing highly competitive bidding for some time to come. For clients who want the most economically sustainable bid, we need to think of other ways of sharing risk in a more equitable way. This doesn’t necessarily need out-of-the-box thinking - going back to the future may be enough.

The first contract I worked on, way back in the inflationary eighties, was based on fluctuating prices. Since then, risk sharing mechanisms like these have been used so rarely that the clauses have been taken out of the main body of common contracts. Perhaps now is the time to dust off these clauses once again. 

Price risk sharing is no panacea. Not having a fixed price will be a concern for many clients, but so is a contractor going bust. If commodity prices do continue to rise, a shared risk may, in the final analysis, deliver better value than a bargain that was just too good to be true.

Simon Rawlinson is head of strategic research and insight at EC Harris