Fuel alert

after wrecking new orleans and much of the coastline of Texas and Louisiana, hurricanes Katrina and Rita have gone on to batter the British economy. The storms shut down a dozen oil refineries along the USA’s Gulf Coast and reduced global oil supply by about 6%. The result was an unprecedented surge in petrol prices, and this helped to push British inflation to 2.5%, a full half-point above the Bank of England’s target rate. If you don’t include energy, the figure is only 1.7%.

Although the effects of Katrina and Rita are clear, they accentuated a situation that was already becoming difficult. A combination of factors, ranging from the conflict in Iraq to the decline in the world’s refining capacity relative to demand, has been pushing up energy prices for for the past couple of years. Indeed, just a few days before Katrina made land, American analysts were warning that diesel could hit £1 a litre by Christmas.

The construction industry is particularly vulnerable to rising oil prices. DTI statistics show that the cost of petrol-based materials have risen steeply as a result. In the 12 months to August, cement went up 8% and asphalt 8%. Allan Wilén, economics director at the Construction Products Association, says: “The concern is that the price increase in the UK is particularly sharp because of the way our market operates. It is very open, so margins are getting squeezed or are leading to higher selling prices.”

One contractor feeling the squeeze is Midas. Its head of procurement is Simon Denham, who points out that gas oil prices have doubled over 18 months. Gas oil, also known as red diesel, is the fuel put in vehicles not used on roads, such as forklift trucks. It is untaxed so is much cheaper than the petrol used in road vehicles. It also contains a red dye that stains the petrol tanks and deters people from filling their cars and vans with it.

But this tax break is becoming less significant. Gas oil was about 20p a litre early last year, and is now closer to 35p. The first 15-20% of work on a construction site is the most petrol intensive, with diggers doing the groundwork and forklifts moving materials. One contractor estimates that the increases are costing his company up to £2000 extra per site per day.

As the price of gas oil has increased, so has its volatility. Increases in prices used to be no more than 0.5% at any one time, but can now be as much as 10%. Such extreme changes are difficult to predict, and so are not always accounted for in tender bids, which means that contractors can easily underprice and cut their profit margin.

Vaughan Burnand, managing director of Shepherd Construction, points out that contractors inevitably pass on some of their costs to their customers, particularly as many have been used to dealing with a volatile oil market since the 1970s. However, he concedes that it is not always so simple to manage: “You can see by the rash of contractors’ results at the moment that they're not as they should be and this is caused by hikes in steel and oil prices.”

This financial pain is also being felt by the material supplier. For example, if primary aggregate costs £10 a tonne, about £5 will be transport costs, £3 will be production costs and the remaining £2 will cover overheads and profit. As a typical project might require the laying of 20,000 tonnes of primary aggregate, the impact of rising petrol costs is obvious: margins will be squeezed. Some suppliers are tackling this by adding a fuels surcharge to their price, which sources say is about 5% of the value of what is carried.

Then there is the cost of actually producing construction materials. It is an energy intensive process, as Mike Betts, construction materials analyst at investment bank JP Morgan, points out: “Plasterboard uses a lot of natural gas. Historically it has accounted for 20% of the costs, but it is much higher now. Natural gas used to cost about £3 for 1 million British thermal units, but it’s now about £14.”

The rising oil prices are also pushing up the cost of petrochemical products. Support Site is one of the country’s leading distributors of building and civil engineering products. Andy McDonald, the branch manager of its Plymouth depot, says the market has been “highly volatile” for 12 months and uses the example of polythene. Support Site has increased the price of this 8-12%. This has put £60 on the price of a pallet of 25 4 × 25 m rolls. The increases may inflate Support Site’s turnover, yet McDonald insists it does not increase its profit margin. This is because the distributor does not pass all the costs on, but instead absorbs a couple of per cent to ensure that it remains competitive as a distributor.

The latest rash of company results are not as they should be and this is caused by hikes in steel and oil prices

Vaughan Burnand, Shepherd Construction

McDonald adds that he has had to deal with half-a-dozen price increases in the past year directly linked to fuel hikes. He adds that the volatility means that contractors simply cannot accurately estimate the cost of polythene in their tenders, so they inevitably end up absorbing the cost rather than their clients. “With so many price increases, costing becomes impossible,” he says.

One materials firm, which did not want to be named, said it was particularly hard hit by price fluctuation. It says the price it pays for its electricity has increased 250% over the past 24 months and gas prices have doubled. The latter is particularly volatile. In July it reached an all-time high of 107p a therm, then was below 70p a month later. The net effect is a further degradation of the commercial environment: this firm estimates that its inability to foresee the impact of energy prices could cost it about £1m this year.

Construction inflation may yet intensify. Peter Fordham, an associate at cost consultant Davis Langdon, points out that readymix concrete firms have indicated to customers that prices will go up 10% to £66-67/m3 in January, and that cement is following suit. Castle Cement, for example, introduced a 10% rise in its prices at the start of this month and CEMEX has just written to customers to say that cement prices will go up by £6.45 per tonne as a result of “fuel and transport pressures”. Fordham warns: “If energy prices continue to rise, these materials prices will inevitably go up further.”

Although major contractors and materials companies are undoubtedly hurting, it should not be forgotten that it is the one-man bands that could eventually feel the most acute pain. “It’s the man in the van who could well suffer,” says Mike Foster, construction analyst at KBC Peel Hunt.

Even in the economic wake of Katrina, the majors should have the balance sheet to overcome these problems. But those guys in vans filling up their principal capital asset at £1 a litre are the ones who might not have the financial means to survive this particular devastation.

With so many price increases, costing becomes impossible

Andy McDonald, Support Site