The white knuckle ride

When construction work started in spring 2004 on Trinity Academy in Doncaster, one of the government’s new breed of privately sponsored schools, steel prices were relatively stable. By the end of the year those prices had shot up by over 20%. The result was that Ewan Peacock, a quantity surveyor at the project’s consultant Faithful & Gould, was left with a headache – how to absorb additional, unforeseen costs in the £20m project.

It’s a familiar scenario to all cost consultants – and the headaches could get worse still.

Increases in material prices have been outstripping inflation for over a year; steel is the worst offender with a cost rise of 15% on last year, while concrete is now 11% more expensive this year compared to last. Steel price increases are now relenting but energy prices show no signs of stopping their inexorable rise.

Oil affects everything

Oil averaged $62 (£33) a barrel in August, which is a 50% increase on a year ago. This has led to overall energy costs (also including gas and electricity) to be up 20% on last year (fact file).

Alan Wilen, director of economics at the Construction Product Association (CPA), says: “Energy cost rises affect everything from bricks and equipment rentals to deliveries and cement. Timber might be less affected but it still needs to be transported. Petroleum is also used in producing a wide range of chemicals in the building sector. If a single material cost rises, it’s a small proportion of the total cost, but when energy costs rise, the ripple effects can be extensive.”

Unsurprisingly, this is a concern for consultants. Phil Jones, senior partner at Oxford-based Ridge Property & Construction Consultants, says as well as affecting so many construction inputs, energy costs are surrounded by uncertainty. “The oil price spikes we’ve seen are yet to filter in and at present it’s difficult to predict exactly what will happen to material and other input costs further down the line. It’s a headache for the market and it’s a headache for us,” he says.

Predictions certainly vary. Investment banks Goldman Sachs and Merrill Lynch have recently revised upward their predictions for the long-term price of oil. Goldman Sachs expects that a barrel of US light crude will still cost close to $60 at the end of the decade, while in the shorter run, its analysts predict prices to hover at around $68 a barrel until the end of the next year. In contrast, Merrill Lynch’s energy team have predicted a more manageable price of $42 a barrel by 2009.

The causes of energy cost – and building material cost – rises are easier to grasp. Global demand for oil is increasing year on year, partly fuelled by the demand of the burgeoning economies of China and India, which have also increased demand for steel. While the recent spike in oil price is clearly a consequence of Hurricane Katrina in the US, as well as costing thousands of lives the tragedy has caused oil output in the Gulf of Mexico region to fall by 90% and the closure of eight refineries. OPEC has agreed to increase the supply of crude oil to the market, but the reduction in global refinery capacity means these supplies will not immediately find their way to consumers.

Inputs and indexing

If materials aren’t indexed and it’s a fixed price contract then it is the contractor who usually has to swallow the extra costs

David Craigie, commercial director, Avid Construction Management

So what effects are these global trends having on the ground, on UK building material prices and, in turn, cost plans and project management? For starters, manufacturers have, according to the CPA’s Wilen, seen unit costs rise by 5% over the past year, which is “faster than productivity is able to rise”. Given that it is factory gate prices rather than raw materials that determine building material costs, some of these cost increases have been passed on to purchasers, although the CPA says manufacturers’ margins, especially steel manufacturers, are also under pressure. And with building materials accounting for around 60% of total project input costs, according to the BCIS, price increases of the like seen for steel are having an impact.

David Craigie, commercial director at Glasgow-based Avid Construction Management, says the effect of price increases depends on the project and the contract it uses. “We are working on a hotel project for which the budget was set in July 2004. The price of certain materials was indexed and so, in this case, the developer will have to absorb costs,” he says, “But, of course, if materials aren’t indexed and it’s a fixed price contract then it is the contractor who usually has to swallow the extra costs.”

Craigie says the strategy for dealing with uncertain costs is negotiation with the client about how to tackle costs that crop up unexpectedly. He says: “For inputs like labour, we can, to a certain extent, predict the cost.

But when material prices are rattling up then you have to be careful to qualify your costs – it is a difficult thing but we have to take a view on it. For example, if steel accounts for say 5% of your material costs then an increase is going to have a big impact in an industry where margins are tight and in some areas are getting tighter, for example, residential. On a civils project where steel is a key material even small price increases will have a big effect.”

In the case of Doncaster’s Trinity Academy development, F&G’s QS team went through a value engineering process to absorb the brunt of the steel cost increases; costs that could not be soaked up had to be borne by the contractor and the client (the Department for Education and Skills). F&G’s Peacock says value engineering means savings are made rather than costs cut, but it’s a huge task. “We were already on site when the cost increase came through,” he says. “It was a big but essential job to get together with the client, design team and contractors to consider our options.”

The rise in building material and energy costs is partly responsible for edging tender prices up, although in the long-term tender prices are driven, on balance, by demand.

The CPA and Construction Confederation’s (CC) Construction Industry Trade Survey for August showed tender prices rose slightly in the second quarter of this year, while contractors’ profit margins fell by over 10% in the same period. CPA’s Wilen says contractors are being squeezed by both material and labour costs. “They cannot pass these increases on to their clients or on to their purchasers. So there is pressure across the supply chain,” he says.

Other economists agree that in the short term the sector is faced with challenges.

The CPA, for one, has warned that trading conditions are difficult given a weakening in consumer and housing market related areas. There is still a question mark over the extent to which steel prices will settle and oil looks set to worry cost plans for the short term at least. But as F&G’s Peacock says: “There is always a degree of uncertainty about future prices and that’s where our expertise as cost consultants comes in. We have to make provisions and allowances for these uncertainties, but we don’t have a crystal ball.”