The significant volatility exhibited in the US market for construction materials since late 2003 has impacted the costs of projects and availability of materials required to complete projects. Over the past three years the markets for different construction materials have exhibited different forms of volatility at different times. For some materials cost has remained relatively flat while supplies have been limited, for other materials prices have spiked only to return to prior levels, while still other materials have experienced alternating price increases and supply shortages. The only consistent trend in the market for construction materials has been the existence of continued volatility and the only accurate prediction for the future cost and availability of construction materials is that volatility will continue.
The impact of this volatility has been exaggerated on projects utilizing a design-bid-build methodology. The amount of time that transpires between design decisions, financing arrangements, document preparation, bid solicitations, bid acceptances, authorizations to proceed, and actual construction mitigates against controlling the impact of volatility.
The key to effectively managing construction material volatility is to select the most advantageous project delivery methodology for the overall design and construction process. Design-build project delivery provides the inherent structure best suited for addressing the challenges of today’s marketplace. Even on projects being delivered under a design-bid-build methodology the utilization of design-build principles such as early involvement of specialty contractors, integration of design and construction expertise, clear knowledge of the supply chain for construction materials, equitable and clear delineation of risk and, of course, quality communication, teamwork, and collaboration are key to a successful project.
In order to effectively manage material volatility it is important to understand the genesis of what is happening in the marketplace.
First, construction material volatility has not been limited to a single product or material. While steel received the majority of the initial coverage in the press, all construction materials are exhibiting similar trends. In some cases the volatility has expressed itself primarily in terms of price, in other cases availability. Even within components with the same base material the impact has been different. Structural steel, reinforcing steel, coil and plate have all behaved differently at different times during this cycle.
Structural steel experienced a rapid run up of prices in early 2004, relative stability (including a dip in the summer of 2005) through the end of 2006, only to see another increase in early 2007.
Second, the construction materials market is highly sensitive where any one of a number of factors can trigger volatility. In the initial stages of the current round of instability all fingers pointed to China as a source of growing demand for raw materials, particularly scrap materials. Yet the market for various materials has been impacted by events with out any direct connection to China. Global demand for construction materials has increased, ocean shipping resources have been in short supply and of high cost, and rail cars are unavailable to move scrap and product within the United States. Other nations have limited or terminated exports of scrap and construction materials, the US dollar has weakened limiting imports, material producers have modified their processes and product mixes due to changes in energy and demand requirements, which have resulted in increased domestic competition for resources and price speculation on the part of raw material purchasers.
Third, a transition is occurring from the pricing of domestic construction materials being based on a cost of production model to pricing being based on a global demand model. The United States construction market is changing. No longer are prices determined by domestic production and demand, but by the relative value of products as part of the global market. It is not just demand for scrap that impacts the cost of construction materials in the United States, but the global demand for the actual materials.
The bottom line is that volatility is a long-term trend. It will continue to affect all construction materials. Even when brief periods of stability occur, it should be anticipated that volatility will quickly return to the marketplace.
The question then is not whether volatility will continue, but how can that volatility best be managed?
First, there must be a clear understanding of the supply chain and pricing dynamic for the material in question. The US market for structural steel is primarily supplied through domestic production with less than 10 percent of overall market demand being met by imports. Structural steel fabricators obtain their materials either directly from producing mills or from service centers. Approximately 70 percent of the structural steel in the United States flows to projects from domestic producing mills through service centers. While much attention has been given to lengthening lead times, little recognition has been given to the fact that 70 percent of the material demand can be supplied within a matter of days from a local steel service center.
Large projects typically have design and detailing lead times that allow for ordering of mill material within the current 14 to 16 week mill lead time for open rollings. In addition, the larger projects benefit from a higher degree of sophistication and understanding in terms of managing material acquisition in today’s market. Smaller projects that are typically supplied from service centers have been unaffected in the current period of peak demand. Some mid-size projects that have been relying on mill supply are now switching to service center supply with a corresponding increase in cost. The choice between increased material costs and accelerated delivery is one that must be made on a project by project basis. It should be noted that many fabricators have optimized their material handling and production process for service center delivery, offsetting a significant portion of the increased cost.
The rapidly increasing demand for structural steel has led some suppliers in the US to initiate a controlled order entry process to ensure that customers have an adequate supply of steel for the projects they are working on. With controlled order entry, rather than selling steel on a first-come, first-served basis that could allow a small number of buyers to corner the market on all available steel, customers purchase steel on the basis of how much they purchased in the past.
Second, specialty contractors that deal with the materials on a daily basis must be engaged early in the design process. No longer is the specialty contractor a commodity provider that simply delivers and installs material at a project site. The specialty contractor brings expertise regarding material pricing, cost saving techniques, project coordination and working with material suppliers that owners, architects, general contractors, construction managers and structural engineers do not possess. Why? Because specialty contractors, such as steel fabricators, live the challenges of their slice of the project over and over again. Specialty contractors are better prepared by experience and knowledge to deal with the challenges and assume some of the project risks. But that can’t happen if the specialty contractors are not fully integrated into a project team. To lessen the risks of construction material volatility the specialty contractor must be brought in early to the project and integrated into the design and construction team.
In terms of structural steel, integrating a certified steel fabricator early into the project team can bring significant advantages. Fabricators monitor steel pricing on a continuous basis and can recommend value engineering opportunities. Since not every shape specified by a structural engineer may be readily available through a local service center or mill, the fabricator can provide valuable input on the range of shapes to be utilized in the project. Designs can be directly influenced to take into account fabrication and erection efficiencies. Fabricators can also recommend other cost savings strategies such as the implementation of interoperability between design, detailing and fabricating programs. The cost savings available through this technique often exceeds the recent increases in mill material cost.
Third, the process of material acquisition must be defined early in project’s life cycle and should emphasize the early reservation or purchase of the construction materials. The greatest ally of volatility is procrastination. Producing mills allow the reservation of material within family ranges prior to the completion of the structural drawings with final order quantities not being set until the next rolling cycle for that family of shapes. In the past many fabricators acquired material on an as-needed basis to fit the fabrication schedule of a project. Today, particularly on projects purchasing directly from a mill, more material is being purchased up-front limiting the opportunity for an adverse impact from marketplace volatility. However, such a change requires an adjustment in the traditional compensation schedule for the fabricator moving his reimbursement for materials purchase and storage forward in the project time frame from the point of material fabrication or erection to the time of delivery of material to his shop.
Fourth, risks related to material acquisition should be defined, assigned and accepted by the project team member or members most capable of managing the risk. The acceptance of this risk should be adequately compensated for in the project’s financial structure.
Since late 2003 the structural steel fabricator became the default holder of the risk engendered by volatile structural steel prices, particularly on design-bid-build projects. Initially faced with fixed price contracts and rapidly increasing material costs, many fabricators approached their clients for relief. In the vast majority of cases relief was not made available at any point along the project’s contractual chain (fabricator to general contractor to owner/developer to financing institution) and the fabricator was forced to assume the higher costs. In an effort to protect themselves on future projects, many fabricators sought to include escalation clauses in new contracts allowing increases (or decreases) in material costs to be passed on to the project owner. While many owners were open to discussing the use of escalation clauses their financing institutions were reticent to allow projects to proceed with what were perceived to be open-ended contracts.
With mills being forced to pass on at least a portion of higher scrap costs and financers unwilling to accept escalation clauses in construction contracts being funded, the structural steel fabricator was caught in the middle and had to assume the financial risk of material volatility. One of the paradigms of business is that the assumption of risk brings with it the opportunity for reward. While not occurring overnight, compensation for this additional risk began to be built into contract prices. Compensation for this risk typically takes two forms. First, contract prices rise to cover at least a portion of the contingency necessary to cover the risk of material cost increases. The “cost” of this risk varies between fabricators based on their skill in sensing the direction of price movement.
Second, the benefit of potentially decreasing prices is factored into the equation. When a temporary price reduction in the mill price of structural steel occurred in mid-2005, many owners, developers, and general contractors approached steel fabricators for price reductions on projects that were already awarded. It was these same owners, developers and general contractors that had earlier denied relief to steel fabricators when mill prices escalated. Yet, when prices dropped, they desired those reductions to be passed back to their projects. On the surface the desire for an adjustment based on falling prices is understandable, yet what was not recognized was the fact that the steel fabricator had already factored in the potential for both upward and downward volatility in the submitted price. The fabricator was still being asked to assume the cost risk of upwardly volatile prices without the potential reward from a price reduction.
For assuming that risk the structural steel fabricator must be compensated adequately and consistently. That is the legitimate reward that comes from assuming risk.
For a design-build project the project owner and design-build team must clearly define who will hold the risk for changing material prices. The only mechanism available to the project owner to gain the benefits of material price reductions is by assuming the risks of cost increases through the use of an escalation clause. If such a clause is utilized, cost savings on materials will be passed back to project and fabricating prices will be lower as risk for material pricing is not being assumed by the fabricator. That is the reward that legitimately belongs to the project owner for assuming the risk of increasing material prices.
The same scenario holds true if the owner wishes the risk of material price volatility to be held by the project team. The project team must either assume that risk is being shared by all team members and develop the project price accordingly or if the team as a whole is unwilling to assume the risk, the specialty contractor must assume the risk. If the specialty contractor (in our case, the steel fabricator assuming the risk of volatile structural steel prices) assumes the risk, then compensation for that risk must be factored into the price for the fabricated material.
Under any of the scenarios — risk held by the fabricator, the project team or by the project owner — good communication, rapid turnaround of bids and issuance of notice to proceed, immediate material orders with front end compensation and storage fees paid to the steel fabricator, early involvement of the structural steel fabricator as part of the project team with the opportunity to impact design decisions and use of productivity enhancing tools can mitigate, but not eliminate the impact of material pricing risks.
The bottom line? On every project it must be clear who will hold the risk of volatile prices. The holder of the risk, typically the fabricator, must be fairly compensated for holding the risk. The party shedding the risk, typically the project owner, must recognize that they “can’t have their cake and eat it too!” and allow the risk holder to gain the legitimate reward of a higher level of compensation.
Fifth, as market conditions change during the life of the project the project team must be willing to make appropriate adjustments in the design of the project to ensure an adequate flow of material to the project.
On a design-build project much emphasis is placed on the value of early involvement of construction expertise into the design process. Today’s market conditions certainly increase the value of that early involvement but also highlight the value of continuing involvement of the design team members in the construction phase of the project. As market conditions change with respect to either cost or availability, feedback must be provided to designers who can adjust designs to take advantage of current conditions. With respect to a structural steel building frame, choices can be made during the construction cycle to substitute hollow structural sections for traditional rolled sections or visa versa if warranted by price or availability. These should not be looked at as “change orders” but meaningful design responses coordinated with construction activity during the life of the project.
The examples used in this article reflect the experiences of the structural steel industry, but certainly are reflective of the same challenges faced across all materials. Volatility is not a steel problem, it is a challenge to be faced by all design and construction professionals. No project delivery structure can remove the challenges of volatility, but the inherent increased level of team work present under design-build project delivery creates an ideal context for the management of that volatility. But the team must be truly be a team, embracing both designers, design-builders and specialty contractors.
INFO: AISC (www.aisc.org)