May 2008
Volume 4 Issue 1
In this issue we examine the rising construction costs affecting the manufacturing industry.
In reviewing costs for 2007, we find that the leading insurance indicators continued to show a year-on-year increase in the 2.8% to 4.7% range. Taking into consideration increases in construction costs from 2004 to 2008, the past four years represent a cumulative increase of 25% to 30% in some regions of the U.S. Although preliminary first quarter numbers for 2008 indicate a slowdown in cost increases, it remains to be seen whether this will continue for the rest of the year.
Lest you feel somewhat overwhelmed by our rate of cost increase, spare a thought for the country whose annual inflation has climbed to 26,470%.
Is a perfect storm brewing?
Are the indices used for process plants truly measuring cost increases? Or is the combination of a construction boom and the falling US dollar creating a situation for much greater cost increases of a permanent nature?
Capital-intensive process industries are undergoing a major construction boom, particularly in the refining, energy and chemical sectors. Currently, an estimated $86 billion worth of projects are under construction or planned in the Athabasca Oil Sands in Northern Alberta(1). A $1.65 billion integrated iron ore mine/steel mill production facility in the Mesabi Iron Range of Minnesota is about to break ground(2). Globally, oil refining capacity is expected to expand 1.7% per year for the next five years, this is 20 – 30% more expansion activity per year than recorded in the recent past(3).
The downside of this boom is that it is exhausting labor pools near and far; from carpenters and pipe fitters to project managers and engineers. In Alberta, firms have built new airstrips to fly in personnel. Temporary foreign-employee programs are being established with workers coming from as far afield as Portugal, South Africa, the U.K., India and the Philippines. Competition for labor has been so fierce that companies are now offering perks such as food service, recreation and internet/TV.
Additionally, the global shortage (and in some areas a backlog) of raw materials and specialized process machinery is adding further fuel to the fire. As a result, we have seen steep cost increases during the past couple of years:
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Lead times for engineered equipment have increased by up to 50% in the last 6–12 months(3).
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In some areas there is a backlog that has directly increased the lead times for specialized equipment, hence delaying projects or adding cost if you are willing to pay a premium for a position higher up the waiting list.
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The new IHS/ Cambridge Energy Research Associates (CERA) Downstream Capital Cost Index (DCCI), which measures the costs of building new oil refineries and petrochemical plants indicates an 8% increase in the six months preceding October 2007, and a 66% increase since 2000(3).
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Capital costs for Athabasca Oil Sands projects in Alberta (including extraction facilities, upgrader plants and support infrastructure) have increased from $25,000 (US$) per daily barrel of oil (four years ago) to $40,000 per barrel today(1).
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Even small ticket items are increasing; tires for CAT 797B heavy haul trucks which normally cost $40,000 each, have risen to $60,000(4).
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Although not as dramatic, the construction activity in Northern Alberta has caused localized construction costs to increase at double the rate of other areas in Canada. Statistics Canada’s latest non-residential construction index for Edmonton shows a 13.3% increase versus only 6.1% for Toronto(5).
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Since 2000, the worldwide capital cost of liquefied natural gas (LNG) plants has tripled from $200 per tonne to $600 per tonne (6).
Anecdotally, American Appraisal Clients are reporting increases of even greater proportions.
Add all of the above to the dramatic change in US$ exchange rates and a perfect storm is brewing. While such market driven price fluctuations are not unprecedented, the challenge is to measure them accurately and account for when market demand rebalances, and cost increases slow or even reverse.
Sources
1. Engineering News Record, Canada Cost Report 4Q, December 17, 2007
2. www.minnesotasteel.com
3. Cambridge Energy Research Associates, Press Release, Refinery and Chemical Plant Construction Costs Reach New High, November 7th, 2007
4. Engineering News Record, Alberta’s Booming Oil Sands Boast Cold Weather, Hot Market. February 20, 2008
5. Statistics Canada, Non-Residential Construction Price Index, Fourth Quarter 2007
6. Swiss Re, Energy Construction Boom – a paradigm shift for insurers, November 2007 & Petroleum Economist, April 2007
7. The Rough Notes Company, Risk Management–Bye-Bye Agree Value?, November 2007
Insurance Term of the Month: ‘Margin Clause’(7)
The loss payment on an individual property under blanket coverage will be limited to its stated value, plus a percentage of that value (or margin). In other words, the maximum amount payable after loss will be determined by applying the margin clause percentage, as indicated in the endorsement, to the value of the property shown in the latest statement of values on file with the insurer. For example, a property insured for $10,000,000 with a margin clause of 15% would result in a maximum loss payable of $11,500,000.
Fortunately, the challenges faced by the process industries are not appearing elsewhere...
Inflation Tracker: 2007 Summary
Construction Cost Indices
It has been a wild ride for the past four years for those of you who have been tracking construction costs in the U.S. Fortunately, there is a light at the end of the tunnel, with major indices reporting national average 2007 increases ranging from 2.8% to 4.7%. In 2004, we hit record inflation trends of 10.5% due to high material cost increases fueled by a booming global economy.
In 2007, with the overall slowdown in both residential and commercial/industrial construction markets, inflationary trends are returning to somewhere near normal. Material costs have been a controlling factor in the moderating construction cost trends, with the increase in structural steel costs ranging from 1.7%-3.3%; cement in the 6.5% range and lumber costs falling approximately 7% in 2007, as reported by Engineering News Record in their weekly Construction Economics report.
Cumulatively the past four years represent an increase in average U.S. construction costs of 25%, with some regional increases surpassing 30%. To put this into perspective, the increase in average U.S. construction costs reported by FM Global from 1992 to 2004 was 31%. Hence, during the past four years we have experienced 11-12 years of “normal” inflation.
Prudent valuation practice recommends reappraising a facility every five to seven years, with a decrease in the cycle time during periods of higher-than-normal inflation. Given the last four years of above-normal inflation, it is now time to consider appraising facilities that were last appraised prior to 2003.
As we approach the midpoint of 2008, market volatility relative to construction materials appears to have disappeared and primary construction material prices are predicted to remain stable or even decline during the remainder of the year. The forces acting on the market include a declining housing sector; a sub-prime crisis spilling over into the non-residential market; material capacities meeting market demand and labor rate increases predicted to be in line with multi-year collective bargaining agreements of 4.3%. Overall constructions costs are projected to increase 2%-3% in 2008.
Equipment Cost Indices
Recent equipment cost trends have shown a slight increase from the steady 2% per annum rate during the 1990s and early 2000s. As illustrated by the table and chart to the right, the Marshall & Swift/Boeckh Industrial Equipment “average of all” index has had significant increases for the last four years. FM Global’s “Industrial Equipment Average” is somewhat more moderate, and the U.S. Bureau of Labor Statistics Producer Price Index (PPI) for “Finished Goods, Capital Equipment” has shown the lowest increases, in the 1%-2.5% per annum range.
Care should be taken whenever selecting an index to track the rate of change in the price of a company’s capital equipment. The three indices shown here, all track capital equipment cost change percentages, and indicate the significant differences that have occurred over the past four years. Developers as well as insurance brokers, underwriters and valuation consultants can all recommend appropriate indices for your particular facilities. Once an appropriate index is selected, it should be used consistently. Do not change from one index to another without a valid reason.
Inflation Reality Check
For a reality check, it is worth taking note of the current rate of inflation in Zimbabwe. The Reserve Bank of Zimbabwe recently reported(13) that its annual inflation has climbed to 26,470%, although this is somewhat short of independent estimates of 150,000%. A CNN article quotes examples of gasoline prices tripling in a week, school fees rising by 600% in a month and the price of chicken increasing more than 236,000% to 15 million Zimbabwe dollars (US$3.00) a kilogram between January 2007 and January 2008(14).
Sources
8. Engineering News Record, Monthly Construction Economics Report
9. FM Global, Industrial Cost Trends
10. RS Means, Construction Cost Indices, 30-City Average
11. Marshall & Swift/Boeckh, Quarterly Cost Index, Industrial Equipment Average
12. U.S. Bureau of Labor Statistics, Producer Price Index for Finished Goods Capital Equipment Non-Seasonally Adjusted
13. Reserve Bank of Zimbabwe, Monetary Policy Statement–31 January 2008
14. CNN.com, “Zimbabwe inflation tops 24,000 percent, officially”