Metal Price Increases: Strategies for Mitigating the Risk

The price of metals is rising due to world economic growth and higher demand. The price of metals has direct effects on equipment costs for hydro project development and rehabilitation. Project developers and owners, equipment manufacturers, foundries, and consulting engineers share strategies for mitigating the risks created by increasing metal prices.

The cost of most metals has been extremely volatile over the past five years. In many cases, raw materials costs have increased by 200 to 800 percent. Project owners, developers, suppliers, and consultants in hydro are using a variety of methods to mitigate the risk of increasing metal prices. These methods include hedging and inventory strategies, clauses in bids and contracts, and risk-sharing techniques.

Hedging strategies

Although it is challenging, there are methods available to lock in lower metal prices for future work. For example, manufacturers are offering customers the option of booking the metal as soon as the contract is signed. This gives hydro project owners or developers a firm fixed price without the risk of escalation during the design period. Litostroj Steel Ltd. in Slovenia has an arrangement with its suppliers – in Germany, Austria, and the United Kingdom – to book in advance all materials needed to cast components, at firm fixed prices. Litostroj offers customers the option of paying an advance of 30 to 40 percent of the contract price to book the material and fix the metal price for up to two years. This arrangement prevents the company from gambling on future steel prices, and Branko Mardjetko, sales manager with Litostroj, says customers are choosing this type of contract.

Some companies are giving customers the option of buying and providing the metal themselves. Although customers likely will not be able to obtain a price lower than that offered to manufacturers, this method allows them to buy now, when they know the price of metal, rather than waiting through six months of escalating prices, says John Roberts, sales manager with Sko-Die Inc., a generator core manufacturer, in the United States.

Another way to mitigate increasing metal prices is to consolidate acquisition at the highest possible level, says James Patterson, a consultant who formerly was marketing vice president for turbine manufacturer Impsa in Argentina. This involves reviewing forecasts of your company’s metal requirements, then working with foundries, steel mills, or commodity exchanges to get the best price. For example, if your company anticipates purchasing 100,000 tons of metal over the next year, provide a guarantee to take 25,000 tons in the first quarter of the year. Then, request a fixed price. Patterson recommends this method because it is difficult to negotiate with mills or foundries unless you have substantial volume and, in some cases, a long-standing relationship.

Hedging strategies may not work in some situations. For example, it may be 12 to 18 months before a supplier is prepared to purchase metal to fulfill a contract, as in the case of a contract that includes model testing of the equipment before beginning full-scale production. A contract that involves production of multiple units may require purchasing metal several times. This can increase a manufacturer’s exposure to higher prices, says Douglas L. Miller, P.E., manager of international and government sales for American Hydro in the United States. To minimize this exposure, the company agrees with its customers to accept a price for one unit at a time, with the other units in the contract being optional based on the price of metal at the time of release for subsequent units.

Inventory strategies

In some cases, stockpiling materials can be an effective strategy. For example, Steel-Fab Inc. in the United States recently received a $1 million order that included a large amount of structural beams for a project where the design was not yet complete, says Louis Bartolini, vice president. The customer identified the size of the beams needed and authorized Steel-Fab to order the beams as soon as the contract was signed. The beams are sitting ready for use at Steel-Fab’s plant as soon as the design is complete. In this case, stockpiling the inventory saved the customer about $50,000 in escalation, Bartolini says.

Another option for keeping steel in inventory is to require a down payment at the time of order and progressive payments over the course of the contract. Lokomo Steel Foundry in Finland uses this method to secure cash flow and allow the company to buy raw materials at known prices, says Timo Norvasto, sales manager.

Sko-Die finds buying steel already in inventory, perhaps at a steel service center, to be a cost-effective option. This can be difficult for the hydro market because of the volume of steel required for the equipment, Roberts says. The company also recommends that customers have some flexibility in scheduling to allow them to take advantage of brief periods when prices are down from a peak. Sko-Die uses scrap and energy prices to develop a two-month “vision” into the future of metal prices. When scrap and energy prices begin to back down, there will be a point two months later when steel prices will be a little lower, Roberts says. Sko-Die tries to buy metal during those periods.

Consultant Patterson agrees that it may make sense to hold off buying some material to finish components to see if the price is going to stabilize or even go down. Before employing this strategy, the manufacturer must determine how long the delay might be or the potential severity of any liquidated damages, he says.

Clauses in bids and contracts

Appropriately addressing the issue of metal cost increases in contracts and bids is a challenge. The price manufacturers pay for materials from steel mills is the price in effect at the time of shipment, not when the material was ordered. It can take four to eight months to produce metal at a mill, depending on the type of material being purchased. Manufacturers have worked out a variety of options for language in bids and contracts to address the escalation in cost both until the bid is accepted and over this period of the contract.

With regard to bids, many contractors are shortening the validity period (i.e., the time interval over which the terms of a contract apply). For example, a bid might have a validity period of 30 days where before it was valid for six months. If the validity period passes without a contract award, the manufacturer and customer must renegotiate based on current metal prices.

This is why Impsa recommends what it calls a “way-out clause” in bids. With this clause, the validity of a price is attached to the risk of price variation for a critical component, says Francisco Diaz Aguiar, electromechanical engineer with Impsa. With this structure, the terms of the contract continue as long as the price of the critical component stays within a reasonable level. Renegotiation is required if the price of a primary metal changes by, for example, more than 10 percent.

Many manufacturers include escalation clauses in contracts with purchasers. Plant owners who are ordering equipment may be reluctant to accept escalation clauses because they feel the clause protects the manufacturer and not the buyer, according to Steel-Fab’s Bartolini. However, these clauses also have the potential to protect the buyer if metal prices begin to decrease, he says.

As the hydro industry faces significant increases in metal prices, project owners and developers, equipment manufacturers, foundries, and engi-neers are finding ways to mitigate the risks of these rising prices. (Photo courtesy Impsa)
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In many countries, escalation clauses are readily accepted, Litostroj’s Mardjetko says. Customers are satisfied because the transaction is transparent and they can make sure the contract is fair. Consultant Patterson says that in many areas of the world, there are escalation clauses on all materials.

Escalation clauses take a variety of forms. For example, in the United States, clauses have been tied to Bureau of Labor statistics or other widely recognized indices, such as London Metal Exchange prices. Steel-Fab’s Bartolini says that these indices do not match actual metal price increases. To address this issue, Litostroj Steel lists in its contracts the main metal elements required and the price at the time of contract signing. Then, when the order is placed, the manufacturer checks the price of the material and makes an adjustment, Mardjetko says.

Norman A. Bishop, Jr., P.E., vice president with MWH Americas Inc., recommends what is referred to as an “escalation neutral clause.” This type of clause establishes the cost of metals at the time of contract execution and allows for either an upward adjustment if the metal price has increased at the time of actual purchase or a credit if the metal price has dropped. The contract clause must clearly state that the adjustment is made once the project is “invoiced and paid.”

If escalation clauses are not used, manufacturers may attempt to assign a certain percentage to the risk involved in increasing metal prices. However, this is problematical because it involves a lot of guesswork about the direction of the metals market.

Above all, any clauses should be fair to both the owner and equipment supplier or contractor, Bishop says. Neither party should benefit or be penalized. However, if you wish for the equipment supplier or contractor to bear the volatility risk, you should expect to pay for this service and its perceived cost, he says. In this case, the risk premium will result in a much higher price for the purchaser, Bishop says.

Putting together an open-ended, indefinite quantity contract is a method Bonneville Power Administration (BPA) uses to buy equipment, says Louis Tauber, electrical engineer with BPA. BPA is a United States’ government agency that markets wholesale electrical power from federally owned hydroelectric projects in the Pacific Northwest. This type of contract is a specification that allows BPA to buy an indefinite quantity of a certain piece of equipment. For example, BPA may guarantee that it will buy a minimum of seven circuit breakers over the next five years. In most cases, BPA will purchase many more than the minimum specified. The advantage of this type of contract is that it saves the costs of administering multiple solicitations and contracts. Also, the design for equipment installation is simplified because manufacturer shop drawings are readily available from previous installations of the same family of breakers.

Risk-sharing perspectivesand approaches

According to Odd Ystgaard, vice president of Norconsult AS in Norway, the ultimate goal of a risk-sharing approach is to allocate risk to the party (developer, contractor, supplier) that can best assess and mitigate it. Proper risk allocation is the key to minimizing the cost of risk mitigation. If the risk of increasing metal prices is allocated to the supplier, the project developer must pay a premium to help cover this risk, Ystgaard says.

Naturally, developers prefer a fixed price contract. To get a better idea of the price of development, Pà¶yry Energy in Switzerland gets pre-bids from suppliers. This provides a current cost overview, which can be used to estimate the cost of development, says Stephan Grà¶tzinger, managing director and head of hydropower. Pà¶yry then asks for a certain fixed current price for a specific period. If this is not possible, the company asks for an escalation scheme based on metal indexes. The company has developed a generic model that allows it to forecast what will happen to the project if metal prices continue to increase. This gives more security to the investment and allows the company to plan if mitigation measures are needed, Grà¶tzinger says.

To mitigate the risk of increasing metal prices, Voith Siemens Hydro Power Generation develops a material cost estimate analysis. This is one method the company uses to help determine materials prices when bidding for equipment supply contracts, says Somasundram Pillai, estimating and pricing manager at Voith Siemens’ office in Pennsylvania in the United States. Use of the analysis avoids having to build a contingency into the contract that is either artificially inflated to minimize the risk to the manufacturer or too low, causing the manufacturer to lose money on the job.

This material cost estimate analysis involves two steps. The first step consists of working with the project manager or lead engineer to establish a projected timeline for the work being bid on. This includes, for example, determining when the company might buy material required for equipment manufacture. After receiving a contract award, six months of engineering might be required before placing the purchase order for the material.

The second step is to develop a forecast of the actual market price for steel. Most readily available indexes, such as the Producer Price Index (PPI), track past performance of the market. The PPI – published monthly by the United States’ Bureau of Labor Statistics – is a broad index that tracks historical manufacturing costs. In periods of rapid change, the PPI and similar backward-looking indexes have limited usefulness for forecasting. Thus, Voith Siemens has developed an internal index that the company tracks along with the PPI. The company uses information from both indices to establish a percentage to apply to a contract to more closely match the actual price paid when the material is purchased.

Such an analysis enables Voith Siemens to incorporate appropriate metal price factors into its bids, Pillai says.

Another option is to limit to a pre-established amount the risk to be taken by the parties to the contract, says Nelson Buhr Toniatti, senior engineer with Brazilian utility Companhia Paranaense de Energia (Copel). If this risk limit is exceeded, the excess would be assumed by the owner/developer. This open-book process helps drive the required contract negotiations and keeps everyone comfortable with the process, he says. A fair negotiation based on the good faith among all involved agents is needed because contract clauses or agreed-upon conditions can be upset by the current market, Toniatti says.

Toniatti quotes a saying: “Getting a not-so-good arrangement is much more important than getting a very good fight.” In some cases, this fight can drive prices so high that hydro project development is no longer feasible, he says.

BC Hydro in Canada is taking a more comprehensive approach to address the risk of metal price fluctuations. To appropriately allocate risk, the utility recommends considering price fluctuations for two time periods: from tender issuance to the contract award and from contract award to receipt of the final payment. During the first period, the individual suppliers cannot take measures to reduce exposure to metal price fluctuations because there is no certainty that a particular supplier will be awarded the contract. In this case, BC Hydro believes requesting a fixed price contract could result in higher bid prices because you are asking the supplier to bear a risk over which the supplier has no control. To relieve the supplier of this risk, BC Hydro recommends making a price adjustment based on tendered metal quantities.

During the second period, from contract award to payment, BC Hydro says the supplier should bear the risk. The supplier has a better idea of delivery times and can fix the metals price. This transfers any risk with respect to fluctuations after the award to the supplier. The supplier then has an opportunity to reduce the risk via hedging or even to benefit should metal prices fall.

Oregon Iron Works, a metal fabricator in the United States, has developed a method for sharing risk with its customers, according to Thomas J. Hickman, sales and marketing manager. The company prefers using the government system of a cost-reimbursable contract with an incentive fee, which provides an incentive if the fabricator completes the project with a lower overall cost. If this occurs, both the purchaser and Oregon Iron Works share in the savings. Such a contracting method eliminates the need for contingencies regarding material costs.

Before signing any contract, it is important to evaluate all proposals thoroughly, even if they meet the engineer’s cost estimate, MWH’s Bishop says. Terms and conditions directly affect the project cost and the quality of the completed project. Bishop says purchasers must learn what they are paying to transfer risk to the equipment supplier and/or contractor. If an owner can best control a risk item, the cost of the risk should stay with the owner. If an equipment supplier or contractor can best control a risk item, the cost of the risk should remain there. If the risk cannot be controlled by either party, Bishop recommends assigning the risk to the party with the best financial ability to insure against the risk or pay outright for the risk item.

This article was prepared by HRW’s editorial staff. Sources of information include interviews and communications with project owners, developers, suppliers, and consultants.

Long-Term Strategies for Mitigating Metal Price Increases

In addition to the short-term strategies discussed in the article, four hydro developers and consultants recommend long-term strategies that can help mitigate the risk of increasing metal prices.

With the limited supply of metal available and the long lead times for getting metal from mines, some say non-conventional intervention is needed. H. Irfan Aker, general manager with Dolsar Engineering Limited in Turkey, recommends finding alternative non-metallic products (such as plastic, glass, and composite materials) for the automotive, domestic and industrial equipment, and building industries. Through proper engineering, it can be possible to reduce the use of expensive materials in the hydro industry, says Odd Ystgaard, vice president of Norconsult AS in Norway. However, this could be at the expense of sustainability and performance of the equipment, he says. The trade-offs of this approach must be accurately identified.

To better manage the metal supply and risks caused by price volatility, Raghunath Gopal Vartak recommends creating a bank for steel products. Vartak is corporate executive, technical, with AFCONS Infrastructure Limited in India. This bank would be based on the type of product needed by a specific industry. This bank would partner with project owners to make steel purchasing better and more predictable, he says. He also recommends creating an index that is based on the actual price of the commodity, rather than on past costs. This would be possible if the rise in price structure has a defined base. Using trends over the past five years, developers should have a base for future metal prices, at least during the development period of the project, Vartak says.

A more efficient and predictable regulatory approval process for development of new hydro projects would help to contain the effects of increasing metal prices on development, says Roger Gill, principal consultant with Hydro Focus Pty Ltd. in Australia. The longer and more drawn out the approval process, the more exposure the developer has to price increases. Gill says it is incumbent on governments to help make hydro project development more predictable if they want to keep the price of energy under control. And without a good understanding of the regulatory risks involved, developers will not move forward on projects. The project developer needs increased certainty on regulatory timelines to limit the effects of significant metal price escalation on initial project estimates.

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