Costs related to the construction industry have been volatile in recent
years. Some of the volatility may be related to higher energy prices. Prices
for iron and steel, cement, and concretecommodities used heavily in the
construction of new energy projects rose sharply from 2004 to 2006, and
shortages have been reported. How such price fluctuations may affect the
cost or pace of new development in the energy industries is not known with
any certainty, and short-term changes in commodity prices are not accounted
for in the 25-year projections in AEO2007. Most projects in the energy
industries require long planning and construction lead times, which can
lessen the impacts of short-term trends.
From the late 1970s through 2002, steel, cement, and concrete prices followed
a general downward trend. Since then, however, iron and steel prices have
increased by 9 percent from 2002 to 2003, 9 percent from 2003 to 2004,
and 31 percent from 2004 to 2005. (Early data from 2006 indicate that iron
and steel prices have started to decline, but the direction of future prices
remains to be seen.) Cement and concrete prices, as well as the composite
cost index for all construction commodities, have shown similar trends,
although with smaller increases, from 2004 to 2005 and 2005 to 2006 (Figure
11).
The cost index for construction materials has shown an average annual increase
of 7 percent over the past 3 years in real terms. Over the past 30 years,
however, it has shown an average annual decrease of 0.5 percent, with decreases
following periods of increases in the early 1970s and early 1990s. AEO2007
assumes that, for the purposes of long-term planning in the energy industries,
costs will revert to the stable or slightly declining trend of the past
30 years.
Oil and Natural Gas Industry
Exploration and Production Costs
The American Petroleum Institute publishes an annual survey, Joint Association
Survey of Drilling Costs [67], which reports the cost of drilling oil and
natural gas wells in the United States. As shown in Figure 12, the average
real cost of drilling an onshore natural gas development well to a depth
of 7,500 to 9,999 feet roughly doubled from 2003 to 2004 [68].
Offshore drilling costs largely reflect the cost of renting an offshore
drilling rig. ODS-Petrodata, Inc., has reported that, in real dollar terms
from August 2004 to August 2006, daily rental costs for offshore jack-up
rigs drilling at water depths of 250 to 300 feet increased by about 225
percent, while fleet utilization increased from about 80 percent to 89
percent; for semisubmersible rigs drilling at water depths of 2,001 to
5,000 feet, daily rental costs increased by approximately 340 percent,
while fleet utilization increased from about 80 percent to just under 100
percent; and for floating rigs drilling at water depths of 5,001 feet or
more, daily rental costs increased by approximately 266 percent, while
fleet utilization increased from about 88 percent to 100 percent [69].
Petroleum Refinery Costs
Oil & Gas Journal uses Nelson-Farrar refinery construction cost indexes
to track the overall cost of refinery construction. According to the Nelson-Farrar
indexes, refinery construction costs increased overall by about 17 percent
from 2002 to 2005 in real dollar terms. The escalation rate associated
with petroleum refinery construction is lower than the rate for oil and
natural gas drilling, because refinery costs in some categories have either
declined or increased only slightly. Specifically, from 2002 to 2005, the
following escalation rates for refinery construction were reported by Oil
& Gas Journal: refinery composite index, 9 percent; pumps and compressors,
3 percent; electrical machinery, -10 percent; internal combustion engines,
-5 percent; instruments, -3 percent; heat exchangers, 36 percent; materials,
22 percent; and construction labor, 5 percent [70].
In the aggregate, the large increases for heat exchangers and materials
were largely offset by smaller increases or decreases for the other categories.
More importantly, the 5-percent increase in labor costs is largely responsible
for keeping the overall cost increase low, because labor costs account
for about 60 percent of the overall cost of refinery construction.
Discussion
Although the cost of steel and other commodities used in the oil and natural
gas industry have posted significant cost increases over the past few years,
the escalation of industry costs has not been caused by commodity cost
increases alone, but also by higher crude oil and natural gas prices and
the resulting increase in demand for exploration services (contract drilling,
seismic data collection, well logging, fracturing, etc.). While iron and
steel prices increased by 72 percent from May 2002 to June 2006 [71], onshore
drilling costs increased by 100 percent and rental rates for offshore drilling
rigs by 200 percent or more.
The growth in demand for services has occurred primarily in the E&P segment
of the industry rather than refining sector. Higher crude oil and natural
gas prices increase both producer cash flows and rates of return; greater
potential profitability provides producers with the incentive to invest
in and produce more oil and natural gas; and increased cash flow gives
them more money to invest in more projects.
The increase in demand for services in the oil and natural gas industry
is best illustrated by offshore drilling rig rates and fleet utilization.
Similarly, the increase in demand for onshore drilling services is best
illustrated by the growth in the number of onshore drilling rigs operating.
Baker-Hughes, Inc., has reported that 1,656 onshore drilling rigs were
in operation at the end of August 2006, compared with 738 at the end of
August 2002 [72].
The refining sector has not experienced the same degree of cost escalation,
largely because there has not been a significant increase in U.S. refining
construction activity over the past few years. Consequently, cost increases
in the petroleum refining sector largely mirror the increases associated
with the various commodities used in refineries (steel, nickel, cobalt,
etc.) rather than a significant increase in demand for refinery services
and equipment.
Future cost changes in the E&P and refinery sectors of the oil and natural
gas industry are expected to follow different patterns. Over the long term,
new service capacity will be added to meet demand in the E&P sector; and
if oil and natural gas prices stabilize, the demandand consequently pricesfor
E&P services will decline. Conversely, if oil and natural gas prices increase
in the future, it will take longer for E&P service capacity to catch up
with the increased level of demand. In the refinery sector, construction
costs are more likely to follow the path of construction commodity costs,
barring a significant surge or reduction in demand for refinery equipment
and construction services.
In NEMS, the real-world interaction between escalating petroleum E&P costs
and the supply and demand for E&P services is captured in two ways. First,
as oil and natural gas prices rise, E&P activities, such as the number
of wells drilled, also increase. The increase in E&P activity, in turn,
causes the cost of E&P activities to increase in the NEMS projections.
Second, changes in E&P costs are addressed through annual econometric reestimations
of equations related to oil and natural gas supply activities. The annual
reestimations capture the latest trends in E&P costs and their impacts
on E&P activity levels and outcomes. For example, for the AEO2007 projections,
the reestimations capture all the cost increases and outcomes for E&P activity
that occurred through December 31, 2004. With regard to petroleum refining,
the recent cost escalation for refining equipment resulting from higher
commodity prices (including steel and concrete) is considered to be temporary
and self-correcting over the long term, both through the addition of new
commodity supplies and through a reduction in demand for those commodities.
As a result, equipment costs for the petroleum refining sector are expected
to rise at the overall rate of inflation over the long term.
Coal Industry
In the coal industry, both the mining and transportation sectors have been
susceptible to the volatility of steel prices over the past few years.
Higher prices for steel can make investments in machinery and equipment
for coal mining more expensive; and coal transportationpredominantly by
raildepends on investments in freight cars, locomotives, and track, all
of which require steel as a raw material.
The costs of rail equipment and, to a lesser extent, mining equipment and
machinery followed the general pattern of declining steel prices from the
mid-1970s through 2001 and 2002 (Figure 13). Although steel prices began
to rise in 2003, rail equipment and mining machinery and equipment prices
did not begin rising until 2005 and 2006, respectively. Although the early
2006 data suggest that steel prices have started to decline, there is no
evidence yet of a decline in the equipment prices.
Coal Mining
The U.S. Census Bureau, in its Current Industrial Reports, combines surface
mining equipment with construction machinery. In the construction machinery
category, some subcategories provide better indicators than others of the
price changes that have affected the surface mining industry. For example,
the subcategory that includes draglines, excavators, and mining equipment
has increased by 26 percent (average value in constant dollars) since 2002,
while the number of units shipped has increased by 10 percent (Table 4).
A smaller subcategory that includes draglines has increased by 33 percent
in average value since 2002, with a 59-percent increase in quantity shipped.
Larger hydraulically operated excavators show a different pattern, with
a 10-percent decline in average value and a 57-percent increase in quantity
shipped over the same time period, as does the subcategory that includes
coal haulers, which did not show a significant increase in value between
2004 and 2005. For the subcategories with increases in average value, the
largest increases occurred in 2004, coinciding with higher steel prices.
Both surface and underground mines rely on machinery made largely from
steel to produce coal efficiently. Although specific costs typically are
not publicly available, many of the major mining companies, including Peabody,
CONSOL, and Massey, have indicated in their annual reports that they are
susceptible to higher costs for machinery purchases as a result of increases
in the cost of steel. Census Bureau data indicate that the mining industry
as a whole (including coal mining) spent $597 million on underground mining
machinery in 2005, as compared with $393 million in 2004 (constant 2005
dollars) [73]. In addition to higher steel costs, the increase may also
be due in part to the amount or mix of mining machinery purchased and in
part to increases in other manufacturing costs.
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Peabody listed the value of its mining and machinery assets at $1.2 billion
in 2005, up from $910 million in 2004 and $759 million in 2003 (2005 dollars)
[74]. The more recent annual increase, from 2004 to 2005, is larger than
the earlier one, but the portion attributable to the effect of higher steel
prices on the cost of newly acquired equipment is not publicly known. The
companys operating costs, in constant dollars, rose by 8.4 percent from
2003 to 2005, from $11.23 per ton to $12.17 per ton of coal produced [75].
CONSOL cited both higher labor costs and higher commodity prices as the
reasons for a 5.9-percent real increase in operating costs (to $30.06 per
ton) in 2005 compared with 2004 [76]. For Massey, the average cash cost
per ton of coal has risen to $35.62 per ton in 2005 from $26.58 per ton
in 2001 (2005 dollars) [77].
Joy Global, a manufacturer of mining machinery [78], has mentioned in its
annual report that some customers have delayed orders for manufacturing
equipment in response to the short-term price volatility for steel and
steel parts and that steel availability, in addition to prices, has been
a problem in recent years. In general, the company has long-term contracts
with steel suppliers, which help maintain steel availability, but those
contracts also have surcharge provisions for increases in raw material
costs. Caterpillar, Inc., another mining equipment manufacturer, has also
been paying surcharges for steel.
As of February 2005, some steel prices paid by Joy Global were 100 percent
higher than they had been 15 months earlier [79]. The company appears to
have been able to pass through the higher steel prices to its customers
(including coal producers), increasing its overall gross profit margins
from 2004 to 2005.
Although the coal mining sector is hurt by higher costs for steel as an
input factor in the production process, higher demand for steel and steel
products also helps to boost metallurgical coal prices. Some coal companies
are paying more for steel-based equipment, but at the same time their profit
margins may be protected by their ability to sell their coal at higher
prices.
The cost increases for coal mining equipment that occurred in 2006 are
included in the AEO2007 reference case. Thereafter, mine equipment costs
are assumed to return to the long-term trend, increasing at the general
rate of inflation.
Coal Transportation
Railroads are the primary mode for coal transportation in the United States,
carrying about two-thirds of all coal shipments. The railroads use both
steel and concrete to keep pace with the increased traffic demands placed
on their network. (Concrete is used to provide a foundation for rail beds
and, increasingly, is being used to make ties for tracks that carry heavier
loads.) Consistent with the recent increase in steel prices, BNSF Railway
Company, one of the largest coal haulers in the United States, has cited
a $70 million increase in material costs associated with locomotive, freight
car, and track structure in 2005 [80]. Freight cars and locomotive orders
and new track installation often represent long-term decisions by railroads.
BNSF, for instance, has contracted to take delivery of 845 locomotives
by 2009. As of 2005, it had acquired 405 of the total [81]. Depending on
the terms of those contracts, BNSF may or may not be susceptible to variation
in steel prices.
For new freight car acquisitions, aluminum cars, lighter than steel cars
and thus capable of carrying larger volumes of coal, tend to be preferred.
The construction of aluminum cars still depends on some steel components,
however, because more than 50 percent of the weight of a 42,000-pound aluminum
car is made up of steel [82].
In 2005, more than 40,000 new freight cars of all types were acquired,
representing an investment of roughly $3 billion. Some industry experts
project that an additional 40,000 new freight cars per year is the minimum
level that will be required to replace retired cars and maintain current
capacity [83]. The average cost of all freight cars, including coal cars,
ordered from Freight Car America was $68,000 both in 2004 and in 2005,
as compared with $60,000 in 2003 (2005 dollars) [84]. In addition to reflecting
the increase in steel prices in 2004 and 2005, the averages may vary according
to the mix of cars delivered; however, 93 percent of the cars sold by Freight
Car America in 2005 are used for coal transportation. Freight Car America
has also indicated in its annual report that raw steel prices increased
by 155 percent from October 2003 to December 2005, and that the company
has successfully passed the increase on to purchasers for 96 percent of
its car deliveries [85].
The railroads have already added a record number of locomotives to their
fleets in recent years. In 2004, Class I railroads purchased or leased 1,121
new locomotives91 percent more than in 2003 and 21 percent more than the
previous high since 1988. In 2005, Norfolk Southern (NS) added 102 locomotives
to its fleet, bringing its total to 4,000. In the same year, Union Pacific
(UP) had plans to add 315 new locomotives. In 2004, Kansas City Southern
ordered 30 new locomotives that were capable of transporting 9.6 percent
more 110-ton cars than the rest of its existing fleet [86]. In 2006, BNSF
has plans to add 310 locomotives to its fleet, at an estimated cost of
$550 million [87]. Each new piece of equipment can have a much larger marginal
impact on a railroads capacity than its older existing equipment. Over
time, the added economic benefit of more efficient equipment capable of
moving heavier, longer train sets is likely to outweigh the recent increase
in steel costs.
Finally, with increasingly heavy loads of coal being moved, the repair
and maintenance cycle for existing railroad infrastructure becomes shorter,
and the maintenance is more likely to be affected by short-term volatility
in steel (and labor) prices. In 2004, for example, the seven Class I railroads
spent $403 million (constant 2005 dollars) on rail and other materials
for repair and maintenance of existing track [88]. In addition, over the
next few years, the major railroads have plans to expand their network
by adding multiple track systems and sidings. New track must be laid to
handle higher freight volumes, and with heavier loads, more steel will
be needed. For instance, track weighing 131 pounds per yard might be needed,
as compared with 90 to 110 pounds per yard for less heavily used track.
BNSF laid 749, 695, and 711 miles of track in 2003, 2004, and 2005, and
an additional 884 miles is planned for 2006 [89].
The AEO2007 reference case assumes that railroad equipment costs will rise
in real terms through 2009, then return to their long-term declining trend.
Electric Power Industry
The Handy-Whitman index for electric utility construction provides an average
cost index for six regions in the United States, starting from 1973. A simple
average of the regional indexes for construction of electricity generation
plants is used in Figure 14 to show a national cost trend relative to the cost index
for construction materials. Because equipment and materials generally represent
two-thirds to three-quarters of total power plant construction costs, it
is not surprising that the trends are similar.
The long-term trend for construction costs in the electric power industry
shows declining costs from 1975 to around 2000, after which it is relatively
flat in real terms. The two indexes diverge in the early 2000s, with electric
power construction costs showing a flat to slightly increasing trend, while
general construction costs continue to decline. The difference coincides
with a construction boom in the electric power sector from 2000 to 2004,
when annual capacity additions averaged 38 gigawatts per yearwell above
previous build patterns (Figure 15). Over those years there were shortages
and price increases specific to construction in the electric power industry
due to the pace of building. For the past 3 years, the Handy-Whitman index
shows an average annual increase of 5 percent, slightly less than that for
the overall construction cost index.
Currently, new construction in the electric power sector is slowing down,
with generating capacity additions averaging 16 gigawatts per year from
2004 to 2006. The slowdown is more likely a response to the oversupply
of available capacity than a response to higher commodity prices. It is
typical for investment in the power industry to cycle through patterns
of increased building and slower growth, responding to changes in the expectations
for future demand and fuel prices, as well as changes in the industry,
such as restructuring.
AEO2007 does not project significant increases in new generating capacity
in the electric power sector until after 2015. A total of 258 gigawatts
of new capacity is expected between 2006 and 2030, representing a total
investment of approximately $412 billion (2005 dollars). If construction
costs were 5 to 10 percent higher than assumed in the reference case, the
total investment over the period could increase by $21 billion to $41 billion.
Notes and Sources
Contacts: Laura Martin/Philip Budzik
Phone: 202-586-1494/586-2847
E-mail: laura.martin@eia.doe.gov
E-mail: philip.budzik@eia.doe.gov |