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Impacts of Rising Construction and Equipment Costs on Energy Industries |
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 concrete—commodities 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 demand—and consequently prices—for 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 transportation—predominantly by rail—depends 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.
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 company’s 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 locomotives—91 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 railroad’s 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 year—well 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.
Contacts: Laura Martin/Philip Budzik |
