Hot topic: Impact of oil prices

In September, the Consumer Prices Index recorded its highest figure for almost nine years and a year-on-year increase of 2.5%. The blame was laid firmly at the door of higher oil prices with transport costs, principally petrol prices, the predominant force behind the rising trend.

Manufacturing input prices in the third quarter 2005 show a 12.5% rise over last year, the highest registered figure for more than 10 years. The increase in crude oil prices accounts for more than half that figure. Excluding food, beverages, tobacco and petroleum industries, input costs in the shape of materials and fuels purchased by other industries still show a rise of 7.1% over the year. This measure has been running at this level throughout 2005 but industry had not had to endure this level of cost pressure for the preceding 10 years.

Factory gate inflation, however, rose in the second half of 2004 to record a rise of 2.4%, the highest since the first half of 1996, but has not continued to accelerate; in fact output prices (excluding food, beverages, tobacco and petroleum products) in the third quarter 2005 show a rise of just 2.1% on the year, indicating that industry has continued to absorb much of its input cost inflation, choosing or being unable to pass it on to the end user.

Oil prices look like they peaked at the end of August (Brent Crude fell just short of $69 a barrel in the wake of Hurricane Katrina – see graph, right) but most forecasters now believe that prices are likely to remain around the $60 mark. This compares with $30 in mid 2003

(after the invasion of Iraq), less than $20 at the beginning of 2002 and $10 at the end of 1998. The doubling of prices over the past two years has led to soaring energy prices, consequential inflationary effects and economic slowdown.

Since the peak at the end of August, there has been some drift downwards (spot prices at the time of writing are at $58) but, in spite of spikes caused by problems in Iraq, terrorist activities and hurricanes in the Mexican Gulf, the underlying upward trend has been caused by higher demand (from China as well as elsewhere), which is forecast to continue to grow. Most seem to bet on prices remaining in the $55-60 a barrel mark, at least in the short term. High oil prices have already dented economic growth in a number of countries including the UK and any further increase in prices may pose a more serious risk to the global economy.

In 2004, models compiled by the International Energy Agency in conjunction with the OECD and IMF concluded that a sustained $10 rise in oil prices from $25 to $35 a barrel would increase consumer prices by 0.5% in the first year and 0.6% in the second. An alternative paper produced by the National Institute of Economic and Social Research came up with much lower figures, so the jury is out. But the UK’s consumer price data appears to confirm this trend (up from 1.5% in mid 2004 to 2.5% now) and, with oil prices $30 rather than $10 higher than the base figure, considerable further inflation may well be in the pipeline.

Inflation in construction materials prices in 2004 was dominated by the rise in steel prices. Steel prices have been in decline since the beginning of the year but the DTI’s Construction Materials Price Index still registered a 2.6% rise between January and July. Materials behind this increase include cement (up 8%), ready-mixed concrete (6%), fibre cement products (5%), rigid plastic pipes and fittings (5½%), and asphalt products (7%). Manufacturers of all of these products blame oil or energy prices. Cement manufacture is one of the most energy-intensive construction materials processes and manufacturers warned of, and tried to introduce, a further price rise of 5-10% at the beginning of October. Ready-mixed concrete prices are expected to rise, possibly by at least £6/m3, in January in response to price increases in both cement and aggregates.

The level of construction price inflation over the next couple of years will, as always, be determined by supply and demand, but underlying factor cost increases may be higher than recent historical trends.

Construction output

Government statistics suggest that construction activity in the first half of 2005 matched the record workload of 2004. Both Experian Business Strategies and the Construction Products Association have forecast slight increases in construction output for 2005, so the second half of the year will have to move on a little further for this to be the case. The latest figures for new orders won by contractors (see below) suggest that this may well occur.

However the first half figures were only saved by an increase in repair and maintenance work with new work output running 2% below last year’s levels. Spending in both the infrastructure and public non-housing sectors was down (by 10% and 7% respectively), leading to questions about government commitment to, or ability to deliver, their spending plans. Output in the private commercial sector was also slightly down; combined education spending in the public and private sectors was about the same as last year but combined health spending was some 8% lower.

Workload has picked up most strongly in the first half of this year in the East and the East Midlands, the former enjoying stronger activity in private commercial and infrastructure work in particular and the latter benefiting more from public non-housing and private industrial work. By contrast, activity in the North-west has declined a little from its heady workload output last year with public non-housing and infrastructure work failing to maintain last year’s levels. Construction output in the South-east, London, Wales and the North-east is also running slightly below the levels achieved in 2004.

Contractors’ new orders

The volume of new orders obtained by contractors in the first eight months of 2005 according to the DTI indicates that the short-term outlook at least for contracting remains rosy. The figures show a 4% increase in real terms over the same period of 2004, itself a year when contractors had never had it so good.

Infrastructure

The big winner has been infrastructure, which has bounced back with some large orders in 2005 after two years of decline and neglect in 2003 and 2004. Civil engineering contractors operating in the water sector really do think that Christmas has come early with the value of new orders running 155% higher than last year: the tap has been turned on with the start of OFWAT’s Final Determination capital investment programme for 2005-2010 worth nearly £17bn. This represents an 8% increase in monetary terms over the previous 2000-2005 period though, in real terms, a reduction in workload.

Every other sub-sector of infrastructure has also picked up significant new orders this year with roads registering a 45% increase in value after a dismal 2004, the electricity sector in possession of new orders worth 54% more than last year (which itself was the best year this decade) and “other”, which includes railways, registering a similar strong first half-year with the value of new orders running 55% above 2004.

So the civils contractors should be very happy. They are also the first to benefit from additional spending emanating from London winning the 2012 Olympics. Building work will probably not begin in earnest until 2008 but the infrastructure work (valued at £8.5bn in London’s Candidate File submission to the Olympic Committee, though that includes ongoing projects such as the Channel Tunnel Rail Link) begins straight away and the £200m contract for undergrounding the power lines in the lower Lea Valley has already been let.

Education

Although output figures for education work give cause to wonder whether projects were reaching site as quickly as planned, new orders figures this year suggest that any bottleneck has been removed. The value of orders for privately funded school and university work so far this year is more than double that of 2004, and the value of publicly funded work has risen 19%. Publicly funded work still accounts for a large majority of education building and, in real terms, the overall increase in school and university work is running at a level 26% higher than last year. This is well ahead of the DfES published investment strategy, which envisages 13% growth in 2005/06 compared with 2004/05, followed by 7% growth next year.

Health

New orders for hospital building on the other hand show a declining trend in both public and private sectors, down in total some 14% in cash terms or 20% in real terms, but this is in relation to a massive 48% increase in orders last year. Nevertheless, in spite of the substantial investment in health building that has occurred, spending has always lagged behind the promised programme. Despite the latest statistics, the flow of health-related construction work is projected to pick up substantially over the next three years.