Hedging raw material costs in construction?
June 11, 2024
by a searcher from Massachusetts Institute of Technology - MIT Sloan School of Management in Austin, TX, USA
Hi,
I'm looking at a niche construction deal right now, at the point of negotiating the LOI.
The company had a pretty big swing in EBITDA from 2022 to###-###-#### barely profitable in 2022 and hugely profitable in###-###-#### on slightly higher 2023 revenue. The seller has chalked that up to fluctuations in raw material prices. Obviously, if levered up with SBA debt, a repeat of 2022 could be very problematic.
I have a masters degree in finance, so I've studied hedging, but I've never actually done it in practice. Is there a cost effective way (futures contracts on lumber, etc.) to hedge the majority of the risk away? I know I will be giving up upside to get a low-cost hedge, but I'm ok with that if I can take away the risk of an unfavorable fluctuation causing a default.
I'd love to chat with anyone who has experience in hedging construction supplies or any other commodity.
from University of Toronto in Toronto, ON, Canada
https://www.amazon.com/Optionology-Complete-Handbook-Successful-Options-ebook/dp/B0CFH7TNZ9
Regarding your specific question, the following options seem most logical:
- **Futures Contracts**:
- Lumber Futures: Purchase futures contracts to lock in prices for future delivery, mitigating the risk of price increases.
- Copper Futures: Use futures to hedge against price volatility in copper, particularly useful for large projects.
- **Options Contracts**: - Call Options: Buy call options on commodities like lumber to hedge against price increases while limiting downside risk to the premium paid.
- **Commodity Lock Solutions**:
- Fixed Price Contracts: Lock in prices for materials for a set period###-###-#### months) to provide budget security and protect against price volatility. - **Contractual Provisions**:
- Price Escalation Clauses: Include clauses in contracts to pass on increased material costs to the client. - Force Majeure Provisions: Provide protection against unforeseen events that cause material shortages or price spikes.
- **Purchasing Inventory in Advance**:
- **Advantages**: - Eliminates uncertainty around future pricing by locking in known costs up front. - Avoids supply chain disruptions or shortages closer to the construction timeline.
- Provides price protection without premiums or fees associated with financial hedging instruments. - Allows benefiting from any price decreases that occur after purchasing inventory.
- **Disadvantages**: - Requires adequate storage space and capabilities to take delivery and handle inventory months in advance. - Ties up working capital in inventory that can't be readily accessed if cash flow needs arise.
- Potential for inventory to be damaged or degrade while in storage, leading to wastage. - Inventory carrying costs like insurance, taxes, and security over the extended holding period.
- **Practical Considerations**:
- Cost and Feasibility: Weigh the costs of hedging (e.g., premiums for options) against the benefits, especially for smaller projects.
- Expert Consultation: Consult with brokers or financial advisors specializing in commodity hedging for tailored advice.
Hedging construction material costs through futures and options contracts, fixed price solutions, and contractual provisions can effectively mitigate the risk of price fluctuations. While these strategies involve additional costs, they offer a way to stabilize financial planning and protect against adverse market movements. Consulting with experts can further enhance the approach and ensure the implementation of the most cost-effective and efficient strategy for construction projects. Additionally, purchasing inventory in advance can be a straightforward way to lock in costs, though it requires careful consideration of logistics and capital requirements.
from University of Pennsylvania in Seattle, WA, USA
To answer you question directly: If lumber is your biggest cost input, you can simply go long on a futures contract for lumber. In practice, I could see this looking like 1.) January booking a contract for construction that needs 1m LBF in lumber that will start construction in July. 2.) Going long on a future contract for the same amount of material dated as near to the material delivery timing as possible. If prices go up, you have your futures contract to cover the materials at the originally locked price. If prices go down, you buy on the open market and your future contract is not exercised. You will have costs associated with the hedging strategy that need to be considered and need to ensure the contracts can be workable at the futures price rather than the current price when you write them. Not all materials that are inputs to your process will have perfect hedges via futures contracts but you can do your best to find the most impactful ones.
I will say in practice that this carries a lot of risks that you may not have considered, with one big one being counter party risk. If you sign a contract and take out a long position in a future contract and prices drop significantly, I would expect that the counter party will try to negotiate and may even break their contract, leaving you in a bad place as well. Hedging is also a significant departure from typical skills required in construction and I could see it being a major distraction from the operations of your business. You will also need to tie up cash in the futures contract when you take your hedging position. Construction agreements can and do get renegotiated and projects are stopped all the time before breaking ground.
I have normally seen construction bids have a contingency bucket with 5-10% for cost over runs that you can dip into if prices change. Yes, during the past couple years, many projects have busted their contingencies but I think sticking with industry standards is probably easier.