Magazine article Risk Management

Construction, Ingenuity and Derivatives: A Profile

Magazine article Risk Management

Construction, Ingenuity and Derivatives: A Profile

Article excerpt

Grubbs Construction Company, based in Brooksville, Florida, was tired of whistling the rainy day blues. So, faced with an inability to control the weather, it did the next best thing--it entered the weather derivatives market.

The weather derivatives market was initially used by the energy sector to insure against the perilous effects of weather. It has only recently begun to be used by a broader base of consumers and is now looking to fuel interest from the construction industry. Grubbs has become a pioneer of sorts for these derivatives users, and in so doing, hopes to bring some relief from the crippling effects even the slightest drizzle can have on a construction schedule.

A Meeting of the Minds

This summer, Grubbs' executives were looking over the poor results from June. Complicating matters was an approaching construction project that threatened to bring even further financial difficulties. As Gary Grubbs, company owner, Vic Taglia, chief operating officer, and Kendra Sittig, controller, poured over the June results, Grubbs had a thought.

"Do you remember when we talked with Granite Construction a year and a half ago?" Grubbs asked Taglia. "They said they made as much money when it rained as when they were working."

Taglia thought for a minute, vaguely recalling the conversation in which Granite Construction had discussed using a weather derivatives program. "That's something that we probably ought to check into," he responded. "I know who to call."

A week before that meeting, Taglia had read an article about the Enron Corporation in The Economist. Taglia is a shareholder at Enron and has always respected its risk management approaches. He called Enron, telling the switchboard operator what he was looking for. She connected him to Partho Ghosh, manager of Enron Global Markets' weather risk management department.

"We chatted about what we were looking for, the location of the project and the kind of duration we'd have," says Taglia. "He told me the kind of information he needed to price it for us."

Taglia called Grubbs and detailed his conversations with Ghosh.

"I think Gary was pleasantly surprised," Taglia says. "He must have talked to me at three or four o'clock on a Friday afternoon, and by six o'clock that afternoon I had Partho's name, he and I had talked already, and he was pricing out a model.

"Working here, it's not a lot of committees and fooling around before you make a decision. We go check it out and it's yes or no."

Handling Construction Risk

Grubbs Construction is a midsized construction company expecting to do over $50 million in business this year. Its projects vary in size, ranging from $40,000 to $10 million. Grubbs has a unique working environment in terms both its exposures to risk, as well as the way risks are handled.

"Think of a factory that is open to the elements," says Taglia. "You never really know what your raw materials are. You don't know exactly what's underneath the ground when you start to dig and lay pipe. You don't actually know what you're going to run into when you start moving garbage on a landfill. I mean, you know what should be there, but is there a possibility you'll be surprised? Absolutely."

Taglia meets with Grubbs weekly or even daily to discuss these risks. "We'll ask: What risks do we face in our business? Which ones can we avoid? Which ones can we buy our way out of? Which ones do we have to accept?"

According to Taglia, finding answers to those questions is a matter of hiring smart people, hiring experienced people, and with its most recent dilemma, finding specialty products like weather derivatives.

The Risks of Rain

Contractors, by and large, are taking big risks every time they sign a contract.

"Most municipal and government contracts have some pretty tight deadlines," Taglia explains. "Some jobs have tighter time limits, and rain could be much more damaging not only because of the fixed costs you would incur without having any additional revenue, but also because you run the risk of having to pay the owner of the project for liquidated damages. …

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