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Construction, ingenuity and derivatives: a profile.

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.

"It's very common to have a contract completion date. And if you go beyond that date you pay the owner so many dollars per day, whether it's a thousand or five thousand or ten thousand. That could be a big deal on a contract."

Rain was a particular problem for the August project located in Ocala, Florida. "Landfills, just by their nature, require a lot of garbage moving and dirt moving. All of which become more difficult if it gets real wet," says Taglia. "You can't move the garbage if it gets real wet because you can't get any traction for your bulldozers and loaders. You run into a similar situation when you're trying to cover the garbage with fill dirt because you're working on an angle. If it's wet, you start to slip and slide. You just don't get as much work done in the day as you would if you were operating under dry conditions."

Finding the Derivatives Solution

"What I liked about Grubbs," says Enron's Ghosh, "and one of the reasons that Grubbs did this transaction, is that in addition to them being forward thinking, I was dealing with the number one and the number two people in the company. So they didn't have to go into a committee. They basically understood what was going on and they made the decision. I was talking to the decision makers."

Another reason for the expeditious nature of this transaction is Taglia's financial background.

"What fascinated me," says Ghosh, "was even though they're a construction company, and Vic [Taglia] himself is the COO he has a finance background. So he really understood the financial impact of weather derivatives, which is to protect earnings, margins and revenues. He saw the value immediately. So we started to target an area where we could immediately apply some of these derivatives." Within days of that first phone call, Grubbs and Enron were deep in discussion on how best to customize the derivative package.

How Derivatives Work

The basic structure of a weather derivative is fairly simple. A company determines that a certain weather event, be it rain, snow or extreme temperatures, has harmful effects on its business. That company then turns to a weather derivatives dealer and works out a package wherein it will pay the dealer an agreed upon premium, and will receive a payment of a certain amount of dollars whenever that weather event occurs.

Weather derivatives can be customized and therefore the terms of contract are malleable. The amount of the premium, the specifics of the weather event, the amount and number of the payouts and the length of time of the contract are all tailored to fit the specific needs of the client.

Some construction companies, for example, may need to cover the effects of extreme temperature variations. Consider a company building roads. When the temperature falls to freezing or below, concrete is difficult to mix, and asphalt might have to be thrown away. So the company can work with a dealer to devise a structure stating that if the temperature falls below freezing, they get paid X dollars for every day it remains below that temperature.

Grubbs, on the other hand, needed protection from the effects of variable or subtle weather events, such as off-and-on rainfalls or even continuous drizzle. In the case of Grubbs, a more sophisticated derivative package needed to be built.

"The bottom line for them," says Ghosh, "was that they needed the ground to dry out. The problem was not a ton of rain. If there's a ton of rain they just send everybody home and pack up the equipment for a week or two weeks. But if it rains often and they can't come back to work, then that's when they get hit."

Ghosh suggested a fairly innovative structure that measures the frequency in addition to the amount of rain.

Details of the Deal

The contract was developed to cover the landfill project from August 1, 2001, when the project began, until the middle of November 2001, by which time the project would be finished.

The parameters of the weather event decided upon by Taglia and Ghosh are more than five inches of rain in five days. Measurements of the duration and amount of rainfall are obtained from the National Weather Services' Ocala measuring station. There are also two alternative weather measuring stations that can be used as backups.

Grubbs can have up to ten events in the period of its contract, and the contract is based on a one-time premium payment. In other words, if Grubbs receives $10,000 for each event, and it rains six inches on ten separate occasions over the course of the contractual agreement, it would get a payment of $100,000 for those ten events, paid out when the contract comes to an end.

Many companies are not used to negotiating this kind of financial package. Most search through a bevy of products, asking about the set costs of each item. Derivatives, however, are not prepackaged. Ghosh sees this as one of the advantages derivatives have over traditional insurance.

"We're in the business of actually creating risk management products from a portfolio that's sitting there," explains Ghosh. "It doesn't exist until I create it. And so I have the ability to customize it. We build something based on what you need. That is a concept that is still hard for most people to understand."

Another potential advantage of the weather derivatives approach is that the terms of payment are clear. There are no claims to fill out, no inspectors to prove damages to.

"If I had to go out and show how much lost productivity I had, we could be arguing about that forever," says Taglia. "[With weather derivatives], if it rains more than five inches in five days, we get a check. If it doesn't, we don't."

There are, however, some expected complications in this system.

"The rainfall gauge at the airport is five, six miles away from the landfill," Taglia explains. "Is it possible that it rains like crazy at the landfill and there's no rain at all at the airport? In Florida that happens sometimes."

Not to mention the sunk cost of premium when the contractual period yields little to no expected weather complications. "I haven't seen the Ocala newspapers," says Taglia, "but the Tampa newspapers say that it's the driest season in one hundred and twenty years."

Does this discourage Taglia? Not particularly.

"This was sort of a learning experience for us," Taglia explains. "What's available? What kind of pricing is there? How do you define an event?

"If you're asking me if we're going to regret spending the money if we don't have a claim, you always risk that."

Reading for Solutions

Grubbs is a good example of a company that is always looking for innovative ways to get around obstacles. Taglia assumes much of the role of risk manager and credits the majority of his success in this area to his insatiable preoccupation with reading.

"I have a tendency to read most anything I can get my hands on," says Taglia. "My wife used to complain that I would sit at the breakfast table and read the back of a cereal box. Wherever I am, I pick up something to read."

This habit has led Taglia to occasionally stumble upon a great idea; more often, however, the breadth of knowledge Taglia has accumulated in this manner allows him to continuously offer solutions as problems present themselves. Taglia considers himself lucky to work in an environment where this kind of innovative thinking is cultivated.

"One of the nice things about working with Gary [Grubbs] is that he has a lot of imagination, and he encourages the use of imaginative answers to business problems," says Taglia. "We just think of ourselves as a small construction company in west central Florida. We're trying to do things a little bit smarter than other folks."

Whether or not the rains come before the culmination of their landfill project, Grubbs seems to have developed an intelligent business environment appropriately equipped to weather any storm.

Billie Swift is associate editor at RM.
COPYRIGHT 2001 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2001 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Grubbs Construction Company enters weather derivatives market
Comment:Construction, ingenuity and derivatives: a profile.(Grubbs Construction Company enters weather derivatives market)
Author:Swift, Billie
Publication:Risk Management
Geographic Code:1U5FL
Date:Nov 1, 2001
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