April 15, 2016
As the energy capital of the world, Houston has been severely impacted by the prolonged decline in oil and gas prices. The results, however, have not been even across the city.
Within Houston’s industrial market, this has created a distinct geographic delineation between the haves and have nots. The geographic boundary that has developed can be seen by dividing the city along U.S. 59. Specifically, the west side is bound by Houston’s Grand Parkway on the west and extends east to U.S. 59 to include downtown. The east side is bound by U.S. 59 on the west and extends east to include Baytown, the Port of Houston and the ship channel. The west side is marked by an upstream oil and gas focus, and typically is thought of as containing more white collar office positions within exploration and production (E&P) companies. The east side is traditionally more downstream-centric, focused on refining and processing petrochemical products for export.
West side woes
Prior to the downturn in oil and gas, Houston’s west side experienced a relatively sustained period of robust growth. Technological advances in methods for extracting natural gas from the country’s unconventional shale plays, such as hydraulic fracturing (fracking), drove white collar job growth in west Houston. This growth trickled to luxury apartments, suburban homes and retail, in addition to the office and industrial buildings directly associated with these jobs and increased business activity. The drop in oil prices caused by increasing global supply, stagnating demand and severely exacerbated by the 2014 OPEC meeting, has dramatically affected the west side – essentially halting commercial real estate development, growth and leasing activity.
As a result of the drastic drop in the price of oil, the U.S. has seen a 60 percent decrease in rig count, a key industry metric important to investors as it reveals the sector’s supply and demand dynamics. Spending on exploration activities has been cut by about 50 percent, and in some cases significantly more than that, further impacting the jobs that make up Houston’s west side.
For west Houston, the oil price slump has had a definite negative impact on commercial real estate. At the end of 2013 and in the first half of 2014, many energy companies were expanding, looking for space and initiating new projects. By October 2014 that activity was over, and now many of those same companies are actively subleasing space and contracting their real estate footprints to reduce costs.
Of the oil and gas-centric submarkets that have been hit the worst, the Energy Corridor along I-10 has been seriously affected by the slump in oil prices. Currently, there is an excess supply of newly constructed and existing vacant office space, in addition to sublease space that’s on the market. This supply of space is growing as energy companies continue to reduce their business operations.
The industrial sector has also suffered on the west side. Currently, approximately 700,000 square feet of industrial sublease space is on the market in west Houston. This space is directly tied to energy service providers that during the boom had extensive needs for storing material assets and took additional space to meet the increasing demand of clients’ expanding drilling programs. Of total industrial vacancies in the west submarket, 37 properties have 100,000 square feet or more available. Furthermore, the northwest submarket contains a significant supply of available industrial space that the current market cannot support. The northwest submarket is the largest industrial submarket in Houston, encompassing more than 111 million square feet of industrial warehouse, distribution and manufacturing space. The excess space in this area has made for an extremely tenant-favorable market.
In the near-term, reduced real estate development driven by the excess supply of space in west and northwest Houston will continue.
East side excitement
While the west side wanes, there is a variety of positive ongoing industrial, distribution and storage real estate activity on the east side of Houston, much of which derives from new refining and natural gas cracking capacity under way. The ship channel area is also busy; this is highlighted by the fact that as of Q4 2015, there was no available land along the ship channel, a first in Houston’s history. Available large blocks of space on the east side are only a fraction of that which is seen on the west side, resulting in low vacancy rates.
Over the last several months, east Houston has been the benefactor of approximately $50 billion worth of construction and development associated with the petrochemical and downstream oil and gas industries. Downstream activity, especially as it relates to natural gas liquids like ethane, propane and butane, is driving development in east Houston. The refining of crude oil has also served as a significant advantage to the east. Currently, more than 2.2 million barrels a day are being refined in east Houston and along the ship channel. With low oil prices, the upstream oil and gas industry suffers, but downstream feedstock costs fall and refining and chemical margins grow. This has allowed companies on the east to maintain high levels of production of resins and polyethylene products. The stimulus of low oil and gas prices has also supported and coincided with the expansion of petrochemical plants and refineries that were already under way on the east side.
Increased activity has created approximately 10,000 new jobs in east Houston. Numerous large projects and dozens of smaller construction projects will add thousands of construction jobs in 2016. This construction is a timely offset to the economic problems presented by the drilling downturn; however, it is far from a perfect solution to the drilling bust. Construction jobs are inherently temporary. While the uptick in construction is timely, it will only last a couple of years. As construction winds down, these large-scale capital-intensive petrochemical and refining construction projects will leave much fewer permanent jobs behind. Construction will continue at high levels through 2016 but will begin to significantly wind down throughout 2017. When that occurs, the construction that has served as a stimulus to east Houston, will become a slight drag on the economy as temporary jobs come to an end. It is a boom that comes with a well-defined expiration date.
The temporary nature of these jobs also means they have a different economic impact than the permanent office positions that – until recently – made up the influx of new Houston workers. Additional construction workers won’t contribute to demand for luxury apartments, office buildings, high-end retail or expensive suburban homes. While the jobs created on the east side are well compensated, especially for skilled crafts, many workers will seek temporary housing while working on site and may send portions of their wages to their permanent homes and households in other cities, counties and states. While the jobs are being created here, the broader economic impact of these temporary project-based positions on the local economy is significantly less than that of full-time, permanent office or manufacturing workers.
The past several years saw the west and northwest portions of Houston dominate regional growth. Stimulated by high oil prices, E&P and oil field service companies saw major growth and significant hiring in well-compensated, permanent office positions that spurred massive office and industrial construction, in addition to supporting real estate development in other sectors. During this same period the east side of Houston saw some growth as a result of Houston’s increasing population, but overall petrochemical expansion was cautious and slow.
The prolonged decline in oil prices and the resulting natural gas advantage created through lower feedstock prices have shifted the market balance. Global supply and demand dynamics, coupled with OPEC’s decision to maintain production, have caused the most severe price collapse since the 1980s. West Houston, previously a beacon of growth and high-dollar positions, has suffered significantly as seen in the more than 10,000 jobs lost. The northwest, a major industrial submarket, is seeing increased vacancies and reduced leasing as a result of the large supply of inventory. Meanwhile, east Houston is more than 95 percent occupied, and property pricing has increased 25 percent over the last two years. East Houston is seeing increased outputs from plants and refineries, activity that, along with $50 billion worth of construction, has created approximately 10,000 jobs.
Experts expect an upturn in oil and gas prices by the end of 2016 and continuing into 2017; however, real estate will not respond to that immediately. Oil and gas companies are unlikely to change operating and capital budgets unless convinced oil prices have gone up and are going to stay up for a long time. This likely means at least four to six months of prices above $60 a barrel before oil companies change operating plans and rig counts rebound. Only months after that will the real estate market begin to respond.
Houston in 2017 and beyond…
Exactly how the east and west sides of Houston will react to increases in oil prices is a story that has yet to be written. Prevailing thought is that the temporary nature of the east side boom from development programs and reduced feedstock prices means that it will likely stabilize at a lower level of activity than what it is currently experiencing. As the price of oil recovers, Houston can expect to see a favorable swing back to the west side, where despite the impacts of low oil, a well-educated workforce, popular lifestyle amenities and a significant inventory of Houston’s premier office and industrial buildings still exist.