The drop in oil prices and its impact on the Texas economy has dominated the headlines and conversation in the 4th quarter of 2014. This McAlister Investment Real Estate report will identify the variables in and the impact of the recent drop in the price of oil on the Houston and the Texas real estate markets. The analysis will address the magnitude of the drop in the price of oil, the length of time it may remain low and the impact on the growth of the real estate values in Texas and in Houston
- The production from the oil producing countries can currently meet and exceed world demand.
- The price drop is a supply/demand issue with Saudi Arabia resisting production cuts to maintain market share.
- The price drop is a political issue created by the oil producing countries delivering an unrestricted amount of crude into the world market, which currently exceed demand.
- Saudi Arabia has significant reserves of cash and other liquid resources to allow them to meet their budgets for the next several years.
- Russia, OPEC and other oil producing countries need oil to be in excess of $100/bbl to meet their budget needs.
- The US national and local economy has abundant income from sources other than oil exports.
- Oil prices may stay low for the mid-term of 2 to 3 years or less with oil company capital budget cuts, layoffs, and company consolidation dominating the headlines creating a perceived panic.
- Consistent among the prognosticators of real estate activity and economic occurrence is that the impact of price reduction for oil will create a slowdown in energy and production job growth in Texas and Houston. However, the impact is a slowdown in growth, causing a temporary decline in oil and gas employment, but an overall positive growth for Texas and Houston from the growth stimulus in other economic sectors.
- Cheap energy prices will accelerate personal consumption, broaden economic growth and create new jobs and continued population growth in Texas and Houston.
- In short, the U.S. and Texas economies will benefit and grow from low energy pricing.
- Texas housing demand will remain strong. Houston alone is projected to have 32,000 to 35,000 new home starts in 2015, up from 30,000 in 2014.
- Financing and investment capital for residential development will continue to be difficult to obtain and will continue to bottleneck real estate development.
- Texas major metropolitan areas are still experiencing new home and new home lot shortages.
- The combination of the resilient Texas economy, the continued bottleneck of development financing exacerbated by the headlines, and the persistent supply shortage of new home lots will create a near-term opportunity for private investors similar to the 2008 to 2012 recession.
An International View of Oil and Gas Exploration and Production:
- The recent decline in the price of oil is the result of additional supply of crude production flowing into the world market from the U.S. shale revolution provoking a response from OPEC, primarily Saudi Arabia, to maintain market share. It is also the result of the slowing demand from China and India and the economic softness in Europe.
- The main culprit for the oversupply is the rapid entrance of shale oil from the US into the world market in large volume. Currently, the 9.0 Million barrels per day (“MMBD”) production from the US is only 1 MMBD less than Saudi Arabia. Oil producers in the US have completed approximately 20,000 wells since 2010. Shale oil still has a large number of sites to drill and add new production. The added new production brings the potential for a tremendous increase of oil to the world market from the U.S.
- Production of U.S. crude oil capacity has increased by one third since 2010 and provides 9 Million bbl/day to the world market. The U.S. is well positioned to overtake Saudi Arabia as the major producer of worldwide crude and become energy independent. Politically, Saudi Arabia’s influence in the crude oil arena will be challenged.
- Through the control of production output, Saudi Arabia, and OPEC have historically influenced the price of oil since 1974.
- In 2014, when it was apparent that excessive crude was being produced, Saudi Arabia refused to decrease its 10 MMBD production and OPEC’s 30 MMBD into the world market. OPEC produces more than one third of the world demand of 80 Million bbl/day.
- There has been much speculation on Saudi Arabia’s reason for not slowing the production of oil and allowing the dramatic drop in the price of oil. It appears that their goal is: (1) reduce exploration and production in the U.S. “shale play” by over-supplying the world with oil. The over-supply will reduce oil prices and negatively impact the profitability from the U.S. drilling new oil and gas wells (2) economically undermining Russia and Iran by severely impacting the amount of oil revenue available to meet their respective budget needs, and (3)helping a sputtering global economy grow by decreasing energy costs. This will give an effective boost to consumer’s cash flow, purchasing power, and spending capacity to emerging countries and the U.S. It will increase the long-term demand for oil. In the end, maintaining market share seems to be the primary objective of Saudi.
- The price of oil will likely not reach $100/bbl in the near or midterm absent geopolitical unrest, production interruption, or intentional action by OPEC countries. Many of the OPEC countries currently have significant cash flow problems which brings pressure on other OPEC members for production cuts to push oil prices up.
- Saudi Arabia has cash reserves estimated between $750 Billion and $1 Trillion and can meet budget with these cash reserves for possibly 10 years. However, other countries that depend primarily on oil revenues to meet their budget such as Venezuela, Nigeria, Iran, and Russia cannot cover budget commitment with oil prices at current level.
- It is difficult to project the future pricing of oil or the depth of this price reduction in the short term. OPEC currently is in the driver seat to control the price of oil by controlling their crude volume in the world market. When and if the OPEC countries moderate their overall production to reduce crude supply and the global economic demand begin to improve, it is reasonable to expect that oil prices will return to at least the $70 to $80/bbl range.
- Because of its extreme dependency on oil revenue to support government activities, Russia has experienced a dramatic drop in the value of the Ruble of nearly 50% vs the dollar since mid-2014. Nigeria and Venezuela are in a steep recession and may default on their debt if prices remain at this level. They are pressuring Saudi Arabia to increase oil prices.
- Iran requires $130/bbl from production to balance its budget. Venezuela requires $150/bbl from production to balance its budget. Saudi requires $90/bbl from production to balance its budget. This sets the stage for the need to raise oil prices in the mid to long term.
Impact of the Shale Revolution and Lower Oil Prices:
- The United States oil and gas production activity has exploded since 2009 with the rig count increasing from 1000 rigs daily to 1900 rigs daily in 2014.
- The 2014 oil price decline could retard current US drilling activity of approximately 1900 rigs daily by at least 25%. Approximately 1400 rigs daily are associated with shale exploration.
- The oil and gas exploration and manufacturing sectors of the Texas economy account for only 13% of its employment base and 11% of its GDP.
- Natural gas prices collapsed in 2010 because of the abundant supply resulting from shale drilling. Gas prices fell from $5.84/mcf to $1.95/mcf in 2012. December 2014 pricing for natural gas was $3.62/mcf. The rig usage for natural gas exploration fell from 1300 rigs per day in 2008 to to 344 rigs per day in 2014. This decrease in natural gas pricing did not have a noticeable impact on job growth as the Texas recovery was strong from 2011 to 2014. The Texas economy was boosted by oil exploration and production from shale which increased more than enough to offset the job losses that occurred in the gas sector.
- The abundance of cheap natural gas created an unprecedented competitive advantage to the downstream domestic chemical and refinery sectors of Texas by reducing this primary cost of production. Philips 66, Dow Chemical, Valero, and other major energy companies have committed billions of dollars to the expansion and increased capacity in their chemical and refinery activities. The positive economic effect of these projects are currently being felt in Houston and Texas.
- Lower oil prices will cause a near term decline of rig activity and jobs will be lost through layoffs and consolidations. As oil price recover, shale oil and gas exploration and production will quickly resume and jobs will return. Downstream plants are currently expanding and growing, which helps offset job losses in upstream production.
- Well-capitalized major oil companies will continue to drill large prospects with long term production possibilities. Multibillion dollar projects often have 20+ year time horizons. The drilling and production programs may not be strongly affected by short term volatility in oil and gas prices.
- Shale wells can be drilled and completed inexpensively and quickly. The shale oil development will resume quickly upon an increase in the crude price level that supports profitable oil exploration and production. The characteristics of shale oil exploration is that the wells initially have strong production but decline rapidly within three (3) years.
- While oil well profitability differs from field to field, 80% of U.S. oil development on the average breaks even from $50 to $80/bbl. Shale oil in many fields break even at less than $ 60/bbl.
- For the U.S. and World economy, cheaper oil is good for economic growth. Domestic and global GDP will rise and employment will increase in many countries as the reduction in gas and cost of energy gives consumers and business an effective pay raise. Cheaper oil will help create jobs in many sectors of the economy in Texas, the U.S., and the rest of the world. Cheap oil will increase consumer income and spending, and jobs will be added to service the expanding consumer needs. This will have a long-term response of revitalizing economies worldwide and have a lasting increase in demand.
- A 23% reduction in gas prices at the pump adds roughly $100 in monthly income to the average consumer.
- The losers in the mid-term are E&P companies and oil producing countries whose budget demands are satisfied by high oil prices.
- One of the U.S. Federal Reserve’s prime objectives is to keep inflation in check. Low oil prices will keep the current Fed program of low interest in place and reduce the risk of inflation.
The Fall Out and Benefits From Falling Oil Prices Affecting Texas and the US:
- In the short-term, U.S. will reduce its drilling because of reduced profitability and cash flow. This will reduce the rate of increase in production capacity from the U.S. Still, production estimates for the US in 2015 are nearly 9.5MMBD vs 2014 at 9.0MMBD.
- In the near-term, many independent oil companies are undercapitalized and will be forced to sell, merge with stronger companies, or go bankrupt. This is history repeating itself as this pattern happens in every oil cycle and will certainly dominate the headlines. Long-term, the U.S. is poised to be the dominant country producing energy in the world.
- Similar to real estate, acquisition opportunities for the larger and stronger oil companies to buy or merge will create long-term windfall profits and add to their reserves.
- The losers will be the undercapitalized oil producers.
- The winners will be well-capitalized energy companies and the non-energy dependent companies and countries.
- New drilling and production development will continue, but at a reduced rate until oil prices recover. Drilling and development of new production will not go to “0”. It is reasonable to forecast 20%-25% cuts in the capital budgets for most companies for exploration and development by 2016.
- The upstream energy sector will lose jobs through a decrease in drilling activity and mergers while downstream enjoys the benefit of cheaper cost of goods. Current oil fields must be maintained and the office staff to support company’s current operations both will be reduced. The potential of growth in downstream energy and the energy-dependent sectors will bring both construction and operational jobs.
Impact on New Housing Starts and Real Estate:
- Texas and Houston have experienced rapid growth in housing and virtually all other real estate asset classes since the 1950’s.
- Texas has experienced four downturns of falling oil prices in the last 20 years (1991, 1995, 1997 and 2008) and still had positive home starts. The same should occur with this projected downturn.
- In 2009, at the bottom of the last recession oil was priced near $40/bbl and rig count dropped from 1600 rigs to 900 rigs. By contrast, the 2015 slowdown is forecasted to be 20-25% reduction in drilling from the 2014 level of 1900 rigs to 1400 rigs.
- Even in the depths of the last recession, Houston home starts were between 18,000 and 20,000 per year from 2009-2012. This absorbed approximately 10,000 acres of land per year for home development.
- Texas and Houston have consistently lead the nation in job and population growth. Since 1950, the annual population growth has been 3.4%/year. Between 2000 and 2010, Houston added an average of 123,000 people/year.
- The Greater Houston population will reach 6.5 Million in 2015. Long term trends point to Houston population growing to as much as 7.7 Million by 2025 and 9.9 Million by 2040. This is a strong positive for real estate investors and developers.
- In 2013, Texas and Houston job growth was 252,400 and 82,000, respectively. Estimates for 2014 are 259,000 and 110,000 new jobs, respectively. Job growth estimates for 2015 are forecasted to be between 60,000 and 72,000 for Houston. For a healthy growing new housing market, Houston needs roughly 50,000 new jobs per year.
- In Houston and in Texas, the job growth has been robust across all economic sectors. Oil and gas exploration and production is not as large of a job growth producer as generally thought. Exploration and Production accounts for approximately 13% of total employment and growth for Houston. Job growth in Houston has been broad and has affected virtually all economic sectors.
- Even with recent price jumps, the cost of living in Houston is less than other metropolitan areas in the U.S. It is 5.7% less than the national average. This is a big attraction for population growth and real estate developers.
- The forecast is for 32,000 to 35,000 new home starts for 2015 up from 30,000 new homes in 2014. The start of 35,000 new homes will consume approximately 17,500 acres of land in Houston MSA’s.
- Forecast for new home starts in the U.S. is an increase of 21% according to Realtor.com as the U.S continues to recover from the Great Recession and a strong real estate market. Texas housing starts are projected to grow 5% in 2015.
…AND THE OPPORTUNITY
- The McAlister family of companies has purchased properties in previous downturns when the market was under real or perceived stress. These investments created strong returns to McAlister investors at an extremely low risk. This current down cycle in oil prices will indeed create a slowdown in Houston and Texas. It is possible that the cheaper oil prices may last 2 to 3 years, the decline in oil prices will slow the pace of growth in the short term but not create a disaster.
- In the great decline of the oil and gas and real estate industries in the mid-1980s, Houston was greatly overbuilt in virtually all sectors from previous overdevelopment. The depth of the recession in real estate development and the extended length of time before recovery began was due to an oversupply of real estate inventory in both developed lots and constructed space. In both cases, the underlying fundamentals for residential real estate were undermined by a gross over supply of homes, lots and rent space, fueled by easy financing and an extremely optimistic estimate of future oil prices and population growth.
- Today’s underlying real estate fundamentals are much stronger for Houston and Texas than those in the 1980s. House and lot inventory are in short supply, and Texas and Houston have diversified their economies and are experiencing strong population growth.
- Houston and Texas are in an ideal position for real estate investors in 2015 due to an undersupply of inventory in homes, lots, and constructed space. For years, Houston has led the U.S. in job growth which will continue to fuel the demand side of the equation for new homes and lots. A low supply of homes and home lots and the growing demand through population growth are huge factors to maintain a healthy real estate market. Since the 1980’s, Houston has diversified and job growth has occurred in all economic sectors.
- During the recent dynamic population growth in Houston and Texas, obtaining financing for the development of land for single family housing has remained extremely difficult and scarce for developers and home builders. This ‘bottleneck’ to growth of single family real estate development in Texas has created opportunities for the McAlister Funds to invest in high quality land investment opportunities.
- The lack of readily available capital to support new and ongoing development coupled with an inevitable pull back by the banks reacting to the headlines will create even more availability of distressed properties coming on the market from banks and undercapitalized developers.
James A. McAlister, Sr.
McAlister Investment Real Estate