OPEC Cuts Won't Help Houston's Energy Sector

A new agreement between global producers to reduce crude oil production won’t be enough to help Houston’s struggling oil and gas industry, at least in the short term.

Economists had already predicted a downturn in the energy sector, which was anticipated to dampen Houston’s economic growth this year. Those expectations have taken a sharp downward trajectory, reflecting the dramatic effects of the coronavirus pandemic and a price war between two of the world’s largest oil producers, Saudi Arabia and Russia.

“This will likely hurt as keenly as any recession we've documented,” Jesse Thompson, a senior business economist at the Houston branch of the Federal Reserve Bank of Dallas, told Bisnow.

The energy sector is deeply tied to Houston's office market, influencing both demand and rent prices. When there is a downturn in oil and gas, the office market is usually the first to reflect an impact.

Last week, OPEC reached an agreement to cut 9.7 million barrels per day of global oil production. Many speculators hoped that by reducing production, oil prices might have a chance to stabilize — with less supply, pricing might increase.

But while it may be a historic production cut, the reality of how the OPEC decision will affect oil prices is actually less significant.

“They're not cutting from where they were producing last month, they're cutting from where they were producing at an earlier time,” Thompson said. “As far as the market's concerned, the net cut will be smaller, somewhere in the order of between 7 and 8 million barrels per day, depending on compliance and a bunch of other factors."

An even bigger problem is the global decline in demand. Global energy demand in April is expected to fall by 29 million barrels per day from a year ago, down to a level last seen in 1995, according to the latest oil market report from the International Energy Agency.

For the entire second quarter of 2020, demand is expected to average about 23.1 million barrels per day lower than Q2 2019. That plummeting global demand for oil means that even with the major OPEC production cuts, oil prices won’t see much improvement.

“You're still in a dramatically oversupplied market,” Thompson said. “We're actually physically running out of space to store excess crude very quickly.”

The combination of a major oil downturn and the coronavirus pandemic doesn’t bode well for Houston’s economy. Though the city has made strides in diversifying its workforce across other sectors, energy is still a dominant force in Houston.

“Oil markets are always the differentiator between Houston and the rest of Texas, and Houston and the rest of the country,” Thompson said.

“When oil markets are doing poorly, then Houston is going to underperform the rest of the country.”

The timeline for the recovery of Houston’s broader economy is uncertain, but will be impacted by how quickly coronavirus-related shelter-in-place orders are rolled back so people can return to work.

However, Thompson said that it could take as long as 18 months to two years for Houston to recover, even with the OPEC production cuts, as huge global inventories will continue to weigh on prices through 2021.

“Any kind of recovery that we might see on the other side of the virus effects is going to be muted by that lackluster recovery, just off the inventory side,” Thompson said.

Cushman & Wakefield Executive Vice Chairman Tim Relyea told Bisnow that ever since the oil bust in late 2014, Houston has been one of the softest office markets in North America. Even in the last year or two, energy companies have been working to shed excess space.

“We have personally subleased probably over 2M SF in the last 24 months for energy companies that just had more space than they needed,” Relyea said.

He has worked with midsized and large energy companies for decades, helping them lease office space, buy buildings, sublease space, sell land and perform industrial transactions.

Houston's overall office vacancy rate is now at 21.5%, according to NAI Partners' Q1 2020 office market report. That represents an increase of 20 basis points from the prior quarter, and an increase of 70 basis points from a year ago.

One area that has been particularly hard hit over the past few years is the Energy Corridor along I-10 West. Many oilfield service companies like Baker Hughes and Schlumberger have been based in that area for years. As furloughs and layoffs begin to gain momentum, demand for office space is anticipated to keep shrinking. 

Halliburton, Baker Hughes and Noble Energy are just some of the energy firms that have announced furloughs and layoffs in recent weeks, affecting thousands of jobs.

Relyea noted that three of the four buildings within the Westlake Park office complex are almost entirely vacant. The complex is generally considered one of the best office developments in the Energy Corridor area. Another landmark site, the former ConocoPhillips headquarters, has been vacant for more than two years.

About 40% of office tenants in Houston are in the energy sector, according to Relyea.

Though upstream energy companies involved with exploration and production are currently the hardest hit by the downturn, midstream and downstream companies may weather the disruption better. 

Global chemical companies, such as Aramco and LyondellBasell, have offices in the Downtown Houston area, and Relyea doesn’t see any serious issues associated with those tenants.

“A lot of the major tenants in the buildings Downtown, the major tenants, I can't think of any of them that are at financial risk,” he said.

Aside from being an obvious bellwether for the overall health of the energy sector, crude oil prices also influence the price of office square footage in Houston. 

It all comes down to demand. When oil prices are strong, energy companies are expanding and looking for space. When a downturn occurs, headcounts begin to shrink, and the need for square footage retracts.

“I look at the price of crude, sadly, probably about half a dozen times a day,” Relyea said.

However, rapidly changing oil prices don’t translate to equally fast changes in office rent. When prices rise, office rents are usually fairly quick to follow. But when prices fall, it can take longer for rents to reflect that change, as landlords try to maintain their margins.

“They have a definite correlation, there's just some timing differences,” Relyea said.

While prices for West Texas Intermediate crude oil have fallen from between $50 and $60 at the beginning of the year to around $20 per barrel over the past month or two, office rent prices are not yet reflecting the severity of the price drop. 

“I feel people think [a decrease in average office rent] is going to happen. Landlords are going to hang on as hard as they can, and I think it's going to take a little more time for that to shake out and really have an impact,” Relyea added.

During the first quarter, office rent in Houston averaged $29.33 per SF, down from $29.84 per SF in Q4 2019, the NAI Partners Q1 office market report said.

New construction of office buildings in Houston has mostly halted. When they do start to be built again, rents could be more expensive. That may also reflect tenant demand for upgraded features, like advanced air filtration systems and underfloor air conditioning.

“Where materials come from will be more heavily debated. So I think prices could honestly only go up higher,” Relyea said.

The price differential between rents in a new Class-A building and an existing one could also widen. Relyea said that it already varies by $10 to $15 per SF, and could increase over time.

Despite the grim near-term outlook for the energy sector, Thompson said that sooner or later, the market will recover to prices that oil and gas firms can operate at. 

“This is going to be painful, but this is not the end of shale, or the end of the U.S. oil and gas industry,” Thompson said.

When it comes to the intersection of energy and real estate, Thompson has questions around whether remote work will transform the nature of office demand, both from employees and workers.

“Now that everybody has been forced to invest in developing the infrastructure and the human capital in their firms for dealing with remote work, does this structurally change the outlook for office demand?” Thompson said.

“From the employment side, it was already a trend. A lot of people are now going to say, as a part of my compensation, I am going to demand for flex time to work from home.”