Energy sapped on the journey from boom to bust

Justin Slaughter reflects on the implications for real estate lending in US cities hit by the plunging oil price

Bruce Rutherford, international director at JLL, compares the US oil boom that began in 2010 with the infamous American gold rush.

He recalls a visit to the small, prairie town of Williston, North Dakota in 2013, when the new hotel where he stayed required a three-day minimum stay at prices that were even higher than those in Rutherford’s home city of Houston, Texas.

By July 2014 the cost of a barrel of crude oil had shot up to $105.54, the highest in 50 years, and the boom that led to high hotel prices in Williston was reflective of the prosperity several oil-dependent US cities were experiencing at the time.

US oilfield production has slumped
US oilfield production has slumped

‘Dropped off a cliff’

But of course, the high crude oil prices didn’t last. Starting in the middle of 2014, oil prices dropped off a cliff, due in part to overproduction and the announcement last summer that the US would lift trade sanctions on Iranian oil, experts said. And by January 2016, the price sunk to $33.65 per barrel, the second-lowest level since 1946.

Williston’s boom has crashed, as thousands of guest workers in the area’s oil fields left, and daily hotel room rates plunged to $122 per night last year as corporate travel dropped off, according to a Reuters report.

Meanwhile, in Houston – considered America’s energy capital and headquarters of the largest oil and energy companies, including Exxon Mobil, Chevron, and Shell – the boom led to a surge in office construction as oil companies expanded and upgraded their spaces.

In 2015 Houston had the highest number of new office space delivered and added of any regional market in the US, with 86 buildings totaling 12.1 million sq ft delivered. But 40,000 jobs were lost due to the oil downturn there, and newly built office buildings remain empty, according to a report Professor Adam Perdue, regional economist at the University of Houston Bauer Business College, wrote for West Houston Chamber of Commerce.

Houston, we have a problem

Earlier this year, major rating agencies put several CMBS transactions backed by Houston office properties on watch for potential losses.

“The real estate activity that does exist now revolves around disposing of excess real estate and restructuring corporate properties,” says Rutherford.

A Kroll Bond Rating Agency report released last month shows that Houston has felt the most direct pain of the drops in crude oil prices, even more so than North Dakota. The report shows that over the last year, recently built office towers were vacated or remained empty as some of the city’s largest employers downsized.

And many of Houston’s largest employers, including Anadarko, Baker Hughes BP, Chevron, ConocoPhillips, Halliburton and Shell Oil have announced layoffs. The city lost around 40,000 jobs due to the oil downturn, while unemployment numbers in the city went up from 4.0 percent last year to 4.6 percent this year.

Because such a high percentage of residents work for the local oil industry, Houston ended the year with an office vacancy rate of 13.5 percent, up 2.6 points year-over-year, the largest annual increase since 1999 and higher than the US average of 10.4 percent.

“There’s virtually no way to get a new office deal or multifamily deal done,” says Jason Walker, senior vice president, commercial real estate lending, at Bank of Texas. “We’re glad we didn’t try to stretch and play in this space.”

Rutherford adds that JLL has worked with energy companies renting office space in Houston on sublease transactions, leaseback transactions, purchase-to-lease transactions, and negotiating and restructuring leases with landlords to ease the pain they are feeling due to the oil price drops.

The Kroll report points out that in Houston, the office market will continue to be negatively impacted from depressed oil prices, as well as the 8.7 million sq ft of office space that is under construction, potentially curtailing occupancy and rent growth in the area over the next one to three years.

Perdue says that employment growth during the boom led to a burst of office development in West Houston.

About 25 percent of office space existing there at the end of 2015 was delivered since 2013, according to Perdue’s West Houston Chamber of Commerce report.

Developers over-reached

“It’s going to be a challenge” to fill that space, he says, adding that developers got “ahead of themselves”.

However, other energy-dependent cities like Denver, Colorado have been able to weather the oil price storm. Despite Denver’s proximity to the Niobrara oil fields, the University of Colorado Boulder estimates that the number of oil-related jobs in the city hovers around 9,800, well below the number of energy-related jobs in Houston.

And the largest drivers of job growth in the economy in Denver are non-energy sectors like the education and medical fields. Rutherford mentions that other local energy-heavy economies in cities like Dallas, Texas, Pittsburgh, Pennsylvania and Anchorage, Alaska have also been less impacted than places like Williston and Houston.

The impact of dropping oil prices on Houston real estate has been further exacerbated because, as energy commodity prices started to decline, most expected the downturn to last less than a year and then rebound, says Mari Salazar, senior vice president and market manager for energy lending at Bank of Texas.

“A lot of companies were not wanting to hedge,” says Salazar.

Like other experts, Perdue adds that an important factor in the fall of the price of crude oil was overproduction in the years between the Great Recession and leading up to 2014.

“With 1,800 rigs looking for oil, we produced too much,” he says. “US production went up from 500 million barrels per day to 900 million barrels per day. We got better and better at it, but we over-met demand and that came back to get us.”

Perdue adds that everyone believes crude oil prices will go up again, and when they do, there will be more discipline from oil companies and their investors going forward.

“When we were at $100 a barrel, people were just giving out $10 million and saying ‘go out and drill a hole,’” he says. “We should see a relatively smooth transition working off excess supply and people making more appropriate bets to match future demand.”

Rutherford, however, notes that “this is not the last time we are going to see this kind of energy recession or depression”.

Impacts on the CRE debt markets

The Houston office market has broad implications for the US CRE debt markets as well. Earlier this year, Standard & Poor’s, Morningstar Credit Ratings, and Fitch Ratings all released reports about potential losses in CMBS transactions that are backed by office properties in Houston.

This March, S&P downgraded three classes and put on “watch negative” the $1.7 billion CMBS conduit LB-UBS Commercial Mortgage Trust 2006-C3 after a loan on Houston’s Northborough Tower office tower was forced into maturity default after the property’s single tenant, Noble Energy, vacated the building.

Fitch announced that month that the agency would continue to monitor losses and cash flow at the four-office tower Two Allen Center – which backs the second-largest loan in the $1.3 billion JPMCC 2011-C4 transaction – after that building’s largest tenant, Devon Energy Production Company, vacated.

In February, the Houston-based Energy XXI Ltd. also missed an $8.8 million interest payment on its lease at the city’s One City Centre, which secures a $60.0 million note in JPMBB 2015-C29 and a $40.0 million note in JPMBB 2015-C30 CMBS transactions, according to Morningstar Credit Ratings.

However, it’s not all bad news. Of the 48 oil and gas companies that have declared bankruptcy since the price of oil started falling in 2014, only one CMBS transaction had major exposure: the $1.2 billion WFC 2014-L14, which has a $45.5 million loan backed by the Williams Center Towers, whose largest tenant, Samson Resources Corporation, filed for bankruptcy in September 2015, according to Morningstar.