Category: Economy

Last year, on the morning of June 12, the market price for a barrel of West Texas Intermediate Crude Oil was $107.12. When the ball dropped to announce the arrival of 2015, the price of oil did a spot-on impression and dropped 51% (to $53.45). As I write this article, the price sits even lower at $44.80.

As you read through those numbers, you are probably asking yourself two critical questions:

1. Why did oil prices drop in 2014?
2. How will the drop in oil prices impact the real estate market in Houston and across Texas?

If you own investment real estate in Texas (and especially Houston) you might be substantially more interested in the answer to the latter question vs. the former. However, in order to understand the impact that a significant change in market conditions can have on real estate demand and prices, you must first have a clear understanding of the causes behind the drop in oil prices as the two are deeply interconnected.

Over the last month or so, I’ve been answering those questions almost on a daily basis in one-on-one conversations with clients and long term real estate investors. In this article I will share the answer to the first question backed by empirical data in Greater Houston Partnership’s annual report.

Why did oil prices drop in 2014? Too much of a good thing

Have you ever heard politicians of both sides of the isle talk about “reducing our dependency to foreign oil” during presidential election campaigns? They might disagree on exactly how to do it (more exploration/production vs green/renewable energy), but the idea of reducing our dependency is as bi-partisan as they come.

Did you know that we’ve been significantly reducing our dependency on foreign oil since 2008? Courtesy of innovations in oil exploration and extraction (i.e. hydraulic fracturing or “fracking”), domestic oil production has gone from 5M to 9.1M barrels/day since 2008. The result: In 2005 imported oil accounted for over 60% of U.S oil consumption – ten years later, that figure is expected to be lower than 20%.

Wait a second – you thought reducing our dependency on foreign oil was a good thing. It is… however, oil is a commodity and as such it is governed by supply and demand. While the U.S increased its domestic production, other oil producing countries (read: OPEC) didn’t stop or taper their production. So if we weren’t importing 40% of our oil consumption anymore, what happened to those millions of barrels? They either got directed elsewhere (see: growing economies of China and India) or got stored. In fact, OPEC’s surplus in 2015 is expected to be 2.7M barrels/day!

In a nutshell, we have too much supply and not enough demand to absorb it. So what happens to price when supply is excessive? Second half of 2014 happens.

But what about demand? Well, demand for fossil fuels rises when there’s economic growth. The U.S economy has shown signs of solid growth during the last three quarters but that’s the exception to the rule these days. The Eurozone has fallen prey of their austerity measures that have stifled growth while China’s growth is gradually falling with the latest annual growth at 7.7%.

Therefore, the fall in oil prices is primarily due to a glut in supply as a result of increased production without increased demand.

Who controls Supply?

Unlike supply-demand dynamics in a free market, oil supply is controlled by a handful of nations – with Saudi Arabia as the headliner. In the past, OPEC (Oil Producing and Exporting Countries) have cut production as a way to shore up oil prices pretty much immediately.

However, this time it’s different. If OPEC cuts production while U.S producers keep their supply steady, prices would rise but OPEC would lose market share. They have a very different idea on how to cut supply. Saudi Arabia would like to see U.S production reduced rather than their own. But how can they do that? The Saudis know that the very innovations that we’ve employed to increase our production (i.e. hydraulic fracturing and shale oil) carry with them a higher cost of production. Namely, if the Saudis can extract oil at a cost of $10/barrel (making essentially any oil price profitable), wells that utilize some of the new technology have breakeven points at $50-$65/barrel.

Therefore, their plan goes something like this: Let’s keep prices low for an extended period of time and U.S production will blink first because their cost structure is so disadvantageous. While that might prove effective, low prices come with a high price to the majority of OPEC members. In fact 9 out of 12 member countries need oil prices to be between $70-$120/barrel to balance their oil revenue dependent budgets.

Deja Vu of 2008?

“But wait a second” – some of you might say – “haven’t we seen this movie before, not too long ago? In 2008 oil prices dropped in similar fashion from a peak of $145 in July to a low of $30/barrel. Then a year later, prices were back up to $89/barrel in 2009 and hit $100/barrel again in 2011.

There’s a fundamental difference between 2008 and 2014. The former drop came as a result of a substantial drop in demand due to a global economic crisis. When the economic conditions improved, so did demand and the price of oil rebounded. Last years drop came as a result of too much supply. The only way to re-establish balance between supply and demand in such an environment is to taper supply until glut is absorbed or for demand to rise sharply due to economic growth.

Impact on Economy and Employment

A sixty percent drop in oil prices will have a substantial impact despite the fact that the local Houston economy is much more diversified now than it was in the woeful 80s. According to the GHP annual report, “broadly defined, Energy accounted for 38.1% of Houston’s GDP in 2013. Of which, Oil and Gas Extraction (mining) accounted for 19.8% and Other sectors that are typically identified as part of the energy industry (chemicals, refining, oil field equipment manufacturing, fabricated metal products, pipelines and engineering) contribute another $83.9B or 18.3% of total”.

The energy sectors that will be impacted the hardest from the drop in oil prices are new exploration, oil field services and oil field equipment manufacturing. And that makes sense: Once the investment has been made to find out whether or not there’s oil in a particular area, the cost to drill and extract crude oil from the ground is very low. So existing wells will continue to  produce at max capacity as their cost per barrel still affords a handsome profit even at $40/barrel oil. If instead an oil company has to invest money into new exploration that increases the break even cost for that new well 20-30 fold. Therefore it would no longer be feasible for the company to make that investment. That’s why you have probably heard news of capital expenditure budget cuts across the board from all the major oil companies.

But let’s not get it confused. Integrated big oil companies (Exxon, Shell, Chevron, Conoco etc) will be least impacted by the current economic conditions. They sit on impressive piles of cash (always handy in a situation like this) and have hedges in place to weather longer term storms. In fact, 2015 will be somewhat of a Black Friday Sale for big oil companies as they look to pick up struggling smaller outfits on the cheap.

Since budgets for new exploration will be cut and unfeasible rigs will be shut down, oil field services and equipment will bear the brunt of it. As a matter of fact, some of the big players like Schlumberger and Baker Hughes have already announced layoffs. In 2015, there will be job losses coming from this subsector. In addition, smaller companies with unsustainable debt levels will have to merge or fold – in either case, that will result in layoffs.

However, the GHP expects net employment in the area to rise by 69,500 jobs in 2015 with the bulk of growth coming from sectors outside energy: Construction, health care, retail, professional services, public eduction etc.

Materials:

Employment-Forecast – Source: Greater Houston Partnership

Economy_at_a_Glance – Source: Greater Houston Partnership

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Next Up: We will take a look at the impact of this climate of lower oil prices on the real estate markets in Houston and across Texas. Stay tuned.

 

Every year, the Greater Houston Partnership publishes a detailed report on the Houston economy which is a great chance for a numbers geek like me to sink my teeth on an ungodly amount of data.

Below are a few highlights from the report.

As of November 2013:

1. Unemployment rate: 5.6% (vs. 7.0% national unemployment rate)
2. Employment: 2.8% Job growth – Greater Houston area added 86,200 jobs during the previous 12 months (Number #1  in the State of Texas). During 2014, the GHP predicts that the Houston area will experience 2.5% job growth and add 69,800 additional jobs.
3. Affordability: Living costs in Houston are 6.5% below national average for large metro areas
4. Home Sales: 87,635 homes sold during the previous 12 months for a total volume of $20.8B (+19.4% and +31.9% respective increases over 2012)

Or feel free to download the complete reports below:

Full Reports:

Houston Economy Report for 2013 – Greater Houston Partnership

Population_Employment_Forecast- GHP 2014

Employment-Forecast 2014 GHP

These days you can’t turn on your TV or radio without hearing something about Armageddon the impending fiscal cliff. And in hearing these pundits and newscasters and their lame, over stretched metaphors you would swear that the cliff must’ve been what the Mayans were talking about – they just missed it by a week and a half. But recently, some of our clients have called and asked me about the potential impact of the fiscal cliff on the real estate market as a whole and real estate investing in particular. Because of their concern, I think it would be beneficial to do take an objective look at the scenarios that could unfold and their real estate implications.

Scenario #1: No deal to avoid fiscal cliff

Under this scenario, if Congress does not reach an agreement to avoid the fiscal cliff, taxes increase on everyone (tax cuts expire) and deep spending cuts are applied across the board. The real estate market as a whole would suffer deep negative consequences on several fronts. First, a study by a leading commercial real estate services provider cited in a recent article on TheStreet shows that spending cuts from sequestration in 2013 would hit hard government contractors and their demand for commercial office space. The same study predicts that if these cuts were allowed to happen, office space the size of the entire Dallas office market would become vacant. Such an increase in the  supply of vacant office space would put downward pressure on prices as buildings compete to lease out their vacant space. On the other side, higher taxes across the board in 2013 mean everyone’s tax bill will be higher and their take home pay will decline. Everyone that’s ever done a family budget on the kitchen table will tell you that you budget based on your net income – not your gross. So with less money to spend on housing, potential buyers will opt for lower priced properties or worse yet, hold off on a purchase they were planning on making. So even the residential market would not come out unscathed from this scenario. Last but not least, an overwhelming majority of economists agree that the combination of cuts and tax increases would push the economy back into recession. And a receding economy is never good news for real estate markets.

But as gloomy as all that sounds, there’s no need to worry. In my opinion, this scenario has worse odds of becoming reality than snow in Cancun. That’s because in order to have a real negotiation, leverage has to exist. When it comes to the fiscal cliff Republicans have exactly zero leverage. If they do nothing, taxes go up. If they agree to a deal, taxes go up. The reality of it is that taxes are going up and everything else that’s going on is just political theater. In the next week or so, you will see how “very reluctantly and unwillingly” the parties will agree to an increase in tax rates on incomes over $250k per year.

Scenario #2: Fiscal cliff deal is reached along the lines of the Democratic proposal

Under the Democratic proposal put forth by the Secretary of Treasury, the deal would involve raising just over $1T in revenue over the next 10 years by raising tax rates on incomes over $250k. The plan also involves some spending “cuts” – mostly mathematical maneuvers of inflation adjustments and reductions in planned increases. The plan would leave the current tax deductions and most importantly the mortgage interest deduction largely untouched.

The effects of such measures on the economy as a whole can certainly be debated but it is not the purpose of this article to create and address a political debate. As far as the real estate market is concerned, this proposal  largely preserves the status quo. The luxury real estate market will be impacted somewhat as the income tax bills of higher income earners rise. But as much as sending the IRS a bigger check hurts like hell, higher earners can economically absorb such a hit better than a lower income earner with much less disposable income. That’s not an endorsement of higher taxes – god knows I’ve never met a tax bill I deemed too low 🙂 – but rather a statement of fact. However, when it comes to investing, this will produce two counter currents.  On one hand, higher income earners are usually active investors and now they will have less capital to invest because they had to send it to Uncle Sam. On the other, higher tax rates will push higher income earners to seek more tax sheltered investments like real estate.

Scenario #3: Fiscal cliff deal is reached along the lines of the GOP proposal

The GOP proposed solution involves $800B in new revenues that would be obtained by not raising tax rates but by closing loopholes and eliminating deductions. The plan does not outline which loopholes and deductions would be eliminated but judging by the size of the revenues it seeks to raise, you can’t make the numbers work without eliminating the mortgage interest deduction – a darling of the National Association of Realtors and a pretty popular deduction overall. I was listening to the Diane Rheem program on NPR a few days ago and one of her guests that day was Lawrence Yun, chief economist of the National Association of Realtors. In his opposition to the elimination of the mortgage interest deduction he offered the following analogy and I’m paraphrasing:

One way to look at the mortgage interest deduction is as a dividend on your asset (your home). If the dividend on an asset is cut or eliminated, the value of that asset declines. So if the mortgage interest deduction is eliminated, property values across the board would decline by an estimated 15%.

That sounds like a solid, well thought out analogy. It’s too bad that it’s wrong. Your home isn’t an asset in the same way that a stock is one and the mortgage interest deduction isn’t the same as a dividend. Sure, there’s an investment component to owning a home. Most people buy properties in desirable neighborhoods because they want that property to be worth more in 10, 20, or 30 years than what they are paying for it. And if you itemize on your tax return, the mortgage interest deduction can result in substantial tax savings that certainly affect your decision to purchase that home vs the alternative of renting. But a property is a home first and foremost and the most important thing it does is to provide shelter. You couldn’t go live in your stock or bond, could you? So when you look at it that way, a home is worth what buyers have been recently paying for similar shelter in that location. The value of that asset to its owner isn’t exclusively determined by the income or yield it produces in the way of tax deductions. Because if that were true, when the mortgage interest deduction was created in 1986, property values should have immediately increased by the same amount Mr Yun is projecting them to drop now.

Now that we’ve addressed the issue of a drop in values across the board, there are still an unanswered questions: If a prospective homeowner cannot deduct the interest on their mortgage, does that change their decision to purchase? In other words, would the elimination of this deduction affect real estate demand? Could this elimination perhaps tip the scales towards renting? The short answer is: Not really. First and foremost, buying a house satisfies a need and the elimination of the deduction does not eliminate that need. People still have to have a place to live. But what about the alternative of renting? The truth is that rents have been increasing across the country for the past two years at the same time that interest rates on mortgages have plummeted to record lows. If you have the means and the ability, buying beats renting by a long shot right now, regardless of the deduction. Last the mortgage interest deduction can only be claimed if you itemize your deductions. According to the IRS, two out of three taxpayers claim the standard deduction instead and as such don’t deduct their mortgage interest. Of the remaining 30%, a large portion makes less than the $250k a year income threshold where the deduction would be eliminated. So the short of it is – only a very small portion of taxpayers would actually feel the effects of such an elimination.

But a real estate investor has a different perspective on this issue. To the long term investor, the asset’s worth is determined by the after tax yield it produces for her. Currently, the mortgage interest paid in a particular year is deducted from the income the investment property produced in that same year as an expense – not a deduction. So investors would not feel the effects there. But the portion of investors that make over $250k per year will see their after tax returns go down as their ordinary income tax rate rises.

I don’t have any means to predict the future as my crystal ball’s been in the shop for a few years. But something tells me that the deal that will be reached will not involve the elimination of deductions but rather an increase in income tax rates. We will find out in two weeks time if my hunch was right.

Jim via Compfight