Ugly picture will get uglier before improvement sets in

Three or four times a week, I meet with office tenants to talk about their business, macroeconomics and how they relate to the Houston office market.

Just the facts: Last year, oil gyrated from a speculation-driven $140 per barrel, to a low of $32 per barrel and is now approximately $78 per barrel. Most important to our local economy, natural gas has plunged from last year’s high of $13.69/mcf (thousand cubic feet), to less than $3.00/mcf and is now about $5.60/mcf.

The rig count was cut in half, but has eked back to 1,220 (as of the week ended Jan. 8). Job growth in Houston is a negative 80,800 (through July 2009). Office rental rates are down approximately 20 percent. Vacancy is up, new building starts have stopped and building sales are virtually nil.

What do these facts lead you to believe about the economic health of Houston? Not so fast…

In just three years’ time, estimates of natural gas supplies in the U.S. have grown from 30 years supply at current consumption levels, to 100 years supply as revolutionary new drilling technologies have enabled producers to economically extract huge amounts of the fuel out of previously inaccessible shale.

Producers were able to hang on until now because approximately 75 percent of their production was hedged at $8-$9/mcf in 2009. This year, it’s a different story. The independents, which account for the majority of U.S. onshore production, particularly those that are leveraged, only have 30-35 percent of their natural gas production hedged in 2010. Many of the smaller E&Ps simply won’t make it.

Logically (in the short term), natural gas prices should come down as hedges come off and storage, which is currently now filled to overflowing, is no longer available. Imported liquefied natural gas (LNG) is also going to become a factor as the infrastructure is finally in place to accept it and Europe’s/Asia’s demands for LNG have decreased somewhat. Producers with any wherewithal do not want to lose their domestic leases and must drill, typically within a two-to-three year time frame — and they don’t often hit dry holes when drilling in shale (think of shale as a blanket). As a result, supply will continue to increase.

Structural demand for petroleum is largely inelastic, thus demand for oil has become the most significant influence on the global economy. Our federal government’s willingness to run its printing presses full out 24/7/365 is, in my opinion, doing just the opposite of what we should be doing. It is significantly undermining the U.S. dollar; though nominally good for oil prices, it is not what the doctor should be ordering. What we should be doing is deleveraging — slowly raising interest rates, thus encouraging saving. In other words, taking our medicine while there is time to recover.

It seems the price of oil has an ever greater interdependency with the wider economy. The global economy is staring down a series of boom/bust cycles that will be caused directly by the price and availability of oil. In the short term, my prediction is that oil will hold its own and then slowly increase as the dollar’s debasement continues. Natural gas prices will come down and then rise again and level off between $6 and $8 mcf, as large electric utilities embrace clean burning natural gas (under long term fixed price contracts) rather than “clean” coal (an oxymoron). I truly believe that natural gas will ultimately be seen as a big part of the solution to the perceived “global warming” threat.

The question is how does this affect the Houston office market? My prediction: More pain is to come. Baker Hughes Inc. reuniting with B.J. Services Co., 18 years after it spun it off, and the ExxonMobil Corp. acquisition of Fort Worth-based XTO Energy Inc. are respectively the first major service company and exploration and production acquisition “shoes to drop” in this consolidation cycle. Increased merger and acquisition activity is coming and it will leave huge amounts of empty office space in its wake.

Additionally, there are huge difficulties over the horizon in refinancing bullet commercial mortgage backed securities, or CMBS, loans. Understand that 342 of the 1,300 class A and B buildings in Houston are financed with CMBS. These loans, most of which will come due between now and 2015, are currently not refinanceable. The wave of deteriorating CMBS loans and other troubled commercial real estate debt held by banks and insurance companies, when coupled with a bolus of “Alt A” residential loan foreclosures and, indeed, prime loan failures, will keep the financing markets from regaining true health.

Contrary to popular opinion, I do not believe that the recession is over. The government cannot continue to shore up the financial markets ad infinitum. None of this bodes well for leveraged office building owners.

Houston is one of the best places in the country to be in business, but if you’re a tenant here, in my opinion, you should stay lean and mean. Be conservative. Stay flexible if you can’t stay short. I believe that the market is moving in your direction and we are 18 to 36 months from the bottom of the cycle. When the “extend and pretend” motto of CMBS special servicers and banks finally ends and foreclosures take place, the new owners will have a much lower basis from which to compete, thus lowering effective rental rates dramatically.

Nevertheless, when interest rates finally pop and inflation truly takes hold, rental rates will firm and then jump. In the meantime, there will be incredible opportunities to sublease space, often in “plug and play” condition. Again, continue to go slow, it’s going to get uglier.