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Energy Outlook North America | 2018

...adapting and overcoming

of energy markets – office and industrial

Even in an industry known for boom-bust cycles, the extreme oil price correction experienced from 2014 to 2017 left an indelible mark on energy companies and their real estate.

Thankfully, late 2017 marked an inflection point with West Texas Intermediate’s (WTI's) prices crossing the $50-per-barrel threshold and still moving upward today. But the recovery process has been quite measured. This is evident in most energy office markets, which continue to reel from erratic demand for new space and record sublease inventories.

Office

Industry cyclicality can create hyper-growth situations punctuated by atrophy periods. Unfortunately for the energy sector, this transition occurred within a few brief months, leaving many companies overcommitted to office space at a time when they needed to cut costs. The most recent down cycle has left energy-dense markets across North America grappling with outsized sublease volumes and rising vacancy amid occupiers’ efforts to restructure real estate footprints. Denver is the outlier, having seen increased absorption and shrinking sublease inventories.

Turning the corner

Energy office markets are still in a weakened state but have finally stabilized, with most of the right-sizing, space give-backs and consolidations complete. WTI’s recent close above $70 per barrel has provided some budget clarity for firms, which is one reason 2018 has seen an uptick in energy leasing activity in some markets.

Office markets: Energy tenant occupancy as a percentage of overall office tenancy

Price stabilization has allowed for capital budgets to increase, and firms are starting to eye new rounds of hiring. Though this activity has not yet translated into net growth, the increased volume in space requirements and energy transactions is encouraging. A long road remains, as energy-tenant occupancy levels have grown only in Pittsburgh so far this year.

Sublease space is down 15.5 percent collectively across the markets from 2016, backfilling at a steep discount to direct space. Houston continues to have the largest sublease inventory in North America at 9.5 million square feet.

Office tenants signing leases in most energy markets today are capitalizing on the bottoming of the cycle by negotiating cheaper rents more flexible expansion and contraction options, and signing on for shorter lease terms. Tenant concessions remain elevated but have plateaued. Looking ahead, Houston, Calgary and Fort Worth are each expected to remain tenant-favorable through at least 2019.

Industrial

Energy-heavy industrial markets have remained steady over the course of the downturn, with pockets of weakness far outweighed by increased downstream investment. Distilling or cracking crude oil into petrochemical feedstocks is driving investment along the Gulf Coast and Appalachian areas. Houston is projected to export up to 4 million tons of resins by 2021, while the Pennsylvania, West Virginia, and Ohio region is considering a multi-billion-dollar ethane storage hub. In contrast to the office market, this most recent cycle has parlayed into many opportunities for industrial real estate.

Industrial UC vs. forecasted completions 2018-2020

Downstream multiplier effect

The value of these feedstocks, as well as plentiful, cheap natural gas and emerging markets for liquefied natural gas (LNG), has created demand for new industrial development. Industrial completions forecasted over the next three years almost doubled between 2017 and 2018 to 21.5 million square feet, driven in part by energy demand. Even in Edmonton, which has been slower to recover, expected deliveries tripled from last year as stronger oil prices have resulted in increased drilling.

With oil prices climbing considerably over the last year, new avenues for growth are emerging, especially for industrial energy markets.

The sector is capitalizing on opportunities at all stages of production, from the well-head to exports destined for the global marketplace.

On the office side, markets like Dallas and Denver are seeing energy-related private equity open new doors, while the Canadian markets face further turbulence due to legislation, infrastructure uncertainties and an imbalance between Canadian and American pricing. Despite upticks in activity, all energy office markets, outside of Denver, are projecting no growth in overall energy occupancy through 2020; companies are more focused on adopting innovative technology and securing talent. In an industry where paradigm shifts are not uncommon, an effective real estate strategy is more critical than ever.

A look into flexibility and space use

The energy industry is moving into a new cycle, defined by a breakneck expansion of American production and refining capacity, incredible technological advances and a generational shift among its workers. Most importantly however, laser-focus on cost control and the new normal of "doing more with less" is now influencing energy tenants' lease structures and space use.

Building flexibility into your lease

When oil prices were high, energy companies―especially upstream firms―were not as concerned with real estate exposure. They foresaw continued expansion and executed “large and long” real estate strategies to lock in massive amounts of space for an extended period. This over-commitment and inflexibility proved very costly.

The rapidity of the fall left markets with rising vacancy, record sublease volumes and little hope for recovery. Today, because of lessons learned, scrutiny from financial markets and a new culture of cost-cutting, more creative approaches to real estate are now being employed.

Office lease “layer cake” structure

By and large, the deal structure desired today is shorter, much more flexible, and allows energy companies to hedge risk by baking nimbleness into their lease document. This “layer cake” approach typically involves a core amount of space reserved for traditional occupancy with expansion options available for smaller amounts of space over the term. In addition, rights to contract and/or terminate―also at various points throughout the lease term―are negotiated to provide the flexibility needed to manage operational fluctuations.

Flexible, or "co-working" space is another avenue energy firms are now exploring.

Though some specialties within the sector like private equity have already planted flags in the flex space world, even the most traditional multinationals are now exploring options.

Whether to act as a relief valve by absorbing immediate employee growth or to establish satellite locations in metros after a consolidation, flex space allows companies to ebb and flow without the burden of long-term leases or costly buildouts. As flex space providers scale at a shocking pace and their focus evolves from startups to more traditional corporate users (which now make up more than 30 percent of WeWork’s clientele), expect more energy users to adopt this model.

Considering forecasted growth in the industry in the near term, firms should contemplate a more layered occupancy strategy that includes flexible space. This will help to mitigate the risk of market and human capital fluctuations and avoid the sting of space over-commitment as seen in the last cycle.

Workplace strategy for a new generation

Given generational preferences for traditional office-heavy buildouts, energy tenants, especially those in the upstream sector, have been one of the last industry groups to implement modern occupancy strategies. However, space use in this industry has finally begun to evolve to meet the needs of today’s workers―and also react to cost pressures in today’s "lower for longer" environment.

Energy firms are embracing space plans within well-amenitized, modern workplaces preferred by the next generation of talent. These serve as not only a recruiting and retention tool, but also a place that is more productive and healthier for its employees.

Recent benchmarking data from Gensler shows energy firms have reduced their space per employee since the oil downturn, both in the usable square feet (USF) per person and office/workstation size. The USF-per-person metric peaked in 2014 at 375 USF, but tenants today are using far less, between 200 and 300 USF/person. Additionally, the percentage of open office space has increased.

Looking ahead, the clear movement toward well-amenitized, modern properties that support efficient buildouts will accelerate. A more even split between open workstations and private offices with more hoteling, collaboration and private space will become the norm. However, the "full mobility" office buildouts used by some professional firms―where employees are untethered by permanently assigned workstations―are unlikely to take root on a broad scale in this sector.

Long-term, these systemic shifts in office buildouts will result in slower rebound in the absorption of vacant space, given that firms are using less space per employee.

Moving the industry forward, and what’s keeping it back

With the price of oil strengthening, crude inventories falling and North American oil rig counts now above 1,100, the energy industry is finally gaining momentum.

Putting aside traditional success measures, there are systemic changes afoot playing a role in either bolstering the industry or hampering its progress. The adoption of the latest technologies and the need for a more robust energy delivery infrastructure are presenting challenges and opportunities for further expansion.

Pipelines

Essential to the oil and gas industry is the underlying infrastructure and none is as important as the pipeline network. Pipelines transport oil, gas or their derivatives to ports or refineries where it can then be shipped to other parts of the world or refined and used domestically. Where some regions benefit from a vast network of pipelines, areas such as Alberta and west Texas are facing a capacity shortage given burgeoning production and overburdened infrastructure.

In Canada, Kinder Morgan’s Trans Mountain pipeline project is a $7.4 billion expansion proposed to run parallel to the existing Trans Mountain pipeline. Connecting output from the Alberta oil sands to the Pacific coast, the expansion will increase capacity from 300,000 to 890,000 barrels of oil per day and unlock access to world markets. In a time in which trade agreements with the U.S. are not entirely guaranteed, Canada is looking to take the initiative in seeking out trade partners overseas, though it has some domestic hurdles to overcome first. The project has been met with strong opposition from British Columbia and today sits in limbo.

In the meantime, energy-centric cities such as Calgary have seen minimal improvement in the office market despite the price of oil rising considerably. Should the pipeline projects gain approval, Canadian markets will see an increase in demand for office space. The pipeline construction itself would present opportunities to those in the industrial manufacturing sectors.

In west Texas, more than half of the oil rigs in the United States can be found in the Permian Basin where a severe shortage in pipeline capacity exists. To meet this demand, EPIC Midstream is planning to construct a 730-mile pipeline spanning the New Mexico border to Corpus Christi, with Apache Corporation and Noble Energy signing on as primary users.

North American LNG export terminals

Other firms like Phillips 66, Enterprise Products Partners, and Magellan Midstream are also working on pipelines to alleviate this bottleneck. Continued expansion of Texas pipelines will also further solidify the U.S.’s role as a leading exporter of LNG while the number of North American LNG export terminals is expected to boom from 3 to 16 in coming years.

A technology boom

Where the need for pipeline capacity is holding back the potential of the North American energy market, technology is playing its part in advancing it―not just in the oil patch but at the desktop as well.

Energy firms have made enormous investments into cutting-edge technology to develop resources and generate operational efficiencies. In the field, artificial intelligence, IoT connectivity and machine learning are outfitting drillers with the tools they need to optimize production.

In the office, big data, cloud computing and new mapping capabilities have grown increasingly sophisticated as geologists are able to visualize shale fields and subsease formations in real time in 3D visualization labs.

Importantly, these advances have been diffused into office settings without the burden of massive supercomputers directly on-site. Thus, technology has allowed energy companies to scale back on operational costs and the number of employees while requiring best-in-class, digitally connected real estate to support the technology demands.

Technology has unlocked efficiencies in the daily operations of energy firms and have altered the way energy firms evaluate their office footprint. Innovations seen today in the office were largely foreign concepts to the oil and gas industry of the past, but when paired with all the new tech being seen at the well-head to optimize production, the future is now for the energy industry.

Quick insights into the office and industrial markets

Houston

Office
  • Energy leasing activity up, but not net growth―renewals, contractions
  • Concessions high but plateauing
  • Worst behind us, improved conditions in next few years
  • High office vacancy, sublease space
  • Sustained weakness in energy-heavy submarkets
Industrial
  • Energy leasing activity across all sectors but focused on certain submarkets
  • Southeast and downstream dominant but tight vacancy limiting options
  • Construction and land price increasing
  • Pockets of weakness in specialized manufacturing
  • Jump in rig count increasing oilfield services demand

Want to know more? Ask Roman

Roman Rodriguez

Pittsburgh

Office
  • Energy tenant demand weak but still present
  • Some improvement in conditions but not due to energy
  • Large sublease blocks being added
  • Increasing vacancy through reduced footprints for efficiency
  • Shortage of energy leasing in traditional energy-heavy submarkets
Industrial
  • Metallurgical coal gaining momentum for steel
  • Rig count up, new pipeline construction
  • Ethane storage investments up with Shell under way, hub could be coming
  • Tight vacancy limiting options
  • Development limited by topography of land

Learn more! Ask Tobiah

Tobiah Bilski

Calgary

Office
  • Turbulent with regulations and legislation
  • Pipeline uncertainty―market in holding pattern without new infrastructure
  • Sublease space still prevalent
  • Economic recovery occurring but not enough to improve office conditions
  • Nimble companies taking advantage of discounted rates
Industrial
  • Logistics and distribution growth helping to stabilize market
  • Spec development ramping up as economic conditions improve
  • Oil and gas vacancy declining
  • Not a lot of large energy users in the market, more small- to midsized

Find out more! Ask Thomas

Thomas Forr

Denver

Office
  • Rebounding oil prices leading to increased leasing activity
  • Rightsizing, restructuring, renewing, reduced footprints
  • Sublease down from 2016 high, half of energy sublease backfilled
  • Legislative initiatives creating risk and uncertainty
  • Energy private-equity investments at highest point since slump commenced

Want to know more? Ask TJ

Thomas Jaroszewski

Dallas

Office
  • Energy sector stable and diverse―shake-out complete
  • Efficiency and cost control still rule the day but measured growth anticipated
  • Investment activity, spin-offs and unit purchases occurring
  • New corporate campus for Pioneer Resources

Have questions? Ask Steven

Steven McCord

Fort Worth

Office
  • Rightsizing continues, but some expansion and growth occurring
  • Industry diversification for metro―decreased energy occupancy
  • Tenants becoming more efficient as leases roll, shedding excess space
  • Startups and spin-offs are leasing space
  • XTO move to Houston putting owner-occupied assets into play―redevelopment potential

Curious about something? Ask Steven

Steven McCord

Edmonton

Industrial
  • Broad energy growth improving leasing activity for energy sector
  • Large energy users still hesitant, wait-and-see approach
  • Political and price risk concerning, pipeline disputes
  • Energy-centric submarket still hurting, minimal investments
  • Downward pressure on lease rates

Learn more! Ask Thomas

Thomas Forr

Ask our experts!

Eli Gilbert | Director, Energy Research | eli.gilbert@am.jll.com
Rachel Alexander | Manager, Energy Research | rachel.alexander@am.jll.com

© 2018 Jones Lang LaSalle IP, Inc. All rights reserved. All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof.

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