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Oil Downturn Spurs Change in Energy Company Leasing Strategies

Many Companies Now Seeking Smaller Spaces, Demanding More Flexibility
June 7, 2018
Pictured: Bruce Rutherford, international director and co-lead of JLL's energy practice group.

The energy sector is finally being forced to implement modern occupancy strategies. After years of being high on the hog while the price of oil topped $100 a barrel, energy companies are now feeling the squeeze of real estate costs. Though oil prices have recovered in 2018, the trauma of the downturn has generated a new culture of ultra-disciplined spending that is slowing Houston’s recovery.

"Fundamental changes in the way oil and gas companies do business is impacting real estate markets in energy-centric cities," said Bruce Rutherford, an international director and co-lead of Jones Lang LaSalle's energy practice group in Houston. "Shifts toward efficient, high-density office build-outs will mitigate the demand for office space in energy-centric office markets as firms use less space overall."

Rutherford is an expert on the energy industry in the corporate real estate services sector, having managed city and regional master plans totaling more than 33 million square feet.

When oil prices were above $100 per barrel, many companies executed "large and long" real estate strategies, which proved costly when the price of oil took a dive. Today, desired lease structures are shorter, smaller, more flexible and mitigate risk with options throughout the lease term.

"Contraction options have become much more important as energy companies realize the cyclical nature of the business," Rutherford said.

The new layered approach from energy companies typically involves a core amount of space for traditional occupancy, expansion and termination options throughout the lease term, and access to flexible or coworking space. Rutherford said he’s seeing five-year leases with the option to terminate at year three, or 10-year deals with the option to terminate at five and again at seven. Other options include more first rights of refusal and sale, and shorter leases in general.

You might think energy companies are paying a premium for that type of flexibility, but Rutherford said flexible lease contracts are, in effect, concessions from landlords, rarely leading to price premiums. In Houston's slow office leasing environment, most landlords are happy to work through an energy company's flexibility needs. In some cases, flexible leases may actually be preferred.

"I've seen many occasions where a landlord has negotiated a lease with a tenant with the expectation that the marketplace would be much better, thinking the space an energy company could potentially give back would have a better chance of leasing at a higher price later," Rutherford said. "It’s a gamble on the future."

Oil and gas companies have large real estate holdings that primarily come in three forms. The first is hundreds of thousands of acres and subterranean rights used for extraction. The second type is what energy companies refer to as operational real estate - warehouses to store equipment, lay down yards to park rigs, and repair facilities. Often operational real estate has an office component attached.

The third type is traditional office space, where energy companies plan, administer and analyze operations. The third type, which unsurprisingly is the most expensive, is where energy companies have focused their real estate cost cutting measures, according to Rutherford.

That has slowed Houston’s recovery despite rising oil prices. Recent benchmarking data shows energy firms have reduced their space per employee, in some cases by more than 40 percent, since the oil downturn. That means despite oil price stabilization allowing for energy company capital expenditures and hiring to resume, the activity will not translate into new real estate demand.

A protracted oil downturn has driven technological and operational advancements in the industry. From a profit perspective, $70 a barrel oil today is what $100 a barrel oil was 10 years ago, according to Rutherford.

But Rutherford isn’t so sure that cost discipline is permanent. He’s seen a few booms and busts in his 35-year career.

"Historically, energy companies have been like alcoholics who fall off the wagon when oil goes back above $100 a barrel," Rutherford said. "We have not seen energy companies lose the discipline, but if oil continues its upward rise, we can expect oil companies to be rushing to get into the market."

In the fast-paced world of oil and gas, speed to market can easily overcome pricing and negotiation discipline.

"I wouldn’t be surprised if we see some energy companies forgetting the lessons they learned during this downturn, becoming, as Alan Greenspan once said, ‘irrationally exuberant,' " Rutherford said. Officially, JLL advises against that.

Kyle Hagerty, Houston Reporter  CoStar Group   
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