March 10, 2020

Executive Summary

  • Oil prices plummeted by more than 30% on Monday, the largest drop since 1991, putting financial markets on edge.
  • The U.S. 10-year Treasury fell to a record low of 0.32%, down by 80 basis points (bps) in one week, and the S&P 500 fell by 7.6%—its largest decline since December 2008.
  • Energy markets were roiled over the weekend by the failure of OPEC and Russia to agree on production cuts, which was followed by unilateral price cuts by Saudi Arabia.
  • A rare dynamic of increasing supply amid lower demand is responsible for the rapid drop in crude prices.
  • Commercial real estate fundamentals of large energy-dependent North American markets that had not fully recovered from the 2015 decline in oil prices now confront another drop.

The Big Picture

Amid on-going concerns about the economic impact of COVID-19 (coronavirus), oil prices fell by more than 30% on Monday before staging a modest recovery. Energy market turbulence then spurred a flight to safety across asset classes, affecting markets more broadly. Crude oil has lost nearly half of its value since the start of the year. This is due to a rare combination of a supply shock—exacerbated by Saudi Arabia’s plans to increase production—and a demand shock (due to slowing global economic activity).

Recent events are sure to put additional pressure on smaller independent shale producers, which have already been squeezed. In the Permian Basin—the largest petroleum-producing region in the U.S.—major oil companies like ExxonMobil and Chevron, which have strong balance sheets that allow them to better weather price drops, could account for one-third of total production by 2024. 1

1Reuters. Oil majors rush to dominate U.S. shale as independents scale back. March 2019.

Figure 1: WTI Crude Oil Price History


Source: Federal Reserve Bank of St. Louis. CNBC. March 2020.

CRE Implications

Monday’s plunge in oil prices will further rattle less-than-favorable dynamics in North American energy markets. Office vacancy rates in Houston and Calgary have yet to recover from the 2015 collapse in energy prices and coinciding peak in office completions (Figure 2). Between 2015 and 2018, Calgary’s vacancy rate nearly doubled, and Houston’s rose by almost 10 percentage points.

Figure 2: Office Market Trends in Key North American Oil Markets


Source: CBRE Research, Q4 2019.

Since 2017, new supply in Houston and Calgary has declined significantly, mitigating a more severe shock. The two cities combined had nearly 8 million sq. ft. of office completions in 2015. Today, they have less than 2.6 million sq. ft. of office construction underway (less than 200,000 sq. ft. of that in Calgary). In Houston, 36% of new construction has been preleased. In short, real estate fundamentals in oil-dependent markets are weaker than they were in 2015, but today’s new supply levels won’t exacerbate the effects of plunging oil prices to the same degree.

The severity of effects on major North American energy markets will be uneven. For example, Houston continues to diversify economically and benefit from high levels of in-migration, which will help buffer it from some of the negative impacts of falling oil prices. In contrast, Calgary’s continued high dependence on energy will test its dynamics and accelerate efforts already underway to diversify the city’s economy. Other, more diversified energy markets like Denver and Pittsburgh likely will better weather the turbulence. In Mexico, the energy-dependent market of Tabasco will be affected most. But because manufacturing dominates industrial market activity in Mexico, diversifying supply chains and nearshoring by U.S. companies could mute some of the negative impacts.

The Bottom Line

The sharp plunge in oil prices and accompanying economic stress is set to hit already weakened energy-dependent real estate markets. More diversified economies such as Pittsburgh and Denver will have fewer adverse effects than less diversified ones like Calgary and Tabasco.

Overall commercial real estate fundamentals are generally well-positioned heading into a period of economic uncertainty, but downside risks have increased as COVID-19 spreads worldwide. Monetary policymakers still retain many tools beyond rate cuts to counter negative economic shocks. The market expects another 50-bp cut in the federal funds rate this month, as well as more later in the year.

On the fiscal side, the Trump administration is discussing a temporary payroll tax cut and is reportedly mulling other options, such as paid sick leave and aid to small businesses and certain sectors most impacted by the coronavirus outbreak. Over the longer term, pent-up demand and the lagged effects of monetary policy, along with potential fiscal policy responses, will help restore markets as concerns over COVID-19 eventually subside.

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