University of Houston Energy Fellows , Contributor
The oil industry divides itself between upstream exploration, production and oil services, and downstream refining and petrochemical operations that turn crude oil and natural gas into useful products. Since 1980, Houston’s upstream sector has been through five major downturns in drilling, all with adverse consequences for the local economy. The current drilling downturn — the worst since the 1980’s – has hit Houston’s West Side particularly hard.
Meanwhile, largely neglected compared to its upstream sibling, the downstream refining and chemical plants in East Houston are enjoying a massive and unprecedented $50 billion construction boom. A combination of strong US economic growth and this downstream construction may be just enough to keep the Houston economy out of recession, despite the current collapse of drilling. If, in fact, newfound economic diversity keeps Houston out of a drilling-driven recession in 2015 and 2016, who would have thought the key piece may turn out to be refining and petrochemicals?
Blame it on the wind. In North America, prevailing winds follow the jet stream and blow from west to east. So if you were looking to locate a smoke-belching factory, you put it on the East Side of the city so the wind can blow smoke and soot right out of town. Put the nice homes and shops on the West Side, where smoke is hardly ever an issue. Of course, factory workers will live in more modest East Side homes close to the factories.
This is the history of many American cities, and what we mean when we refer to East Los Angeles, East Chicago, East Austin and East Houston. Heavy industry and working-class housing goes east, upscale suburbs and shopping moves to the west, and we create a civic divide that is both industrial and cultural – factory vs. office, blue collar vs. white collar.
In Houston, the split comes along Highway 59, and the Galleria, Energy Corridor, Katy and Sugar Land define the white collar, professional west, while Ship Channel cities like Pasadena, Baytown and Deer Park are inevitably tabbed as blue collar and working class. Since 1980, seven years out of 10 have seen the West Side out–perform the East Side, as drilling thrived, and the eastside refineries and chemical plants got little recognition.
This has been all the more true since 2004, as high oil prices set off a boom in fracking, and soaring drilling activity mostly worked to the benefit of West Houston. Petroleum engineers, geologists, geophysicists and high-level executive talent were in strong demand, local wages grew and tens of thousands of professional workers poured into Houston. Demand soared for high-end apartments inside the Loop, upscale retail, millions of square feet of new office space and shiny new suburbs around Beltway 8 and the Grand Parkway.
But now the biggest-ever drilling boom is over. OPEC announced in November 2014 that it would no longer act as swing producer in global oil markets, curtailing its production whenever a surplus of oil arose. OPEC would simply accept the market price and maximize revenue by producing oil at high levels. The price of crude quickly crashed to near $45 per barrel early this year and U.S. fracking and offshore drilling bore the brunt of the damage.
Spending for exploration and drilling is down by 40 percent, and the number of working rigs is down by over 60 percent. By most measures, it is the biggest collapse in drilling since the 1980s and Houston’s West Side is ground zero for this reversal. Even the light industry that supports much of the upstream demand for machinery and fabricated metal production is located in the West, along the Hardy Toll Road or on Belt 8 between the Energy Corridor and George Bush Intercontinental Airport. Since last December, about 5,400 oil-related jobs have been lost and another 16,300 in manufacturing.
Houston’s Business Cycle
Three factors drive Houston’s business cycle: exploration and production spending, the U.S. business cycle and downstream construction spending. The table below lists the five periods of largest decline in drilling since 1980. Right now, as drilling bottoms out, Houston is lucky to have both a strong U.S. economy and a major boom underway in petrochemical construction. The only other time that the U.S. economy grew strongly during a drilling collapse was the Asian financial crisis, and it was enough to keep Houston out of recession. The only other time that downstream spending was strong was the combined 2001 U.S. recession and fall of Enron, but it failed to keep Houston out of recession. All these drivers turned negative during the U.S. financial crisis and Great Recession and Houston quickly lost more than 100,000 jobs.
Even with help from the U.S. economy, the current upstream collapse would probably be enough to pull Houston into a mild recession. But two out of three growth factors are positive, with a massive East Side construction boom also underway. Once we add in these construction jobs, Houston may well skirt recession. So far in 2015, the metro area remains on track to add about 15,000 new jobs, and we expect something similar in 2016. It is not the 100,000 jobs per year of the fracking boom, but neither is it the economic disaster of the 1980s, when more than one job in eight was lost.
Stimulus from Downstream
Where does the downstream construction activity come from? Consider the role played by these large plants in the oil industry. For example, the Texas/Louisiana Gulf Coast is a major center for refining crude oil into products such as gasoline, kerosene, diesel and jet fuel. With over 6.6 million barrels per day of processing capacity, about a third of it in East Houston and the Ship Channel, the Gulf Coast is the most important refining region in the U.S. measured either by quantity processed or by the sophistication of operations.
In contrast to the refiner, the North American petrochemical producer takes natural gas liquids (propane, butane or ethane) and produces intermediate products that ultimately become plastic or synthetic rubber. For example, ethylene is the major building block on the Houston Ship Channel. In the chain of production, ethane is the natural gas liquid, ethylene is the petrochemical, and ethylene is processed into plastics such as polyethylene or polyvinyl chloride.
If you are an integrated oil company, this downstream activity nicely balances out the drilling cycle. For example, suppose oil and natural gas prices are high: exploration and production are profitable, but the downstream industries see the cost of feedstocks rise. The refiner has to reprint company price sheets and call customers to explain why gasoline or jet fuel prices are rising. In contrast, with low oil prices, the exploration business suffers, but downstream feedstock costs fall. Refining and chemical margins grow, and downstream profits offset upstream losses.
Houston is unique among large U.S. energy cities in having very extensive operations both upstream and downstream. The obvious analogy is to a large integrated oil company that smooths its revenues by combining both upstream and downstream processing. If Midland and Odessa are analogous to independent producers like Apache or Anadarko, then Houston is Exxon, BP or Shell. In the current cycle, the timing of the swing from upstream debacle to downstream success has been extraordinarily good for Houston as a whole, but it has pushed boom times from the metro area’s West Side to the blue collar East Side.
Construction of New Plants
The current construction boom in East Houston is primarily built on cheap natural gas. Fracking brought a bonanza of new domestic natural gas supplies that – unfortunately — arrived just in time for a major U.S. recession followed by a prolonged period of slow growth. Worse, there was no means to export surplus gas to global markets. The result was a collapse in natural gas prices in late 2011 that slowed drilling but set the stage for an extraordinary period of high profits in the petrochemical industry.
The low price of gas quickly spurred two kinds of investment. The biggest push was for new petrochemical plants that use natural gas liquids (priced much like natural gas) to make plastics. Why the excitement? Outside North America, the rest of the world primarily uses oil-based naphtha to make plastics and until early this year naphtha cost $100 per barrel. Meanwhile, the North American producer could make plastics with natural gas liquids at the equivalent of $20 per barrel. The result of was very large profits. From 2011 to 2014, ethylene’s price was around 60 cents per pound and for the North American producer the all-in profit margin was 40 cents per pound. Needless to say, this generated a lot of excitement about new North American petrochemical capacity and over $32 billion in construction has been announced in the Houston metro area alone.
A second major source of industrial construction spurred by cheap gas is the export of liquefied natural gas (LNG). These plants are to move natural gas out of North American and into global markets. About $7 billion in construction is underway in Houston and much more in nearby Corpus Christi, Beaumont and Lake Charles.
Finally, cheap oil has improved refining margins, and refinery expansions have recently joined the long parade of East Houston construction projects. Nearly $5 billion in projects are now underway.
Not a Perfect Offset
East Side projects now total about $50 billion and the list continues to grow. How big is this? Think of $250 million as the cost of a good-sized downtown office building and $50 billion is the capital equivalent of 200 office buildings. The employment impact? Each of a dozen large projects could easily peak with 2,000 or more workers on site and there are dozens of smaller projects. There may be another 10,000 construction workers hired in 2016. Indeed, this construction is a timely offset to the economic problems presented by the drilling downturn.
This is very good news, but not a perfect solution to the drilling bust. First, these are temporary jobs. The construction is timely, but it only will last a couple of years. As construction winds down, these large capital-intensive industries leave a much smaller number of permanent jobs behind. Construction will continue at high levels through 2016 but begins to wind down rapidly during 2017 and construction stimulus turns into economic drag as blue collar layoffs begin. It is a boom that comes with a well-defined expiration date.
The temporary nature of these jobs also means they have a different economic impact from the permanent; professional jobs that — until recently — made up the influx of new Houston workers. Additional construction workers won’t contribute to the recent strong demand for luxury apartments, office buildings, high-end retail or expensive suburban homes. These are well-compensated jobs, especially for skilled crafts, but many workers will seek temporary housing and may send money home. While they are here, the broader economic impact of these workers on the local economy might be half that of full-time and permanent office or manufacturing workers hired with similar compensation.
All qualifications aside, it is time for a tip of the hat to East Houston and the boom-time conditions on the industrial East Side. Jobs are plentiful, wages rising, rents are up and properties with rail or Ship Channel access are in strong demand. A list of the largest projects put Baytown and Freeport squarely at the epicenter of this boom. As oil-industry profits move from upstream to down, all the Ship Channel cities will shine while west Houston’s producers and oil service companies are in full retreat.
The wheel will turn again in a couple of years, oil and natural gas prices will rise and profits swing back upstream. Local economic momentum will once more shift from east to west. Meanwhile, the big winner is the entire Houston metropolitan area as the American oil industry delivers continued growth — whether energy prices are high or low.