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October 2013 Exclusive Story

Real Estate Development Key In Oil & Gas Resource Plays

By Bruce Rutherford

HOUSTON–After multiple years of skyrocketing growth and production activity, why are there so few real estate options in these oil- and natural gas-rich regions? While horizontal drilling technologies promise to keep shale plays in production mode for decades, conventional thinking among real estate professionals is only beginning to catch up with the trajectory of production from the plays.

Intense demand for both commercial and residential real estate has driven production teams to improvise temporary solutions such as trailer offices and temporary housing units constructed of modular boxcar-like compartments, but that simply will not suffice much longer. This challenge represents a clear and present issue for communities in regions such as the Bakken Shale in North Dakota; the Marcellus and Utica shale plays in Pennsylvania, West Virginia and Ohio; the Eagle Ford Shale in South Texas; and the Permian Basin in West Texas. In these regions, populations of small rural towns are exploding, and the number of both temporary and permanent employees often eclipses the original size of the town itself.

Rapid economic growth is a welcome opportunity for any region, but one that can also come with growing pains. The communities near America’s oil and natural gas “shale zones” face many challenges resulting from booming development activities. One obvious challenge is infrastructure, including a significant lack of buildings to provide housing and structures appropriate for conducting highly technical operations and business.

However, real estate solutions to these challenges are emerging as investors learn more about the long-term potential of shales. This evolving interest will help address the dearth of residential and commercial real estate in communities in and around the nation’s unconventional oil and natural gas deposits.

Exploring the challenges and opportunities posed by the lack of infrastructure, and commercial and residential real estate in these economically booming regions, requires examining both their shared challenges and the unique dynamics in each of these shale zones.

Shared Challenges

Once an energy company decides to invest in a location, it needs to act fast. That is true from the perspective of competitive pressures in a business where time is money, but the company also may be racing to establish production within the primary terms of its leases in order to avoid possibly losing valuable properties.

Because most of the preproduction work needs to occur during that condensed time frame, senior management will offer little understanding if delays are caused by real estate issues, such as the inability to locate or build a warehouse, or recruit workers to a site because of a lack of housing.

Energy companies and the communities in which they operate share a number of challenges. It is important to keep in mind that for every shared challenge, there are significant shared opportunities that result from all the investment activity in areas with shale development. Some of the shared industry/community challenges include the need for additional infrastructure, housing, retail, hotel, office space and industrial facilities.

Infrastructure is a key shared challenge. Roads and utilities are sorely lacking in both the Bakken and Eagle Ford regions. While communities are funding new infrastructure projects, these large-scale installations often require longer for government approvals than energy company land leases can accommodate. Municipalities handle the issue in different ways, often asking oil and gas companies to fund and manage infrastructure projects, and working with third-party experts to identify, manage and execute construction of basic needs such as roads, and electric and water utility services.

Given the rapid swelling of communities, housing is the most visible real estate challenge in shale-rich regions, and often is the most problematic as well. Worker demographics are overwhelmingly male, and there are limited options for housing. Therefore, most are unable to bring their families to the production site.

The result is the phenomenon of “man camps,” a politically incorrect term at best, but descriptive of the temporary housing that is taking place wherein modular units are linked in strange-looking structures that are packed with single men earning high salaries, yet living in dorm-like conditions. Real estate solutions to this problem vary, but in general, communities are seeking ways to provide permanent, family-friendly housing.

To date, real estate investors and developers have been reluctant to invest in building more permanent apartments and single-family homes. After all, who wants to build an apartment complex that will be a ghost town in five years?

As the business community outside the energy industry embraces the opportunity in the long-term potential brought by horizontal drilling and hydraulic fracturing technologies, this challenge can be met with new housing stock. Energy companies are beginning to work with third-party consultants that specialize in public/private partnerships to address the broader issues of schools and community services for families, as well.

Long Lines, High Rates

Much like residential housing, there are too few stores and restaurants to effectively serve the growing energy communities. In Williston, N.D., the lines (and men shaving in the bathrooms) at Walmart and McDonalds are legendary.

Also, much like housing, as investors and retailers become more comfortable with the long-term potential of these communities, stores and restaurants will begin to open at a more rapid pace. Municipalities generally welcome retail, particularly as an immediate source of tax revenue that can often be used to solve some of the other challenges such as the need for more roads and schools.

The housing shortage is creating demand for the limited number of hotel rooms available near production sites. Therefore, for visiting energy company executives or managers on site for limited periods, the expense of visiting production sites has risen significantly. The lack of supply has resulted in skyrocketing hotel rates.

For example, on a recent stay, a run-of-the-mill hotel room near Epping, N.D., (with a permanent population of 109) required a three-day minimum at $267 a night. A comparable hotel room in suburban Houston on the same dates likely would have cost more than $100 a night less, and would not have required a minimum stay.

Hotel owners are beginning to build more properties in these regions, so additional rooms are expected to address the lack of demand in the near future.

In many of the small towns serving production areas, there is little suitable office space available. After the defense industry, the energy industry is the most technologically intensive in the world. Extraordinary technological infrastructure is necessary to address technical challenges in the field. Now, picture that requirement operating out of temporary trailers.

When addressing these needs for the longer term, most oil and gas companies want to lease space, rather than purchase. Right now, many companies are integrating their office requirements into build-to-suit industrial facilities, but they would rather not tie up capital to support real estate.

Because of that, energy companies are building office properties themselves, given that real estate is a major factor in speed-to-market. When a company has made an extraordinary investment in leases that require drilling within a certain time, the real estate must come quickly and avoid becoming a hurdle to production.

Of course, before production can begin, the drilling process requires a host of highly specialized facilities. Technological requirements are high, and other building features also differ from properties required by other industries. For example, companies specializing in downhole services and equipment need facilities in which to store monitoring equipment, both the extensive computer rooms and the actual equipment that goes into the wellbore.

Moreover, many industrial facilities must store vehicles and drilling equipment indoors, particularly in the harsh winter climate of the Williston Basin. The size of that equipment can require ceiling heights up to 60 feet, or triple that of a traditional warehouse. The facilities also must meet critical health, safety, security and environmental regulations to ensure the on-site activities are safe for the employees and the environment. Essentially, where buildings do not exist, there is now a requirement for some of the most sophisticated industrial real estate on the planet.

Bakken Build-Out

Borrowing from a political axiom, all real estate is local. Each of the challenges highlighted thus far are shared almost universally by the communities in shale-rich regions. Each region also offers a unique set of economic and social factors, as well as real estate market dynamics. So what are the real estate opportunities native to major shale areas such as the Bakken, Eagle Ford, Permian Basin and Marcellus?

The epicenter of the Bakken Shale play is the town of Williston, N.D., but the play itself spreads far and wide to include significant rural areas on all sides. Because of its geographic proximity, Williston is representative of all the great opportunities and corresponding challenges that energy companies face as they ramp up production in new communities.

North Dakota has become the second-largest oil producing state after Texas, and its crude oil production has doubled about every two years over the past decade. In response, the population of Williston has exploded, expanding from a quiet town of about 15,000 before the boom to a community of nearly 40,000.

Before this wave of drilling began, there was no real estate suited to energy company uses in any of the communities in the Bakken play area. As a result, the infrastructure is significantly overtaxed. There are more than 20,000 individuals housed in temporary camps today–the source of quite a few frustrations and social clashes with the town’s original residents.

While hotels and apartments are under construction, a two-bedroom apartment rents for $3,000 a month, and can be afforded only by highly paid energy employees, leaving other residents (including firefighters and police officers) without affordable housing options.

Oil and gas companies are turning to real estate service providers to help address the problem, bringing in developers to build the needed apartments, houses, stores, restaurants and schools. These emerging projects are expected to reduce the amount of temporary housing, and bring women and families into the community.

While North Dakota struggles with these real estate issues in real time, neighboring states are seeking to advance-manage the expected issues, once production expands into communities in eastern Montana (ironically, where the horizontal Middle Bakken drilling trend started in 2000 in the Elm Coulee Field in Richland County) and other locations west of the current drilling activity. For example, a group of 17 counties in eastern Montana has commissioned a study on how to preplan housing. The Bakken formation also extends into northeastern Colorado, South Dakota, Saskatchewan and Manitoba.

While institutional investors are intrigued by the opportunity in the Bakken area, many are concerned about an exit strategy. Additionally, concerns have been raised about overbuilding. Long-term risks are offset by rapid investment returns, with real estate investments in this region generally paying off faster and delivering double to triple the returns on similar investments in other locations.

The exit strategy conundrum also can be met by building properties flexible enough to adjust with the economy. For example, a new, full-service hotel under construction in Williston is incorporating a relatively easy way to convert the hotel into apartments, if hotel demand dips. Investors are thereby given multiple options to potentially generate revenue. Similarly, an industrial warehouse can be built for multitenant use.

Texas Two-Step

The Lone Star State is home to two of the largest and hottest unconventional resource plays in the world: the Eagle Ford Shale in South Texas and a litany of formations and horizons in West Texas’ Permian Basin.

Eagle Ford deposition underlies much of the southern part of the state, extending southwest into the Burgos Basin in Mexico. The closest major city is San Antonio, but many of the most promising drilling sites are situated in rural areas nearly devoid of infrastructure or buildings. The challenges in the Eagle Ford region are strikingly similar to those in the Bakken, with a slight advantage when it comes to weather. In South Texas, the summers may be hot, but there are no long winters during which operations cease and employees temporarily leave town.

Electric power is one of the most immediate infrastructure issues in the Eagle Ford. Discussions are under way with the state and local utilities to identify existing power lines and the best way to expand capacity. Selecting building sites is being driven both by access to electrical infrastructure and the limited roads that can carry the load capacities needed by energy companies transporting heavy equipment, pipes bound for lay-down yards, and underground drilling/production components.

Third-party real estate service providers are helping energy companies, which are not experts in land use and real estate development, to address the need to ramp up quickly by analyzing tax records, government incentive programs, and real estate development opportunities to meet their production speed-to-market goals. Operating in a desert environment with little infrastructure and few facilities within miles of a drill site is challenging enough; finding office space and housing is a different equation.

Deep in the heart of the region that gave Texas its original oil boom, new unconventional oil and gas deposits are being found and developed economically using horizontal drilling technology. Drilling locations in the Permian Basin reap more advantages of “civilization,” compared with either the Eagle Ford or the Bakken. Even though the economic activity driven by the new round of drilling in resource plays has made Midland, Tx., one of the fastest-growing cities in the United States, the city (population of about 300,000) has long been an oil and gas services hub, so infrastructure and housing are less-pressing challenges.

The need for operating real estate is less acute in this area, since it was developed years ago for conventional formations. Sites need improvement, upgrades and expansion, but it is not a case of developing from scratch, as it is in the Eagle Ford and Bakken plays.

Real estate investment in the Permian region also faces fewer challenges because the economic growth in Texas’ cities has been well documented. Since the Permian Basin is closer to those population centers, the real estate investment exit strategy is easier to articulate, and institutional investors are familiar with the economic potential in the state’s major cities.

But on the western edge of the Permian Basin, the challenges are even greater than in the Eagle Ford region. Loving County, Tx., ranks as the least-populated, least-developed county in the United States.

Different Scenarios

The Northeast United States also has experienced the emergence of two major shale plays in the Marcellus and Utica, with activity focused in southwestern Pennsylvania, eastern Ohio and northern West Virginia.

While proximity to population centers is an advantage for the Permian Basin, it can be a mixed blessing for Appalachian Basin producers. Land-use and regulatory challenges have defined where drilling may occur, creating a scenario of “haves” and “have-nots” along the Pennsylvania/New York border. The have-nots are the many farmers on the New York side of the border that are prevented from leasing their land for drilling as a result of environmental regulations and restrictions.

Real estate trends follow this same dichotomy, as the Pittsburgh area has experienced an economic renaissance. Energy companies–particularly oil and gas operators–have driven a revival in the real estate market around Pittsburgh. One new office campus hosts the regional headquarters for Shell, CNX Gas and ExxonMobil. Several million square feet of additional space has been leased since 2009 that is directly attributable to the energy industry, including a significant expansion by law firms. In the downtown office market, tenants are fighting over prime spaces, and new housing is adding to one of the most stable residential markets in the country.

Outside of Pittsburgh, some small towns are facing challenges reminiscent of the Bakken and Eagle Ford regions. However, the issues are somewhat muted because there is existing, if outdated, infrastructure and real estate that can be repurposed. In one town, a former elementary school has become an operations center.

Unemployment has become virtually nonexistent in small towns near drilling operations, and hotel room and apartment rental rates have increased along with employment in service jobs serving the expanded populations.

Energy companies have committed to significant real estate development in the region, which sends the message that they expect production operations measured in decades, not years. For example, Shell selected a site in Monaca, Pa., for a new ethane cracker that is expected to service Marcellus and Utica production volumes. Shell reports it already has commitments for the multibillion-dollar project from operators such as CONSOL Energy, Noble Energy and Seneca Resources.

Other manufacturers are expected to locate in the vicinity, and more than 10,000 jobs are expected to be created in this area.

Solutions are coming from collaborative efforts that draw on the needs and resources of the local communities, the energy companies, and the real estate community. For example, residential developments are being backed by energy companies committing to filling a number of apartments for a given time. That confirmed demand can then take the leasing risk out of a development, and assist a developer in confirming financing.

Preleasing also may emerge as a driver for the much-needed office, industrial and retail real estate in these economically booming regions. Ultimately, a preleased development–even at premium rates–is much less expensive than the temporary solutions now in place.

While the challenges of rapid growth are real, they remain a set of “good problems to have.” And solutions abound from the real estate development community and its financial partners as it works with the energy industry to address growing real estate needs across new energy frontiers.

Bruce Rutherford

Bruce Rutherford is an international director of Chicago-headquartered Jones Lang LaSalle and a specialist in tenant representation. He is also the global energy practice leader for the firm, working with energy sector companies to create real estate solutions to complex business problems. With 29 years of experience, Rutherford has managed city and regional master plans totaling more than 20 million square feet of corporate and regional headquarters transactions. He has extensive experience across North America and Asia Pacific, and has had the additional responsibility of managing many of Jones Lang LaSalle’s international client relationships. Rutherford holds a B.S. from the Georgia Institute of Technology and an M.B.A. from the Stanford University Graduate School of Business.

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