Oil prices have climbed by 27% in the past year, climbing 10% in the past month alone. As of March 2, prices for light crude U.S. oil hit $101 per barrel. Retail gasoline prices have increased 25% over the same time period, including 19% in the past month alone, and as of the last week of February they averaged $3.38 per gallon for regular grade and as high as $3.72 per gallon in California. Many believe that we will reach $4 per gallon by this summer. Food prices are also climbing sharply due, in large part, to weather conditions, thus compounding the squeeze on consumers.

As recently as a month ago, when oil hovered in the high $80s per barrel and gasoline was in the high $2.80 per gallon range, it appeared that in 2011 the nation’s GDP would grow by 3% to 3.5%, enabling job growth of two million to 2.5 million (+1.9%), up from 1 million or 0.8% in 2010. This projection will be reduced moderately with GDP taking a 0.5% to 0.75%. hit, assuming that oil stabilizes in the $100-per-barrel range and gasoline prices level off in the mid $3-per-gallon range. However, if oil should climb to $150 per barrel, and gasoline reaches the mid $4-per-gallon range, it would lower the GDP projection by approximately 1.7 percentage points and the job projection to approximately one million. This is because every $10 per barrel sustained increase in oil causes an annual decline in the GDP of approximately 0.25%. If a worse-case scenario comes true (oil reaches $175 per barrel, for example and gasoline reaches $5 per gallon), the formula says the GDP would drop to approximately 1.4% and job growth would approach zero, or the addition of only 400,000 jobs.

The broader implication of the surge in oil prices is on sentiment, which is already fragile. This recovery has lacked momentum largely due to weak corporate confidence.  Normally, I would mention consumer confidence before worrying about Corporate America, but in this recovery, the typical shopping spree of the consumer is not going to be a driver of expansion. Companies have to become confident enough to expand and add workers.

So far, they have largely opted to preserve cash, hire temporary workers and remain very conservative. Now, with a whole new concern about energy prices, this conservative stance may last longer than it would have without the recent turmoil in the Middle East. Central banks around the world lack the political will to provide further stimuli of any size and emerging markets are already in a battle against inflationary increases, so not much can be expected in terms of large-scale fiscal intervention.  The real solution is easing political tension and/or increasing energy supplies, both of which are difficult to predict.

The fundamental drivers of the economy are strong enough to avoid contraction unless the crisis truly escalates, but real estate investors need to prepare for a slower recovery in fundamentals should energy prices remain high for an extended period of time. 

Corporate profits would be squeezed by the rising cost of energy, materials and the reduced purchasing power of the consumer. Additionally, the positive net absorption of space witnessed at the end of 2010 for office, industrial and retail would be stalled as would the potential for further rent growth. Particularly hard hit would be hospitality assets (again) and properties serving industries reliant upon transportation. Remote facilities would also be hit hard. Winners – or at least minimal losers – might be commercial real estate buildings in energy-producing areas and/or near public transportation and apartments near jobs. The spread between inflation and interest rates would also likely remain low, providing opportunities for well-qualified borrowers.

On the other hand, oil and gasoline prices may stabilize, enabling the recovery to continue unabated, which would run contrary to Federal Reserve Chairman Ben Bernanke’s testimony before the Senate Banking Committee on March 1. Without question, the next few months will be interesting times.

 

Hessam Nadji is managing director, research and advisory services at Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.