Practical analysis for investment professionals
22 December 2014

Connecting the Dots: From US Shale Oil to London Real Estate

Posted In: Economics

What do the US shale oil play and London real estate have in common? A lot, it turns out. And if oil prices keep falling, the London (and for that matter Paris) property bubble(s) will burst. So, if you want to avoid the carnage or short real estate bubbles, builders, or banks in Europe, focus on the US energy sector and OPEC. Many investors are blinded by too narrow a focus, something I call micro-macro bias.

At present, London real estate is still rising sharply. In Q3 2014, London average house prices were up 18% over the last year. The average cost of renting in London is 49% of the average income. The median house price to median income ratio in London is approaching all-time highs, registering 800% in Q1 2014. Individual neighborhoods like Chelsea and Kensington are approaching 27 times income. Average earnings are rising an anemic 1.3%, while home prices are rising at 18%. In short, Londoners, it seems, can’t afford to live in London anymore. And the problem is getting worse with time. In the past few months, the housing market in London appears to be changing. In fact, some observers are now wondering where the buyers have gone.

Let’s start the analysis by putting all of the moving parts into proper perspective. Globalization, economic reforms, aggressive use of leverage, and its enormous population have burst China onto the global stage as a burgeoning superpower. In fact, over the past 15 years or so, China has become the marginal buyer for virtually all commodities. Indeed, demand for commodities in emerging markets has increased dramatically over the last decade and a half, indicating that the locus of economic power is shifting to developing economies. In addition to China, other emerging markets (e.g., Russia) have liberalized their markets to one degree or another. Combine that with low interest rates and aggressive use of debt in the developed markets, and we had a formula for “super-consumption” of commodities worldwide.

As China’s demand for all commodities skyrocketed upward, its demand for oil increased in lockstep. As global demand for oil and other commodities shot up, it created a great deal of wealth throughout the emerging markets, for export-driven countries like China (products and manufacturing) and Russia (energy). This economic success led many investors in these countries to seek investment opportunities abroad. In Russia, the collapse of the pension system in the 1990s left many scars on the Russian people that won’t soon be forgotten. In China, the desire to protect wealth and avert government control has driven many Chinese to invest in overseas real estate. It just so happens that many Russians and Chinese chose to spend their newfound wealth on real estate in London. In recent years, 70% of new homes in London have been bought by foreign investors.

A recent article by Joe Wiesenthal illustrates that new mid-range homes in London are being bought by the Chinese and high-end homes are being purchased by Russians and Eastern Europeans. These are the marginal buyers of London real estate. And these marginal buyers have earned their wealth by the growing industrial commodity complex of developing markets. But the status quo is changing.

It is now almost 2015 and many markets have had 10 years or more to respond to higher prices as well as the higher growth levels of demand for commodities. New capacity has been added at a robust pace and continues to come on line across the commodity spectrum. Only now, China is hobbled by an enormous amount of bad debt and misspent capital. In fact, a recent study by two Chinese government researchers suggests that China wasted as much as $6.8 trillion of capital invested in the past five years alone. In order for countries to grow, there must be return on investment. Without it, all that stimulus just leads to inflation. China has seen elevated levels of wage inflation, and while official Chinese government statistics claim that overall inflation has fallen, there is ample reason to doubt those figures are accurate. And numerous stories are leaking out in the media suggesting that all is not what it seems in this Asian wonderland.

Last month, at a Russian art auction at Sotheby’s in London (a market dominated by affluent Russians), the selling rate dropped from 71% to 57% versus a similar sale last year. Moreover, sanctions against Russia, aggressive monetary policy, and falling crude oil prices have coalesced to drive down the ruble approximately 45% against the dollar this year.

Enter US energy. As a backdrop to the dramatic increase in demand from emerging markets in the past 15 years, energy companies in the United States embraced an oil-drilling technique known as hydraulic fracturing. The technique enables companies to harvest much greater amounts of oil from difficult to reach deposits locked in shale rock formations. The oil shale revolution taking place in the United States has gotten a fair amount of play in the media over the past two years. Impressively, the United States has completely reversed a roughly 30-year decline in production. Since falling to a low of about 5 million barrels a day in 2008, the United States has increased production by about 77% in the past five years to reach about 8.9 million barrels per day today. And recent reports suggest the trend has some longevity (at least over the next 5–10 years) and at lower prices than many thought. So, the US contribution to marginal supply looks strong.

But what about OPEC? Well, we just received a big clue from them last week. Despite the massive increase in production from the United States, and rather than cut output in an attempt to keep prices stable, OPEC announced that they will maintain their current production levels and let the market sort it out. Ergo, marginal supply will continue growing.

Oil prices are now down about 45% from their 2014 peak of about $102 per barrel in June to $57.13 as of this writing. But marginal demand (outside the United States) is slackening. Japan is in recession. China’s bad debt problems are slowing its growth. Emerging markets are sputtering and the ruble is falling. Europe is weakening as well. Unless something changes these emerging trends, the flow of new money out of Russia and China will slow to a trickle and then new real estate investment in London will weaken.

And Londoners can’t make up for all the diminishing Chinese and Russian wealth. And if oil prices continue to fall, pop goes the real estate bubble in London. Boom.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: © Li

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

15 thoughts on “Connecting the Dots: From US Shale Oil to London Real Estate”

  1. RG says:

    Good second degree and other derivative impacts of the falling oil prices

    1. Thanks for the comments RG.

  2. myda zafar says:

    so by this logic (slowing down of europe’s & china’s economy), the real estate bubble in london is all set to burst!

    1. Myda, thanks for your comments as well. And yes, I agree, a weakening of other markets only bolsters this case. Cheers!

  3. jcrick says:

    Be good for London to be affordable for Londoners once more…

  4. Jeff M says:

    I think the overall connection of capital flows is prescient, but fails to acknowledge deeper drivers in real estate markets. Those drivers being inventory levels, new housing starts and absorption rates.

    Your analysis suggests that the London market is going to experience a slowing in absorption, and I don’t think any reasonable person (including me) would disagree with you in that regard.

    However, if a real estate market is going to experience any significant decline, lower absorption rates have to combine with inventory levels reaching overbuilt levels (I believe the US had something like 3-5 years of unsold housing inventory at its peak) and housing starts that are significantly above the market’s requirement to fulfill demographic needs.

    Finally, the market needs some sort of impetus for selling activity. Given the political situations that have brought wealth from developing markets to London, I don’t see a lot of wealth preservation alternatives for these buyers so a mass exodus is pretty unlikely in my view.

    1. Hi Jeff, thanks for the comments. You raise excellent points about the dynamics within the London real estate market, regarding which my article is silent. Nevertheless, the elevated prices have clearly been driven by demand from Russia and China and as that marginal demand dries up, prices should fall. The only thing that would stop it is if a third party (say wealthy Americans) began buying up London real estate to resume the demand levels that had been in place. However, this seems unlikely that another country would step in, in my view. Thanks again – I appreciate your suggestions.

  5. Gulzhan says:

    Yup, that does sound logic. Why does Europe then go on pushing those sanctions against Russia?! It’s like cutting a tree branch on which one is sitting. Insane.

  6. Hasan says:

    Hi Ron, The latest developments in international markets (few inter-connection u’hv beautifully highlighted), wud lead 2 another ever growing global systematic risk, much of the legislation being made in recent past like Basel counter cyclical buffer, Liquidity ratios, centralized Counterparty for OTC trading, CVA /DVA adjustment, solvancy II rules, Dod act and many more etc, would all lag to highlight JUMP 2 Crisis behaviour of sovereigns. I reckon de up coming mounting pressure b again on Europe including Germany, n China Russia US n offcourse gulf b out of trouble in early years due to large manufacturing base, Huge inside potential, n indeed potential 2 transfer the endangers 2 other economics.

  7. Hasan says:

    Pls treat a full-stop after Germany. Thanks

  8. Prafulla Saboo, CFA says:

    Well written article Ron. There are similar trends in the real estate in NYC too . We have heard of crazy cash down real estate purchases in Manhattan in the past few years by Chinese and Russian buyers . The connection and conclusion looks logical. My only skepticism is that we are basing this on the premise that these investors are a major % of market makers , that number may not be very high in my opinion. Therefore their ability to cause a burst may be limited . They will certainly affect the prices and inventory .

    1. Hi Prafulla, Thanks for your comments. I would be curious to see foreign ownership of real estate in NYC. As noted in links to the article above, that data is published for London. And it is quite clear that foreign demand there has been large and growing and that demand is coming from China and Russia.

      1. Andrew Arbenz says:

        Related to New York, I recently read in the New York Times that 70% of new condos sold in the most desirable midtown Manhattan area are unoccupied most of the year. One can assume that many of these homes were purchased by international buyers.

        1. Thanks for the anecdotes, Andrew! I’m sure there are many cities feeling the pinch in real estate as flows from China and Russia dry up…

  9. Saleem Ansari says:

    It would be interesting to include the impact of 100s of billions of loans to the fracking industry going sour and the possibility of a forced rate hike by the Fed.

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