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FMI Quarterly/June 2013/June 1, 2013

A Case for Optimism in the U.S. Construction Industry

getty_clover_imageThe idea that North American energy independence is achievable has major geopolitical implications for our country.

The construction industry downturn that followed the Great Recession proved to be the most severe and prolonged decline in most of our lifetimes. For the last 24 months, most of our industry has bumped along the bottom of the cycle and has shown few signs, if any, of a pending, robust recovery.

Meanwhile, the adversarial political climate in Washington and ineffectual federal policies have failed to stimulate strong Gross Domestic Product (GDP) growth and rising employment, but have managed to increase the national debt to more than $16 trillion — equivalent to the total U.S. annual GDP.

LOSS OF MIDDLE-SKILL JOBS

The broader economy is not performing much better. The federal government’s official unemployment rate as of March 13, 2013, was 7.7%, and the real unemployment rate is likely closer to 10% (see Exhibit 1). Moreover, manufacturing employment in the U.S. has declined by 19.6%, or 2.9 million jobs, over the past decade. Since the end of the Great Recession in June 2009, the manufacturing sector has added only 230,000 jobs. The loss of manufacturing and other middle-skill jobs in the U.S. workforce is a primary factor behind our nation’s shrinking middle class, which has been the mainstay of our economy for a century.

2013q2_optimism_ex1

IS AMERICA IN DECLINE?

Instead of optimism, editorial pages and cable news talk shows continuously debate the decline of America’s political and economic leadership, while touting the rise of China and other developing economies. A December 9, 2012, Washington Post editorial made the case that the economy has created a “lost generation,” and a 2012 Gallup Poll reported 53% of Americans consider China the world’s dominant economy. Can this be true? Is the U.S. a declining economic power?

The answer to such questions in the past usually came in the form of robust recovery that time after time propelled the U.S. forward as the world’s largest economy. Since WWII, the main drivers of each recovery have been federal spending, technical innovation, residential housing and/or consumer spending. Unfortunately, none of these forces will be the catalyst to get America and its construction economy growing faster in 2013.

NO MORE FEDERAL STIMULUS

In order to have sustained economic growth with full employment (less than 6.5% unemployment), U.S. GDP growth must rise to more than 3%. It is clear that federal stimulus spending and a decade-long funding of two wars has had limited, if any, sustained impact on the private-sector economy. Looking ahead, as the political drama of sequester plays out in Washington, D.C., it is fairly safe to assume that further government stimulus, let alone a robust multiyear transportation bill, are highly unlikely. In the near term, federal spending is unlikely to be the next driver of engineering and construction activity.

NO REPLAY OF THE TECH BUBBLE OR REAL ESTATE BOOM

In the first half of the 1990s, rapid growth of information technology, together with a strong stock market, resulted in a sustained business investment in technology and capital equipment, which drove U.S. economic expansion. Growth during the second half of the decade was fueled largely by a sharp rise in consumer spending and productivity gains from information technology. Following the brief “tech recession” of 2001, the residential housing sector, fueled by federal policies that kept interest rates low and cheap credit available, drove economic growth.

It has been seven years since residential construction took a nosedive into an empty swimming pool. In spite of unprecedented devaluations of residential real estate and years of historically low mortgage rates, annual housing starts remain less than 50% of their historical norms and only recently have been trending higher. Furthermore, even though housing affordability remains near its all-time high, 50 million homeowners remain behind in their mortgages. That the housing market is beginning to recover is a positive sign, but any substantial upturn will be a byproduct of falling unemployment and rising wages.

RECORD HIGH CONSUMER DEBT
American consumers have shed $1.3 trillion, or 10%, of housing (mortgage) debt since 2008. The federal government, mortgage bondholders and U.S. banking industry absorbed these losses. Unfortunately, U.S. households still owe more than $11.3 trillion in total debt, an amount that is 50% more than a decade ago. Non-mortgage consumer debt has recently reached an all-time record level of $2.8 trillion, due mainly to increases in student and auto loans. At the macro level, the American consumer is tapped out, if not under water financially. Unless wages rise and unemployment falls dramatically, consumer spending will not be a catalyst that drives the construction industry.

IN DEFENSE OF THE U.S. ECONOMY

While it may be a safe conclusion that none of the above factors will drive strong growth in the near term, it is too soon to wave the white flag and surrender U.S. economic dominance to the world’s other economies. For instance, Goldman Sachs pointed out the following statistics in its recent “2013 Outlook.”

  • U.S. economic output is more than 2.0 times that of China, 2.5 times of Japan and 4.5 times of Germany.
  • The U.S. has 5.0 times the arable land of China and 2.0 times that of Brazil. Only Russia has more arable land and water resources than the United States.
  • American stocks outperformed European, Japanese and emerging economy stocks by a wide margin from 2009 through 2012.
  • The U.S. leads the world in innovation and performs the largest amount of research and development (31%).
  • The U.S. still has a young and growing population of skilled workers compared to China, Japan and Russia. By 2035, China will have more people older than 65 than the United State population — and China has almost no social welfare structure.
  • A Gallup Poll of 151 countries reported that among those people seeking to move, the U.S. is the top destination of choice.

How will the U.S. economy remain pre-eminent in the years ahead, and what will drive economic growth and construction spending? The answer is both unconventional and promising.

THE CASE FOR AN UNCONVENTIONAL RECOVERY

The U.S. possesses some of world’s largest reserves of oil and natural gas. This fact has been known for decades. The challenge always has been how to extract the resources economically. Fortunately, recent technical advances in horizontal drilling and recovery methods involving hydraulic fracturing have made these resources accessible, transforming the global energy landscape and, more importantly, the U.S. economy. U.S. oil and gas production is booming and will have a major effect on nearly all sectors of the economy, particularly engineering and construction. While there is vocal opposition to hydraulic fracturing due to concern over potential groundwater contamination as well as air quality issues associated with drilling near population centers, these environmental challenges have had little or no effect in slowing the rate of domestic exploration and production.

TRADITIONAL PARADIGMS CONCERNING THE U.S. AND ENERGY

The U.S. is both a producer and the world’s largest consumer of crude oil products. U.S. oil consumption has exceeded production for decades, resulting in the country being a net importer of oil. Similarly, although the U.S. has one of the largest proven reserves of natural gas, it is a net importer of liquefied natural gas (LNG). Natural Gas Liquids (NGLs) from crude oil (associated gases) and natural gas production are valuable due to their use in petrochemical-based manufacturing. The U.S. is a large producer and supplier of NGLs to both domestic and international petrochemical manufacturers.

For decades, the established paradigm has been that the U.S. is dependent on imported foreign oil and increasingly less competitive against foreign suppliers and manufacturers of petrochemical and petroleum-based manufactured goods. As a result, the country’s petroleum and downstream petrochemical infrastructure has been in steady decline, due to underinvestment caused by competitive inequities and other factors, such as cost-prohibitive environmental regulations. Until recently, politicians, economists and corporate strategists assumed these trends were irreversible.

Fortunately, the established paradigm no longer holds true.

THE U.S. BECOMES THE WORLD’S LARGEST PRODUCER OF LIQUID PETROLEUM PRODUCTS

Much of the U.S. oil and gas reserves is trapped in tight formations called shale plays. Recent innovations in horizontal drilling technologies and hydraulic fracturing methods allow U.S. exploration and production companies to cost effectively extract crude oil, liquid petroleum gases (LPG) and natural gas from these shale plays. The ability to extract these resources economically has profound global implications.

Development activity in these oil and gas or gas-only shale plays is well under way, which is driving up domestic production. Exhibit 2 shows the relative size and approximate number of remaining locations to be developed within six of the most prominent U.S. shale plays.

2013q2_optimism_ex2

U.S. crude oil imports have declined by more than 2 million barrels per day since 2005. During this period, the U.S. has gone from being a net importer to a net exporter of refined petroleum products (see Exhibit 3). More significantly, the U.S. is now second only to Saudi Arabia as the world’s low-cost producer of ethane, a natural gas liquid (NGL) that is the primary “building block” for the many intermediate chemicals, plastics and resins used to manufacturer thousands
of consumer products.

2013q2_optimism_ex3

Natural gas prices in the U.S. are one-fifth of the cost in Western Europe and one-eighth the cost in China. The economic implications for U.S.-based energy producers, the petrochemical industry, utilities and industrial manufacturers are enormous.

ENERGY IS THE NEW DRIVER OF U.S. ENGINEERING AND CONSTRUCTION

The benefits of increased domestic energy production extend well beyond the U.S. oil and gas industry and are having an immediate positive impact on U.S. heavy industry, power generation, transportation and consumer product manufacturing. These activities are being funded by private-sector investment and are having significant economic impact on a growing number of regions throughout the United States. This private-sector-funded activity will be the lead driver of growth in U.S. engineering and construction activity for the next several years. The following are a few relevant facts to consider:

  • The U.S. has more than 100 years of proven natural gas reserves. The amount of reserves continues to grow each year. Much of these reserves is in unconventional shale plays in parts of the country that lack exploration and production infrastructure.
  • There is a massive build-out of oil and gas infrastructure under way, including production wells, gathering pipelines, gas process facilities, takeaway pipelines, compressor stations, transmission pipelines, fractionation plants and downstream processing and refinery facilities.
  • U.S. consumption of liquid petroleum products is projected to remain fairly constant over the next decade, according to the U.S. Energy Information Agency and PIRA Energy Group.
  • The U.S. is on pace to achieve near energy independence as early as 2020. By then, any shortfall in crude oil consumption will be sourced from Canada or Mexico.
  • Over the past seven years, the U.S. has gone from being a high-cost producer to the world’s low-cost producer of natural gas liquids (NGLs). The U.S. is both a consumer and exporter of NGLs and refined petroleum products.
  • NGLs are the primary feedstock in petrochemical manufacturing. NGLs and electricity account for as much as 80% of the total input cost.
  • There are approximately 4,700 major industrial capital and maintenance projects under way in 2013, totaling $285 billion. $55 billion of these projects are located in Texas and Louisiana.
  • Natural gas (methane) is a low-cost fuel source for power generation and has fewer emissions than coal. Natural gas is forecast to account for 80% of all added generating capacity through 2035.
  • The majority of the 12U.S.-based LNG import terminals are idle due to abundant domestic supply — operators of these terminals are seeking to convert these facilities to handle export of LNG and refined products.
  • There is currently no global market for natural gas, and U.S. exports of liquefied natural gas (LNG) are restricted to re-export of imported LNG — only at three facilities in Texas and Louisiana. New export terminal permits have been filed in the Northeast and Pacific Northwest.
  • Global demand for energy outside the U.S. will grow by 33% through 2035.
  • Worldwide demand for electricity will increase by 70% by 2035.
  • U.S. coal exports have grown by more than 100% in the previous three years as European and Asian demand continues to rise. There are currently nine new export facilities planned in the continental U.S.

The implications of these energy-related trends for the U.S. engineering and construction industry are significant. Design firms, pipeline contractors and multitrade industrial firms are experiencing tremendous demand for their services. Many U.S. and Canadian pipeline and industrial firms are growing as much as 50% per year. Already there is a growing level of concern regarding how to address shortages of skilled labor in both Western Canada and the U.S. Gulf region.

OPPORTUNITIES FOR NORTH AMERICAN DESIGN AND CONSTRUCTION FIRMS

Growth opportunities for North American engineering and construction firms extend well beyond the oil and gas and downstream refinery markets. Consider the strategic and business development implications of the following trends and scenarios:

TREND 1: Unprecedented capital investment in industrial infrastructure

Five ethane plants totaling $35 billion of construction are slated for the Texas Gulf Coast. These plants alone will consume an extraordinary amount of open-shop industrial trade labor, raising the following questions:

  • What are the implications to owners with additional projects in development, in respect to securing available labor and controlling costs?
  • Will wage inflation due to skilled labor shortages along the Gulf Coast pull open-shop labor away from Western Canada and other parts of the United States?
  • Are there opportunities for self-performing union firms to offer compelling value propositions in open-shop markets due to having negotiated wage rates and the ability to scale?
  • What do Canadian owners do to source qualified skilled labor to projects in the oil sands if U.S. labor supply is tight?

TREND 2: Current and potential revitalization of stagnant or declining regional economies

In addition to Texas and Oklahoma, much of the new unconventional oil and gas production is taking place in regions of the country where there is limited infrastructure. The regions include the Bakken Shale play in North Dakota and Montana, Utica Shale in Ohio and Marcellus Shale in Pennsylvania. Questions to consider include:

  • In addition to upstream and midstream energy construction (pipelines, stations and processing plants), what are the civil, residential and commercial construction opportunities for housing, retail, education and civil infrastructure in these markets?
  • North Dakota’s population is growing for the first time in decades. What about population centers in North Central Pennsylvania and Western New York, such as Elmira, Corning, Binghamton, Scranton and Wilkes-Barre? These declining industrial towns are being revitalized based on a new energy-based economy.

TREND 3: The transition of North America toward energy independence

North America is moving rapidly toward energy independence, and the U.S. may soon become the largest producer of liquid petroleum in the world and a net exporter of LNG and natural gas liquids. The advantages of low-cost electricity and petrochemical feedstocks are drawing petrochemical, chemical and industrial manufacturing back to the United States. Consider the following:

  • How likely are these predictions of a major U.S. manufacturing renaissance to come true, and what is the implication for U.S. industrial construction for the next decade?
  • Much of the oil and gas production is taking place in the Upper Plains and Midwestern regions that are traditional strongholds of middle-skill union labor. Is this an opportunity for these industrial communities and labor organizations to reverse years of decline through proactive measures to capitalize on these trends?
  • Other than the Gulf Coast, where will industrial manufacturers, such as BASF, Dow, Dupont, General Electric and Air Products, invest?
  • How will the transition by the U.S. market from a net importer of energy to a net exporter of energy affect global trade and national defense priorities?

TREND 4: A sustainable competitive advantage for U.S. manufacturing

China, India and other large population countries with expanding economies and rising middle-class populations have tremendous demand for electricity and energy (see Exhibit 4). North America has an abundance of coal and cheap and cleaner-burning natural gas and major cost advantages over China and India, which have neither asset.

  • How will the balance of trade manufacturing output be affected by this new reality?
  • Will U.S. coal-fired power plants be decommissioned or converted to natural gas faster than current predictions? What are the implications for design and construction of simple and combined cycle power generation and associated transmission and substation construction?
  • What is the impact overall for the growth of renewal generation from wind, solar and biomass, with U.S. carbon emissions declining due to energy conservation initiatives and the growth of natural gas as a primary fuel source?

2013q2_optimism_ex4

TREND 5: Private investment in U.S. transportation and port infrastructure

Oil transportation via truck and rail is scaling rapidly. Oil and petroleum transported by rail grew 46% in 2012. There are nine new coal export facilities planned in the U.S. and five existing plants undergoing expansion. There are at least five new export terminals in the permitting process, two newly approved LNG storage terminals in Mississippi and several more on the horizon. The total investment in intermodal transportation and port infrastructure totals in the tens of billions of dollars.

  • How can design and construction firms that lack intermodal transportation, marine and port infrastructure experience participate in these markets?

CONCLUSION

The previous recession was severe and the recovery for the engineering and construction industry has been slow. However, the potential for a sustained recovery led by private-sector investment in energy infrastructure is becoming more of a reality each month. The idea that North American energy independence is achievable has major geopolitical implications for our country. The fact that the U.S. is on the verge of being a net exporter of oil and gas to energy-dependent and fast-growing developing countries makes U.S. industry globally competitive and could very well be the solution to our national debt, trade deficit and employment challenges. Knowing that the U.S. engineering and construction firms are primary beneficiaries of these emerging trends is reason to be optimistic that a strong recovery for our industry is under way.


W. Chris Daum is a senior managing director at FMI Capital Advisors, Inc. He can be reached at 919.785.9264 or via email at cdaum@fminet.com.

 

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