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DALLASFED
SECOND QUARTER 2014

Southwest
Economy

}

Strength of Economy, Limited
Benefit Eligibility in Texas Curb
Long-Term Unemployment Rate
PLUS
ffBanking Recovery Could Be Vulnerable to Interest Rate
Increases

ff‘Reforma Energética’: Mexico Takes First Steps
to Overhaul Oil Industry

ffOn the Record: Texas Students Often Lack Skills,
Financial Knowledge for College Success

ffSpotlight: Would a Texas Central Bank Set Rates Higher?

PRESIDENT’S PERSPECTIVE

long-awaited
}Mexico’s
energy reform should, if
carefully and deliberately
implemented, increase oil
and gas production and
reverse a nine-year trend
of declining output.

s someone who spent his childhood in Mexico
City, I find the growing prominence of Texas’
southern neighbor and largest trading partner
one of the most gratifying developments of my
lifetime. Structural reform in Mexico—handled judiciously,
especially as U.S. economic growth accelerates and Europe
recovers—can pay off handsomely for its population and
those who work and invest there.
Mexico’s Congress approved a dozen reform bills that
became law in 2013, five requiring constitutional amendments. To put that in perspective, the current government
accomplished more in the past year than the three preceding administrations combined. Mexico has revamped its
education and telecommunications systems, amended its
labor laws and liberalized its financial and energy sectors—
including a plan to open up the oil and gas sector to private
investment.
Mexico’s long-awaited energy reform should, if carefully and deliberately implemented, increase oil and gas
production and reverse a nine-year trend of declining
output that has constrained Mexican exports, industrial
production and gross domestic product and adversely
impacted government revenues.
My colleagues and I at the Federal Reserve Bank of
Dallas visited with our counterparts at Mexico’s central
bank, Banco de México, in March. We were impressed by
the optimism these reforms have inspired, and we would
encourage others to pay close attention as Mexico’s oil and
gas industry, in particular, is opened to outside investment
and expertise. Michael Plante and Jesus Cañas explain in
this issue of Southwest Economy the potentially far-reaching effects Mexico’s energy reform could have on future
prosperity.
Unlike many emerging-market nations, Mexico has
seized the opportunity to make some tough decisions
during a difficult period in the past few years and is more
resilient and globally competitive as a result. Macroeconomic stability, openness to trade and a unified commitment to confront rather than run from market forces
indicate that the Mexican economy is no longer emerging;
it has emerged.

Richard W. Fisher
President and CEO
Federal Reserve Bank of Dallas

Strength of Economy, Limited
Benefit Eligibility in Texas Curb
Long-Term Unemployment Rate
By Anil Kumar

unemployment rate
}An
with a persistent longterm component can
be more detrimental to
the economy than the
same jobless rate with
a smaller share of longterm unemployed.

sharp rise in the U.S. unemployment rate was a defining
feature of the Great Recession.
The rate more than doubled,
from 4.5 percent in prerecession 2006–07
to a postrecession peak of 10 percent in
2009.
The increase in the percent of longterm unemployed—those jobless for
more than six months—was even more
compelling. The 12-month moving average of the long-term unemployment rate
rose more than fourfold, from 1 percent
before the recession to a postrecession
peak of 4.1 percent, a level unprecedented in the postwar United States.
While the overall unemployment
rate is of central concern for policymakers, its composition has important policy
implications. An unemployment rate
with a persistent long-term component
can be more detrimental to the economy
than the same jobless rate with a smaller
share of long-term unemployed. Very

Chart

long durations off the job can lead to
considerable skill depreciation, permanently limiting productivity. Moreover,
the relative effectiveness of Federal
Reserve monetary policies and federal
government fiscal policies differs when
the long-term component of unemployment is high.
Increases in the Texas unemployment rate, reflecting a shorter recession and stronger job growth during
the recovery, were somewhat subdued
relative to those of the nation. Similarly,
the spike in long-term unemployment
was comparatively limited in Texas,
although the state still experienced a
surge.
From prerecession long-term rates
similar to the nation’s 1 percent of the
labor force, the Texas rate almost tripled
to a high of 2.9 percent in 2011 (Chart 1).
The average period that a Texas worker
was unemployed doubled from 15 weeks
before the recession to a high of 30 weeks

Texas Long-Term Unemployment Rate
Remains Below U.S. Rate

Percent of labor force, 12-month moving average*

U.S. unemployment
rate

9
8

Texas
unemployment rate

7
6

6.1

U.S. long-term
unemployment rate

5
4
3

2.7

Texas long-term
unemployment rate

1
0

7.2

1.8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

*Seasonally adjusted.
NOTE: The long-term unemployment rate depicts the percent of the labor force that has been unemployed 27 weeks or
more. Shaded areas indicate U.S. recessions.
SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

in 2011; nationally, it increased from 16
to 37 weeks.
Long-term unemployment in
Texas—along with headline unemployment—continues to be below national
levels across almost all major demographic and industry groups, though
it remains higher than prerecession
averages, the Bureau of Labor Statistics’
monthly Current Population Survey data
show. Differences in demographic and
industrial composition account for only
a small portion of Texas’ lower incidence
and duration of unemployment vis-à-vis
the nation.
Those out of work in Texas continue
to enjoy a higher job-finding rate than
their counterparts nationally, whether
they are unemployed short term or long
term. The state’s higher job-finding
rate has resulted from a combination of
factors that include greater job growth,
a strong energy sector and a milder
housing market downturn. During much
of the recession and recovery, a somewhat greater percentage of unemployed
Texans left the labor force—where they
were no longer counted among the jobless—relative to their counterparts across
the nation. Both the greater ability to find
work and higher incidence of dropping
out of the labor force helped keep longterm unemployment lower in Texas than
in the U.S.

Long- and Short-Term Unemployment
During the recovery, the headline
unemployment rate and the ranks of the
long-term unemployed have decreased
slowly but steadily in the state and nation. The Texas unemployment rate has
declined 3.1 percentage points from its
peak of 8.3 percent in 2011 and stood at
5.2 percent in April 2014, approaching its
prerecession average of about 5 percent.
Meanwhile, long-term unemployment is less improved. The 12-month
moving average of the long-term rate
in Texas has declined a percentage
point since 2011 to 1.9 percent of the
labor force in February 2014. The share
of the long-term unemployed among
all jobless workers is 30 percent—14
percentage points higher than the
prerecession share, suggesting that
improvement within this group hasn’t

ployment rate remains lower than the
nation’s across virtually all demographic
groups (Chart 3). The rate for most demographic groups in Texas was about the
same as the national average before the
recession. Thus, almost the entire difference among groups between Texas and
the nation emerged after the recession.
Prerecession differences in longterm unemployment between Texas and
the U.S. were significant only in the construction and manufacturing industries
(Table 1), and the gap widened after the
recession. The construction sector was
the hardest hit of all sectors in the Great
Recession’s sharp housing downturn.
At the national level, long-term un-

kept pace with advances for the shortterm unemployed.
Tepid gains among the long-term
unemployed are a key reason the headline rate remains high relative to prerecession levels four years after the Great
Recession ended. The overall unemployment rate in Texas is broken down
into short term (less than 15 weeks),
medium term (15 to 26 weeks) and long
term (27 weeks or more) in Chart 2. The
short-term rate is already back to prerecession levels, and the medium-term
rate is not far behind. But the long-term
unemployment rate remains well above
prerecession levels.
However, Texas’ long-term unem-

Chart

Short-Term Unemployment Rate in Texas
at Prerecession Levels as Long-Term Rate Lags

Percent of labor force, 12-month moving average*

Short-term
unemployment rate
(<15 weeks)

4.5
4
3.5

3.3

3
2.5
Long-term
unemployment rate
(27+ weeks)

2
1.5

1.8

Medium-term
unemployment rate
(15–26 weeks)

.5
0

1.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

*Seasonally adjusted.
NOTE: Shaded areas indicate U.S. recessions.
SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

Chart

Texas Long-Term Unemployment Rate Declines,
Remains Below U.S. Rate for All Major Groups

Percent of labor force

9
8
7
6

Percent of labor force

Texas
2010-11
2012-13
Prerecession

9
8
7
6

le g 4
e k p. str. g.
f
ale a n 5 + it c
M Fem You 25– 55 Wh Bla His Con M

U.S. minus Texas
2010-11
2012-13
Prerecession

le g 4
e k p. str. g.
f
ale a n 5 + it c
M Fem You 25– 55 Wh Bla His Con M

NOTE: The long-term unemployment rate depicts the percent of the labor force that has been unemployed 27 weeks
or more.
SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Table

Long-Term Unemployment Rate Varies Across Industries,
Lower in Texas
Texas

U.S.
minus
Texas

2004–07 2004–07

Texas

U.S.
minus
Texas

2008–09 2008–09

Texas

U.S.
minus
Texas

Texas

U.S.
minus
Texas

2010–11 2010–11 2012–13 2012–13

Mining

0.6

0.5

1.6

1.7

3.8

3.5

1.3

1.6

Construction

0.7

1.1

1.5

3.5

3.2

7.6

2.5

4.6

Manufacturing

0.8

1.2

1.5

2.8

2.9

5.4

2.2

3.1

Wholesale/retail

0.9

1.0

1.2

2.1

2.6

4.2

2.1

3.3

Transportation

0.6

0.7

1.1

1.7

2.1

3.7

1.5

2.6

Information

0.8

1.1

1.7

2.2

4.3

4.1

2.3

3.1

Financial activities

0.6

1.1

1.7

1.9

3.5

1.8

2.2

Professional and
business services

1.2

1.1

1.4

2.3

2.9

4.4

2.1

3.4

Educational and health

0.4

0.5

0.6

1.0

1.4

2.1

1.4

1.9

Leisure and hospitality

1.2

1.3

2.4

3.7

4.4

2.3

3.5

SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

employment in construction increased
from about 1 percent before the recession
to 7.6 percent in 2010–11, before declining to an average of 4.6 percent over
2012–13. Texas, benefiting from a milder
housing downturn and stronger recovery,
experienced much smaller swings, with
long-term unemployment in the sector
standing at 2.5 percent in 2012–13.

Persistently High Rate
Economists and policymakers have
been puzzled about the headline unemployment rate’s slow decline following
the Great Recession. Recent research
shows that structural factors involving
age, education, industry or occupation
are relatively less important than other
supply- and demand-side explanations.1
The extension of unemployment
benefits may have boosted the supply of
individuals looking for work, reducing
their job search costs and possibly contributing to the higher unemployment
rate. On the demand side, recruiting
intensity declined as employers less aggressively filled vacancies after the Great
Recession, a recent paper found.2
Supply and demand factors affect
the transition of workers in and out of
unemployment. Joblessness rises if the
“inflow” rate—employed workers leav-

ing jobs, or people out of the labor force
seeking to reenter it—exceeds the “outflow” rate—individuals finding employment or dropping out of the labor force.
The outflow rate is a key determinant of the extent of long-term unemployment. The part of the outflow rate
measuring the proportion of individuals
moving from unemployment to employment—known as the job-finding
rate—plunged nationally from 28 percent
in prerecession 2006 to an average of
17 percent during the downturn. It
remained sluggish during the recovery
from the 2007–09 slump (Chart 4A).3
The rate at which unemployed
individuals dropped out of the workforce also declined dramatically during
the recession and, along with the lower
job-finding rate, contributed to the rising unemployment rate (Chart 4B). The
number of unemployed people quitting
the labor force has slowly increased during the recovery.
The Texas job-finding rate has
exceeded that of the nation since the
recession—helping tamp the state’s unemployment rate increase. Additionally,
because relatively more people in Texas
dropped out of the workforce, the state’s
unemployment rate increase wasn’t as
great as in most of the U.S. The higher

rate of labor force exits in Texas could be
in part because the duration of unemployment benefits was, on average, lower
and eligibility for benefits more limited
than elsewhere in the country.
Nationally, the entry of those who
had been outside the labor force also
helps explain the rising unemployment
rate during the Great Recession.4 Moreover, the rate at which people returned
to the workforce and managed to find a
job declined significantly across the U.S.
The figure in Texas was smaller—indicative of people finding jobs in a relatively
healthier economy.

Duration Dependence
Economic job search models during times of unemployment show that
the length of joblessness is negatively
correlated with the likelihood of landing
work—a phenomenon also known as
duration dependence. In other words,
the longer someone is away from the
workplace, the less likely he or she is to
find a job (Chart 5A).
There are several potential explanations for this. First, skills and productivity are lost over time. Employers
subsequently question why no one else
has hired the long-term unemployed,
inferring that the candidate has negative
qualities. Recent research shows that
exiting unemployment becomes particularly difficult if joblessness lasts longer
than nine months; there is no significant
duration dependence for lesser periods.5
Nationally, someone just out of
work has a 30 percent chance of finding another job, on average, in the next
month, while a person whose joblessness
has lasted more than 26 weeks has about
a 14 percent probability of finding a job
in the next month, as seen in Chart 5A.
Due to stronger job growth and shorter
unemployment-insurance benefit duration, an average worker in Texas is more
likely than someone in the rest of the
nation to exit joblessness and find a job
at all durations of unemployment.
There doesn’t appear to be a similar
relationship involving time without
work among the unemployed who
subsequently drop out of the labor force
(Chart 5B). Additionally, the likelihood
that an unemployed individual will

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Chart

Fewer People Find Jobs, Drop Out of Workforce
During Recession

A. Job-Finding Rate for Unemployed Higher in Texas than Nation
Percent, annual average*

50
45
40
35
30

27.7

Texas

20
15
2006

U.S. minus Texas
2007

2008

2009

2010

2011

2012

2013

18.7
2014

*Unemployed in a given month who found a job the next month.

B. Some Unemployed Exit Labor Force During Weak Recovery
Percent, annual average**

31
29
27

Texas

24.4

23.5

U.S. minus Texas

19
17
15
2006

2007

2008

2009

2010

2011

2012

2013

2014

**Unemployed in a given month who exit the labor force the next month.
NOTE: Shaded area indicates U.S. recession.
SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

leave the labor force is somewhat higher
in Texas than in the rest of the nation,
regardless of unemployment length.
A slightly higher transition rate from
unemployment to nonparticipation,
particularly among Texans off the job
for longer periods, could be partly due
to a two-week shorter average potential
duration of unemployment insurance
benefits in the state. A longer period
of benefits in the rest of the U.S. likely
prompted the unemployed to keep looking for jobs and remain in the labor force.

Extended Unemployment Benefits
Generous unemployment benefits
subsidize the cost of a lengthy job search
and have long been linked to longer
joblessness periods. Although enhanced

benefits can lengthen duration by lowering job search intensity, they also provide
fiscal stimulus by increasing consumption among the unemployed who are
otherwise credit constrained. Recent
studies regarding the impact of benefit
generosity on unemployment duration
and the jobless rate find only modest
positive effects.
The average period of unemployment nearly doubled, from 18 weeks to
35 weeks, during the Great Recession.
The increase was larger for those eligible
for unemployment benefits, whose duration rose by more than 20 weeks.6 This
longer length of joblessness is equivalent
to a 0.8 percentage point increase in
unemployment that can be attributed
to unemployment benefit extensions.

Estimates in the literature indicate that
the impact of extended benefits on the
unemployment rate in the postrecession
period was likely less than 1 percentage
point. To be sure, part of the increase in
the unemployment rate was due to the
unemployed either reducing job search
efforts or declining some job offers in order to prolong benefit receipt—economically, not a desirable outcome.
But some of that increase was also
due to individuals prolonging their job
searches—to qualify for unemployment
insurance—rather than dropping out of
the labor market. As much as half the impact of extended benefits on the unemployment rate can be traced to increases
in the labor force participation rate,
according to a recent study. The remaining half was attributable to the benefits’
disincentive effects on reemployment.7
Texas historically has had fewer
unemployment benefit recipients as a
percent of the total unemployed than the
nation (Chart 6).
This is partly due to the shorter duration of unemployment benefits in Texas.
Data from the U.S. Department of Labor’s
Employment and Training Administration indicates that the average potential
duration of unemployment benefits—the
maximum entitled benefit divided by the
weekly benefit amount—reached a high
of 22.2 weeks in 2009 in Texas, about two
weeks less than the national average.
Regular unemployment compensation is a state-funded, federally administered program that provides a maximum
of 26 weeks of benefits and is designed to
replace, on average, 50 percent of wages
for individuals who are involuntarily
dismissed from jobs without cause. Once
regular unemployment is exhausted, and
if a state’s unemployment rate is high,
benefits can be extended 13 to 20 weeks
under the permanent Extended Benefits
program, which the federal and state
governments fund equally.
Additionally, Congress can authorize 100 percent federally funded
temporary unemployment insurance
during national recessions. Congress
last created such a temporary Emergency Unemployment Compensation
program in July 2008; it expired last
Dec. 31 after several extensions. The

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

program provided 47 to 63 weeks of
additional benefits in 2012 and 2013,
the exact length of payments dependent
on the jobless rate in individual states.
In states with persistently high rates of
unemployment, the maximum potential
duration of benefits under the three
programs reached 99 weeks.8
The duration of extended benefits
under the Emergency Unemployment
Compensation program was relatively
short in Texas, whose unemployment
rate was lower than most other states’.
Benefits were further limited by the
state’s milder downturn, as well as by layoffs and permanent job losses that were
significantly lower than in the nation.

Policy Implications
The extent of long-term unemployment has important implications for
Federal Reserve monetary policy, whose
goals are price stability and low unemployment. A higher unemployment rate
typically depresses wages and prices. A
relatively higher proportion of longterm unemployed among the jobless
can dilute this influence on wages and
prices, and implies a diminished impact
of monetary policy on the unemployment rate.
While chronic long-term unemployment potentially weakens the
case for monetary policy intervention,
it raises the stakes for fiscal policy. If
workers are potentially exposed to long
periods off the job, they may start saving
more money when they do work, simply
to get by when they are unemployed.
Such savings most immediately slows
consumer spending and impedes shortterm economic growth.
Moreover, the long-term unemployed may have considerable difficulty
finding jobs. If employers have inadequate information about worker quality,
they may use length of unemployment
as an indicator. Workers also are wary of
investing in their own skill improvement
if they think they will be unemployed
for a long time and, thus, become even
more unmarketable to employers.

Chart

A. Job-Finding Rate Declines with Length of Joblessness
Percent*

40
35
30
25
20

Texas

9.5

U.S. minus Texas
8.4

5
0

25
29
33
41
Unemployment duration

*Percent of unemployed in a given month who found work the next month, by weeks of joblessness between 2008 and
2013 (1 = 1-4 weeks, 5 = 5-8 weeks, etc).

B. The Unemployed Exit the Labor Force at All Lengths of Joblessness
Percent**

35
30

Texas

28.0
25.8

25
20
U.S. minus Texas
15
10

25
29
33
41
Unemployment duration

**Percent of unemployed in a given month who left the workforce the next month, by weeks of joblessness between
2008 and 2013 (1 = 1-4 weeks, 5 = 5-8 weeks, etc).
SOURCES: Bureau of Labor Statistics’ Current Population Survey; author’s calculations.

Chart

Texas Has Fewer Unemployment Insurance Claimants
than Nation

Percent unemployed claiming unemployment insurance

50
45
40
35
30

U.S.

28.2

25
Texas

20
15

(Continued on back page)

Length of Unemployment Affects Job Finding,
Influences Labor Force Departures

21.4

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

NOTE: Shaded areas indicate U.S. recessions.
SOURCES: Bureau of Labor Statistics; Department of Labor Employment and Training Administration; Haver Analytics.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

ON THE RECORD
A Conversation with Jeff Webster

Texas Students Often Lack
Skills, Financial Knowledge
for College Success
Jeff Webster is assistant vice president for research and analytical
services for TG (Texas Guaranteed Student Loan Corp.), a nonprofit
that promotes educational access and administers the Federal Family
Education Loan Program. He has studied student loan default, debt
burden and student retention.
Q. When it comes to college enrollment, education funding and
graduating on time, how do Texas
students fare?
Unfavorably, if you are concerned
about college attainment and timely
repayment of student debt.
Among all U.S. ninth graders, 21 percent will go on to graduate high school
on time, enroll in college the next fall
and graduate within 150 percent of the
program length. Only 14 percent of Texas
ninth graders managed to do the same.
The difficulties begin early.
Based on 2012–13 Preliminary SAT
(PSAT) scores, only 37 percent of Texas
high school juniors who took the test are
college ready, compared with 49 percent
nationally. Texas students’ SAT scores
in critical reading, math and writing
trail national averages, reflecting a lack
of preparation for college. Regardless
of income level, taking a college preparatory curriculum greatly enhances
your odds of going to college. Without a
college-prep high school diploma, many
will forgo or delay college enrollment. If
they do enroll, nearly all will do so in an
open-admission community college.
The readiness gap partially explains
why Texas students choose community
college at higher rates. Community
colleges account for 45 percent of Texas
postsecondary students, compared with
32 percent for the nation. Community
colleges are also the lowest-cost option
for students—and this matters to Texas
students. One’s ability to pay for college
shapes his/her educational experience in

important ways.
Since community college students
tend to be more cost sensitive and debt
averse, they often delay enrollment,
attend part time and work full time.
While this strategy limits out-of-pocket
expenses, it disengages students from
campus life and can lower their odds
of completion. Although less than 27
percent of Texas undergraduates at fouryear colleges enroll part time, 64 percent
of Texas community college students do.
This large group drops out at higher rates.

Q. What are the biggest barriers
to bachelor’s degree attainment in
Texas?
It’s a combination of low academic
preparedness and inability to afford college. The two interact in interesting ways.
Texas has pockets of high poverty where
underfunded school districts often lack
the resources to adequately prepare their
students for college. While polls indicate that American parents want their
children to go to college, low-income
families are far less confident in their
ability to pay. When college isn’t financially viable, few students will commit to
a challenging high school curriculum. In
2011–12, Texas provided only a quarter
of the college grant aid that California
did. Student aid has always held out the
promise of removing financial barriers
and, for many, it has been crucial to their
access and success in college. But each
year that federal and state governments
reduce their commitment to college affordability, more students are unable to

earn a college degree.
My team conducted a study in 2009
that estimated that Texas loses about
52,000 bachelor’s degrees per year due
to financial barriers. If students from
the bottom three quartiles of earnings
enrolled and graduated at the same rates
as students from the top quartile, our
state’s workforce would be the envy of
the country. What makes the college experience different for the upper income
quartile? They are far more likely to enroll at a four-year college straight out of
high school, attend college full time and
work manageable hours that complement their academics. This makes for an
enriching college experience that is far
from the norm in our state.

Q. How much student loan debt do
Texas college students have, and
how does that compare with students in the rest of the nation?
Texas students borrowed about
$5.5 billion in 2011–12. Cumulatively,
current and former Texas students have
about $70 billion in outstanding student
loans. The national figure is $1.2 trillion, so per capita, Texas students have
borrowed less than students in other
states. Most of this borrowing is from the
federal government. Because of inadequate grant aid, 60 percent of direct aid
awarded annually in Texas is through
loans, compared with 51 percent nationally, so loans remain especially important here.

Q. Why do Texas college students
take on less debt?
Texas students are more likely to enroll in short-term, low-cost community
colleges, so borrowing is less frequent
and loan amounts are lower. It is also
more common for Texas student borrowers to fail to complete their programs of
study; these students borrow less than
the graduates.
Low-income students, especially
those who have had negative experiences with debt, usually fear debt. They
pursue strategies to limit their need to
borrow—such as enrolling part time at
community colleges and working full
time. This comes at a greater risk of dropping out of college.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

message to students should adjust to a new
}Our
understanding: Go to college with a plan for what
you will study and how you will use that education
in a career.

Q. Default rates on student loans
are high and rising. Why do students
take on more debt than they can
repay?
Texas students gravitate to shortterm programs, whether at community
colleges or at for-profit career colleges,
where default rates are more than twice
as high as at four-year schools. But we
need to think carefully about that comparison. Remember, these schools serve
a different population than four-year
schools. Their students are more likely to
be from low-income families and need
developmental education. While Texas
short-term programs generally offer
quality education at affordable prices,
they serve a population at much higher
risk of dropping out and defaulting on
their student loans.
Students want to graduate, but
whether due to financial or academic
circumstances, some will not. Without
that credential, and the skills acquisition it represents, students rarely get the
income boost they were expecting when
they borrowed. Those who fail to earn
their degrees are about three times more
likely to default than those who graduate. But they aren’t the only ones who
struggle to repay their loans.
TG and other large student loan
guarantee agencies participated in
a study with the Institute for Higher
Education Policy, which resulted in the
report “Delinquency: The Untold Story of
Student Loan Borrowing.”
Researchers learned that even student borrowers who graduate encounter
repayment difficulties. Thirty-eight
percent of such graduates either became

delinquent or defaulted on their loans
within five years of graduation. Many
in higher education are familiar with
U.S. Census Bureau data showing that
bachelor’s degree recipients earn about
$1 million more over their lifetimes than
those with only a high school diploma.
Typically, this is depicted with an
upward-slanting line showing greater
lifetime earnings with higher levels of
education. Many use this iconic chart to
tell students, “Just go to college.” But if
one digs deeper into the data, one sees
a different picture that requires a more
nuanced message.
The deeper dive reveals substantial
variance in earnings outcomes, especially for the highest levels of education. By
looking at the 25th and 75th income percentiles by level of education, we learn
that significant percentages of people
with “lower” levels of education out-earn
many people with advanced degrees.
From National Center for Education Statistics data, we discovered that students’
choice of major explains much of this
variance, along with how they apply their
training to an occupation.
Our message to students should
adjust to this new understanding: “Go
to college with a plan for what you will
study and how you will use that education in a career.” Granted, this is a more
complex message to deliver, but by heeding this advice, students will see more
favorable debt-to-income ratios and
have a more realistic expectation of their
future standard of living.

Q. With rising college tuition and
relatively flat income growth, what
are the alternatives to debt?
The state should view student grant
funding as the valuable investment it is.
Otherwise we will continue with more
part-time enrollment leading to lower
graduation rates and higher default
rates. Clearly, more high school students
taking more rigorous classes, especially

advanced placement credit courses,
would ease the debt burden of students,
but this is unlikely to happen without a
clear sense that college will be affordable. So, debt will remain a necessary
evil to students with financial need. This
makes more thoughtful and directive
counseling of students crucial.

Q. What does your work suggest is
the biggest problem with student
loan debt in Texas? How do we fix it?
Students seldom understand the
commitment they’ve made when they
take out a student loan. Required loan
counseling occurs twice, once when
students are still figuring out college
life—and are unlikely to contemplate the
importance of their debt—and then at
the time they leave school. Those most
in need of loan counseling have already
dropped out of college, and they seldom
bother to complete the exit counseling.
Students participating in both of
these federal online counseling sessions often report that the experience is
complex, legalistic, unintuitive and often
irrelevant to their individual circumstances. These online tools need to be
fundamentally revised to make them
more user-friendly and comprehensible.
Students also need access to comprehensive counseling on an as-needed
basis.
The state of Texas will soon launch
a pilot program that will provide critical
consumer information for students,
especially as it relates to borrowing and
career planning. The pilot will include
financial literacy training, annual loan
counseling, college-going tips and access
to a contact center with expertise on a
wide range of financial and student aid
topics. This pilot will also convene practitioners and experts from financial aid,
academic advising and career counseling to explore ways of better coordinating
counseling messages to students.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Banking Recovery Could Be Vulnerable
to Interest Rate Increases
By Kenneth J. Robinson

}

The earnings on assets—
generally loans—may not
respond as rapidly as the
cost of funds—deposits—
leading to declining
profits.

fter being hit hard by the
financial crisis and resulting
recession, the banking industry
is bouncing back amid a prolonged low-interest-rate environment.
Still, even as profitability rose last year
and asset quality problems continued
to recede, questions remain about what
will happen when interest rates return
to more normal levels, challenging bank
performance.
The traditional business of banking
can result in a mismatch in the maturity
structure of assets and liabilities. For
example, banks may offer 30-year mortgages or long-term loans to businesses
and fund these loans with short-term
deposits that either have no explicit
maturity, such as savings accounts, or
maturities that might last five years or
less, such as certificates of deposit. This
type of asset and liability structure exists
because customers often want long-term
loans but relatively quick access to their
savings.
Because of this mismatch, banks
are exposed to what is known as interest
rate risk. In particular, an institution with
more long-term assets than liabilities is
vulnerable to rising interest rates. In this
scenario, the earnings on assets—generally loans—may not respond as rapidly
as the cost of funds—deposits—leading
to declining profits. Banks can cushion
the impact of rising rates in several ways,
including with various hedging strategies.
Available data on banks’ balance
sheets indicate that the maturity structure of assets has lengthened considerably and has not been offset with a
corresponding lengthening among
liabilities. As such, the “gap” facing banks
has increased. The good news is that
banks appear to have sufficient capital to
mitigate the potential impact of higher
interest rates.

The Recovery Continues
In 2013, banks based in the Federal Reserve’s Eleventh District earned
a return on assets of 1.14 percent, up
from 1.09 percent in 2012.1 Across the
U.S., banks recorded a return of 1.09
percent in 2013, up from 1.01 percent the
previous year. Eleventh District banks
continued their recent performance
trend, outperforming their counterparts
across the nation, although the differential narrowed (Chart 1). Since the
financial crisis, the biggest contributor to
profitability gains has been a reduction
in provision expense—the amount banks
set aside to cover potential bad loans.
Asset quality, as measured by the
noncurrent loan rate, also strengthened.
After peaking in 2009 across the country
and in 2010 in the district, the noncurrent loan rate has declined steadily and
now stands at 2.6 percent for banks
nationwide and 1.3 percent at district
banks. The largest category of noncurrent loans has been residential real estate
nationally, while commercial real estate
made up the largest group in the Eleventh District.2
Despite the good news regarding
profitability and asset quality, banks have
struggled with a traditional core element of their business. Their net interest
margin—the interest earned on assets
minus the interest paid on deposits—has
continued to decline (Chart 2). As a
result, banks face the challenge of finding
alternative sources of revenue.3

Reaching for Yield?
One potential strategy to boost
revenue is lengthening the maturity
structure of assets. Bonds and loans with
longer-term maturities tend to offer a
higher return to compensate for less
liquidity and greater risk. The current
low-interest-rate environment could
make such a “reach for yield” particularly

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Chart

Bank Profitability Continues to Improve

Net income (percent of average assets)

1.6
1.4
Eleventh District banks

1.2

those banks
}Nationally,
with less than $60 billion

1
.8
.6

U.S. banks

.4
.2
0
–.2
2005

2006

2007

2008

2009

2010

2011

2012

2013

SOURCE: Report of Condition and Income from the Federal Financial Institutions Examination Council.

Chart

Downward Trend in Net Interest Margin Persists

Net interest income (percent of average earning assets)

4.9

in assets—a group that
resembles the makeup
of the industry in the
Eleventh District—
recorded a significant
increase in the maturity
structure of their asset
portfolios.

Eleventh District banks

4.5
4.1
3.7
3.3
2.9

U.S. banks
’85

’87

’89

’91

’93

’95

’97

’99

’01

’03

’05

’07

’09

’11

’13

SOURCE: Report of Condition and Income from the Federal Financial Institutions Examination Council.

appealing. In fact, it appears that banks
have lengthened the maturity structure
of their asset portfolios.
In the Eleventh District, holdings
of loans and securities that mature or
reprice in five years or more stand at
almost 27 percent of assets (Chart 3).
This is up from the recent low of 15 percent before the onset of the crisis and 21
percent in 2003, when interest rates were
also quite low.4
However, U.S. banks as a group have
not lengthened their maturity structure
appreciably. This is because the largest institutions heavily influence the
national figures. The biggest institutions
often turn to alternative sources of revenue that preclude the need to reach for

yield. Nationally, those banks with less
than $60 billion in assets—a group that
resembles the makeup of the industry in
the Eleventh District—recorded a significant increase in the maturity structure of
their asset portfolios.
On its face, this lengthening could
indicate a significant increase in interest
rate risk. However, institutions have also
recorded a large increase in nonmaturity
deposits, defined as checking accounts,
other types of transactions accounts,
savings deposits and money market
deposit accounts (Chart 4). These “core”
deposits, as they are sometimes known,
represent a typically stable source of
funds, suggesting there may not be a
mismatch between assets and liabilities.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Chart

Banks Increase Their Long-Term Assets

Long-term assets (percent of total assets)

30
Eleventh District banks

25
U.S. banks (all)

20
U.S. banks
with assets
< $60 billion

10
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
NOTE: Long-term assets are loans and securities that mature or reprice in five years or more. Data are adjusted for
structural changes involving recent relocations of banks into the district.
SOURCE: Report of Condition and Income from the Federal Financial Institutions Examination Council.

Chart

Banks’ Nonmaturity Deposits Also Increase

Nonmaturity deposits (percent of total assets)

70
65
Eleventh District banks

60
55
50
45

U.S. banks
with assets
< $60 billion

U.S. banks

35
30

25
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
NOTE: Nonmaturity deposits are demand deposits, other transaction accounts, money market deposit accounts and
other savings deposits. Data are adjusted for structural changes involving recent relocations of banks into the district.
SOURCE: Report of Condition and Income from the Federal Financial Institutions Examination Council.

The low-interest-rate environment gives rise to uncertainty about the
stability of these deposits, however. The
2002–03 period was also a time of very
low interest rates. When rates began
rising in 2004, banks experienced a mild
decline in nonmaturity deposits relative
to assets.5 If banks lose nonmaturity
deposits when rates begin increasing,
institutions’ earnings could be squeezed
as they attempt to replace these funds
while maintaining asset portfolios that
don’t adjust as rapidly.

The Gap Measure
The structure of assets and certain

deposit liabilities at community and
regional banks suggests that exposure to
interest rate risk might have increased.
The extent of the maturity mismatch
between assets and liabilities offers a
clearer picture.
The gap measure that banks report
is a “net over three-year position”—defined as loans and securities that reprice
in more than (over) three years minus
their liabilities that reprice in more than
(over) three years, expressed as a percent
of assets. A positive value indicates a
greater proportion of long-term assets
than long-term liabilities. When interest
rates increase, a bank with a positive gap

would see its liabilities reprice faster than
its assets, contributing to losses.
What is not captured by the gap
measure is a bank’s ability to offset its interest rate risk through hedging activities.
Institutions can use instruments such as
interest rate swaps and other derivatives
to counteract exposure to rising rates.
To ascertain the possible extent of
interest rate risk, it’s useful to concentrate
on community banks, those institutions
with assets of less than $10 billion. Community banks are less likely to engage
in hedging activity than their larger
counterparts, reflecting the less-complex
structure of the smaller entities’ balance
sheets as well as the costs associated with
hedging. Thus, the gap measure can be
a more meaningful indicator of interest
rate risk for community banks than for
larger institutions.6
The gap measure for community
banks nationally and in the Eleventh
District indicates that banks’ exposure to
increases in interest rates rose from 2003
to 2013 (Chart 5).
During the period of low rates in
2003, community institutions nationwide
and those based in the district experienced similar patterns of repricing their
assets and liabilities. By the end of last
year, the gap measure increased for every
decile, and every grouping of community
banks in the Eleventh District recorded
a larger gap than their counterparts
nationwide. In other words, the gap increased across the industry, and district
banks were more mismatched in 2013
than were their peers nationally, leaving
them potentially more exposed to rising
interest rates.

Cushion Against Losses
While rising rates are a concern for
bankers and supervisors alike, certain
factors can mitigate the impact. Apart
from hedging, retaining capital as a
cushion against losses is another way to
offset rate risk.
Community banks generally hold
sufficient capital, and 98 percent of them
were classified as well capitalized at yearend 2013.7 Well-capitalized institutions
recorded equity capital ratios—capital as
a percentage of assets—of 11.2 percent
nationally and 10.4 percent districtwide.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

A pronounced negative relationship
between capital and the gap measure
could provoke some notice. In other
words, are those banks that are the most
mismatched in terms of their gap measure also those with the lowest capital
ratios? A comparison of equity capital ratios at community banks nationwide and
the gap measure at year-end 2013 reveals
that this was not the case (Chart 6).
Community banks nationwide had
a slightly negative and statistically significant relationship.8 The good news is that
equity capital ratios at the end of last year
were relatively robust across the distribution of banks. Those in the decile with

Chart

the largest gap recorded average equity
capital to asset ratios of 9.8 percent in the
Eleventh District and 10.4 percent in the
U.S. Those in the decile with the smallest gap recorded capital ratios of 10.8
percent in the district and 11.1 percent
nationally.

On the Radar
The banking industry’s recovery
from the financial crisis continues apace.
Profitability and asset quality have
steadily improved.
The long-run decline in net interest margins coupled with the current
low-interest-rate environment has likely

80
2003

2013

U.S. banks
Eleventh District banks

50
40
30
20
10
0

9 10

Decile

9 10

NOTE: Values for each decile are the mean values of the gap measure for banks within the group. Decile rank based on
mean gap measure. Community banks are defined as those institutions with assets less than $10 billion.
SOURCE: Uniform Bank Performance Report from the Federal Financial Institutions Examination Council.

Chart

Gap and Capital not Closely Related at U.S. Community Banks

Equity capital (percent of assets)

40
35
30
25
20
15
10
5
0
–40

The Eleventh Federal Reserve District consists of Texas,
northern Louisiana and southern New Mexico.
2
See “Bank Performance Strengthens,” by Kelly Klemme,
Federal Reserve Bank of Dallas Financial Insights, vol. 3,
no. 1, 2014, for more evidence on the role of provision
expense in earnings. Noncurrent loans are loans past due
90 days or more and loans on nonaccrual status. Data are
adjusted for structural changes involving recent relocations
of banks into the district.
3
Banks were able to maintain strong levels of profitability
before the crisis despite continued declines in the net
interest margin mostly by lowering their noninterest
expense.
4
In 2003, the federal funds rate fell to 1 percent.
5
From the end of 2004 until 2007, banks’ nonmaturity
deposits increased 11.4 percent while their assets increased
33.1 percent. Some of this relative decline in nonmaturity
deposits to assets could have found its way into money
market funds. Over this same period, retail money market
funds grew 20.5 percent while institutional money market
funds increased 41 percent.
6
See “Interest Rate Risk Management at Community
Banks,” by Doug Gray, Federal Reserve System Community
Banking Connections, Third Quarter, 2012. In addition to
concentrating only on community banks, also excluded were
credit card banks and bankers’ banks, newly chartered banks
(those less than five years old) and banks with equity capital
ratios greater than 40 percent.
7
To be classified as well capitalized, a bank must have a
total risk-based capital ratio of at least 10 percent, a tier 1
risk-based capital ratio of at least 6 percent and a leverage
ratio of at least 5 percent.
8
In regressions of the equity capital ratio on the gap
measure, the coefficient is small and negative (–0.009) but
statistically significant at the 1 percent level for U.S. banks.
This estimated relationship implies that a 1 percentage
point increase in the gap is associated with a 0.9 basis
point decline in the equity capital ratio. (100 basis points
equal 1 percentage point.) The relationship is statistically
insignificant when considering only Eleventh District banks.
In 2003, the relationship is statistically insignificant for both
bank groups.
1

Percent of assets

Robinson is an assistant vice president
in the Financial Industry Studies Department at the Federal Reserve Bank
of Dallas.
Notes

Asset/Liability Gap Increases from 2003 to 2013
for Community Banks

contributed to banks seeking out higher
returns by lengthening the maturity
structure of asset portfolios and, thus,
often boosting exposure to rising interest
rates. This exposure appears to be greater
than what was observed in the prior period of low interest rates but is mitigated by
sufficient amounts of capital. So in spite
of the relatively good banking industry
news over the past few years, supervisors
remain vigilant to potential risks.

–20
0
20
40
60
80
Three-year asset-liability gap at year-end 2013 (percent of assets)

NOTE: Community banks are defined as those institutions with assets less than $10 billion.
SOURCE: Uniform Bank Performance Report from the Federal Financial Institutions Examination Council.

100

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

NOTEWORTHY
AGRICULTURE: Texas to Avoid Worst of Projected Farm Income Drop

.S. farm income is expected to plummet 27 percent this year, driven largely by lower cash receipts
from crops, according to an initial outlook from the U.S. Department of Agriculture (USDA). But
the decline will be less substantial in Texas, where livestock dominates the agriculture sector.
Texas ranks No. 1 in livestock production among the states, and livestock and related products account for two-thirds of Texas’ agriculture cash receipts. Those receipts will increase slightly in 2014, the
USDA predicts, likely allowing Texas farm income to dodge the steep national decline.
New Mexico will also avoid the bulk of the downturn, as livestock composes 80 percent of that state’s
agriculture sector. Within the New Mexico livestock segment, dairy production accounts for half. Dairy
cash receipts will increase 7 percent in 2014, the USDA forecasts.
Besides the national double-digit decline in crop cash receipts, sharply reduced government payments resulting from the 2014 farm bill also contribute to the anticipated drop in U.S. farm income. The
USDA expects a $5.1 billion decline in government farm payments this year, partly due to the legislation
repealing the direct payments program. The law, however, exempts growers of cotton—Texas’ primary
crop—who will receive direct payments in 2014 at a reduced rate.
—Emily Kerr

MEXICO: New Pipeline May Reduce Reliance on Overseas LNG Imports

exico has been importing increasing amounts of liquefied natural gas (LNG) to meet growing demand for natural gas, particularly for power generation. Now, new U.S.–Mexico gas pipelines could
help Mexico scale back costly overseas LNG imports.
The majority of Mexico’s natural gas imports come via pipeline from the United States, which accounted for about 80 percent of Mexico’s overall gas imports in 2012, according to the Energy Information
Administration (EIA). About 75 percent of these 2012 imports originated in Texas. LNG imports from
countries such as Nigeria, Qatar and Peru fulfilled the remaining imported natural gas needs.
Mexico could reduce these costly, distant imports in favor of cheaper pipelined supplies when the
additional capacity from the U.S. comes online later this year. Three cross-border pipeline projects—two
from Texas and a third from Arizona—under construction could boost capacity by 2.44 billion cubic feet
per day (bcf/d). Pemex, Mexico’s state-owned oil and gas company, is adding pipeline capacity from
these border crossings to power plants and industrial customers in northern and central Mexico.
Mexico’s natural gas consumption totaled 6.6 bcf/d in 2012, up almost 3 percent from 2011, EIA data
show. Domestic production, which fell more than 3 percent in 2012, totaled just 4.6 bcf/d.
—Amy Jordan

AIR TRAFFIC: DFW Passenger, Cargo Growth Lags Other Major Airports

allas/Fort Worth International Airport grew less than other comparable airports from 2002 to 2012,
according to the U.S. Bureau of Transportation Statistics (BTS). The number of enplaned passengers at DFW Airport increased 14.3 percent, compared with an average 18.4 percent among the
nation’s top 50 airports and 21.2 percent at the busiest airport, Hartsfield–Jackson Atlanta International.
Declining domestic market share at American Airlines may be a factor. Along with its American
Eagle affiliate, American accounted for 81 percent of DFW Airport passenger traffic in the year ended in
January, BTS data show. American’s U.S. market share based on revenue passenger miles—one passenger
flown one mile—fell from 20.4 percent in 1992 to 12.9 percent in 2012, a Hofstra University report found.
DFW Airport passenger and cargo traffic remain below peak levels reached in 2000, before 9/11 and
the dot-com bust, though the total number of passengers had nearly rebounded by 2013. Particularly
large declines in passenger traffic occurred from 2000 to 2002—only Los Angeles International Airport
(LAX) experienced a bigger drop among the top five airports for passenger traffic. On the cargo side, DFW
Airport volumes in 2013 were 28.8 percent below 2000 levels. The overall air cargo industry stagnated over
the period, with growth concentrated at hub airports for major freight carriers such as FedEx and UPS.
—Melissa LoPalo

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

SPOTLIGHT

Would a Texas Central Bank Set Rates Higher?
By Janet Koech and Mark A. Wynne

he Texas economy has outperformed the rest of the nation
on several fronts—it did not
experience as big a house price
run-up prior to the economic crisis, nor
was the subsequent housing bust during the crisis as big. Texas entered the
recession later than most other states,
experienced a milder downturn and
recovered its precrisis level of employment and economic activity sooner than
most other states.
With such relative economic
strength, it is interesting to speculate
how interest rates in Texas would differ
if the state had its own central banking
system. In fact, if Texas were a standalone nation, it would rank as the world’s
13th-largest economy.1
Stanford University economist John
Taylor has posited that the appropriate monetary policy rate depends on a
region’s economic output relative to its
potential (popularly known as the output
gap), and the deviation of inflation from
the central bank’s inflation target (usually assumed to be 2 percent). The Taylor
rule prescribes higher interest rates
when inflation is above target and output
is above potential—and lower interest
rates when output is below potential and
inflation is below target.
Computing a Taylor rule rate for
Texas offers possible insight into the
interest rate path a central bank of Texas

Chart

might set in response to regional economic conditions. The implied monetary
policy rate for Texas (Chart 1) shows a
very different path than that set by the
Federal Reserve’s rate-setting Federal
Open Market Committee (FOMC).
While the federal funds rate has
been near zero for several years, a
monetary policy calibrated to Texas’
economic conditions would have called
for an interest rate of zero for at most one
year and rates of about 2 to 3 percent
in 2011 and 2012. Indeed, for the entire
period since the mid-1990s, economic
conditions in Texas would have called for
interest rates higher than the prevailing
monetary policy rates. Conversely, as
Texas recovered from the 1980s recession, it would have preferred interest
rates lower than those set by the FOMC
through the early 1990s.
The smaller deviation of Texas’
actual output from its potential relative
to the nation’s performance corroborates
the state’s better economic performance
over the past few years—economic
activity in Texas did not fall as far below
potential during the recent crisis as it did
in the U.S. (Chart 2).
However, Texas inflation has been
closely correlated with overall U.S. inflation, with an even higher correlation
in recent years.2 The patterns of these
two components of the Taylor rule—the
output gap and inflation—suggest that

Texas Taylor Rule Rate Differs from U.S. Rate

Chart

the preferred path of interest rates in
Texas shown in Chart 1 is driven mainly
by output gap differences.
The Taylor rule rate implies that
a higher interest rate would be more
appropriate for Texas than the current
federal funds rate and, thus, the prevailing lower rate might lead to locally
higher inflation. But inflation in Texas is
broadly similar to inflation in the rest of
the U.S. This is largely because the state
is fully integrated into the broader U.S.
economy. Wage and price pressures are
kept in check by the movement of goods
and especially workers.
Texas has been the No. 1 destination for domestic migrants—U.S. natives
and immigrants relocating to Texas from
other states—since 2006.3 In the euro
area, the absence of such labor mobility makes living with a one-size-fits-all
monetary policy comparatively much
more challenging.
Notes
Texas’ gross domestic product (GDP) was $1.48 trillion
in 2013. See “If Texas Were a Nation 2013,” Texas
Comptroller of Public Accounts, March 2014.
2
The correlation between U.S. and Texas consumer price
inflation is 0.90 for the 1987–2012 period and 0.99 for
2009–12. The output gap correlation for 1987–2012 is
0.79, compared with -0.61 for 2009–12.
3
See “Gone to Texas: Immigration and the Transformation
of the Texas Economy,” by Pia M. Orrenius, Madeline
Zavodny and Melissa LoPalo, Federal Reserve Bank of
Dallas Special Report, 2013.
1

Output Gap Smaller in Texas than U.S.

Percentage points

Texas Taylor rule rate

Target federal funds rate

Prerecession

6
4
2
0
–2
–4
’87 Male
’89 Female
’91 Young
’93 ’9525-54
’97 55+
’99

’01 ’03Black
’05 Hisp.
’07 Constr.
’09 ’11
White
Mfg

SOURCES: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve Board/Haver
Analytics; authors’ calculations.

10
8
6
4
2
0
–2
–4
–6
–8
–10
’87 Male
’89 Female
’91 Young
’93 ’9525-54
’97 55+
’99

Texas output gap
U.S. output gap

White
Mfg
’01 ’03Black
’05 Hisp.
’07 Constr.
’09 ’11

SOURCES: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve Board/Haver
Analytics; authors’ calculations.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

‘Reforma Energética’: Mexico Takes
First Steps to Overhaul Oil Industry
By Michael D. Plante and Jesus Cañas

}

The fiscal health of the
Mexican government
and the living standards
of Mexico’s citizens
are inextricably tied to
that of Pemex, making
declining crude oil
production over the past
decade a particularly
troubling sign for many
in Mexico.

he Mexican oil sector is at a
critical juncture. Output from
state-run Petróleos Mexicanos (Pemex) has declined
more than 25 percent since peaking in
2004, despite increased investment in
production and exploration for new oil
(Chart 1). Mexico now produces less oil
than Texas, and forecasts in recent years
point to further declines.
The ramifications of falling production extend well beyond Pemex. The oil
and gas sector alone accounts for about
5 percent of Mexican gross domestic
product (GDP). Pemex also provides 25
to 30 percent of government revenue;
the company’s tax payments have been
so substantial that they have exceeded
operating income in recent years, causing Pemex to incur losses (Chart 2).
Put in perspective, the size of
Pemex’s remittance exceeds total government spending on social programs,
education, and public health and
safety. As a result, the fiscal health of
the Mexican government and the liv-

Chart

ing standards of Mexico’s citizens are
inextricably tied to that of Pemex (see
box, page 19), making declining crude
oil production over the past decade a
particularly troubling sign for many in
Mexico.
Politicians in Mexico have been
aware of these problems for some time.
In 2008, the administration of thenPresident Felipe Calderón announced
plans to resuscitate Pemex, offering
reforms that would give the company
greater budgetary autonomy and operational flexibility. But political opposition diminished most of the proposed
changes, and the measures that passed
failed to stem production declines.
Against this background, Mexican
President Enrique Peña Nieto sought
to turn the tide of falling production,
recently pushing through a comprehensive reform of the oil and gas industry,
or reforma energética. It will affect every
aspect of the sector, from Pemex’s role to
new opportunities for foreign investment. Although lawmakers haven’t yet

Pemex Investment Hasn’t Reversed
Mexican Crude Oil Production Decline

Million barrels per day

Billions of pesos

3.6
3.4

350
Production

300

3.2

250

200

2.8
150

2.6
2.4

100

Pemex investment in
production and exploration for oil

2.2
2

2001 2002 2003 2004 2005 2006 2007 2008 2009

2010

SOURCES: U.S. Department of Energy; Bloomberg.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

2011 2012

Technology, Investment Required

Chart

Pemex Tax Payment Exceeds Operating Income

Billions of dollars

80
70
60
Taxes

50
40
30

Operating income

20
10
0
Profit (loss)

–10
–20

2007

2008

2009

2010

2011

2012

SOURCES: Bloomberg; International Monetary Fund.

set the details, a framework has been
put in place, leading to newfound optimism about the nation’s energy future.

petroleum products such as gasoline
and diesel and as operator of related
sectors such as petrochemicals.1

Mandated Involvement

Geology’s Blessings (and Curses)

The government is engaged in all
aspects of Mexico’s oil and gas sector.
This involvement is mandated in the
national constitution and in supporting laws, which together spell out rights
regarding ownership of crude oil and its
production.
Article 27 of the constitution stipulates that the state is the sole owner of all
oil and other minerals found under the
ground. Thus, the Mexican government
determines where and when oil is produced and by whom. By comparison, in
the U.S., private citizens may own oil and
minerals found beneath their property.
Although Articles 25 and 28 grant
the Mexican government direct control
over the production of any oil it owns,
foreign oil companies played a prominent role in extraction during the early
1900s. The impact of the constitutional
articles was not significantly felt until
1938, when President Lázaro Cárdenas
partially nationalized the industry and
created Pemex.
Even after the nationalization,
Mexico continued to rely on private
contractors until the Petroleum Law of
1958 prohibited their participation. The
law installed Pemex as the monopoly
producer of oil, natural gas and refined

Pemex was initially blessed by favorable geology and could produce abundant oil at minimal cost and effort. In the
1970s, a supergiant oil field, Cantarell,
was discovered in the shallow waters of
the Bay of Campeche west of the Yucatan
Peninsula (see map, page 18). The discovery dramatically increased Mexican
oil production, yielding enormous
amounts of low-cost crude for decades.
As oil fields get older, their production declines. For Cantarell, the peak
occurred in 2004 when production
averaged 2.1 million barrels of oil per
day (mb/d), accounting for 63 percent of
Mexican oil output that year. Cantarell’s
output has slipped precipitously since
then, falling in 2011 to 0.5 mb/d, or just
20 percent of Mexican production.
Pemex attempted to offset Cantarell’s decline by trying to increase
production at several other fields, some
more successfully than others. The most
notable triumph came from fields known
collectively as Ku-Maloob-Zaap (KMZ),
located in the same general area as Cantarell. KMZ’s 2011 production was more
than 0.8 mb/d, a 177 percent gain from
2004. Despite this increase, Mexico’s
overall production has fallen in the past
decade.

Mexico still has oil underground
and likely has other yet-to-be-discovered sources of both oil and gas. The
Chicontepec field, north and northeast
of Mexico City, contains large reserves,
though recovery is complicated by difficult geology. After billions of dollars
of development, the field produces a
relatively small amount of oil, roughly
equal to 2 percent of total Mexican
output.
There is consensus among geologists that Mexico probably has a significant amount of oil in deepwater areas
of the Gulf of Mexico, though there
has been little exploration to date. This
contrasts with the U.S. side of the Gulf,
which has routinely produced more
than 1 mb/d of crude oil for many years.
Moreover, there are locations
containing varying amounts of shale
oil, shale gas or both. These include the
Burgos, Sabinas and Veracruz basins, as
seen in the map. The prospects for shale
are much more speculative than those
for the Gulf of Mexico because shale
development is expected to be relatively
expensive and risky. Nevertheless, it
is possible that at least some of these
resources could be harnessed to boost
production.
Successful development of these
areas will require technology that Pemex does not possess. The company’s
payments to the Mexican treasury have
left it short of cash for developing technologies. The state-owned firm could
seek joint ventures with foreign oil
companies. However, before the recent
reform, outside concerns were permitted to collaborate with Pemex only
through contracts in which they provided specific services to Pemex. These
agreements have not been conducive to
technology transfer.

Constitutional Reforms
President Peña Nieto signed into law
last December changes to the Mexican Constitution that set the stage for
a dramatic alteration of the oil and gas
sector. While questions remain about
the details—most requiring additional
legislation—the law spells out key points
of the plan.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Major Mexico Oil and Gas Fields Where Production Occurs, Development Likely

Courtesy of Oil and Gas Journal, PennWell Corp.

Under the new system, the state
will retain ownership of any hydrocarbons found underground, allowing the
government to remain in control of
which resources will be pursued and
when and to decide who produces the
oil.
In a major break from the past, the
government will allow both Pemex and
private firms to produce oil and gas in
the country. The companies, both foreign and domestic, can work independently or jointly with Pemex.
How private participation will work
in practice will depend greatly upon
the nature of the contracts Mexico’s
government offers. The reform is carried out through at least four types of
arrangements—profit sharing, production sharing, licensing and service contracts—each with its own risk/reward
trade-off:

• Profit-sharing envisions government payment to oil companies based
on a percentage of the revenue generated after exploration and production
costs are recovered. The outside firms
would not own any of the oil produced.
• Production sharing will provide for
participating companies to be compensated based on a percentage of production, after cost recovery.
• Licensing will allow companies to
acquire possession of hydrocarbons
at the wellhead, upon the payment of
taxes, if commercial production occurs.
• Service contracts will remain part
of the Mexican system. Companies
receive cash payment for performing
specific activities for Pemex and are
paid even if production never occurs.
At least some of the contracts will
allow foreign companies to book reserves for U.S. Securities and Exchange

Commission accounting purposes—a
necessary provision if Mexico wants to
attract private investment.

Round Zero Begins
While Pemex will lose its monopoly on producing oil, the company
will choose geographic areas in which it
wants to operate—subject to government
approval—before outside companies can
enter the country. This selection process,
known as Round Zero, began in late
March when Pemex submitted its official
list of areas to the secretary of energy.
Pemex seeks to retain all of the
areas where it already produces, including low-cost fields such as the KMZ and
more complicated areas in the Chicontepec. Pemex has also sought to retain
access to areas where it has no production in the Gulf of Mexico, including
some deepwater tracts. However, the

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

company has not sought to become
heavily involved in areas with shale oil
or gas, most likely because of cost and
risk.
Regulators must decide by Sept.
17 the areas over which Pemex will
retain full control, those Pemex will
jointly develop with private companies
and the ones where private companies
will operate independently of Pemex.
Sometime in 2015, regulators will allow
bidding by domestic and international
oil companies.

Optimism for the Future
While the exact outcome of the
reforms and their impact on economic

activity in Mexico aren’t clear, the outlook is upbeat.
The government forecasts that
oil production could increase to more
than 3 mb/d by 2018, a 25 percent
jump from 2013, significantly reversing
the recent 10-year decline. Independent research analysts estimate the
reform could add 1 to 1.5 percentage
points to Mexico’s long-term GDP
growth.
The change should also strongly
benefit the economy of Texas, home to
many companies likely to participate in
the oil and gas sector’s opening.
The outcome will, of course,
depend crucially upon the still-to-be-

Government Payments Hobble Pemex
On the face of it, Pemex appears to be an extremely successful company.
Based on annual revenue of $125.2 billion in 2013, it is one of the largest firms
in Mexico, and it ranked 36th in the Fortune Global 500 that year. But size
masks performance; the company has routinely lost money in recent years.
The shortfall reflects Pemex’s large payments to the government, which in
2012 totaled almost $70 billion (roughly 25 percent of government revenue).
With no Pemex revenues and no change in expenditures, the government deficit as percent of GDP would have been much larger (see chart). For example,
in 2013, the deficit would have been almost 9 percent of GDP instead of 1.7
percent.
Mexico has recently enacted fiscal reform, changing the taxation of
corporations and individuals. Specifics of how the new law will affect Pemex
and other oil companies haven’t been released. While the government needs
the revenue, it is also aware that the energy tax regime has to be attractive to
private investors and less punitive to Pemex for the sector to flourish.

resolved reform details. The overhaul, if
effective, should entice private companies to invest in the oil sector and allow
Pemex to become a more efficient and
effective company. The benefits of this
would include greater oil production
and positive spillovers into other parts
of the economy. All are benefits that
states such as Texas and North Dakota
are experiencing as a result of their
ongoing energy booms.

Plante is a senior research economist
and Cañas is a business economist
in the Research Department of the
Federal Reserve Bank of Dallas.

Note
1
For further details on the Petroleum Law of 1958,
see “The Prospect for Further Energy Privatization in
Mexico,” Ewell E. Murphy Jr., The Texas International
Law Journal, vol. 36, no. 1, 2001, and “Energy Reform
and the Future of Mexico’s Oil Industry: The Pemex
Bidding Rounds and Integrated Service Contracts,” by
Tim R. Samples and José Luis Vittor, Texas Journal of
Oil, Gas and Energy Law, vol. 7, no. 2, 2012.

Mexico’s Relative Deficit Would More than Triple Without Pemex
Percent of gross domestic product

Gov. deficit

Gov. deficit without Pemex

0
–2
–4
–6
–8
–10
–12

2007

2008

2009

2010

2011

2012

2013

SOURCES: Secretary of Housing and Public Credit; authors’ calculations.

Southwest Economy • Federal Reserve Bank of Dallas • Second Quarter 2014

Federal Reserve Bank of Dallas
P.O. Box 655906
Dallas, TX 75265-5906

PRSRT STD
U.S. POSTAGE

PAID

DALLAS, TEXAS
PERMIT NO. 151

Strength of Economy, Limited Benefit Eligibility in Texas Curb Long-Term Unemployment
(Continued from page 7)

Texas Economic Influences
Demographic influences explain
neither the postrecession rise in unemployment duration in Texas nor the lower
long-term unemployment rate in the
state vis-à-vis the nation.
Lower long-term unemployment
in Texas likely results from two factors.
First, unemployed Texans experienced
a higher job-finding rate because of the
state’s stronger job growth, booming
energy sector and milder housing market
downturn. And second, a somewhat
higher percentage of the unemployed in
Texas exited the labor force relative to the
nation, in part due to their shorter average duration of unemployment benefits
and lower eligibility relative to their
counterparts nationally.

DALLASFED

Kumar is a senior research economist
and advisor in the Research Department at the Federal Reserve Bank of
Dallas.
Notes
1
For this line of research, see “Long-Term Unemployment
and the Great Recession: The Role of Composition,
Duration Dependence, and Non-Participation,” by
Kory Kroft, Fabian Lange, Matthew J. Notowidigdo
and Lawrence F. Katz, working paper, Harvard Web
Publishing, September 2013. http://scholar.harvard.
edu/files/lkatz/files/klnk_ltu_and_great_recession_
sep16_2013.pdf.
2
See ”The Establishment-Level Behavior of Vacancies
and Hiring,” by Steven J. Davis, R. Jason Faberman and
John C. Haltiwanger, Quarterly Journal of Economics, vol.
128, no. 2, 2013, pp. 581–622.
3
The job-finding rate and all other transition probabilities
are month-to-month and were calculated using matched
monthly Current Population Survey data.

Southwest Economy

is published quarterly by the Federal Reserve Bank of
Dallas. The views expressed are those of the authors and
should not be attributed to the Federal Reserve Bank of
Dallas or the Federal Reserve System.
Articles may be reprinted on the condition that the
source is credited and a copy is provided to the Research
Department of the Federal Reserve Bank of Dallas.
Southwest Economy is available on the Dallas Fed
website, www.dallasfed.org.

Federal Reserve Bank of Dallas
2200 N. Pearl St., Dallas, TX 75201

See “The Labor Market in the Great Recession: An Update
to September 2011,” by Michael W.L. Elsby, Bart Hobijn,
Aysegul Sahin and Robert G. Valletta, Brookings Papers on
Economic Activity, vol. 43, no. 2, 2011, pp. 353–84.
5
See “Do Employers Use Unemployment as a Sorting
Criterion When Hiring? Evidence from a Field Experiment,”
by Stefan Eriksson and Dan-Olof Rooth, American
Economic Review, vol. 104, no. 3, 2013, pp. 1,014–39.
6
See “Extended Unemployment and UI Benefits,” by Rob
Valletta and Katherine Kuang, Federal Reserve Bank of San
Francisco Economic Letter, no. 12, April 2010.
7
See “Unemployment Insurance and Job Search in the
Great Recession,” by Jesse Rothstein, Brookings Papers
on Economic Activity, vol. 43, no. 2, 2011, pp. 143–213.
8
See “Extending Unemployment Compensation Benefits
During Recessions,” by Julie M. Whittaker and Katelin
P. Isaacs, Washington, D.C.: Congressional Research
Service, Library of Congress, May 2013.
4

Mine Yücel, Senior Vice President and Director of Research
Pia Orrenius, Executive Editor
Michael Weiss, Editor
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Kathy Thacker, Associate Editor
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