The discussion that follows was the luncheon presentation at the Sept. 23 meeting of the membership of the Permian Basin Petroleum Association, held at the Midland Country Club, in Midland, Texas. The proceedings were taped and this is an edited transcript of that event.
PBPA President Ben Shepperd: We’re going to hear a conversation today between Mr. Robert Kaplan, the president and CEO of the Federal Reserve Bank of Dallas, and one of the PBPA board members and also a member of the Federal Reserve, Mr. Richard Folger. So, I’ll start with Richard and give you some introduction for those who may not know these fine gentlemen.
Richard Folger is managing general partner of Colbridge Partners Limited, a financial investment partnership focused on energy development. In April 2015, he retired as CEO and President of Warren Equipment, a position he held since 1999. Warren, which was listed as a Forbes 400 of America’s Largest Private Companies, provides equipment to the energy and construction industries. Prior to that, he was president and COO of Compressor Systems Inc. (CSI). He is a graduate of UT Austin with a Bachelor of Business Administration in finance and petroleum land management and a Bachelor of Science in petroleum engineering. He received his Masters of Science in finance from the University of Notre Dame. He’s also a graduate of the Southwestern Graduate School of Banking at Southern Methodist University.
In 2011, he was recognized by The University of Texas Cockrell School with the Distinguished Engineering Alumni Award. His community and professional affiliations are many and include chairman of the El Paso branch of the Dallas Federal Reserve, immediate past-chairman of the Board of Trustees of Midland Memorial Hospital, advisory boards for the Helen Greathouse Charitable Trust and the Rea Charitable Trust, director of PBPA, as I already mentioned, as well as Engineering and Advisory Board for The University of Texas, and Executive Committee of UT System Chancellor’s Council. He is a lifetime member of Texas Exes in support of the University here in Dallas, including the leadership chairman in Petroleum and Geosystems Engineering.
Richard and his wife, Lois, who is also here today, reside in Midland, Texas, and they have two married daughters and two grandchildren.
Now, Robert Steven Kaplan has served as the 30th president and CEO of the Federal Reserve Bank of Dallas since Sept. 8, 2015. He represents the Eleventh Federal Reserve District on the Federal Open Market Committee in the formulation of U.S. monetary policy and oversees the 1,200 employees of the Dallas Fed. Kaplan was previously the Martin Marshall Professor of Management Practice and a Senior Associate Dean at Harvard Business School.
He is the author of several books, including “What You Really Need to Lead: The Power of Thinking and Acting Like an Owner,” “What You’re Really Meant To Do: A Road Map for Reaching Your Unique Potential,” and “What to Ask the Person in the Mirror: Critical Questions for Becoming a More Effective Leader and Reaching Your Potential.”
Prior to joining Harvard in 2006, Kaplan was vice chairman of The Goldman Sachs Group Inc., with global responsibility for the firm’s Investment Banking and Investment Management Divisions. Previously, he served as global co-head of the Investment Banking Division. He was also a member of the firm’s Management Committee and served as co-chair of the firm’s Partnership Committee and chairman of the Goldman Sachs Pine Street Leadership Program.
During his 23-year career at Goldman Sachs, Kaplan served in various other capacities, including head of the Corporate Finance Department, head of Asia-Pacific Investment Banking as well as head of the high-yield department in Investment Banking. He became a partner in 1990. Upon joining Harvard in 2006, he became a senior director of the firm.
He serves as chairman … I think he’s ready to get going [laughter]. Let’s get started. Ladies and gentlemen, Mr. Robert Kaplan.
Richard Folger: Rob, welcome back to West Texas. It’s been about a year since you’ve been here last. Like everything in our business, it changes a lot from one year to the next. So, we’re anxious to hear what you have to say about our economy. What I’d like to do is talk a little bit about recent economies—our national economy and then get your remarks on our global economy followed by a discussion about monetary policy at the Fed. So, how do you see Texas’ economy going since we had a downturn in the ’80s and then I’ll follow up with what you see as your outlook for the industry.
Robert Kaplan: So, we’ll start with the state of Texas.
Richard Folger: Right.
Robert Kaplan: The good news is the story in Texas over the last couple of years is one of migration of people and firms to the state. I’m worried about population growth in the rest of the country that we’ll talk about in a few minutes. But, I’m not worried about the state of Texas as a state. Obviously, there are cities that are hurting, no doubt about it. But, the population of the state ten years ago was about 22 and a half million, is now pushing up in excess of 28 million. The state has become dramatically more diversified as a result. Many of the big cities in the state are among the fastest growing cities in the United States. I think this [is because of] is lots of reasons: central location, low taxes, regulatory environment, you name it. But the long and the short of it is, growing your population and growing your workforce and attracting businesses is key to the state. And so by being the biggest state, I’ve said this before, in the United States you stand by the one you want to play, it’d be Texas.
So, that’s the good news. The energy business is part of that. Energy is not as big a percentage of the state as it was over the last 30 years because of diversification here. But it’s around, even as we sit here now, it’s eight and a fraction percent of the state’s GDP. And, obviously, the rebound in this industry has been a real tailwind. Gone from being a headwind to being neutral to being a tailwind to growth in the state. Job growth in this state is now in excess of two and a half percent year-to-date. That’s the fastest rate of job growth in Texas in the last three years. And, growth in jobs in energy is [inaudible]. So, I’d say in most of the things about Texas … are very positive. The state’s obviously got some challenge in infrastructure to build the port authority, housing, building health care services, all those normal issues. But the good thing about those issues [is that] they’re in control. The state has the ability to address them. It just has to have the will and allocate the resources and I’m confident, I think, that it will.
So that’s the state of Texas.
If you’re going to go to the United States…
Richard Folger: Well, before we leave Texas, a lot of us here in the room export our technology around the world. Could you talk a little bit about trade and what that means to Texas. And, then follow on Mexico and where we stand?
Robert Kaplan: And trade is really a U.S. issue first and a Texas issue second. Texas is a large exporting state in the United States. And… at the Dallas Fed, we obviously monitor policy and spend a lot of time talking about that. But there are three things in particular we bore in on: energy, immigration and trade. And a lot of the trade expertise is because of our proximity to Mexico. So, I’m there frequently. I was just in Juárez recently, Mexico City. And, some of you may have heard me say this, and this relates not just to Mexico, not just to Texas, but to the United States. The trade deficit with Mexico is … it has to be analyzed a little further than just a numbers.
Over the last number of years, on average, 70% of the goods that the U.S. imports from Mexico are intermediate goods. They are not final goods. Most of our trade deficit with China is a final goods deficit. Most of our trade deficit with Mexico is intermediate goods. What do we mean by intermediate goods? These are part of a very complex and sophisticated supply chain of logistical arrangements, which U.S. companies take advantage of so they can actually add jobs and be globally competitive here in the United States. And so, 40% of that content of U.S. imports from Mexico is U.S. content. So, I’ve said publicly a number of times, it is our judgment and analysis at the Dallas Fed that, in fact, this trading relationship with Mexico has a lot of U.S. support [and is] globally competitive and certainly allows Texas to be more globally competitive [and] has added jobs in the United States and in Texas. And, if we didn’t have those relationships or they were impeded, we would likely lose jobs from this hemisphere and from the United States. And, they would likely go elsewhere in the world, most likely to Asia.
So, I been calling that out, not because I sit here in Texas but because I’m worried about the United States. We’ve got to grow business in this state. We’ve got to grow faster in the United States. Globalization has been blamed for some of the local disruptions, job dislocations, either immigration or trade. I think the truth is based on our analysis. That might have been true 10, 15, 20 years ago. More likely today, globalization of the United States is a source of growth and a source of jobs and technology [that] enables disruption, i.e. Amazon vs retail stores, and disruptive modes of competition are much more likely to bring some of this dislocation and that they’re being attributed to globalization. And I talk about it a lot because we’ve got to get this diagnosis right because we get the diagnosis wrong, then the policy restrictions are also going to be wrong. And that will not be good for the United States.
So the trade relations, in our judgment with Mexico, by and large, is beneficial in our judgment to the United States. That doesn’t mean it shouldn’t be reviewed, [and] it doesn’t mean that certain things shouldn’t be leveled out and improved on. We’ve got to be very careful how we do it, because some of the things being discussed actually will be key to competitiveness of U.S. companies. I think likely net net cost U.S. jobs.
Richard Folger: Well, thank you. We’ll move on to talking about the U.S. economy. Growth seems to be the real issue out there trying to understand what’s happening in growth and what the impediments might be. Could you speak to that.
Robert Kaplan: Yes, sir. So we think that… the Dallas Fed like every other Fed Bank is watching what Congress and the world are doing… GDP forecasting. Our own forecast for 2017 is the United States is going to grow a little above 2%. 1.2% the first quarter is the estimate. 2.6% is the number for the second quarter. These will get revised, which is why I said the estimate. But we think when the year is over, we’ll grow a little above 2%.
Sluggish by historical standards but it will certainly be enough [inaudible] more slack labor market, drive the unemployment rate, which is now at 4.3% lower and I look at the thing called U-6 which is a better measure for me, which is unemployment plus discouraged workers plus people working part- time for economic reasons. That’s 8.6%. But the pre-recession low was 8.1%. I really expect that number will continue to go down as we’re going at this rate.
The moral of the story is that we’re headed to full employment. We’re not there, we’re getting close. And most of the year when I’m talking to businesses around the country, the number one they say, used to say, they couldn’t find skilled laborers. Now, they’re saying they just can’t find laborers. You know, there are labor shortages and they’re becoming more obvious. You don’t see it as much in the overall wage numbers but I think if you look … I think we will see more of it. And, if you do a different kind of analysis of the wages, I think there’s actually some wage depression.
Inflation has been offset by the growth that’s so slow in the second. Just to finish that, inflation though has been lagging below 2%. Normally when you have this level of labor slack. You see … now we’re going to see inflation rates we haven’t seen in this time. And, my own judgment is it is because that technology enabled disruption. The cyclical factors, i.e. tight labor markets, normally is enough to create inflation in this country. Wage pressure translates into price structures. The problem is because of technology, and by the way, this may be a good problem; but because of technology pricing power and new disruptive forms of competition, businesses have less pricing power today than they had at anytime in our lifetimes.
You know, try to pass on price increases and you’re going to talk to most businesses that can’t. In fact, worse, they may have to find ways to impact costs because they are in a price war. And that’s because of technology and also unions, business models where technology enabled … and by the way, a lot of people say, “Gee, tell me more about this. I’m not sure I see it,” when I talk to them about their own industry and they go, “Oh, yeah. OK, you may be right. I see it.” Tapping into almost every single business I can think of.
OK, so here’s the issue: Why are we growing so slowly, which is what Richard asked about. The number one driver … there are two things that makes up GDP growth. Growth in the labor force. Growth in productivity. Okay, you add those two together that gives you GDP growth. All right, and the fact is our labor force is growing very slowly. Why? Because the population is aging and people are aging out of the workforce. So that the participation rate, the rate of which people are either looking for work or are in the job market pre-recession, was 66%. OK? Today it’s 63% and we think that at now that decline is due to demographics. And the bad news is, over the next ten years it’s going to get worse. We think the participation rate is going to slip below 61%. This matters because it tells us that the labor force is growing very slowly. It’s going to create a big headwind, which impedes GDP growth. It’s not being talked about now.
So what do you do about that? One, there’s been a big push to get more females into the workforce. That’s seems to apply [inaudible] but that’s been a big push over the last number of years. That helps. Getting people to work later in their career and longer would help and some of that is happening. We talk a lot about the skills gap in the United States being the worst skilled openings that supply workers. You see that here. And, we … that’s why we’re calling for everywhere we go for middle skills training, public/private partnerships. That will help.
But the other thing that we need, historically, [is that] immigrants and their children have made up over half the workforce growth in this country over the last 20 years. Why has the U.S. been able to grow consistently over these many, many decades even with ebbs and flows in demographics? Cause immigration has been used to supplement. And, so I’m confident we’re going to need to come to grips with immigration policy also because if we don’t find a way to grow the workforce faster, we’re lamenting 2% growth today. Five years from now, we’re going to be lamenting 1.75% growth. Ten years from now we’re going to be lamenting 1.5% growth.
Now the other thing I mentioned is productivity. And every industry we’re in, including yours, is dramatically more productive. Here’s the problem. Productivity means workers are being increasingly replaced by people. Okay. And, what’s happening is many workers, especially [those of] high school education or less, are being squeezed out of the job market and they’re going from a highly paid job to a lower paid job. And, I think that … it’s not we’re not far more productive, it’s that…
[portion missing here]
Robert Kaplan: …run down in a way that will minimize disruption. So yeah, my own judgment, having spent my whole career in the markets, my judgment is, I believe we’ll be able to do this without having a material impact on the trading levels of these markets. We may have some impact, but I don’t think it’s going to be material. In this case, I also believe getting them rolling, and getting out of the gate in the first six months, and successfully having the balance sheet begin to roll up without ruining the markets, will allow us to ensure that we can actually accomplish this objective. So in this case slower, or more phased, may turn out to be faster. So I think this is pretty well designed.
Richard Folger: Rob, a little earlier you talked about globalization. Let’s go ahead and move on to the global economy. What’s your assessment of what’s happening out there, and what challenges do you see in each of those challenges?
Robert Kaplan: So the good news is, the global economy is growing faster than people had expected, maybe to start the year, and that includes [the fact that] Europe is doing a little better. Having said that, when you hear Europe is doing better, you have to remember that Europe is still growing less than 2%, 1 and a fraction. Japan is doing better, but they’re still growing at relatively sluggish rates. The other caution is, China is growing at 6 1/2% a year, and it’s big, and it’s a percentage of global economy, so it’s a significant percentage. That’s the good news.
The bad news is, the way they are doing it is by increasing debt to GDP. They’re leveraging it. They’re doing what we have done in our past. They’re using fiscal policy, infrastructure spending, investing in state owned enterprises, building overcapacity in a whole bunch of industries, including steel. So the problem is, I don’t believe that leveraging [that] they’re doing is sustainable. So if they stop doing that, you’re likely to see Chinese GDP float something lower. I think that would be a halting thing, but I’ve said many times, the world is going to have to get used to lower rates of growth from China.
So global growth is a little bit artificially inflated by the Chinese growth rate. So China had been a tailwind for us. They helped us recover from the great recession. I think it’s going to be a little bit less so in the years…
Richard Folger: Well, I want to take the last few minutes to talk about a subject is on the mind of everyone here in the room, and that’s… the oil and gas business. Now, you’ve taken a position, which I’m very proud of, and the 11th district really representing our industry at the table.
Robert Kaplan: Yes. I want to be an expert on the energy market at the table, yeah.
Richard Folger: That’s a wonderful thing. Anytime anybody can represent us in Washington, we appreciate that. Can you give us your thoughts about the industry, and more particularly about this whole concept of supply and demand?
Robert Kaplan: Yes. Let’s start with just the basics. You guys know this much better than I do, and we talked a lot to you in the room. So your views are what are informing our views… But our own view is, global supply and demand may not be in balance right now. Or if it is in balance, it’s a little bit artificial, because you’ve got OPEC and other oil-producing nations, having agreed 1.8 million barrels a day of a cut. Compliance is not 100 percent, and there’s gonna be uncertainty for the next number of months, and years, [as to] what’s the degree of compliance. But even with that, we believe that global oil supply, demand, may be imbalanced today, but it’s heading towards sustainable balance. What I mean is, even with lower compliance, global demand is growing about 1.3 million barrels a day. Okay? Supply is still growing, but if demand growth continues to consistently grow, consistently climb, we should be moving towards balance.
Let me back up and explain what the issue is. In 2014 to 2015, the U.S. cut its production, net, about a million barrels a day. Very, very painful. Okay? We got as low in the United States as about 8.6 million barrels a day. All right, that was painful here. It was painful everywhere in the U.S. The problem was, while we were cutting, OPEC and other oil-producing nations, their increase in production more than offset our cuts. So we probably didn’t even move any closer to balance. Very frustrating.
Then OPEC decides in December of 2016, they’re gonna take strong action, and they’re gonna agree to this 1.8 million barrel a day cut. Fine. Markets responded positively to that, but U.S. production over the last year, looks like to us, by the time 2017, we’ve now grown our production in the United States by about a million barrels a day. Okay? Libya has grown their production approximately 500,000 barrels a day. Nigeria has grown a couple hundred thousand barrels a day, which has more than offset, or has offset substantially the cut. So OPEC is watching this, and it must be very frustrating for a cartel that used to exert a lot of price discipline. We’re still not quite at balance, except for their cut. We’re not as far along as they would’ve hoped.
So I would call this a fragile equilibrium. Every time price spikes up, high 40s, low 50s, as you guys know better than I do, you’re gonna see more drilling, more production. If it gets down, you may see a little bit less. It will kind of be a regulator. So I think we’re gonna go through the next couple of years kind of like this. You’ll turn on the TV one day and they’ll say, “The sky is falling, and oh my God, we’re heading towards much lower prices.” Then two months later they’ll talk about how prices are firming, and it’s because you’ve got this dynamic going on, and you’ve got these artificial cuts.
I think it’s easier to talk about the industry, which maybe a more important five to seven years from now. Because of the decline rates, as you all know better than I do, of shale, and the fact that the big majors not been spending on long life projects, I think there’s a good chance in five to seven years, somewhere in there, we’re gonna wind up in a global under supply situation. So I would say the dynamics of the industry, actually for me as a business person, they look pretty favorable, as long as you’re not leveraged, and as long as you can survive this.
So I think a lot of people in this industry have learned the lesson, staying power matters. We could have a lot of volatility over the next year to. That’s for sure, but I think over the longer, I’d say the dynamics of this industry look to me, as a business person, pretty encouraging.
Richard Folger: You made half the people in the room happy, and the other half are bankers [laughter] so if you’d make one quick comment on the state of banking.
Robert Kaplan: Well, here the concern I have about banking right now, and I know most of the bankers in this state. A lot has been said about Dodd–Frank, and review of Dodd–Frank, and all that. I think that’s a health thing, but my concern is small, midsize banks in this country need regulatory relief. That’s the urgent matter. We talk about lack of small business lending, we’re talking about small, midsize banks. I used to work at a big money center bank. That’s not where the small business lending is going to come from. It’s going to come from small, midsize banks. They need regulatory relief. I actually think big banks, the systemically important banks, need … I’m going to be an advocate of continued tough regulation, regular stress testing. Yes there should be some review, but the regulation on them should stay very tight.
I don’t think the economy is being hurt by tough regulation on the big banks. The thing that I would encourage people looking at this is to segment small, midsize banks, from the big, systemically important banks, because we’ve got an urgent need for small, midsize banks. I don’t think the need for regulatory review at the big banks is particularly … It’d be a healthy thing, but it’s not impeding the economy. I hear too much, they’re being talked about as one big industry, and it’s really not. So I’m hopeful that we’ll segment this, and focus our attention urgently on small, midsize banks, and still do the regulatory review…