But how big is the impact of Bakken activity, and how far does it reach?

To assess the Bakken effect, county-level data on average weekly wage growth and unemployment rates were compared relative to a county’s distance from the Bakken. The data are plotted in 100-mile concentric circles moving away from the 12 counties at the core of oil country (see map).

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Not surprisingly, the strongest wage growth and lowest unemployment occurred in the immediate Bakken area, where average weekly wages have increased 140 percent since 2001, and unemployment has fallen to under 2 percent. From there, the effects dissipate (see Charts 1 and 2). Counties within 100 miles of the Bakken experienced the next-largest increase in wages and the next-lowest level of unemployment. At distances further than 100 miles, the Bakken effect continues to show up with unemployment rates. For example, those counties within 100 to 200 miles saw higher unemployment than those within 100 miles, but lower unemployment than those beyond 300 miles.

Interestingly, wage growth shows no additional Bakken effect after 100 miles. That is, counties 100 to 200 miles away have lower wage growth than those within 100 miles, but about the same wage growth as counties 200 to 300 miles away and those 300 to 400 miles away. This suggests that the Bakken reach, in terms of distance, is greater with respect to unemployment and less so with respect to wages.

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This ripple effect on wages has been fairly recent, however. Wage growth in the Bakken began to separate from other counties in 2004 and accelerated after 2005, the start of the oil boom (see Chart 1). But wage growth in counties up to 100 miles away from the Bakken didn’t separate from other non-Bakken counties until 2009.

Unemployment rates across these areas looked quite similar in 2003 and continued lower in a fairly tight band until about 2008. But a notable divergence sprouted in 2009. While rates went up across the board, they rose faster in relation to the distance from the Bakken. Beginning in 2010, unemployment rates started falling, but did so much faster in Bakken counties, and there is now a much wider spread of unemployment rates that adhere closely to the distance from the Bakken (see Chart 2).

As distance increases, many other factors likely explain wage gains or unemployment rates relative to distance from the Bakken. For example, more agriculture-intensive counties are also benefiting from the strong farm sector. Nevertheless, the negative correlation between wage growth and distance from the Bakken, as well as the positive correlation between unemployment and distance from the Bakken, has been growing stronger over time (see Chart 3).

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Video: fedgazette Writer Phil Davies on energy transportation in the Bakken oil patch

Charlie Roehm and his crew were waiting for an oil train at a rail loading facility in Berthold, N.D. The BNSF Railway train from Minot was behind schedule, but everything was in place to begin pouring Bakken crude into 90 identical tanker cars. At 15 cars a day, it would take a week to fill the unit train, whose payload comes from innumerable trucks driving from oil wells to the west, lined up at Berthold to disgorge their loads.

So much oil is being produced in western North Dakota and eastern Montana that it’s turning competitors—railroads and pipelines—into partners in the vast enterprise of transporting that energy. The Berthold rail hub, an on-ramp to BNSF’s nationwide rail network, is owned by Canadian oil transporter Enbridge, one of the largest pipeline companies in North America.

Enbridge built the rail facility last year to help ease a bottleneck on its large, nearby pipeline that carries oil eastward through North Dakota into Minnesota. The roughly 70,000 barrels of oil loaded on each unit train bypass the pipeline, headed to oil terminals and refineries all over the country. “We can only pump out so much,” said Roehm, supervisor of Enbridge’s rail operations. “What we’re doing is optimizing the use of our facilities by bringing in more oil and putting it onto rail instead of the pipeline.”

A second phase at the site will connect pipeline nodes in the heart of the Bakken to the Berthold facility, eliminating the need for producers to truck oil 50 miles or more. Once completed—shipments were slated to begin this spring—the large, hangar-like building will enable Enbridge to offload oil from its main pipeline into tank cars, boosting Berthold’s rail capacity eightfold and freeing up capacity on the pipeline. The current truck-loading facility “is just temporary, to get us going,” Roehm said. “Phase two is the real deal, because that’s where we’re moving a lot of oil.” Enbridge has spent $160 million on the entire facility.

As has been well chronicled (including by the fedgazette), oil and gas production in the Bakken has surged over the past seven years. Getting that product to far-away markets is no less important and similarly complicated, but given much less attention. In recent years, oil production has outraced the infrastructure to move it to refineries across the country, with predictable results.

“Bottlenecks are occurring at all levels,” said Lynn Helms, director of the North Dakota Department of Mineral Resources (DMR). The transport kinks arise at well sites, where there aren’t enough small pipelines to gather oil (and natural gas produced as a byproduct), as well as on big interstate transmission pipelines such as the Enbridge system. Because of tight capacity on long-haul pipelines, Bakken crude has often traded at a lower price than other flavors of domestic oil, trimming producers’ profit margins and tempering their enthusiasm for further oil investment.

Energy firms have responded vigorously to market demand. Oil and gas producers, pipeline operators and railroads have invested billions of dollars in new or expanded infrastructure to relieve bottlenecks and move fossil fuels as quickly and cheaply as possible from wellhead to market.

Everywhere in the region, contractors are laying pipeline, erecting giant storage tanks and building rail hubs like the Berthold facility that are proving a lucrative—but probably temporary—alternative to shipping oil by pipeline.

Ongoing efforts to increase capacity to move energy commodities are crucial to fully developing the Bakken’s energy resources, the engine of the region’s robust economic growth. But matching supply to demand in energy transport will be a challenge as the Bakken continues to break records for energy production.

The market for shipping hydrocarbons is dynamic and fluid; producers and transportation firms are trying to gauge how much capacity is needed and are experimenting with different transport modes to reduce risk and maximize profit. In addition, the path is not completely smooth for energy transportation projects in the region. Obstacles to rapid development include tightened federal environmental rules and rising costs of securing pipeline right of way from landowners.

Photo courtesy of Enbridge

The pig in the python

Transporting energy within the Bakken region and beyond to markets across the country used to be straightforward. Large pipeline systems carried crude oil and natural gas mostly from western Canada into the United States, and the modest amounts produced in Montana and North Dakota just went along for the ride.

Long-established, major conduits for oil include the Enbridge System, which delivers oil to refineries in the Twin Cities and Chicago via pipeline connections in Minnesota and Wisconsin, and Tesoro Corp.’s High Plains system, the main route for Bakken oil bound for North Dakota’s only refinery in Mandan. For natural gas, two main pipeline systems funnel Canadian gas and coal bed methane from the Powder River basin in Montana and Wyoming toward Midwest population centers, picking up gas from northeastern Montana and western North Dakota on the way (see map below).

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Pipelines are by far the cheapest and safest way to move oil and the only practicable method of transporting gas. But the capacity of this transportation system began to be tested in the late 2000s, as production of shale oil and associated gas from the Bakken and Three Forks formations soared to new heights after the Great Recession.

North Dakota is now the nation’s second-biggest oil-producing state, after Texas. Statewide oil output surpassed 750,000 barrels of oil per day (bopd) in December, more than twice the production of two years earlier. As oil production has climbed, so has the volume of North Dakota gas bubbling out of the ground, also doubling since 2010.

Today the energy transport python is having trouble swallowing the pig—a circumstance few in the oil and gas industry could have foreseen, said Justin Kringstad, director of the North Dakota Pipeline Authority (NDPA), a state agency established in 2007 to facilitate pipeline development. “We way underestimated the potential for the resource,” he said. “We’re realizing now we need more and more pipeline capacity and infrastructure in place.”

Oil and natural gas—oil’s often overlooked sidekick in the Bakken—present different transport challenges. Natural gas, for example, flows freely on dedicated pipelines carrying gas to utilities and other users in the Twin Cities, Chicago and beyond. But hundreds of miles of smaller pipelines are needed to collect gas from wells, and increased gas processing in the region is driving demand for transport for natural gas liquids (NGLs) derived from gas. (See the article “Dealing with gas” for a separate analysis of natural gas production, processing and transportation.)

Constraints on crude oil transport are more straightforward, and more urgent, because oil is by far the most valuable product of Bakken wells. Long-distance oil pipelines can no longer handle the region’s output. According to data compiled by the NDPA, oil pipeline capacity in the Williston Basin—a broad area of western North Dakota and eastern Montana that includes oil-producing areas outside the core Bakken region—was about 300,000 bopd short of total oil production in the Basin as of last September. Based on two scenarios for drilling activity and well output, the NDPA projects that crude oil production in the Basin will exceed pipeline capacity at least until 2015 (see Chart 1).

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Rail—a transportation option up to three times more expensive than shipping by pipeline—has allowed producers to get around pipeline bottlenecks in many areas. But the rail network’s functional capacity is less than Chart 1 implies, due to loading delays at rail hubs, scarce railcars and other constraints.

Because of choked pipelines in the district and elsewhere, Bakken crude has sold for less than oil from other parts of North America in recent years, reducing returns on investment for North Dakota and Montana producers. Together with oil from western Canada, Bakken crude backs up in the middle of the continent, causing a regional supply glut that lowers its price. A benchmark for Bakken oil is the price paid for delivery to Enbridge’s pipeline terminal in Clearbrook, Minn. In early January, Bakken sweet crude was selling for about $5 less per barrel than the West Texas Intermediate (WTI) spot price at Cushing, Okla.—a discount equating to $4 million per day in forgone revenues. For extended periods last year, the Bakken-WTI differential was even greater (see Chart 2).

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Because of a paucity of small-diameter gathering pipelines, producers already cope with high costs at the wellhead: In North Dakota, over 70 percent of oil is picked up and taken to a pipeline terminal or rail hub by tank trucks—a cumbersome and expensive method that exacts a heavy toll on rural roads.

Oil and gas producers and logistics firms have invested heavily in energy transportation infrastructure in the Bakken. Photo by Phil Davies.

Money on the move

Rising demand for energy transport has given pipeline companies, railroads and other market participants ample incentive to invest heavily in the Bakken region—part of a continentwide wave of spending on transportation infrastructure for shale oil and gas. IIR Energy, an energy market research firm, estimates that $10 billion will be spent on crude oil pipeline projects in North America this year—four times the average of the previous seven years.

In the Bakken, pipeline, rail and other infrastructure development has altered the pattern of energy movement in the region and gone a long way toward alleviating bottlenecks. Continued investment may eliminate the Bakken crude discount altogether in the not too distant future.

Little in the way of public data exist on energy transportation investment in the Bakken region—mostly privately held pipeline companies and other “midstream” firms that ship or process energy products closely guard their financials. But a partial list of recently built and proposed energy transport projects gives an indication of the scale of investment (see table).

Getting in the flow

Major pipeline projects in the Bakken region

Pipelines operating or under construction*

*Projects undertaken since 2011.
Sources: North Dakota Pipeline Authority; oil and gas industry reports

Proposed pipelines

Sources: North Dakota Pipeline Authority; oil and gas industry reports

Major rail facilities operating or under construction*

Table lists most hubs built since 2011; information unavailable for some facilities.
Sources: North Dakota Pipeline Authority; railroad and energy industry reports

Outlays by some of the biggest market players run to hundreds of millions of dollars annually. Enbridge, for example, has spent $1.2 billion to construct or expand pipeline and rail facilities (including the Berthold hub) in North Dakota since the oil boom began in the state.

Upfront infrastructure costs are steep; laying a 12-inch diameter transmission pipeline costs roughly $800,000 per mile, Kringstad said. But raising capital doesn’t seem to be an obstacle for energy transportation enterprises. Institutions, venture capitalists, angels and large banks are eager to fund projects in the Bakken, said Rodney Wren, president of New Frontier Midstream, a Texas firm that is developing gas-processing plants and oil and gas pipelines in North Dakota and Montana.

“We have some financial institutions [and] some very wealthy individuals in the billion-dollar range who want to [invest in the company],” he said. “It’s amazing how much money is out there that wants to get into greenfield projects.”

Rather than raising capital, the challenge for many midstream operators is putting together projects that make financial and logistic sense, and securing buy-in from producers who are often reluctant to commit to a particular transport mode or route. Usually ground isn’t broken for new pipelines, rail hubs, storage tanks or other transportation facilities until oil or gas producers have agreed to purchase capacity at a predetermined rate. For pipelines, tariffs must be approved by state utility regulators or, for interstate pipelines, the Federal Energy Regulatory Commission.

Natural gas, a byproduct of oil production in the Bakken, presents its own transport challenges. Photo by Phil Davies.

Laying pipe

Much of the investment in energy transportation has focused on expanding the capacity of the pipeline network. Drive a few miles in any direction in the oil patch, and you come across a pipeline trench being dug or disturbed soil indicating the route of a recently laid line. If all projects under construction or proposed go into service, the capacity of oil transmission pipelines in the region will more than double to about 1.2 million bopd by 2015.

One of the most ambitious oil pipeline projects is Enbridge’s Bakken Expansion—a $700 million effort to increase capacity on the company’s main route spanning North Dakota, which connects in Clearbrook with an even bigger line originating in Canada. The three-year program includes the Bakken Pipeline, a reconstruction and reversal of an existing line that previously carried Canadian crude south to Berthold. The 145,000 bopd line is slated to become fully operational this spring, bypassing a bottleneck in North Dakota by pumping oil into Manitoba and then south on the mainline through Clearbrook.

Once online, the Bakken Pipeline and other projects will increase Enbridge’s takeaway pipeline capacity for Bakken oil to about 400,000 bopd—more than five times the capacity of the North Dakota system in the mid-1990s. Enbridge has proposed another major pipeline that would add 225,000 bopd to the river of Bakken oil flowing east to refineries in the Midwest and the South. The $2.5 billion Sandpiper Pipeline would stretch over 600 miles from Tioga, N.D., to Superior, Wis.

The True Companies of Casper, Wyo., a family-owned group of firms that operates four crude pipelines in the Bakken region, also is intent on expanding its capacity to meet rising demand for oil transport. Vice President Tad True says that revenues from the company’s Bakken operations have roughly quintupled since 2005 as it has acquired pipelines and built new ones to extend and strengthen its network.

Demand from crude producers in central McKenzie and Dunn counties in North Dakota prompted the construction in 2011 of the Four Bears Pipeline, which snakes 77 miles from New Town., N.D., to Baker, Mont., a major transshipment point for oil and gas. “Before production in that area even started to come online, they were calling us and saying, ‘Hey, you guys really need to consider building in this direction,’” True said.

The most famous pipeline in the Bakken is one that is yet to be built—the Keystone XL Pipeline, a 1,180-mile route from Canada to Nebraska proposed by TransCanada Corp. The controversial project would provide a handy on-ramp for 100,000 bopd of oil from Montana and North Dakota producers—if the U.S. State Department approves it. Environmental groups have objected to the transport of much larger volumes of heavy Canadian crude derived from tar sands because the extraction process consumes more energy and releases more greenhouse gases than other types of oil production.

Midstream companies also are busy laying hundreds of miles of gathering pipelines for oil, gas and drilling wastewater (which by law must be hauled to disposal wells). Last fall, Saddle Butte Pipeline of Durango, Colo., was building an oil- and gas-gathering system on the Fort Berthold Indian Reservation near New Town, and a Denver-based oil company formed a $180 million venture to construct oil-, gas- and water-gathering systems near Alexander, N.D.

All aboard the oil train

Many Bakken oil producers and shippers aren’t waiting for pipelines to be built to carry their crude to market. They’ve turned to trains (“pipelines on wheels”) to transport oil long distances, even though shipping by rail costs about $10 to $15 per barrel, depending on the destination, compared with about $5 per barrel via pipeline. The NDPA estimates that the percentage of Williston Basin oil transported by rail went from 6 percent in 2010 to 60 percent last year—over 450,000 bopd.

Trains have become a popular alternative to pipelines chiefly because they allow producers to sell Bakken crude at higher prices than the benchmark prices posted at pipeline hubs such as Clearbrook and Guernsey, Wyo. To get around pipeline chokepoints, producers started trucking their oil to train depots and in the process discovered that coastal refineries accustomed to buying high-priced imported “sweet” crude (which is easier to refine) would pay a premium for similar crude from the Bakken.

“Even with the higher transportation cost, it’s cheaper than buying at the Brent benchmark price,” said John Duff, an oil analyst with the U.S. Energy Information Administration, referring to the leading global price marker for crude oil.

What’s more, the iron horse offers Bakken producers more buyer options, delivering oil to refineries in Texas, Louisiana, New York, Pennsylvania and other areas not easily reached via pipeline. Last fall, Tesoro began shipping 30,000 bopd of Bakken crude by rail to a refinery in Washington state, and in February Delta Airlines received its first rail shipment of North Dakota crude at a refinery it owns near Philadelphia.

Rail hubs can be developed more quickly than pipelines, which must contend with harsh winters—frozen ground hinders trench digging—and a permitting process that can stretch out almost a year. Under the Obama administration, pipelines that cross federal lands are subject to heightened environmental review. (However, with the exception of Keystone XL, no new pipeline or rail facility in the region has been halted or delayed on environmental grounds.)

Over the past two years, about a dozen rail facilities dedicated to oil transport have been constructed in the Bakken, increasing rail hub listed capacity to 730,000 bopd, according to the NDPA. Pipeline operators as well as logistics firms specializing in energy transport are involved in many of the rail hubs.

The Bakken Oil Express, a rail hub located on a BNSF line west of Dickinson, dispatched its first oil train in the fall of 2011. Its anchor shipper is Eighty-Eight Oil, a subsidiary of the True Companies, which delivers oil to the hub via its Belle Fourche Pipeline. Other customers truck in oil from wells scattered all over Stark County. At startup, the facility could transfer up to 100,000 bopd into railcars; its owner, a Kansas-based logistics firm, was planning to build additional track, loading racks and pipeline connections to more than double capacity.

Other oil rail hubs in the Bakken include Enbridge’s newly expanded hub, which will allow Roehm’s team to load one 100-car unit train per day and send it down the line to markets served by BNSF and other connecting railroads, and a large crude oil terminal near Williston, N.D., owned by Inergy Midstream of Kansas City, Mo.

Railroads have made their own investments in tracks, tank cars, sidings and other facilities to support oil transport. BNSF, the biggest railway mover of domestic crude, spent $197 million for North Dakota and Montana infrastructure improvements in 2012 to increase its capacity to haul Bakken crude to about 1 million bopd.

To get around oil pipeline bottlenecks, many Bakken producers turned to the iron horse to deliver oil to distant markets. Photo courtesy of Enbridge.

Widening bottlenecks

All this rail development has dramatically increased crude transportation capacity in the Williston Basin, and producers are reaping the benefits. Sufficient quantities of Bakken crude are moving to the coasts by rail to push up the benchmark price of oil from the region. As midcontinent oil inventories have fallen, the Bakken discount to WTI has shrunk and at times disappeared (see Chart 2).

Rail transport of crude has increased so much that some transmission pipelines in the region are no longer full. True said that oil piped to the Bakken Oil Express hub has “taken away from our long-haul barrels” traveling south on True Cos.’ Butte Pipeline into Wyoming. “Rail is playing a very, very large role in oil transportation,” he said, “and you could argue that there’s not a lot of pipeline bottlenecks anymore because rail has taken so much volume away.”

The rise of rail has also rendered some proposed pipelines superfluous. Last November, Oneok Partners, an Oklahoma-based developer of energy infrastructure, canceled plans to build a $1.8 billion crude oil pipeline from Stanley, N.D., to Cushing because many producers opted to ship by rail instead.

Whether rail has busted oil transportation bottlenecks in the Bakken—and if so, for how long—is difficult to know. One issue complicating infrastructure planning is uncertainty about how much capacity for moving oil and gas will be needed two, five or 10 years from now. The NDPA’s crude oil production forecasts for 2023 range from 1.4 million to 1.7 million bopd, depending on how productive Bakken oilfields prove over time.But those are just estimates, taken with a grain of salt by producers and transportation providers contemplating long-term investments.

“Trying to get a grasp on where we think we’re going to land—what our production numbers are going to be—is absolutely critical as we build out this infrastructure,” said Ron Ness, president of the North Dakota Petroleum Council, a trade association for the state’s oil and gas industry.

The dynamics of energy markets also affect the use of existing capacity and the pace of additional infrastructure development. Preferred routes and transport modes for energy can change weekly as producers and midstream firms grapple with real-time network demand and fluctuating oil and gas prices, and react to decisions by other market players. Last winter, New Frontier Midstream was forced to reroute a proposed $70 million crude oil pipeline from southern Bakken oilfields to the Baker hub because the original line was intended to connect to Oneok’s canceled oil pipeline.

The role of rail in that cancellation is a sign that in the near term oil trains will compete with pipelines and, in some instances, displace them as shippers take advantage of high crude prices on the Gulf and Atlantic coasts. “I think there’s going to be a big tug of war between rail markets and pipeline markets,” True said.

However, most industry sources anticipate pipelines regaining their predominance in oil transport within a few years. New pipelines moving oil out of the Bakken and from Cushing to the Gulf Coast are expected to end the midcontinent oil glut by 2014, permanently shrinking or even eliminating the long-standing differential between Bakken crude and WTI prices. Without a sizable Bakken discount, “the economic incentive disappears” to pay high rail rates to the coasts, Duff said, because producers can earn equal or greater profits by piping oil to Midwest refineries at lower rates.

But maintaining the pace of recent capacity gains may be difficult, especially for pipelines. In addition to winter weather and permitting delays, pipeline developers lately have had to deal with private landowners who either refuse to grant right of way for projects or demand high easement fees. One-time easement fees have risen four- or fivefold over the past three years, said Helms of the North Dakota DMR. “Landowners are tired of being approached over and over and over again. They’ve become more resistant, and it’s become significantly more expensive to acquire that right of way.”

For all these uncertainties, the short history of oil and gas development in the Bakken suggests that producers and other stakeholders in the industry will manage to work the kinks out of the energy transportation system. The region’s mineral riches are simply too great for solutions not to be found.

Said Kringstad of the NDPA: “The industry and the state and all the landowners and the people living and working out there all have the same goal; we want to have a safe and efficient transportation system in place.”

The Quick Take: In North Dakota, about 30 percent of natural gas emitted from oil wells is flared because it’s less valuable than crude. But investment in the infrastructure necessary to process and transport gas is occurring, albeit at a slower pace than oil-related development. Moving gas from wellhead to market is more complex than crude oil transportation. Unlike oil, Bakken gas must be processed to separate out natural gas liquids and make them fit to ship. And dry gas (methane) and NGLs require different modes of transport. Because of relatively higher prices for NGLs, recent gas infrastructure development in the Bakken has focused to a greater extent on producing and transporting NGLs.

In North Dakota, oil is king. That becomes obvious at night, when the western part of the state lights up like a terrestrial birthday cake as oil wells across the Bakken region flare off natural gas that is a byproduct of oil pumping. So much gas is burning that satellite images of the region at night show a city-like constellation of lights, surrounded by blackness.

The associated gas that comes up with the crude is an economic afterthought for producers; despite the fact that gas accounts for one-quarter of the energy output of a typical Bakken well, it contributes only about 13 percent of the well’s value. In North Dakota, about 30 percent of natural gas emitted from oil wells is flared, according to the state Department of Mineral Resources (DMR).

Many developers of oil wells are content to flare gas—essentially wasting it—for several reasons. The first is that they are allowed to, for a while. A second is that collecting it requires significant investment in gathering pipelines and other infrastructure to capture gas and get it to market. And a third is the fact that such investments aren’t as lucrative as oil-related spending; gas prices have fallen sharply due to increased shale gas production across the country.

Nevertheless, the potential economic opportunity has lit a slow investment burn under the gas market in the Bakken. The infrastructure necessary to process and transport gas is getting built—just not at the frenetic pace of oil-related development (see “Busting bottlenecks in the Bakken”). More new wells are getting connected to processing plants, and since 2008 gas-processing capacity in North Dakota has more than doubled, prompting increased investment in gas transmission pipelines.

Part of the impetus for gas development is state law: In North Dakota and Montana, well operators who flare gas for months face restrictions on oil production. But the main reason more Bakken gas is being captured, processed and shipped is that it makes financial sense to do so. Bakken gas is more valuable than gas from other parts of the country because it contains a high proportion of natural gas liquids (NGLs)—so-called “wet” hydrocarbons such as propane and butane that command higher prices than methane (or “dry”) gas burned by power plants and household furnaces.

Natural gas may be produced simultaneously with oil in the Bakken, but the physics and economics of moving gas from wellhead to market are markedly different. Unlike crude, Bakken gas must be processed to make it fit to ship. And both raw and processed gas requires pipelines for transport, while NGLs can be moved by pipeline, rail or truck. Because of relatively higher prices for NGLs, recent gas infrastructure development in the Bakken has focused to a greater extent on producing and conveying liquids.

Construction crews under contract for WBI Energy lay a natural gas pipeline near Williston, N.D. Photo courtesy of WBI Energy.

Bakken oil—it’s a gas

North Dakota and Montana are not leading producers of natural gas (see back page map); federal production statistics lump them into the “other states” category, well behind major producers such as Texas, Alaska and Louisiana. In 2011, North Dakota and Montana accounted for less than 1 percent of U.S. gas production.

But gross gas production—the volume of gas coming out of the ground, including gas that’s flared—keeps marching upward in the western part of the district, along with that of oil. Oil and gas fields in North Dakota and Montana produced over 900 million cubic feet per day (MMcfd) last November, with most production increases over the past two years occurring in North Dakota and within the Bakken region, where gas and oil production go hand in hand (see Chart 1).

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At the same time, dry gas prices have fallen because of rising shale bed production not just in the Bakken, but also in other areas of the country, such as southern Texas and parts of New York, Ohio and Pennsylvania. Nationwide, gas production increased 21 percent from 2007 to 2012, according to the U.S. Energy Information Administration. Natural gas is sold on the basis of its heating value, measured in British thermal units (Btu). Last December, the U.S. spot price of natural gas was $3.34 per million Btu (MMBtu), less than half of the annual average price in 2008—and on a Btu basis, less than one-quarter the price of crude oil.

In areas such as north-central Montana that produce primarily methane—gas extracted from shallow wells or coal seams rather than oil shale—low gas prices have virtually halted exploration and drilling, reducing output. “The price is less than the finding cost,” explained Tom Richmond, an administrator with the Montana Board of Oil and Gas.

But countervailing market forces are at work in the Bakken, where the high NGL content of “wet” gas coming out of oil wells gives energy companies an incentive to capture and process it. Liquid hydrocarbons derived from gas not only provide energy, but also have myriad industrial applications. Gas liquids include propane, commonly used in outdoor grills and space heating; ethane, a vital ingredient of ethylene for making plastics; and butane, a blending agent in gasoline.

Such applications make NGLs much more valuable than dry gas. “It’s the natural gas liquids that are making the gathering and processing of the gas economic at all,” said Lynn Helms, director of the North Dakota DMR.

Liquids account for more than two-thirds of the value of Bakken gas (see “Pricing a Bakken barrel”), and as Chart 1 shows, NGL prices have tracked well above dry gas prices over the past three years. Prices for NGLs used in oil refining, such as butane and natural gasoline (pentane), were much higher, though all types of NGLs had depreciated since 2011 because of surging production from wet-gas plays such as the Bakken and the Eagle Ford in Texas.

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Another spur to gas development is state laws intended to cut air emissions and waste. In North Dakota, producers who flare for more than 60 days are required to cut back oil production, and after flaring for a year, they must either pay royalties on the torched gas or shut down the well. “You can’t burn this gas in the atmosphere forever,” said Rodney Wren, president of New Frontier Midstream, a Texas-based developer of gas infrastructure in the Bakken region. “Sooner or later, you’re going to have to do something with it, or you’re not going to be able to produce your oil.”

However, even after a year, many wells continue to flare gas; exemptions giving operators more time to connect to pipelines and market their gas are routinely granted by regulators.

Hess is expanding and upgrading its gas processing plant in Tioga, N.D. Photo by Phil Davies.

The processing boom

The value of NGLs, together with flaring regulations, is driving construction of new processing plants to separate liquids from dry gas and of pipelines and other facilities to move both commodities to market.

Over the past five years, gas-processing firms have built six new plants and expanded existing facilities in North Dakota, increasing processing capacity in the Bakken region from less than 400 MMcfd to about 925 MMcfd. The plants separate NGLs from dry gas so that they can be transported in liquid form. Some plants produce a blend of NGLs to be fractionated (separated out) later at facilities outside the region; others strip out individual liquids such as propane and ethane to be marketed separately.

One of the biggest players in Bakken gas is Oneok Partners of Tulsa, Okla., a “full-service midstream provider” that stores, processes and transports gas, charging producers a portion of the proceeds from gas sales. In January, Oneok announced up to $500 million in Bakken capital projects through 2015—spending that comes on top of about $2 billion previously invested in the region.

The company operates four processing plants in western North Dakota, including a $300 million, 100 MMcfd plant west of Williston that went into service last fall. Another 100 MMcfd plant is nearing completion near Williston, and a sixth is slated to come online outside Watford City in 2014. “We started ahead of the game before the [oil and gas] boom, and these projects just build upon our base,” said Oneok spokesman Brad Borror.

New York-based Hess has processed gas since the 1950s at its large plant in Tioga, N.D., and is one of the state’s biggest propane suppliers. A $500 million expansion project will more than double capacity to 250 MMcfd by year’s end, making the Hess complex the largest gas-processing facility in the state. As part of the expansion, Hess is upgrading its equipment to capture ethane from raw gas. Ethane makes up the largest proportion of wet gas by volume, but extracting it requires deep refrigeration, an expensive and energy-intensive process.

More new plants and expansions are on the drawing board. New Frontier Midstream has proposed building advanced processing plants near Dickinson, N.D., and Sidney, Mont., capable of capturing virtually all NGLs. The two plants will have a combined capacity of 50 MMcfd and, together with gathering systems, cost about $130 million to develop, Wren said. A total of 300 MMcfd of new processing capacity is slated to come online in the region by the end of next year.

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Burgeoning processing capacity has increased production of both NGLs and dry, residual gas (see Chart 3). The output of North Dakota plants, including two facilities just outside the Bakken region, rose steeply from 2010 to 2012. Propane and butane contained in NGL mixes accounted for most of production.

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Fluid movement

But as processing capacity has ramped up, expansion of gas pipelines has failed to keep pace. In North Dakota, one-third or more of processing capacity goes unused, because vast volumes of gas are burned off at wellheads, never reaching a plant via pipeline. The state has a “severe shortage” of gathering lines to transport gas to processing plants, said Justin Kringstad, director of the North Dakota Pipeline Authority (NDPA). (Flaring is less prevalent in Montana because the slower pace of well drilling gives producers more time to connect to gathering networks.)

“The good news is that over time...the number of wells getting connected is increasing” as processors extend their gathering networks into oilfields, Kringstad said. Over the past 18 months, the percentage of North Dakota gas that is flared has fallen from 36 percent to less than 30 percent, according to the state DMR. Also, the number of wells in the state producing gas for sale—indicating they’re connected to a processor via pipeline—rose about 45 percent between 2011 and 2012.

The rising output of processing plants is also driving demand for transmission infrastructure, especially facilities geared toward moving NGLs, to deliver processed gas to markets. Liquids can be transported by rail, and for years Bakken NGLs have been shipped in high-pressure tank cars to customers in the region (the Tesoro refinery in Mandan, N.D., uses butane as a gasoline additive) or distant fractionating plants.

Oneok operates an NGL rail facility south of Sidney linked by pipelines to its processing plants, and Hess and Texas-based Plains All American Pipeline also ship NGLs by rail. Some liquids are trucked to rail terminals from small field units that perform basic processing at the wellhead.

But as is the case for crude oil, pipelines offer a more efficient route to market for NGLs. Over the past two years, processors and pipeline companies have invested heavily in pipeline projects designed to transport NGLs swiftly and cheaply.

Oneok is spending half a billion dollars on the Bakken NGL Pipeline, the first pipeline in the region dedicated to natural gas liquids. Scheduled to go into service this spring, the pipeline will provide an outlet for Oneok’s own processing plants in the region, carrying 60,000 barrels of liquids daily for ultimate delivery to fractionating plants in central Kansas that supply much of the nation’s midsection. The company plans to spend another $100 million to more than double the pipeline’s capacity in 2014.

Alliance Pipeline, a Canadian firm, is capitalizing on NGL development in the Bakken by transporting liquids in gaseous form. The company’s main pipeline through North Dakota carries unprocessed wet gas from western Canada to a fractionating plant near Chicago. The Tioga Lateral Pipeline, a new $168 million, 79-mile line slated for completion this summer, will collect gas containing NGLs from Hess’s processing plant and pump it into this mainline.

A second $240 million pipeline scheduled to go online this fall will carry liquid ethane from the Hess plant north to a petrochemical facility in Alberta, Canada. (For more detail on gas transportation projects in the Bakken, see the table.)

Getting in the flow

Major pipeline projects in the Bakken region

Pipelines operating or under construction*

*Projects undertaken since 2011.
Sources: North Dakota Pipeline Authority; oil and gas industry reports

Proposed pipelines

Sources: North Dakota Pipeline Authority; oil and gas industry reports

Major rail facilities operating or under construction*

Table lists most hubs built since 2011; information unavailable for some facilities.
Sources: North Dakota Pipeline Authority; railroad and energy industry reports

Low natural gas prices have discouraged massive investment in dry gas transmission—the fat pipelines that deliver methane to utilities, manufacturers and other buyers. But the vapor left after all or most of the NGLs are extracted at processing plants “has to go somewhere,” observed Borror of Oneok. “Only a certain amount can be absorbed by the local market. We rely on long-range transmission lines to take gas out of the region and bring it to the market.” Gas piped out of the Bakken goes to regional markets such as Billings, Mont., and Fargo, N.D., and beyond to Minneapolis-St. Paul and other Midwestern cities.

Instead of undertaking expensive new pipeline projects to accommodate increasing volumes of dry gas coming out of the Bakken, pipeline firms have mostly added capacity to their existing networks.

WBI Energy Transmission of Bismarck, N.D., owns 3,700 miles of gas pipelines spanning North Dakota and extending into South Dakota, Montana and Wyoming. Its transmission lines feed into the Northern Border Pipeline, a major route for Canadian gas headed to the Chicago area. Without putting a lot of new pipe in the ground, WBI Energy has quadrupled its transmission capacity in the Bakken since 2009, said Rob Johnson, the firm’s director of market services and system planning.

Most of the expansion came from improvements (such as higher gas compression) on existing long-haul lines, but the firm has also built small, local pipelines such as a 12-mile segment connecting a Oneok processing plant to the distribution network, completed last year. “We continue to work a number of projects for takeaway out of the Bakken, as well as projects within the Bakken,” Johnson said.

Room to grow

Gas infrastructure development in the Bakken is expected to accelerate as gas production swells along with oil output. An NDPA forecast based on likely oil-drilling scenarios predicts that gas production in western North Dakota and eastern Montana will exceed 1,500 MMcfd by 2018—double last fall’s production—and keep rising for another decade.

As more gathering pipeline is laid to wells and flaring diminishes, additional processing capacity will be necessary to prepare gas for transport and sale. Oneok is operating under that assumption; in January, the firm announced plans to build its seventh processing plant in the Bakken, a 100 MMcfd facility scheduled to go into service near Watford City in 2015.

In the near term, transportation capacity appears adequate to move Bakken gas, including NGLs, from processing plants to regional and national markets. The Bakken NGL Pipeline when completed will absorb the entire liquids output of Oneok’s existing and proposed processing plants. And just as rail hubs have become release valves for crude oil (see “Busting bottlenecks in the Bakken”), trains will likely continue to transport NGLs from processing plants not served by pipelines.

As for dry gas, long-distance transmission pipelines transporting gas out of the Bakken had excess capacity at the end of last year, according to a study by Bentek Energy, an energy markets research firm.

On WBI Energy’s network, surging Bakken production hasn’t made up for reduced flows of methane from gas fields elsewhere in Montana and Wyoming, said Barry Haugen, the firm’s chief operating officer. As a result, only about two-thirds of WBI’s roughly 400 MMcfd of takeaway capacity from the Bakken was being used last fall. “It could be utilized more,” Haugen said. “We’ve got room to grow.”

But oil-like pipeline bottlenecks for natural gas and NGLs may develop within a few years as gas production increases. Unless crude oil prices—which strongly influence NGL prices—drop significantly, Bakken raw gas will continue to be collected and processed for the sake of its valuable liquids content.

Some in the industry believe that growing Bakken gas production will displace some Canadian gas on long-distance pipelines such as Northern Border and Alliance. Because oil is the real moneymaker for Bakken well operators, they may be content to discount their gas—making it more attractive than Canadian gas to U.S. buyers—simply to keep producing oil.

Long relegated to also-ran status, Bakken gas is coming into its own, and may one day—20 or 30 years from now—be as important to the economy of the region as oil. That’s because as Bakken wells age, they produce not only less crude oil, but also an ever higher proportion of gas with each remaining barrel of oil pulled from the ground.

This direct economic impact is difficult to measure. Federal labor statistics, for example, don’t track energy transportation as a discrete industry, with the exception of oil and gas pipelines. But the energy-moving business has clearly made a significant contribution to rising employment and tax receipts in the district’s oil patch.

Western North Dakota and northeastern Montana have seen strong growth in pipeline construction employment since the oil boom began, according to U.S. labor figures. From 2004 to 2011, pipeline construction jobs in North Dakota increased from fewer than 100 to more than 1,700, although the recession caused job losses (see chart). Montana also experienced a substantial jump in pipeline construction positions. Virtually all of these job gains occurred in oil- and gas-producing areas of those states.

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Railroad employment in the Bakken has increased since the recession, and anecdotal evidence suggests that many new jobs are related to rising volumes of outbound crude. Since 2011, BNSF has hired more than 550 new workers to fill positions in North Dakota and Montana. New rail oil-loading hubs in North Dakota, such as the Enbridge facility in Berthold and Musket Corp.’s crude oil terminal near the Montana border, have also generated new employment. At its hub in the hamlet of Dore, Musket employs about 45 workers—almost equal to the ghost town’s population during its heyday in the 1930s.

The fiscal impact of energy transportation is minor compared with that of oil and gas production, which is taxed on a value or volume basis in Montana and North Dakota. But state and local governments benefit from the burgeoning assets of pipeline companies, railroads and logistics firms. In 2011, pipeline infrastructure in North Dakota generated $29 million in property tax revenue, according to state tax records. That’s a 46 percent increase since 2004, adjusted for inflation. And some Bakken counties crisscrossed by pipelines saw bigger tax jumps over the same period; in Mountrail County, N.D., pipeline property tax revenue increased 16-fold in constant dollars.

Land appreciation during the oil boom accounted for some of these increases, but capital investment by pipeline firms also contributed to rising valuations and taxes.

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Not that long ago, North Dakota was one of the have-nots among a nation of haves. The state was losing population, and average earnings were declining compared to the national average. As has been widely publicized, that’s no longer the case. But while most observers attribute the state’s growth to the recent oil boom there, the longer-term story is much more interesting and compelling.

North Dakota’s rise is not unique. Research on historical earnings in three Ninth District states—the Dakotas and Montana—from 1965 to 2011 shows just how far states in the western portion of the Ninth District have come in terms of average earnings. The data also reveal similarities and differences in the performance of these states over time.

From 1970 to the late 1980s, western district states experienced a hardscrabble decline—mostly due to a struggling farm sector—that saw average earnings drop considerably compared to the national average. But the second period, from about 1990 to 2011, has witnessed an economic rebirth, especially in the Dakotas, with earnings climbing steadily and, in the case of North Dakota, streaking past the national average.

Ultimately, this is a story of economic transition brought about by changes in the performance of certain industry sectors that strongly influence the economies of thinly populated states like North and South Dakota and Montana.

Certainly some of this story is about oil, particularly in North Dakota, which is experiencing an energy boom that requires all such previously labeled periods to bear an asterisk. But earnings growth was plainly visible well before the boom, a matter that is particularly obvious in South Dakota, which has virtually no oil production to speak of. The good news is that the Dakota economies appear to still be on the ascent, and economists in those states see solid fundamentals for continued growth.

Tracking net earnings

To home in on the economic performance of the Dakotas and Montana, the fedgazette gathered data on average net earnings per person from 1965 to 2011 for the Dakotas and Montana. Net earnings, roughly speaking, equal wages, salaries and proprietor income after subtracting contributions to government social insurance programs. These earnings were compared to nationwide earnings over the same period, producing a relative earnings measure for each state over time.

The ratio of state to national net earnings per person often fluctuates modestly in any given year. In 1970, earnings in each of these three states were roughly 75 percent to 85 percent of the national average (see Chart 1). Over the next four decades, these states (especially North Dakota) went through an extremely volatile period, cut into two roughly equal halves of a rags-to-reasonable-riches story.

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“These findings fit the North Dakota experience to a T from my perspective,” said David Flynn, director of the state’s Bureau of Business and Economic Research and an economics professor at the University of North Dakota (UND).

Things started positively enough for the three western district states. Crop and livestock prices rose dramatically in the early 1970s in conjunction with rising exports. Strong farm earnings spilled over into farmland prices and other areas of the economy, increasing nonfarm earnings. With small economies (especially at the time), the effect in these states was direct and large (see Chart 2). North Dakota briefly experienced earnings that were well above the national average.

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Ultimately, that growth proved unsustainable; farm prices eroded quickly, pulling the rug out from under farmland values and dealing a harsh blow to these state economies. It’s interesting to note that an oil boom in North Dakota and Montana (to a lesser degree) in the late 1970s and early 1980s had little effect on the economic trajectory in these two states, save for a short blip in North Dakota. By the late 1980s, average earnings in these three district states had fallen to about 70 percent to 75 percent of the national average.
Because much of the earnings drop stemmed from farming, that also meant that rural workers and households took a bigger hit than those in metro areas, though Montana saw a significant drop among earners in both categories (see Chart 3).

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Movin’ on up

What happened over the following two-plus decades hardly could have been predicted. Since about 1990, there has been a remarkable resurgence in the western Ninth District economies (see Chart 1). By 2011, North Dakota had caught up to and streaked past the national earnings average, while South Dakota had earned parity—this from a flat-footed 74 percent in 1989.

Economies are complex entities, so the sources of these gains are multifaceted and vary by state. For example, earnings from agriculture and mining (which include oil and gas production) contributed moderately to the relative rise in earnings, but their effects are concentrated in recent years and unequally distributed among these three states (see Charts 2 and 5).

North Dakota has been a big beneficiary of strong farm and energy sectors. Oil production has led to a gusher of economic activity; with a robust farm sector in recent years factored in, average earnings in the state have leaped over the national average. According to Flynn, “There are clearly spillover effects from these sectors into others such as transportation and retail. We have also seen increased demand for services such as financial services and accounting services.”

Montana has likely benefited from growth in both sectors, but to a much smaller extent, while South Dakota has seen little impact from the oil boom; whereas, its farm sector has prospered. Gains in farming and mining—sectors largely conducted in the countryside—also translated to strong earnings gains in rural areas, particularly in the Dakotas (see Chart 4).

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But even before fracking for oil and gas became a household word, and before robust increases in farm prices, earnings in the Dakotas were making strides against the national average. South Dakota is an interesting case, because its economy has virtually no presence in oil or other mineral mining, yet earnings there have risen dramatically since 1990.

Some of the growth in relative earnings can be attributed to the fact that South Dakota as well as North Dakota avoided the catastrophic effects of the last three recessions—and particularly the most recent one—seen in other parts of the country. The state’s economic performance looks better on paper simply because it “suffered a less severe recession than did the U.S. ... We did not overbuild and participate in the subprime mortgage fiasco to the same extent as the U.S. did,” said Ralph Brown, an economics professor at the University of South Dakota (USD) and a member of the Governor’s Council of Economic Advisors. The state’s peak-to-trough employment loss was 3 percent—less than half of the U.S. rate of job loss, according to federal labor data.

Brown added that South Dakota has benefited from two major industry expansions. The state has a fairly small manufacturing base, but the sector has witnessed significant growth. The rise of computer-maker Gateway in the early 1990s kick-started sharp growth in employment and income. Across the state, manufacturing jobs grew by 10,000 during the 1990s—an increase of about 30 percent—to over 44,000 jobs.

In 2001, on the heels of a recession, Gateway moved most of its operations from North Sioux City to California, and by 2003 the state had lost about 7,500 manufacturing jobs. A subsequent recovery, followed by the Great Recession and another recovery, has pushed manufacturing employment once again over 40,000, according to Brown.

South Dakota has also benefited from “great growth” in the financial services industry, Brown said, fueled by expansion in credit-card banking. From 1990 to its peak in 2008, Brown said industry employment increased from 17,000 to 31,000—an average annual growth rate of 3.4 percent.

The last recession hurt employment in the financial sector, but some of that slack has been taken up by well-timed growth in the farm sector. From 1990 to 2012, farm income accounted for about 7.4 percent of personal income in South Dakota, Brown noted. But since 2011, farming’s income share has risen to over 12 percent. In 2011, farm income averaged $174,000 per farm proprietor.

Earnings capture only part of the farm impact. Farm production expenses amount to 20 percent of personal income, Brown said, “which makes farming a big player in the economy. Farming itself does not create new jobs directly, but the spending by farmers does. When things are going well, farmers purchase more trucks, tractors, farm equipment, farm building [and so on]. When things are not going well, they postpone these expenditures where possible.”

Flynn, from UND, also pointed out that even when farming wasn’t particularly profitable in the mid-to-late 1990s, the sector was still contributing to stronger households and businesses because “land prices continued to appreciate, so asset values for farmers continued to rise.”

Montana lags its neighbors

Among the three western district states, Montana has fared the worst, experiencing both a larger fall from 1970 to 1990 and a smaller rise since 1990 compared with the Dakotas (see Chart 6). Montana saw only modest gains in relative earnings, rising from a low of 69 percent of the national average to 79 percent in 2011.

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Along with farm struggles shared with the Dakotas in the 1970s and 1980s, Montana also saw two major industries—mining and forestry—go through significant upheaval during this period. The city of Butte was home to the Anaconda Copper Mining Co., one of the largest companies in the world in the 1920s and one of the largest in Montana for its entire operational life. The company went through regular boom and bust cycles, but by the 1970s the mine once known as the “richest hill on earth” was at the end of its useful life. The mine was sold to ARCO in 1977, which shuttered it in 1983.

“We lost almost 8,000 well-paid union jobs at the mines and two refineries” that were shut down with the mine, said Paul Polzin, director emeritus at the Montana Bureau of Business and Economic Research at the University of Montana who has studied the state economy for 35 years.

In the mid to late 1980s, the wood products industry also mechanized and restructured, resulting in the loss of thousands of high-paying jobs. Employment peaked in 1979 at about 13,500 and has zigzagged its way to roughly half of that level today—the victim of Canadian softwood and other lumber imports, low prices, slow housing markets and other factors. Montana’s forest products industry made up about 16 percent of the state’s economic base in the late 1980s, according to Forest Service research. That share has steadily dwindled. By 2006—a year before the start of the home-building collapse and recession—it had fallen to 9 percent.

All Montana’s relative earnings growth has come since 2000—and most of it occurred before 2007 as mining and construction industries fed off the housing boom and rising commodity prices. Though the state did not suffer as steep a downturn in the subsequent recession as the nation, the housing collapse nonetheless knocked the state’s growth trajectory lower starting in 2007.

Seizing opportunity

Economic fortunes have swung so dramatically in the Dakotas that it’s easy to forget the arduous economic path both states were treading in the 1980s—well, it’s easy for non-Dakota residents to forget.

Brown, for one, said, “I think South Dakotans appreciate the significant changes that have taken place in the state over the decades.” Some change requires time to take hold. He pointed to the development of a four-year medical school at USD in the mid-1970s “that led to many more South Dakota physicians and the subsequent development of Sioux Falls as a regional medical center.” Combined with the city’s financial services niche and an expanding economy in general, “college-educated students, more than ever before, do not have to move to the Twin Cities, Omaha or Denver to find a job compatible with their education,” Brown said.

The state is also well positioned to benefit from worldwide demand for food, fiber and energy, Brown said. The state’s business climate is an attractive selling point to businesses of all types, and while “growth of the financial sector is a bit more murky ... demographics and public policy will drive the demand for medical care, which will continue to be a growth sector in the economy,” said Brown. “I think South Dakota is poised to take advantage of whatever that future may hold.”

In North Dakota, the oil boom offers the state a unique opportunity to mold its future for generations. Almost fortuitously in retrospect, the state has seen prior booms and subsequent busts that left painful scars. Now many firms, investors and other market participants are battle tested.

As the economic promise becomes more tangible with every new oil well, Brown added, “I think there are more that view this as a once-in-a-lifetime opportunity. ... Individuals tend to recall the oil bust of the early 1980s and use that as an argument for better planning. As a result, I think the gains are likely more permanent in nature.” The boom has sparked discussion across North Dakota about “the structure of the tax system, about infrastructure needs and economic development. I interpret these as efforts to capitalize as much as possible on the current growth environment and lock in whatever gains they can.”

Map: County-level change in earnings

Trust companies tend to charter in states with regulatory environments that are friendly to parties bequeathing substantial wealth. And on that measure, South Dakota is happy to see its secret getting out. For the better part of a decade, the state has seen a flurry of new charters for private and public trust companies. Though there are few solid measures of such matters, it appears that the state is a national leader—possibly top of the heap—in attracting such firms.

South Dakota has become a trust company magnet mostly because it has configured an attractive regulatory environment for trusts, one that emphasizes asset protection, privacy and other traits coveted by wealthy individuals. Though the state’s geographic location is not ideal, neither is it a huge hindrance, as evidenced by the many new trust companies chartered in recent years. But while assets managed or otherwise administered by in-state trust companies have grown to eye-popping levels, the broader impact of this industry on the state economy has been quite modest.

Whom do you trust?
A trust, at its core, is a financial relationship in which one party (the trustor) gives assets to a separate person or organization (the trustee) to be held and managed for the benefit of a third party (the beneficiary). Trusts are created for many reasons: to provide future financial security to children and other family members, for charitable purposes, and for tax savings and improved wealth management.

The trust market is a bit of a data anomaly, despite the huge financial assets involved. Trust companies are regulated by a patchwork of federal and state agencies, and their information is not shared or aggregated at virtually any level. Finding something as innocuous as the number of new trust companies chartered nationwide every year is sheer guesswork unless a person has the time to contact every state (and no one has done it to date, at least publicly).

But industry sources widely view South Dakota as one of the best places to charter a trust company, and the state collects a fair amount of data on its homegrown industry. At the end of 2012, there were 65 trust companies chartered in South Dakota, virtually all of them authorized within the past 15 years. Maybe more intriguing is that total trust assets have grown to more than $120 billion (see chart).

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South Dakota’s trust business dwarfs that of most states. Minnesota, for example, has just three nonbank trust charters, and there have been no new charters since 2005. They have combined assets of a little over $7 billion, the large majority of it with Ameriprise, according to Patrick McLuen, chief bank examiner with the Minnesota Department of Commerce.

Banks haven’t exited the business, according to industry sources, but neither are they beating down the doors of this financial niche. Bank call data analyzed by the Federal Reserve Bank of Minneapolis show that about 15 South Dakota banks (about one in five) reported “income from fiduciary activities” (which includes trust services) in any year since 2001.

Curt Everson, executive director of the South Dakota Bankers Association, acknowledged that most banks in the state are not involved with trusts. But among larger banks that are, “I get the sense that trust operations are a significant and valued part of the bank’s overall operations,” he said.

But it used to be that “banks were the only [trust] game in town,” said Pierce McDowell, co-founder and co-CEO of South Dakota Trust Co. of Sioux Falls. McDowell started Citibank’s trust office back in the early 1990s, which drew clients from around the globe. During that time, “we were lucky to get 100 clients a year, and that was considered a good year.” Today, South Dakota Trust is handling about 75 new clients every quarter, McDowell said.

Trust the driver
South Dakota’s growth in this high-finance sector “is a combination of several factors, in addition to good old appreciation in the markets,” said Bret Afdahl, director of the South Dakota Division of Banking. Some factors are fundamental, generating broad demand for trust business across the United States, like rising wealth, which has been well chronicled for its steep ascent over the past decade or more for those at the top.

Simple demographics also play a role, as the World War II (so-called greatest) generation and the fast-retiring baby boomer generation are increasingly making wealth transfer plans. “It’s been described to me [as] the largest transfer of wealth from one generation to the next in human history,” said Afdahl.

High-net-worth individuals also have been investigating trust options more aggressively given the uncertainty surrounding the estate and gift tax exemptions and the year-end federal fiscal cliff that garnered so much national attention. Afdahl said that trust assets under management “jumped quite a bit as there was a rush to establish and fund new trusts at the end of the year.”

McDowell, from South Dakota Trust Co., believes that his client base was possibly inflated by fears of change to the $5 million estate tax exemption. It was set to expire at the end of last year but was ultimately extended and indexed to inflation by Congress, with the highest estate tax rate raised to 40 percent (from 35 percent, though lower than the 55 percent rate that would have otherwise kicked in).

But the industry had been growing briskly before any talk of fiscal cliffs. In fact, trust company charters and assets increased steeply during the recession—despite huge losses in financial markets—because wealthy individuals exited equity markets in search of longer-term financial security.

For these myriad reasons, the trust industry is not particularly beholden to the ups and downs of the economy. “There is wealth transmission all the time regardless of whether the economy is booming or in recession,” said David Lust, a partner at the law firm of Gunderson, Palmer, Nelson and Ashmore.

Why trust anywhere else?
South Dakota’s large share of this growing market is the product of trust-friendly state law and regulation, part of a pattern of widely recognized friendliness to business. Openness to trusts was kick-started in the second half of the 1990s, when a governor’s trust task force began laying a regulatory foundation that was rigorous yet welcoming to trust companies, according to state and industry sources.

Lust, the current chair of the trust task force, said that the task force was crucial in “creating a friendly environment for trusts.” Afdahl agreed, noting that the task force continues to tweak regulations, and that its importance “cannot be overstated in all of this [trust growth]. ...Every year, we go through and analyze what other states are doing and what we can do better” to remain an attractive location for those considering trusts and trust companies.

“We’re always looking for subtle differences,” Afdahl added. Without this group meeting every year to make incremental changes to South Dakota trust law, “we would be where most other states are currently at—behind the curve of a fast-moving landscape.”

The specific structure of that regulatory environment is hard to describe without getting bogged down in the tedious and often arcane demands of wealth management and related government regulation. Suffice it to say, there are certain traits that the industry seeks for its clients, and South Dakota ranks high on many of these qualities.

According to Afdahl, “It really is a laundry list of things...[but] it all starts with the Common Law Rule Against Perpetuities,” which tries to limit the duration of trusts to about 100 years. South Dakota passed a state statute abolishing the rule, thereby allowing trusts to be established in perpetuity. “Many states have not repealed this common law principle and are therefore not even considered for the dynasty trust business,” which helps families manage multigenerational wealth.

Not surprisingly, the wealthy tend to pay attention to taxes, and South Dakota is one of the few states without a corporate or personal income tax and no tax on investment earnings. Life insurance is also common in trusts, and the state imposes the lowest life insurance premium tax in the country, according to industry sources.

Confidentiality is also critical to trust clients. “Privacy is a big deal....Our confidentiality laws are very strong, and this is a very important factor for most ultra-high-net-worth families,” said Afdahl. South Dakota is the only state in the country with a “total seal forever” law, which means that all records in any lawsuit are permanently sealed. (Delaware is next best with a three-year seal).

Startup capital costs are also low in South Dakota. Afdahl said that many states “view trust companies through the bank lens and require $1 [million] to $2 million in capital, which is very difficult for a startup company.” In contrast, South Dakota requires just $200,000 for private trust companies, “and we are at or near the lowest minimum.”

Trust our soundness
But trust friendliness should not be confused with deregulation or riskiness, according to Afdahl, Lust and other industry sources. For example, like banks, trust companies pay annual fees to the state to support examiners (currently five) who analyze trust companies for financial soundness.

“It’s a matter of balancing the ability of new companies to form versus the costs of failure,” Afdahl said. “As I tell the Legislature every year...we are taking on some degree of risk with every [trust] company that we charter.” That risk might entail the cost of closing down a trust company and the associated harm to the state’s reputation. Since 1996, only one trust firm in the state has failed—a public trust company that went under in 2003 and “was somewhat complicated to resolve, but mostly just very slow moving.” The matter was finally resolved just last year, Afdahl said.

But the nature and consequence of risk is “fundamentally different” for a trust company than for a bank, Afdahl pointed out. The assets that are managed or administered by a trust company “are not on the balance sheet of the trust company like loans are on a bank’s balance sheet.” The trust company itself is independent of the assets, so the financial health of a trust company is not tied directly to market fluctuations. If the asset value of a trust goes down, it’s the trust beneficiaries who suffer. The trust company “will have explaining to do, and may lose some business” in terms of client fees, Afdahl said, but the trust client absorbs the market loss.

The trust market has also been evolving, with new types of trust companies often offering specific, scaled-back services rather than the full service (including asset investment) that has been traditionally common. As a result, South Dakota has seen a spurt of public trust companies offering administrative and custodial services (see sidebar for more discussion), and state regulators have adjusted accordingly, Afdahl said. Because public and private trusts are fundamentally different, “we are now asking more of our public companies [in terms of regulations] and are charging them more in supervision fees.”

This past fall, Afdahl said, the state finalized new regulations and capital requirements for public trust companies. “While representatives of the public trust companies weren’t necessarily happy about the new, tougher regs, they did understand the division’s rationale and did actually testify in support of the new rules.”

Location, location, location?
Despite the gargantuan pile of assets now being managed or administered by trust companies in South Dakota, their growing number has made only a modest economic impact in the state.

Many new (typically public) trust companies do not directly handle asset investment and management services; these tasks are often performed by firms and advisers that already have a relationship with the client before the creation of the trust. Even for in-state trust companies that do manage investments, trust assets are not lent to businesses and households, which means that the concentration of trust businesses in the state doesn’t have near the financial spillover as banks and other financial institutions with similar capital.

Afdahl estimated trust company employment at not even 100. That’s not a lot, even in a small state like South Dakota. But trust company employment has grown 80 percent since 2009. Trust companies also contract for attorneys, accountants, marketing firms and other labor, rather than putting them on payroll. Much of the work related to trusts—whether by a trust company or contract labor—tends to be highly skilled and well compensated. In a place like Sioux Falls, home to more than 50 trust companies, the cumulative effects on employment and business vitality can be considerable. Similarly, there are nine trust firms in Pierre, a city of just 13,000, which gives this small city a little financial cachet.

One might think that being in the middle of flyover county far from the affluent coasts would be a huge hurdle for new trust firms. McDowell, from South Dakota Trust Co., acknowledged that “it takes a lot of work to spread the word” that South Dakota is the locus of smart-money trusts. “I go into board rooms today, and there are a lot of people that are still provincial” in their decisions about where to go for trust services. “You kind of accept it and move on.”

In the past, if you mentioned South Dakota, “you’d get laughed out of the board room,” McDowell said. “But quietly, we’re making great inroads. If someone is achieving success, someone else is going to see it. We’re a little more sophisticated than people give us credit for.”

Lust agreed that not being close to either coast “is somewhat of a barrier. ...You’re a long, long way away” from big client pools and many of the financial firms that ultimately manage trust assets. But wealthy individuals “depend on their experts” to tell them where to do business, and that’s why South Dakota can compete with other trust-friendly states like Delaware and Nevada, according to Lust.

Given that location is not an insurmountable obstacle, the surprising part might be that other states are not competing for this business. “It’s probably a function of [state] culture” and the environment that state lawmakers choose to create for any type of business, said Lust. The best places for trusts and businesses in general, he said, “are usually one and the same.”

Trust companies come in two basic forms: public and private. In a nutshell, private trust companies are family-based and have been the core of trust business until fairly recently. They are limited to a single family lineage, but often include multiple generations. A private trust company does not act for unrelated families or accept outside business. In general, these companies are not required to provide as much regulatory capital as public companies and do not have to establish the same in-state presence so long as the trust company allows state trust regulators to conduct efficient examinations.

The circumstances surrounding the creation of a private trust are many, and they are often unique to the family. In terms of the wealth required—well, as the saying goes, if you have to ask how much money you need, you don’t have enough.

“The general rule of thumb I have heard several times is that a family needs $200 [million] to $250 million in assets to make a [private] trust company worthwhile from a cost perspective,” said Bret Afdahl, director of the South Dakota Division of Banking. “Having said that, we do have families with less assets that chose to establish their own [private] trust company for other reasons,” many of which are specific to South Dakota’s regulatory environment for trusts (see main article).

A public trust company, in contrast, resembles a traditional bank trust department in some ways; it solicits and accepts new accounts from unrelated families or individuals who typically have much less wealth. Think of it as the retail trust business.

Public trust charters have increased dramatically since 2007 (see chart) and now represent 60 percent of all trust companies in South Dakota. But rather than replacing private trusts (which have continued growing), public trust companies appear to be carving an entirely new niche.

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Many of these public trust companies are serving people interested in self-directed independent retirement accounts, according to Afdahl. These financial vehicles allow an individual to make his or her own investment choices for a retirement plan. However, the Internal Revenue Service requires that a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner.

Enter public trust companies, many of which are playing administrative and custodial roles for individual trusts and do not invest or otherwise manage trust assets. “We have had a lot of interest from groups interested in doing [this] work,” Afdahl said.

He added that self-directed IRAs also allow individuals to invest in nontraditional assets such as real estate, precious metals, business ownership and other assets that cannot be held in traditional retirement accounts and have become more common since the financial crash in 2008.

This custodial role distinguishes independent, public trust companies from many bank trust departments, which typically manage assets and offer a full slate of other services. “They [banks] want to manage assets. They don’t want nonmoney assets,” according to Pierce McDowell, co-CEO of South Dakota Trust Co., a public trust company in Sioux Falls that provides administrative trust services. The firm administers more than $9 billion in assets, but it does not invest or otherwise manage those assets. “In our world, I don’t see a lot of banks competing with us.”

And it might be hard to imagine, but Afdahl said—and the South Dakota market is showing—that new public trust companies are serving a previously neglected class of customers a cut below the uber-wealthy.

“We consistently hear from applicant groups that the larger institutions do not provide the same level of customer service to people in certain net worth categories,” said Afdahl. Big trust companies and banks “want the ultra-high-net-worth customers, but do not show as much interest in or provide the same level of customer service to those below the very upper crust. This has provided an opportunity for smaller companies” to pursue clients in different markets nationwide from their headquarters in South Dakota.

Over the past five years, the aggregate value of taxable sales and purchases in the state more than doubled (see Chart 1), averaging over 15 percent growth annually. In the decade preceding the boom, taxable sales averaged just over 2 percent growth annually. In the fiscal year ending in June 2012, taxable sales and purchases totaled $23.4 billion, raising $1.5 billion in sales tax collections.

The source of the state’s growth in sales taxes is not exactly a surprise, given the high-profile expansion of the state’s oil industry. But a look at taxable sales and purchases by industry and geography shows the full influence.

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Over a third of the increase in overall taxable sales and purchases can be directly attributed to oil activity. Sales of drill bits, fracking chemicals, well casings, drilling mud and other inputs used in the production of oil and gas have experienced a 12-fold increase over the past five years (more than doubling every other year). The mining and oil industry now accounts for about 20 percent of total taxable sales and purchases in the state (excluding sales of oil and gas, which are subject to production taxes). In contrast, for most of the decade prior to 2007, the industry’s share barely ever rose above 1 percent of the total.

The other two-thirds of the increase in taxable sales and purchases appears to be largely spillovers from the oil boom. This is hard to prove, but correlations between taxable sales and purchases in mining and oil and other industry sectors were relatively weak before 2007, but very strong afterward. Collections from the wholesale trade sector have nearly tripled since 2007, but were more or less constant over the previous 10 years, hovering at around $450 million.

The oil boom has had a less dramatic effect on consumer spending. Retail sales historically account for half of taxable sales and purchases and have risen since 2007, but at a comparatively modest 5 percent annual growth rate (see Chart 2).

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Impact of the Bakken

Since 2007, nine Bakken area counties have accounted for well over a third of the total increase in North Dakota sales taxes—this despite having just 11 percent of the state’s population. Sales taxes in the Bakken counties jumped in 2008 with the increase in oil drilling, subsided in 2009 when oil prices and drilling dipped and accelerated swiftly once oil drilling picked up again (see Chart 3). Sales to businesses that operate in multiple counties or out of state are not attributed to an individual county, and sales assigned to this “other” category account for 41 percent of the increase. It’s hard to say for certain that these businesses are oil-related, but the movement of this category closely follows that of Bakken counties.

Sales figures from the remainder of the state account for less than a quarter of the increase in total taxable sales and purchases. Ward, Burleigh and Morton counties encompass the cities of Minot, Bismarck and Mandan, gateway cities to the Bakken oil-drilling area. Sales taxes for these counties accelerated starting in 2011. Meanwhile, the state’s largest eastern counties (Cass and Grand Forks counties, home to Fargo and Grand Forks) show only a modest acceleration starting in 2011, similar to all remaining counties in North Dakota.

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The Bakken influence can also be seen in terms of the distance of sales transactions from the oil-producing region. The farther a county is away from the Bakken, the slower is average growth in sales taxes (see Chart 4). Prior to 2007, this spatial relationship with the Bakken area was relatively weak.

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The Bakken effect can also be seen among the state’s larger cities. Between 2010 and 2011, taxable sales and purchases in Dickinson and Williston (the two largest cities in the Bakken area) increased by over $1.4 billion (79 percent), of which $660 million came from growth in the mining and oil extraction industry and $280 million from growth in wholesale trade.

The fastest growing businesses in Williston and Dickinson were in transportation and warehousing, for which taxable sales and purchases increased by 197 percent in 2011. Among the four largest cities outside the Bakken (Bismarck, Minot, Grand Forks and Fargo), taxable sales and purchases in this category fell by 7.4 percent.

Video: fedgazette Editor Ron Wirtz on government employment

Let’s start with introductions. Public sector employment, meet Wile E. Coyote.

You’ve never met, but an introduction is in order because the two of you share a unique characteristic: You both know how to temporarily defy gravity.

Wile E., remember the time—actually, those hundreds of times—you ran off the cliff chasing the Road Runner but stayed suspended in the air in ignorance, until reality finally set in and you plummeted to earth, followed by a huge boulder for a little extra hurt at the bottom. Remember that?

Public sector employment, you were doing the same thing for a while across thousands of state and local government units. At the height of the recession, private employment was falling like it was tied to that boulder. But what did you do? You actually floated higher. But then reality set in for you, too, and look out below. It’s been tough watching you fall because private employment is still trying to pick itself up off the ground below you.

It’s a scene now uncomfortably familiar to thousands of government workers in the Ninth District. Public sector employment has fallen significantly over the past couple of years, following a similar—if delayed, and not quite as steep—decline experienced by the private sector during the recession.

Today, the fact that people are losing jobs doesn’t merit a lot of special attention, even for supposedly secure government jobs. It’s almost like we’re immune to the pain—like Wile E. Coyote dusting himself off after yet another death-defying fall. Yet it’s worth tracing the arc of public sector employment over the past decade to better understand both the moment of levitation and the comparatively sudden fall.

Of course, this is not the first time government workers have lost jobs. But rarely have there been job losses of this magnitude—almost 19,000 from the first quarter of 2010 to the same quarter of 2012, or about 2 percent of the 1 million public sector workers in Ninth District states. In past recessions, public sector employment tended not to decline dramatically, in part because most recessions have been fairly brief, and governments often prefer belt-tightening to dramatic cuts in personnel.

The Great Recession from late 2007 to 2009 was a large—and somewhat ironic—exception to that rule: Public sector revenue and employment actually increased for many governments during and shortly after the recession thanks to the federal stimulus program, which shoveled tens of billions of dollars to state and local governments to stave off further unemployment in the economy.

But the effect was short-lived. A slow economic recovery has kept a lid on tax revenue, and once stimulus funds were gone, government budgets cratered. Tough decisions finally had to be made almost everywhere in the Ninth District, save for North Dakota, whose economy, government budgets and public employment are growing, in contrast to most of the country. Montana and South Dakota have lost public employees since 2010, and government payrolls in Minnesota and Wisconsin have been volatile, especially at the local level, for a decade.

Jobs have been lost at every level of government in recent years, but the biggest losses have been at the local level, in part because that’s where most of the jobs are, but also because state aid to cities, counties and school districts has been cut back as states deal with their own fiscal shortfalls.

Public sector score card

Explicit trends in government employment can be difficult to nail down given some 13,000 government entities just in Ninth District states. But breaking them down by government jurisdictions—local, state and federal—helps identify some of the broader trends.

Recent job cuts have been spread widely among local, state and federal government workers in district states (see Chart 1; see tabs in chart for district state breakdowns of local, state and federal employment trends). Federal employment is the smallest share of total government employment in any district state (between 8 percent and 16 percent, depending on the state). Nonetheless, almost 5,000 federal workers across the district lost their jobs over this two-year period. But rather than being an artifact of the recession, federal job losses stem mostly from the buildup and subsequent wind-down of the decennial census.

State government employment saw steady growth in district states for the better part of a decade—even during the recession—largely thanks to growth of general administration, corrections, health and human services, and higher education, which is seeing record enrollments across the district. But that payroll trend pivoted in 2011, and more than 3,200 jobs were eliminated by the first quarter of 2012, almost two-thirds of them in Wisconsin, and most of the remainder in Minnesota.

But the lion’s share of job losses occurred among local governments, with employment falling in 2010 and accelerating a year later, with almost 12,000 local government employees losing their jobs over this two-year period. More than 60 percent of those cuts occurred in Wisconsin, but every district state except North Dakota saw local government employment fall over this period.

But local government employment trends are diverse and complex, partially due to size and scale; roughly two-thirds of all public sector jobs in a state are at the local level, scattered among thousands of government bodies. Part of it is mission; local governments include county, city, township, school district and special district units, each with its own public service niche. Lastly, part of it is geography and economy; local governments face different financial circumstances depending on their home state’s economy, among other factors. Sources in booming North Dakota, for example, report very different concerns than those in Minnesota and Wisconsin.

The pathway here

Most laid-off government workers ultimately lost their jobs because of the recession and its impact on tax revenues. But many were also victims of a budgetary vise that had been developing for much of the past decade, especially in Minnesota and Wisconsin: persistently falling financial aid from states and rapidly rising property taxes.

States pass along aid to local governments in various forms, and many of them have been flat or declining in real dollars for a decade or better. For example, so-called shared revenue is a formula-driven sum given to local governments. Local governments in South Dakota saw shared revenue fall by 10 percent from 2006 to 2011, according to the state’s latest comprehensive annual financial report. (All dollar figures in this article have been adjusted for inflation.)

States also give categorical aids to help local governments manage things like roads and other services, and many of those aids also have fallen in real terms. Among the top seven sources of local revenue for Wisconsin local governments, all aid categories fell between 2005 and 2010, while property taxes and various charges for services rose (see Chart ). Shared revenue dropped by 10 percent to $924 million, and has continued to fall. According to recent figures from the state Department of Revenue, shared revenue this year is expected to be about 8 percent below 2010 levels.

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States have tried to limit property tax increases, with varying success. Wisconsin local governments have been under property tax levy limits for 10 years, and a property tax freeze for the past two years, according to Richard Stadelman, executive director of the Wisconsin Towns Association. With cuts in shared revenue in three of the past 10 years, the effect on local government finance is “dramatic,” he said.

In Minnesota, it’s the same story, or worse. Total state aid to local (nonschool) governments has trundled steadily lower; in 2012, it gave towns, cities and counties $1 billion less in aid than a decade earlier (see Chart 3).

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“For the last decade, there’s been a significant shift in the financing of local government,” said Jeff Spartz, executive director of the Association of Minnesota Counties. The state mandates that counties provide certain public services with the understanding that “it would fund what it said needed to be done,” he added. “[But] the state has solved its own budget deficit by cutting back on aid to local governments.” (See sidebar.)

To fill out their budgets, local governments in Minnesota and elsewhere persistently chose to raise property taxes (see Chart 4), often along with fees and other revenue sources.

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“The state has passed the buck to the local level for revenues,” said James Hendrickson, clerk of Wang Township in Renville County, Minn. The town’s expenses have risen “considerably” in recent years, he said, requiring the town to raise property taxes three years in a row to continue basic services, and also depleting the town’s reserve fund. As of late October, “we are at the lowest level of financial reserves that we have ever been,” he said.

A stimulating budget filler

The run on rapidly rising property taxes ended around 2008 or 2009, when property values started dropping. Like Wisconsin, many states have bent to voters’ discontent over rising taxes by capping allowable increases in local revenue as well as property assessments, tax rates and levies—or sometimes all of the above.

In years past, this has been less of a problem, as cities, counties and school districts could depend on modest (or better) increases from the appreciation of property values. But with stagnant or dropping property values, these revenue handcuffs meant local government income grew more slowly and sometimes fell; meanwhile, many governments couldn’t shed service requirements.

In Minnesota, for example, property tax revenue from 2002 to 2009 rose at an annual real rate of about 4 percent for Minnesota counties and towns, 5 percent for cities and 8 percent for K-12 school districts, according to the Office of the State Auditor. In the three subsequent years, tax revenue for these same local governments increased by an annual average of 1 percent or less.

But the budget shock was offset considerably by the American Recovery and Reinvestment Act (ARRA)—a.k.a. the federal stimulus program—which funneled billions of dollars to state and local governments starting in 2009, enabling them to keep payrolls afloat. For example, about $750 million went to local governments at all levels and sizes in Hennepin County (home to Minneapolis), according to an October county report [pdf]. The money supported government efforts in housing, infrastructure, job training, education, public health and a multitude of other priorities, many of them with the overarching goal of supporting public sector employment.

Hennepin County government received $12 million directly. But ARRA’s goal of job creation, according to the report, “was challenging … because we rightly saw the infusion of federal funds as temporary, arriving at a time when our basic local and state resources were stressed by the recession. As a result, stimulus funds were often used for ‘job retention’ by replacing declining local funds” or hiring only on a short-term rather than permanent basis.

By 2010, a sluggish economic recovery and the end of the stimulus funding meant the start of hard choices for many, and job cuts were widespread. Wisconsin, however, saw the biggest decline. A federal database on stimulus funding shows that five district states received about $3 billion in education funding, with Wisconsin getting close to $1 billion, via some 3,000 individual grants, with all K-12 school districts receiving multiple grants. State aid to Wisconsin schools had been declining steadily for several years, yet school district employment in 2009 increased by more than 1,500 employees over the previous year, including almost 1,000 new teachers. Higher property taxes were making up for some of the lost state aid, but the federal stimulus was a well-timed budget filler.

But when stimulus funds ran out—starting in 2010 for some and by 2011 for virtually all school districts—jobs started to fall under the ax (see Chart 5). These cuts accelerated when the state Legislature passed Gov. Scott Walker’s controversial plan (known as Act 10) to restrict collective bargaining rights of local and state government unions. It also required workers to pay more for health and pension benefits, and the state used those savings to cut aid to local governments to fill a $3.6 billion state budget deficit. Schools lost $600 million in state aid in the 2011-12 school year, according to Department of Public Instruction figures, and job losses mounted. That trend is not expected to quickly subside: The agency recently noted that 64 percent of the school districts will receive less aid for the current school year.

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The long view of public sector jobs shows that state government jobs are growing, having added about 14,000 since 2001, despite recent losses (see Chart 6). Every district state saw these ranks grow, led by an increase of more than 5,000 in Minnesota.

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But at the local level, the federal stimulus interrupted a long period of stagnant or falling local government employment, especially in Minnesota and Wisconsin. From 2001 to 2007, local government jobs grew by 2,000, a rounding-error increase of 0.3 percent amid 680,000 such jobs. Stimulus dollars saved and created thousands of jobs, but with the economy still struggling, the overarching trend reasserted itself once those funds were spent. Since 2001, total local government employment is pancake flat in district states—by 2012, there were just 13 more local jobs, according to federal data.

However, district states have seen very different local government job trends. Minnesota has lost 8,000 such jobs over this period; Wisconsin saw considerable growth through the recession, but then shed it all in recent years, seeing a net loss of about 200 by 2012. Local governments in Montana and the Dakotas combined have added more than 8,000 workers to payrolls since 2001, much of it in growing metropolitan counties in those states and booming oil country in western North Dakota and eastern Montana.

Which way is up?

Local governments facing tight budgets are reacting in a variety of ways, seeking greater efficiencies and choosing services to either protect or cut (see accompanying article).

More cities appear to be feeling the floor beneath them, but they may be in the minority. In 2009, just 17 percent of Minnesota cities reported an improved ability to meet service needs. That proportion rose over the next two years, to 30 percent, and slightly more (31 percent) predicted more favorable conditions for 2012, according to the most recent State of the Cities report by the League of Minnesota Cities. The report manages to sound half full rather than half empty by stating: “Some challenges cities have dealt with over the last several years may be lessening, or at least not worsening.”

But until the economy gains its footing and state budgets rebound, most local governments are preparing for more of the same. Minnesota, for example, is facing a $1.1 billion state budget deficit.

“I think [local budgets] are going to be pretty difficult given the structural deficit at the state level,” said Spartz, from the Association of Minnesota Counties. Barring dramatic political changes, he’s not expecting any significant new revenue for counties. With baby boomers retiring, demands on county services will increase. Yet most counties expect that persistently tight budgeting is “the fiscal environment we’re going to be in well into the 2020 era,” Spartz said.

Tongue firmly in cheek, Spartz suggested that the only real relief from tight budgets, service requirements and rising costs would be a variation of Jonathan Swift’s prescription for solving economic troubles in his essay, “A Modest Proposal.” “Take geezers like me and put them on Lake Mille Lacs just before ice out.”

Research Assistant Dulguun Batbold contributed data research to this article.

The Quick Take: The recession has induced tighter budgets for many local governments. While payrolls have often been cut, governments have also employed a variety of strategies—cooperative agreements, compensation freezes, deferred maintenance and productivity improvements—to make budget ends meet. While most budget areas have been affected in some fashion, cutbacks on streets and other infrastructure could have consequences down the road.

Nobody likes a crisis. But oftentimes crises have a way of focusing the mind and clarifying some underlying, fundamental values.

State and local government budgets have come under considerable financial pressure in recent years—even before the recession in some states. Jeff Spartz, executive director of the Association of Minnesota Counties (AMC), said a tight budget has some silver lining to it because “it encourages you to see the most important things that you do. It’s a good thing to do occasionally. But we’re doing it chronically now.”

For local governments in particular, tight budgets have put many public services in the barber’s chair, with some getting a trim, others a buzz cut. Local governments are employing many strategies to make the numbers work and still provide service, including staffing cuts, contracting for services and “doing more with less” by seeking greater efficiency and productivity.

Not all local governments in the Ninth District are in the same fiscal boat because state economies have performed very differently over the past decade. Minnesota and Wisconsin governments have traveled the longest and hardest road; Montana and South Dakota have faced some rough sledding, but most of it has been recent. North Dakota’s strong economy, and resulting tax revenue, continues to defy trends virtually everywhere else. Most of the discussion that follows will focus on Minnesota and Wisconsin because those states gather considerably more data on local government spending than Montana or the Dakotas, and both have endured more fiscal stress over the past decade, which offers a larger window for analysis.

How tight the belt?

Local government budgets are determined by a variety of factors, like population growth, local real estate investment and property value appreciation. But many are also at the financial mercy of their state governments, which pass along considerable revenue aid (or not, as recent trends show), place mandates on many locally provided services and often limit the ability of those same local governments to raise local revenue (see cover article and sidebar).

In Wisconsin, local governments have labored under property tax levy limits for 10 years, and a property tax freeze for the past two years, said Richard Stadelman, executive director of the Wisconsin Towns Association. In three of the past 10 years, state shared revenue has also been cut. “It’s dramatic,” Stadelman said about local government finances. “Over time, it’s gotten tighter and tighter.”

What has resulted is often a stark separation of (inflation-adjusted) spending growth between states and their local governments. In Minnesota, local government revenue has shifted lower after each of the last two recessions, while state revenue has maintained consistently stronger growth (see Chart 1).

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Tight budgets have forced local governments to find different ways to keep the books balanced, from straightforward cutting to reorganizing departments and increasing taxes and fees to contracting for services and holding the line on employee compensation.

In Minneapolis, the city’s expenditures last year were about 20 percent lower than in 2009. Job cuts filled in much of the gap; the city eliminated 11 percent of its workforce (445 jobs) over this period. In anticipation of lower property taxes and federal and state aid this year, Mayor R. T. Rybak proposed further spending cuts of 3.4 percent. In announcing his budget, Rybak said, “Reform is not just an option, it’s a necessity. We simply don’t have the luxury of doing things the same old way.”

Harold Blattie, executive director of the Montana Association of Counties (MACo), said his member counties were facing milder budget challenges than peers in other states, but revenues nonetheless were “not keeping up with operational costs in virtually every county in our state.” Most counties have reacted by freezing current employee salaries or granting very small cost-of-living increases, he said, and keeping vacant positions unfilled longer.

Jeff Spartz, from AMC, noted that Minnesota counties have embraced so-called lean concepts—common in manufacturing—“that allow you to identify things that don’t add value,” like multiple workers and redundant tasks involved in a permit approval. “Most counties are looking to find ways of doing things more cost effectively.”

In mid-2011, the League of Minnesota Cities started a database of budget-balancing anecdotes from local communities, and it now lists more than 500 actions either taken or considered by cities of all sizes. “It contains a good range from the simple, low-hanging fruit to the more complex,” according to Rachel Walker, LMC manager of policy analysis, via email. The most common strategies identified—among a couple of dozen—involve contracting for services and doing more work cooperatively with other local governments, either formally or informally. Such strategies attempt to preserve service delivery while cutting back on employee wage and benefit costs, as well as equipment and other operational expenses.

That cooperative strategy appears to have gained some traction since the recession. A May 2012 report from the Minnesota Legislative Auditor found that cooperative agreements increased among almost 80 percent of responding counties and 40 percent of cities from 2005 to 2010; less than 1 percent said they had decreased. A Michigan survey last spring of local government officials found that 37 percent of respondents in the Upper Peninsula expected more intergovernmental agreements, and 10 percent expected increased privatization and contracting for services.

One common cooperative agreement deals with public safety, as many small communities resort to the once unthinkable—putting police and/or fire coverage in the hands of another entity. Since 2009, the city of Mound, Minn., had seen its tax capacity drop by 39 percent, causing its budget to fall as well. Cutbacks followed across virtually all departments, and full-time employees were cut from 50 in 2009 to 41 last year. Several job cuts came in the police department, whose 2012 budget still accounted for more than one-third of all city expenditures, according to city officials.

Faced with further budget troubles, in September, Mound disbanded its police department and contracted with the nearby city of Orono for police coverage. The city reported that the contract will save taxpayers about 10 percent in annual costs, or about $200,000, much of it coming from the elimination of the police chief’s position, which was officially vacant and being manned on an interim basis. None of Mound’s 10 full-time officers lost their jobs.

The move is not uncommon. In a police survey last year by the LMC, one-third of respondents (nearly 150) reported that police service provisions in their community had changed over the past 10 years, but the actions taken varied. The most common change (16 percent) was a reduction in staff, including paid officers, while other cities entered new contracts with the home county for law enforcement services and created new cooperative agreements with nearby cities. A total of 81 cities (18 percent of respondents) said they were currently considering such options.

Canosia Township in St. Louis County, Minn., might be completing the life cycle. More than a decade ago, it had its own police force. Tight budgets convinced it to contract with the county sheriff’s department. The township has not budgeted for future years, and “we are spending down the current balance. When this fund is exhausted, [the town is] not sure if we will do any sheriff contracting,” said Scott Campbell, the town board chairperson.

No money for brass tacks

When budgets get tight, priorities are often defined by the size of the cut because local governments appear to prefer an approach that spreads the pain widely.

The city of Waverly, a community of 1,300 located about an hour west of Minneapolis, has lost almost all of its state and federal aid over the past several years, forcing budget reductions of 13 percent from three years ago, according to Mayor Connie Holmes. The city lowered its property tax levy for 2013 by 3 percent in an effort to hold down property taxes. But a change in state requirements for calculating property tax capacity (and how taxes are allocated among property types) forced taxes on businesses to rise by 20 percent, and Waverly has lost businesses as a result.

Internally, the consequences for city services have been widespread. “All departments have had to cut … and our staff is doing more with less,” Holmes said. All work on parks was eliminated, and spending for general administration and staff overtime has been cut. “Street repair and improvements are not possible. … Snow removal [is] not as often, and other repairs on infrastructure [have been] delayed,” she said.

Other Minnesota cities appear to be taking a similar tack, according to an annual report on fiscal conditions by the LMC. To fill budget gaps from 2007 to 2011, cities depended less on raising taxes and more on decreasing spending—though cities were hardly going all in with either strategy (see Chart 2).

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In terms of the services most affected, local spending reflects a “cut them all” approach. For Minnesota cities and counties, spending decreased virtually across the board from 2009 to 2012, according to data from the state auditor’s office (see Chart 3). The only area of increase came in health care spending, the large majority of which occurs at the county level and includes various health care services and clinics, as well as restaurant inspections, the collection of vital statistics data and communicable disease control.

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Local government sources were reticent about all service cutbacks. But infrastructure seemed to be a central concern for many. “When times are tough, [infrastructure needs] tend to be the first” on the cutting list, because these cutbacks are not immediately noticed, said Dan Thompson, executive director of the Wisconsin League of Municipalities. “You fire a crossing guard at the school, and parents notice immediately. Cut back on road resurfacing, and the average citizen doesn’t notice. But 10 years from now, you’ll have a serious problem.”

Roads and other infrastructure didn’t necessarily see the biggest spending cuts. But they are unique among many public services because they come with spending tails in the form of constant maintenance, and failure to keep up can create backlogs that get proportionately more expensive over time, like the leaking roof you let go for too long, causing eventual damage to your home.

Yet general road spending has been flat or declining in many places. In Wisconsin, inflation-adjusted road and highway spending (including current expenditures and capital outlays) by local governments fell by 3 percent from 2000 to 2010 (the most recent figures), with townships and municipalities sustaining the worst cuts (see Chart 4), according to figures from the state Department of Revenue.

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“Highways aren’t as good as they used to be. We see [towns] back off improvements, and as a result you have rougher roads and more potholes,” said Richard Stadelman, head of the Wisconsin Towns Association. “The problem is compounded by increased traffic from heavy farm and other machinery, including more trucks carrying multiple loads of frac sand destined for oilfields,” prematurely aging inadequately maintained roads. At the same time, federal and state gas taxes are not generating the same amount of revenue to be shared among highway agencies—the result of more fuel efficient vehicles and less driving due to higher gas prices. “There are greater needs, but less funding,” Stadelman said.

Minnesota offers a more recent picture of road spending, and it’s similar to Wisconsin’s. From fiscal years 2009 to 2012, total real road and highway spending in Minnesota fell by about 3 percent, with townships faring somewhat better and counties a bit worse than their easterly neighbor (see Chart 5). There is parallel evidence of slowly deteriorating roads. A Minnesota state transportation plan revealed that the percentage of roads with poor ride quality more than doubled from 2002 to 2011 for principal arterials (2 percent to 4.8 percent) and rose 350 percent on nonprincipal arterials (2.4 percent to 8.6 percent); the state’s freeways ranked 44th out of 50 states (50th being the worst).

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Road budgets also don’t go as far as they used to because costs have been high and continue to rise. “Everything a road department does—from paving roads to crushing gravel—is driven by [high] petroleum prices,” said Blattie, from MACo.

Roads also represent only part of a state’s investment in infrastructure; other types of capital investment include drinking water and treatment systems, schools and other facilities. Since the mid-2000s, total capital outlays have been flat to negative at Minnesota’s many levels of government. In Minnesota, real capital spending by the state government and counties has seen a sharp drop in recent years; school district spending has been flat for close to a decade, and cities saw a small and steady increase through 2011, but a sharp decrease last year (see Chart 6).

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Public opinion? Yes and no

Governments walk a tightrope between balanced budgets, greater efficiency and quality public services.

“It’s a challenge to innovate and invest in this current climate,” said Linnea Mirsch, deputy county administrator with St. Louis County in northern Minnesota. “Doing more with less has now become doing less with less.” The county has cut staff and services or, in some cases, not added staff despite increased service demands, all of which lead to longer wait times for existing services. For example, health and human services has seen a significant increase in demand “due to the effects of the economy on the people we serve,” yet the county has not added staffing, said Mirsch.

The recession and slow recovery have forced cities to adapt to a new normal. Some are likely much better at it than others. “The art of budgeting is to ask for what you want and take what you need,” said Alec Hansen, executive director of the Montana League of Cities and Towns. He described municipalities there as “stable,” which included modestly rising wages, while those of state workers have been frozen. “Generally, I think [Montana] cities are in pretty good shape. We could use more money, but we’re getting by.”

Some of that stability likely rests on a hardscrabble notion of being satisfied with what you have. “In small towns across the prairie, service levels might be lower, but they’re adequate,” said Hansen. “We get by with less. … [Tight budgets] are a condition of survival. It doesn’t mean you can’t do it.”

Montana cities have had a lot of practice, according to Hansen, going back to a 1986 law that froze property tax rates. “If you live under a property tax freeze for 26 years, you learn pretty quick what’s needed.” When budgets get tight, Hansen said the first to go are things like spending for parks and recreation that don’t represent a “middle-of-the-night crisis with sirens.”

Whether tight budgets are seriously eroding the quantity and quality of public services is ultimately a question for taxpayers, whose current attitude appears to run the gamut, according to district sources. Many said constituents have been patient and understanding because they know money is tight. Others said they’ve seen the ugly side of constituents who want services and believe local governments could offer them if only they weren’t so wasteful.

In either case, tight budgets might be encouraging a better understanding of what local government is and does, and what services taxpayers are willing to pay for. Spartz, from the Minnesota counties group, said most people “don’t deal with the county except when writing this big check twice a year” for property taxes, while counties’ core services are for courts and social service programs like welfare and medical assistance. “Most of those are services people don’t want to get entangled with.”

Even the most flexible, forward-thinking government can run into roadblocks not of its own making. Numerous local government sources said unfunded state and federal mandates often prevent cities, counties and school districts from cutting costs and becoming more efficient.

Don’t believe it? Here’s a simple example, born of tradition: Many states still require local governments to post meetings and other official news in a printed newspaper, when web posting is readily available, free and arguably more accessible to the public.

New unfunded mandates show up every year. In Minnesota K-12 schools, the state has mandated new personnel evaluations that are “very prescriptive in statute,” said Gary Amoroso, executive director of the Minnesota Association of School Administrators. The new evaluations will go into effect for principals this year and for all teachers next year, none of which comes with any implementation dollars. “Nobody is arguing with accountability. The challenge is, where are the funds and time [for evaluations] going to come from?” said Amoroso. State legislators, he said, “don’t want to have unfunded mandates. But they keep coming out.”

Many mandates are minor, but others not so much. The Minnesota Inter-County Association (MICA) is a coalition of 12 large Minnesota counties (but does not include Hennepin or Ramsey). In its platform for the 2012 legislative session, it said that “relief from unfunded mandates … has been a recurring desire of counties.” Of particular importance is relief from so-called maintenance of effort requirements, “where the state literally tells counties how much they must spend for certain programs and sanctions them if they do not.”

The state also requires that counties share in the costs of certain state-mandated programs. In 2011, the Legislature raised counties’ share of new sex offender civil commitment costs from 10 percent to 25 percent and counties’ share of chemical dependency treatment costs from 17 percent to 23 percent.

Combined, MICA said these two mandates alone required some $430 million in annual county spending and should be repealed given “the Legislature’s emphasis on living within existing resources without raising taxes. … The Legislature cannot have it both ways. Either give counties the legal authority to actually reduce their expenditures or stop criticizing them when they increase expenditures and the property taxes to support them to meet the requirements of state law.”

States are often cognizant of the problem and have sought input on reforms from local governments. The Minnesota Office of the State Auditor now has a repository of several hundred reform suggestions from towns, cities, counties and schools.

But the task of reform is complicated. “There is a lot of talk about mandate relief,” said Jeff Spartz, executive director of the Association of Minnesota Counties. But mandates are often so entangled in both federal and state requirements “that [state] legislators just throw up their hands.” One example is a recent effort to simplify the application for state-based medical assistance, which is administered by counties. In Nebraska, a person must fill out a two-page application, Spartz said. In Minnesota, the application ran 21 pages, much of it filled with questions (for data-gathering purposes) or resource information for the benefit of applicants. Efforts to simplify the application winnowed it to “just 17 pages,” according to Spartz.

States have also bent to voters’ discontent over rising taxes by capping local revenue increases, along with property assessments, tax rates and levies—or sometimes all of the above (see table). In years past, this has been less of a problem; cities, counties and schools depend on modest (or better) increases merely from the appreciation of property values. But with stagnant or falling property values, other caps can mean local governments are forced to lower budgets without the ability to also shed service requirements.

South Dakota has been under a tax freeze since 1997 that limits revenue growth at the rate of inflation plus an adjustment for new construction, according to Diane Worrall, executive director of the South Dakota Association of Towns and Townships. If a town wants to increase its property tax revenue, it must go through an opt-out process that requires voter approval. That affords some flexibility, and many cities, counties and school districts in the state have chosen this opt-out feature.

But, Worrall said, “there have been very few townships that have opted out—guessing, I would say no more than 20 percent.” Part of the reason is that towns also face a property tax (or “millage” rate) cap of just 3 mils, so “most opt-outs for townships don’t generate much revenue.”

The housing sector is showing signs of recovery and, despite drought in some areas, the agriculture sector remains in good shape. However, concerns remain over government fiscal issues, a recent manufacturing slowdown and global economic conditions. Personal income and employment are expected to grow in 2013.

Cautious optimism

Respondents to the business outlook poll are optimistic overall, but more pessimistic than respondents a year earlier. District business leaders are cautious about economic conditions in the nation and in their respective states, but are more optimistic about prospects for their own businesses.

One place for renewed optimism is the housing sector, where sales and building are bouncing back. According to the Minnesota Realtors Association, closed sales in Minnesota increased 13 percent in November from a year earlier. In Sioux Falls, S.D., November closed sales were up almost 20 percent.

Stronger sales have contributed to lower inventories and higher prices. In third quarter 2012, prices in the Minneapolis-St. Paul metropolitan area increased 13 percent from a year earlier; in Sioux Falls, S.D., and Fargo, N.D., prices increased 5 percent and 4 percent, respectively.

Construction crews had more homes to build in 2012. Through November, housing units authorized were up across all district states. However, other than in North Dakota, housing units authorized totals are still far off their peak levels (see Chart 1 below). According to results of the business outlook poll, overall housing starts are expected to increase during 2013. The Minneapolis Fed’s forecasting models are mixed regarding the 2013 housing outlook.

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A holiday hiccup in consumer spending?

During 2012, consumer spending showed moderate gains; however, initial measures indicate that holiday shopping was relatively mild nationally. Regionally, district retailers were cautiously optimistic for the holiday season. For example, according to the University of St. Thomas Holiday Spending Sentiment Survey, households in the Minneapolis-St. Paul area were expected to spend 10 percent more on holiday gifts than a year earlier. According to retail business contacts in the district, holiday sales in the region were probably somewhat stronger than in the nation.

There are signs that households are moving toward a better position to spend. Household balance sheets have generally improved during the past few years as many have paid down debt. Combined with recently increased home values, the debt pay-down has given households relatively more wealth.

Furthermore, consumers continue to face relatively stable prices. The consumer price index in November was up 1.8 percent compared with a year earlier. Home heating costs remained in check, as natural gas prices were relatively low during the early part of the winter. Minnesota gasoline prices in December were about the same as a year earlier. The core rate of inflation, which excludes energy and food prices, was up 1.9 percent from a year ago.

One area where consumer spending has been consistently strong is vehicle sales. Throughout 2012, district auto dealers have enjoyed substantial gains in sales. For example, during the first 10 months of 2012, registrations for new cars and light trucks increased 31 percent in Minnesota compared with a year earlier. Registrations were up 13 percent nationally.

The Minneapolis Fed’s forecasting models suggest that personal income will grow in 2013, which will help support consumer spending. According to the business outlook poll, 30 percent of respondents expect increased consumer spending in their communities, while 25 percent expect decreases.

Employment expected to grow moderately

Employment in district states during November grew 1.4 percent from a year earlier, the same as in the nation (see Chart 2). Natural resources and mining posted the strongest growth (+10.7 percent), followed by construction (+2.6 percent) and education and health services (+2.5 percent). Leisure and hospitality was the only sector with year-over-year employment losses (-.4 percent).

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Gains in natural resources and mining were supported by continued expansion of oil drilling in western North Dakota and eastern Montana, the location of the Bakken oilfield. In September, 21.4 million barrels of oil were produced there, up from 13.2 million a year earlier, and accounted for 11 percent of U.S. oil output.

The number of active drilling operations in North Dakota decreased somewhat in recent months as oil companies cut costs and increased efficiency after drilling a number of initial producing wells to meet leasing requirements. While employment continues to grow rapidly in the area, the brisk pace of growth has eased somewhat as evidenced by a leveling in the number of online job postings in the North Dakota portion of the Bakken. Meanwhile, drilling in Montana has picked up recently as oil companies have expanded exploration in the western part of the Bakken.

Growth in construction employment was supported by increases in home building. Employment gains in education and health services continue in a sector that has consistently posted increases over the past few years.

According to the Minneapolis Fed’s forecasting models, nonfarm employment will grow moderately in 2013, with stronger growth expected in North Dakota and Minnesota. Employment growth in the Upper Peninsula of Michigan will remain sluggish. Unemployment rates are predicted to drop in all areas. The unemployment rate in North Dakota is expected to drop to 2.8 percent.

Despite employment gains, respondents to the business outlook poll indicated that securing workers will be challenging, but a bit less so than a year earlier. In the recent survey, 39 percent expect securing workers to be a challenge or serious challenge in 2013, down slightly from 41 percent in the prior survey.

Respondents to the business outlook poll expect modest employment gains in their communities during 2013 and somewhat stronger increases in employment at their own businesses. Respondents to the manufacturing survey expect level employment for their state economies and moderate gains at their own companies.

Signs of caution

Despite the overall positive tenor of the forecast, several risks are causing district businesses to remain cautious. Respondents were concerned about fiscal cliff negotiations and other budget issues. Business leaders seem to be looking for a clearer picture of what to expect for tax and spending policy before making some decisions on capital expenditure and hiring plans. With the fiscal cliff deal reached on Jan. 1, some concerns will be alleviated.

Concern was also expressed over a slowdown in manufacturing, which has been a key component of the recovery. According to a survey of purchasing managers by Creighton University (Omaha, Neb.), manufacturing activity in Minnesota and South Dakota decreased for five straight months before posting a gain in December, while manufacturing in North Dakota posted relatively strong growth throughout 2012.

One drag on the manufacturing sector is slowing growth in exports due in part to economic malaise among several trading partners. Through October 2012, manufactured exports among five district states (not including Michigan) increased 5 percent compared with a year ago, down from 11 percent growth for the full year of 2011. Manufactured export growth ranged from a high of 25 percent in North Dakota to a 4 percent decrease in Montana.

District manufactured exports to Europe, where struggles continue with government debt and other fiscal issues, decreased 3 percent through October 2012. Manufactured exports to China were flat during this period. District manufactured exports to China have typically posted strong growth rates, including 13 percent in 2011 and 35 percent in 2010. While China’s economy continues to grow, its growth rate has dropped recently, which has dampened demand for district exports.

Despite the recent slowing in the district manufacturing sector, year-over-year employment levels are up, and respondents to the manufacturing survey are relatively upbeat for their companies’ orders, production and employment levels in 2013.

Agriculture remains strong despite drought

From early in the growing season, many agricultural producers were concerned about how 2012 would turn out. In contrast to 2011, a year marked by substantial flooding around the district, 2012 was a year of drought. Fortunately, much of the Ninth District was spared the worst of the dryness, and low production elsewhere put upward pressure on prices, boosting farm incomes. Livestock and dairy producers haven’t fared as well, however, as higher feed costs squeezed margins. The outlook for both crop and animal product prices remains strong in 2013.

In 2012, farmers and ranchers saw big increases in prices for their products from their already strong 2011 levels (see table below). And in contrast to many agricultural states, the district saw production increases from 2011 for most crops, including corn (+5 percent), soybeans (+7 percent), wheat (+28 percent) and sugar beets (+32 percent). Dramatic production increases for sugar beets and for wheat and other small grains largely reflect a return to normal, since 2011 production was set back by flooding. While prices for several farm inputs, including fertilizer and chemicals, increased during 2012, these prices were offset by gains in crop prices.

According to the Minneapolis Fed’s third-quarter (October 2012) agricultural credit conditions survey, 2012 was a strong year for agricultural income, with 95 percent of respondents reporting increased or steady income following several quarters of increases. Household spending and capital investment increased similarly. Agricultural lenders are somewhat optimistic about farm profits in the final quarter of 2012, with 60 percent expecting increased income and only 6 percent expecting decreased income.

Animal producers enjoyed continued strong prices (see table). After 2011’s large increases, prices retreated slightly for hogs and milk (both down 8 percent), while cattle prices continued to rise (7 percent increase). These prices weren’t enough to offset higher feed costs faced by meat and dairy producers.

Again, the outlook for 2013 is upbeat, as agricultural producers invest their profits. In addition to positive returns on investment, output prices are expected to rise. According to U.S. Department of Agriculture forecasts, 2013 prices for corn, soybeans, wheat, cattle, hogs and dairy are expected to increase. However, this outlook depends on whether the 2012 drought persists or fades into memory.

More on the District Forecast

District Forecast—Nonfarm Employment

District Forecast—Unemployment Rate

District Forecast—Personal Income

District Forecast—Housing Unit Authorizations

Ninth District Economic Forecasts

The multiyear manufacturing expansion that started in 2010 moderated in 2012. Orders were up in 2012 for half of survey respondents and down for 27 percent. About a third reported increased employment in 2012, while 27 percent reported reduced staffing. Manufacturers also reported higher prices and productivity, but lower profits. The Dakotas reported the strongest growth in 2012. Large and medium-sized firms also saw stronger performance compared with small employers. Wages and benefits grew about 2.2 percent in 2012.

Manufacturers across the district expect stable growth in 2013, with the exception of those in the Upper Peninsula of Michigan (see chart). Orders and total production are expected to increase, buoyed by solid productivity gains and higher selling prices. As a result, profits should increase.

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One-quarter of respondents expect manufacturing employment to grow in 2013, while 16 percent expect job cuts. Wages and benefits are again expected to increase by around 2 percent. Increased exports are anticipated across the district in 2013.

This industry optimism runs counter to the negative outlook many have for their state economies. Respondents expect declining state economic growth and decreases in overall corporate profits, capital investments and consumer spending. However, the boom should continue in North Dakota, as all indicators are up. Inflation is also a concern, as 60 expect higher inflation, while only 1 percent foresee lower inflation.

Manufacturing survey data [xlsx]

Ninth District Manufacturing Business Conditions Survey Methodology - November 2012

Business leaders in the Dakotas are very optimistic, thanks largely to the oil boom there, while others are more tempered in their enthusiasm. Companies across most of the Ninth District expect sales to increase in 2013, and they also plan to invest more in capital equipment and hire more people.

Firms expect to raise prices and increase wages, but are concerned about government regulation. More broadly, business leaders expect housing starts to rise, but were mixed in their local assessment of consumer spending, employment and business investment. They also expect higher inflation and slow growth at the national level.

Companies expect continued growth in 2013

“Demand for our products continues to be strong,” said a western Wisconsin agricultural producer, which reflects the overall mood of higher sales among most industries and geographic areas across the district (see Chart 1). Respondents from the Minneapolis-St. Paul area and North Dakota are the most optimistic about sales growth, while respondents from greater Minnesota are the least optimistic about sales.

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Retailers, real estate professionals and manufacturers expect the biggest gains in sales. In addition, sales prices are expected to rise, as 30 percent of all respondents expect to raise prices in 2013, compared with 20 percent who expect to drop prices. With drought covering much of the United States, 47 percent of agricultural producers expect increases, and only 13 percent expect decreases.

Almost 70 percent of business leaders also saw higher productivity last year, a trend that should continue, as capital investment is expected to increase across all geographic areas and most sectors. “We expect high demand for our services that automate back office processes for organizations,” commented a Minneapolis area technology company. In addition to increases in capital investment, slight to modest employment increases are expected at firms across much of the district and most business sectors.

Respondents indicated that they may have an easier time financing capital expenditures because access to credit has improved over the past three months. Seventeen percent of respondents indicated that access to bank credit has improved some or improved a lot versus 9 percent who noted deteriorating conditions. This improvement occurred across industry sectors, save for services, and across district states with the exception of North Dakota and Michigan's Upper Peninsula.

District businesses face some challenges. More than two-thirds of the respondents said that complying with government regulation was a challenge or serious challenge. In addition, 39 percent said that securing workers was a challenge. This labor concern varied across the district, with a high of 68 percent of the respondents from North Dakota and a low of 26 percent from Montana reporting difficulty.

Modest state, sluggish U.S. growth expected

Fewer leaders were optimistic about their state economies compared with last year (see Chart 2). Optimism is strong in the Dakotas, while respondents from greater Minnesota and western Wisconsin are somewhat pessimistic (see Chart 3). “Due to the Bakken oilfield, our state and region are experiencing unprecedented prosperity,” commented a North Dakota transportation respondent. This optimism/pessimism also flows into the outlook for state economies.

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Expectations for local communities generally followed the same pattern. Respondents from the Dakotas were positive about employment, business investment and consumer spending. Respondents from greater Minnesota were negative, and even more so in the U.P. Most industry sectors were slightly positive about their state economies, except agriculture, which was negative about employment and consumer spending.

Most areas of the district expect statewide housing starts to increase in 2013 compared with 2012. The only exception is the U.P. Respondents from the construction, retail, services and finance, insurance and real estate sectors were very optimistic about housing starts.

Wages are also expected to rise modestly, with 62 percent seeing 2 percent to 3 percent increases, while 31 percent expect 0 percent to 1 percent increases. Respondents from North Dakota expect much more robust wage increases; 44 percent expect increases of 4 percent or more. Among industry sectors, construction and manufacturing expect the largest wage increases, while the retail sector expects the lowest increases.

Respondents are pessimistic about national economic conditions. About a quarter expect a recession, while 61 percent expect 1percent to 2 percent growth in GDP in 2013. The national outlook “remains highly uncertain due to the fiscal cliff and implementation of new regulations,” particularly in federal health care, commented a Minnesota manufacturer. Inflation is also a concern, as 26 percent expect CPI to increase by 4 percent or more, and a third expect inflation of around 3 percent.

Business Poll Results [xlsx]

A postcard survey was mailed to each of the selected businesses. The mailing was sent on November 6th, and a second mailing was sent in mid November to businesses that did not respond to the first mailing. A cutoff for survey responses was December 5th. A total of 542 usable surveys were received, for a response rate of 23 percent. Of the usable surveys, 85 were from manufacturers indicating that their specific location had no manufacturing on site.

Survey results were tabulated for all manufacturers. The confidence interval for sampling error was calculated. The 95 percent confidence interval for the table of results for all manufacturers is plus or minus 4.1 percentage points. Results are also subject to errors introduced by other factors, such as the wording of questions and differences between survey respondents and nonrespondents.

Note: The Minnesota Department of Employment and Economic Development produced and processed the surveys for Minnesota manufacturers, and the Federal Reserve Bank of Minneapolis conducted the survey for manufacturers in Montana, North and South Dakota, Ninth District counties in western Wisconsin and the Upper Peninsula of Michigan. Due to some problems with USPS, some of the surveys were not sent in the initial mailing.

See article:
Manufacturing activity up again in 2012; stable activity expected for 2013

Mountainsides of dead trees surround Sun Mountain Lumber, a sawmill in Deer Lodge, Mont. Over the past three years, the needles of countless lodgepole pines turned brown, then red, then dropped off to expose gray, lifeless trunks. The trees were killed by the mountain pine bark beetle, an insect that has ravaged thousands of square miles of pine forests in mountainous areas over the past 15 years, including western Montana and the Black Hills of South Dakota.

“The good news is, in this particular area, the beetle has kind of run its course,” said mill manager Tony Colter. Sun Mountain, the largest private employer in the Deer Lodge Valley with 145 workers, has weathered a severe housing slump and subsequent recession; production has steadily increased since 2010.

But the mill might be undone by a bug the size of a grain of rice; the pine beetle epidemic has drastically reduced the local supply of healthy lodgepole pine, the raw material for two-by-four studs and other dimensional lumber produced by the mill. “The bad news is that it killed over 90 percent of the lodgepole pine, and it’s probably not going to be merchantable within a year or two,” Colter said. “This gray timber is really losing its value quickly.”

While the landscape effects of the pine beetle infestation are stark, the economic effects of the epidemic are more subtle. Pines killed by the beetles have inconvenienced tourists, blighted backyards and spurred efforts by the U.S. Forest Service and state and local governments to try to curb the outbreak by cutting down infested trees.

But the beetle attack has most seriously affected forest products firms—loggers, sawmills and manufacturers trying to bounce back from the housing crash and, in Montana, reverse two decades of industry decline. Here, too, the impact has been double sided: There are good uses for infected logs, and for now widespread cutting has boosted timber supplies for many forest products firms. But much lumber from beetle-killed trees is lower grade than that milled from healthy trees, and because of their short shelf life most infested trees will ultimately go unused.

Most ominously for the industry, over the next few years the epidemic threatens to slash the supply of usable pine logs—ironically, just when housing starts and lumber demand are expected to rebound. “The potential for mill closures is definitely there, especially if they aren’t able to respond to increasing markets,” said Todd Morgan, an expert on the forest products industry at the University of Montana’s Bureau of Business and Economic Research.

Beetles on the march

Each fall, a new generation of mountain pine bark beetles takes up residence in the district’s western forests. Over the summer, swarms of the tiny, dark-shelled insect invaded pine trees, tunneling into the inner bark to lay eggs. The resulting larvae feed on the host tree—disrupting the flow of nutrients and eventually killing it—until the following summer, when they mature into adult beetles and take flight, infesting more trees.

Native to the western United States, the pine bark beetle thrives in old, dense pine forests under stress. Persistent drought combined with overcrowding due to over a century of wildfire suppression has weakened lodgepole, ponderosa and other species of pine, making them susceptible to colonization.

The current outbreak began in the mid 1990s and has steadily expanded its footprint to cover over 5 million acres of forest in Montana. The infestation appears to have peaked in the state—aerial surveys by the Forest Service in 2011 found 1 million acres of newly infested trees, about half the area affected the year before (Chart 1). But the beetles are still gaining ground in the Black Hills (Chart 2 and accompanying maps below).

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Infestation has been spotty, with some areas of western Montana and the Black Hills affected much worse than others. For example, over the past decade beetles have left their mark on over 40 percent of the Helena National Forest in west-central Montana, and last year they made further inroads in the Bitterroot National Forest near the Idaho border. But so far, beetle kill has been light in the Flathead Valley and other parts of northwestern Montana.

In the Black Hills, the damage is concentrated in the central and northern hills, with heavy beetle kill on the northern edge of Custer State Park and hot spots near Lead, on the western fringes of Rapid City and around Mount Rushmore National Memorial—where for the past three years pines have been sprayed with protective insecticide.

To date, the infestation appears to have had little effect on tourism in Montana and the Black Hills—visitation numbers this summer were generally up over last year (see “Tourism survives beetle attack”).

But the epidemic has imposed costs on taxpayers and private landowners. The state of South Dakota has budgeted $6 million for a three-year campaign to control the beetles by felling trees on state and private land. In both western Montana and the Black Hills, property owners have borne the expense of removing dead or dying trees from their own land or public parkland in urban areas. In January, the city council in Rapid City passed an ordinance giving the city the authority to cut down infested trees on private property and bill the owners. Helena, Mont., which has lost thousands of ponderosa pines to beetles, raised property taxes in 2010 to fund a decade-long, $1.5 million effort to cut infested trees on open recreational space.

However, tree removal costs—and indirect or less tangible costs such as travel delays because of blocked roads and marred views for residents and visitors—are minor in comparison with the impact of the beetle epidemic on those who depend on trees for their livelihood. Like termites in a wood-frame house, pine bark beetles threaten the foundation of the forest products industry.

Salvaging value

Sawmills in the western part of the district have long complained about restricted log supply—or, more precisely, the cost of logs given declining production from many national forests—down 85 percent in Montana since the late 1980s. “That has really slowed the ability of [Montana] mills to get timber, even when [lumber] markets were good” in the 1990s and in the mid-2000s before the housing bust, Morgan said.

Thanks to the pine bark beetles’ depredation, more timber is now flowing to sawmills in areas of western Montana hard hit by the infestation and in the Black Hills.

In Montana, over 90 percent of beetle kill has occurred in its national forests, yet commercial logging there hasn’t increased. For the most part, Forest Service managers have focused on taking down beetle-killed trees where they pose a hazard to people or infrastructure—near settlements, along roads and power lines, and in campgrounds and other recreation areas. Much of this wood can only be sold for firewood or is left to rot.

But logging has increased on state and private lands in the state, offsetting the decline in Forest Service timber sales. Since 2007, commercial loggers have cut trees killed by mountain pine beetles and other insects on 7,000 acres of state trust lands, contributing to a 22 percent increase in state timber harvested last year compared with 2010. Revenue from timber sales—mostly to local sawmills—supports state schools and public universities. “We’ve been very aggressive about trying to capture the value” of beetle-killed timber, said Montana State Forester Bob Harrington.

In the Black Hills, national forestland supplies about 90 percent of saw timber. The average annual cut permitted by the Forest Service over a 10-year period fell by one-third in 1997 and has remained at that level. But since 2007, annual timber harvest in the Black Hills National Forest has exceeded the average annual allowable cut. Forest officials attribute higher harvest levels to logging of beetle-killed stands, coupled with strong demand from mills in the region.

Beetle-related cutting on state and private lands has also bolstered wood supplies in South Dakota. Under the state Black Hills Forest Initiative, a joint project with several counties in the region, crews have cut down more than 215,000 infested trees in Custer State Park and on private property over the past year. Private landowners have cut and sold tens of thousands more on their own. (In addition, noncommercial “bug tree” removal has boosted business for tree service firms in Rapid City and other Black Hills communities.)

A “blessing,” but …

A surge of beetle-killed timber has helped forest products firms ramp up production to meet rising demand from a construction industry that, if not booming, is showing signs of life. During the recession, annual production at Sun Mountain Lumber in Montana dropped by more than half, forcing the firm to lay off 30 workers. Over the past two years, annual output has bounced back to about 120 million board feet, allowing the firm to restore those positions.

Increasing production would have been more difficult without the “blessing in disguise” of extensive beetle kill, said Colter, the mill manager. Over the past four to five years, Sun Mountain and other mills in west-central Montana have purchased large amounts of beetle-killed lodgepole pine, mostly from private landowners. Over two-thirds of the lodgepole processed at Sun Mountain is beetle killed. “If we didn’t have the mountain pine beetle epidemic, there probably would be even less wood available for the mills that are operating,” Colter said.

Beetle-killed timber has also helped to sustain loggers who work under contract to sawmills or who cut and sell timber independently. Keith Olson, executive director of the Montana Logging Association, said that logging activity has been “steady,” even during the recession, because of beetle-related cutting on state and private land.

But there’s a problem with such timber, an almost literal fly in the ointment: It’s worth less than green wood because the beetles carry a fungus that leaves a blue tint on the outer rings of logs. This flaw makes much beetle-killed wood less desirable and has limited the amount of beetle-killed timber that mills can process.

Lumber marred by “blue stain” is structurally sound and fine for use in stud wall construction, where the wood is hidden behind sheetrock or paneling. But for some applications, this wood isn’t good enough. Colter of Sun Mountain says that some customers are willing to pay 10 percent to 15 percent more for unstained lumber milled from uninfected trees. But such trees are increasingly rare in the Deer Lodge Valley, and “those customers who are willing to pay a premium for green lodgepole are getting harder and harder to satisfy,” he said.

Some Montana mills, such as F. H. Stoltze near Columbia Falls, have shunned blue-stained wood, preferring to seek out uninfested lodgepole or use tree species unaffected by pine beetles, such as Douglas fir and larch.

Blue stain is particularly troublesome for forest products firms in the Black Hills, which primarily produce lumber for visible finish applications such as home interiors and decks. (In contrast, a higher proportion of Montana’s output consists of basic framing lumber.)

Neiman Enterprises is the biggest forest products company in the Black Hills with 430 employees at mills in Spearfish and Hill City, S.D., and Hulett, Wyo. The bulk of its revenue comes from the manufacture of boards, paneling and molding for home construction and remodeling. But blue-stained ponderosa pine can’t be used in those products, said resource manager Dan Buehler; consumers find the color off-putting, a sign of mold or rot. Instead, many of the 600,000 beetle-killed trees Neiman processes annually end up in particle board, crating and inexpensive painted furniture.

The company restricts its use of blue-stained logs to about one-third of its total intake. “If we get beyond that, we’re basically making product that sits in the yard,” Buehler said. “We can’t make a profit if we can’t get rid of it.”

Because of blue stain and other problems with beetle-killed timber—it can be harder to process and its dryness increases fire risk in mills—the region’s forest products industry can’t process all the available beetle-killed wood, said Carson Engelskirger, former forest programs manager for the Black Hills Forest Resource Association. “This thing has festered, and now it’s bigger than us,” he said.

A changed forest

The looming uncertainty for the forest products industry is how this infestation plays out over the next few years, with consequences for decades to come. Pine tree seedlings in regenerating stands take 60 to 100 years to grow into harvestable timber.

Some efforts are being made to stanch the beetle’s spread. Forest Service officials in the Black Hills have proposed treating 248,000 acres of recently infested tree stands in hope of slowing or halting the advance of the beetles. A drought-ending change in the weather could also tamp down the infestation in some areas. But for the most part, the infestation is expected to run its course, abating when the beetles have consumed most of their preferred host—mature pine trees.

An ongoing severe infestation would put additional pressure on a beleaguered industry. In Montana, employment in wood products manufacturing fell by more than half between 2001 and 2011 as operations closed or consolidated (Chart 3). Logging and private forestry jobs also declined precipitously over that period. In South Dakota, wood products manufacturing has held up better, but the industry still shed about 500 jobs since 2004.

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Further retrenchment wouldn’t significantly harm the economies of either Montana or South Dakota; in both states, the forest products industry accounts for less than 1 percent of total nonfarm employment, according to government figures. But forestry, logging and wood manufacturing still support scores of jobs in communities such as Deer Lodge, Columbia Falls, Spearfish and Rapid City.

A prolonged beetle infestation would likely inflict more hardship on forest products firms in the Black Hills than those in western Montana. In both places, tighter pine supplies could drive up log prices, especially if demand for lumber rises with an expected housing rebound. But Montana sawmills have a greater ability to adapt their product lines to whatever logs are available at the lowest price. Beetle-proof Douglas fir makes up about 30 percent of incoming logs at Sun Mountain. Colter foresees that percentage increasing if healthy lodgepole pine becomes more expensive. “At least as far as our mill is concerned, there will be a shift to more Douglas fir,” he said.

Switching to other types of trees isn’t an option in the Black Hills, because loggers and wood products firms depend on a single species, ponderosa pine, growing in a region cut off from other sources of logs. Shipping in timber from other states such as Montana or Idaho is too expensive. “We’re on an island, and we have this bug epidemic, and it’s chewing through the forest. … If we let the island get eaten up, we lose; everybody loses,” Engelskirger said.

Buehler of Neiman Enterprises said that if the epidemic worsens, the company may have no option but to close one of its mills, perhaps within five years.

More trees and forest products jobs could be lost in Montana and the Black Hills if large wildfires break out in dead pine stands—a scenario feared by tourism businesses and many residents as well as sawyers and mill operators. Fire has scorched thousands of square miles of forests decimated by pine bark beetles in Colorado, Idaho and other states.

What’s certain is that after the pine beetle infestation subsides, other insect pests and diseases will afflict trees and vex forest products firms in the district. Last year’s Forest Service aerial survey identified over 1 million acres in Montana affected by western spruce budworm, a moth that attacks spruce and fir trees.

To endure, the forest products industry must adapt not only to changing market conditions, but also to “whatever comes out of the forest, given the different disturbances, whether it’s fire or different kinds of insect diseases,” Morgan said.

Densely forested western Montana drives the Treasure State’s tourism industry. Yet there’s no apparent beetle effect on Montana’s visitation numbers. Preliminary figures from the Institute for Tourism and Recreation Research show that in the first half of this year the state attracted 4.1 million travelers from other states, a 5 percent increase over the same period last year. Tourist visits also increased year over year in 2011 after two consecutive years of heavy beetle activity.

In the Black Hills, an intensifying beetle infestation “hasn’t turned off visitors,” said Nort Johnson, president of the Black Hills, Badlands and Lakes Tourism Association. “It was a great spring and great early summer, and that’s continued.” Early warm weather boosted motel occupancy and visits to attractions and special events, according to association figures; Mount Rushmore saw 8 percent more visitors through July of this year than in the first seven months of 2011, and traffic counts for the Sturgis Motorcycle Rally in August were up 5 percent over last year’s tally.

Tourism in the Black Hills could feel the beetles’ bite next year; several sources said dead or dying trees were more evident near attractions and along roads this summer—a possible deterrent to return visits. For now, tourism officials and businesses are keeping their fingers crossed and emphasizing the positive aspects of the infestation. For example, Johnson noted that some tourists have commented on “some amazing new outcroppings of rocks that we haven’t seen for a couple of generations” revealed by deforestation.

From floods to hurricanes to blizzards, natural calamities can threaten livelihoods and devastate entire regions. Unfortunately for many, natural disasters appear to be getting harder to avoid. Since 1953, the number of disaster declarations—unique disaster events—issued each year has increased significantly, according to a recent report by the Congressional Research Service (CRS). In the 1960s, there were about 18 major disaster declarations per year in the nation. But from 2000 to 2009, annual declarations reached 56. Last year was the busiest year on record, with 99 major disaster declarations.

Disaster declarations in the Ninth District closely follow the national trends. The number of major disaster declarations in the district more than doubled from an average of 2.6 per year in the 1960s to well over five per year in the past decade, according to data from the Federal Emergency Management Agency (FEMA).

As a result, the number of disaster areas, which are declared by FEMA at the county level, also has been rising strongly, even if you ignore the comparatively small number of disaster-declared counties during the 1980s (see Chart 1, top panel). From the 1960s to the 2000s, the average number of disaster-declared counties in the Ninth District nearly tripled. This growth has been particularly prominent in the Dakotas and Montana, where disaster counts per year show a nearly sevenfold increase.

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Disasters tend to be regional events; therefore, annual disaster counts in district states do not often coincide with those at the national level (see Chart 1, bottom panel). However, both national and district disaster counts follow a similar, rising trend line since the 1960s, though the rate of increase in disaster declarations is slightly higher at the national level.

Floods and severe storms are the biggest sources of FEMA declarations in the Ninth District, accounting for more than two-thirds of all disaster declarations. But each state has a unique disaster profile, based on geography and climate. More than half of FEMA declarations in Montana since 1953 are the result of fire, easily the largest share among district states (see Chart 2, bottom panel). South Dakota also has a high incidence of fire. In 2000, more than 1 million acres burned in the northern Rockies, and FEMA declared disaster areas in over 54 counties in Montana. Wildfire-related declarations have been recurring in Montana almost every year since then.

In terms of reported fatalities and injuries, tornadoes traditionally posed the highest risk to human life in district states, particularly if they hit densely populated areas. The tornadoes that tore through counties near Minneapolis-St. Paul in 1965 caused over 700 reported injuries and fatalities. However, injuries and deaths related to tornadoes have declined over time, from about 1.8 deaths and injuries per reported tornado during the 1970s to just 0.2 per tornado in the 2000s. The combined territory of the Upper Peninsula of Michigan and northwestern Wisconsin (roughly two-thirds the size of Minnesota) has comparatively fewer disasters, but a relatively large share of them are tornadoes.

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The growing number of reported disasters appears to come from several sources. Most obviously, there has been an increase in the incidence of severe weather events as reported in the Storm Events Database by the National Oceanic and Atmospheric Administration, which catalogs severe weather incidents that resulted in fatalities, injuries or property/crop damage since 1950 (see Chart 2, top panel).

There are several other possible sources for the increase in disaster declarations, according to the CRS report. For example, the uptick in storm events is likely a function—to some unknown degree—of greater interest in and improved measurement of severe weather. The U.S. population also has roughly doubled since the 1950s, with the Ninth District population growing by about two-thirds, and developed acreage has correspondingly increased. As a result, severe weather events are more apt to affect people and property—triggering disaster declarations—today than in the past.

The report added that declarations might well be influenced by tight state budgets (which demonstrate financial need), the enhanced capabilities of professional state and local emergency services to identify and quantify disaster costs, and even “declaration creep”—the tendency of states to seek aid received by others for the same disaster, assisted by the political pressure generated by 24/7 news coverage.

Whatever the source of disaster, the other notable trend is rising costs. Over the past decade, average FEMA grant amounts have skyrocketed (see Chart 3). The majority of these grants are allocated in response to severe storms and floods, which tend to affect a greater number of counties per occurrence. Last year’s floods inundated 120 counties in the Dakotas and Minnesota and cost U.S. taxpayers $436 million in public assistance grants and aid to individuals.

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But the incidence of natural disasters is volatile and unpredictable, which is evident this year; things have been rather quiet in the district, at least in some respects. Drought has gripped the district and much of the nation, and wildfires have been a problem in Montana and South Dakota. But lack of rain tends not to destroy commercial or residential property; nor do wildfires because they usually occur in forested areas with comparatively sparse development. Through October of this year, FEMA had declared three major disasters in the district—two in response to severe storms and flooding in northern Minnesota and Wisconsin and one related to wildfires in Montana.

What happens next year in terms of natural disasters is unknown, of course, but that’s apropos given their connection to the notoriously unpredictable weather in the Ninth District.

It’s a common belief that there are no manufacturing jobs left in the United States, much less in sparsely populated places like the Dakotas.

The data suggest otherwise. While the overall economy’s share of manufacturing jobs has been in decline for several decades, manufacturing still has a major presence in the Ninth District economy. That’s particularly the case in some district states, and even certain regions in the Dakotas and Montana, three states whose economies have historically depended more on agriculture and natural resource extraction than manufacturing.

Across the 303 Ninth District counties, fully one-third have more manufacturing jobs (as a percentage of all jobs) than the national average of about 10 percent (see “Ratio” map). Thirty-seven counties have manufacturing job ratios above 20 percent—more than twice the national average. All of them are located between western Wisconsin and the eastern portion of the Dakotas. Seventeen counties have more than 5,000 manufacturing jobs, and Hennepin County (home to Minneapolis) has more manufacturing jobs than North and South Dakota combined (see “Total” map).

Last year was also a very good year for manufacturing employment growth (see “Change” map). The majority of district counties saw positive growth, and some saw extraordinary growth. A handful of counties in western North Dakota, for example, experienced double-digit manufacturing job growth last year, thanks to the voracious appetite for equipment used in the booming oil and gas industry in the Bakken oil shale formation.

Full Ninth District manufacturing maps

That philosophy might explain the success district manufacturers are having in international markets: More firms are exporting and, as a result, total exports have helped many manufacturers grow since the recession.

“We’ve seen a lot of changes” among businesses that export, said Bob Kill, CEO and president of Enterprise Minnesota. Companies today have greater market savvy, regardless of size, Kill said. “Companies used to think you had to be big to export.”

Save for a brief but hellacious drop in 2009, exports have been flying off the shelves of district manufacturers for the past decade (see Chart 1). Exports were particularly strong in 2010 and 2011, rising 17 percent and 10 percent, respectively. That’s due in large part to rising numbers of manufacturers looking elsewhere for new markets. Again, except for the drop in 2009, the number of Minnesota firms exporting some product has steadily increased and is currently at record levels, according to the Minnesota Trade Office (see Chart 2).

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Many of those firms have moved into international markets because of the weak dollar against most currencies, which makes U.S.-made products more competitive (a.k.a. cheaper) in other countries. For the past decade, the dollar has been persistently falling in value, except for a spike during the financial crisis and a recent uptick during the first half of 2012 in response to the European debt crisis (see Chart 1).

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By far the biggest—and often first—destination for district exports is Canada, thanks to a common border as well as similar language and culture. Exports there grew by more than 40 percent from 2009 to 2011 (to $14 billion) and are up about 10 percent through the first half of this year.

As firms get a feel for the procedure—and potential—of exporting, they also start to spread product wings, so to speak. “As companies grow, they get more sophisticated, and they realize where growth is,” often leading them to Latin and South America, and later into China and other parts of Asia, according to Kill. Mexico and China round out the top three destinations for district exports; each exceeds $3 billion in exports, a 50 percent rise since 2007.

Some believe there is great potential for still more export growth. In July, Minneapolis became home to a new branch of the Export-Import Bank of the United States, an independent federal agency that supports exports by doing things like insuring payments from foreign buyers. Given a “wealth of export-related assets” in the Twin Cities and statewide—including 19 Fortune 500 companies and high visibility in many industries—“we believe that Ex-Im Bank can help this area increase exports at a faster rate in the coming years,” said Denis Griffin, the bank’s Minneapolis regional office director.

While the most obvious markets for local exports are Canada, China and Mexico, “we want to encourage companies to seek out opportunities across the globe.” The bank has a presence in 175 countries and, based on internal research, it believes countries like Brazil, India, Indonesia, Nigeria, South Africa, Turkey and a few others are well positioned to become larger importers of U.S. goods, according to Griffin.

Slower, but still growing

This year, exports to all destinations have continued to increase, but at a more modified pace, rising 6 percent through May of this year compared with the same period a year ago. Sources attributed some of the pullback to nervousness over the sovereign debt crisis in the European Union and its effect on the global economy. But to date, that nervousness has not translated to lost sales.

The Minnesota Trade Office, for example, typically helps small to medium-sized manufacturers export their goods. “They may have nervousness regarding what is taking place in the EU, but haven’t indicated that things have changed dramatically, and not enough to alter their outlook on this market,” said Jeffrey Phillips, an MTO international trade representative, via email.

In fact, EU exports appear to have stabilized since the recession. From 2007 to 2009, exports to the 27-country EU fell by close to $1 billion and have since been flat. Most of that drop came from the 17 countries in the single-currency eurozone (see Chart 3).

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Phillips pointed out that Europe still has 10 of Minnesota’s top 25 export markets, and “there remains huge opportunities for manufacturers to enter or expand their sales in the EU.” In fact, the agency has seen an increase in manufacturers asking for assistance or attending training seminars related to so-called CE marking—consumer safety certification that allows products such as machinery, medical devices and telecomm equipment to be sold within the EU.

But while things play out in the EU, firms are looking elsewhere for growth. In 2009, the EU represented 27 percent of Minnesota’s overall exports. By 2011, it had fallen to 20 percent.

“Europe is not on the minds” of exporting businesses because there are many other burgeoning markets on the radar, said Kill. “China, South America, Asia clearly are larger [export targets] because they are growing.”

Editor’s note: American manufacturing continues to get leaner and meaner, booking strong productivity gains every year and allowing production of more goods with fewer people. But wages for manufacturing workers haven’t kept pace, as economics suggests they should if workers are more productive. What gives?

Some research indicates that productivity growth may be overstated. The fedgazette interviewed Susan Houseman, a senior economist at the Upjohn Institute in Kalamazoo, Mich. Houseman and three Federal Reserve System economists authored a 2010 study that identified biases in the way manufacturing productivity is measured.

Houseman holds a Ph.D. in economics from Harvard University, has taught at the University of Maryland School of Public Affairs and worked as a visiting scholar at the Brookings Institution.

fedgazette: Your research, which takes a close look at how productivity in manufacturing is measured, was a collaboration with three Federal Reserve economists. How did you come to work with them?

Houseman: I had the idea that some key manufacturing output and productivity statistics were biased because of offshoring and was looking for a way to estimate the size of the bias. My co-authors had documented the growth of offshore outsourcing by American manufacturers, and we were able to estimate that bias using their detailed data and models of the manufacturing sector.

We intentionally ended our analysis in 2007, because we did not want to incorporate the recession into the paper. Things got pretty quirky then. Imports were tanking along with the rest of the economy, and we wanted to focus on longer trends.

fedgazette: We’ve been hearing about impressive productivity gains in manufacturing for a while. Is your research essentially saying they aren’t really there?

Houseman: I would like to make two points. First, a very important fact, but one I find most people don’t know—including some people who write a lot about the manufacturing sector—is that manufacturing growth in real [price-adjusted] value added and productivity wasn’t that strong without the computer and electronics industry. The computer industry is small—it only accounts for about 12 percent of manufacturing’s value added. But it has an outsized effect on manufacturing statistics.

We make that point, I think, pretty clearly in our 2010 paper. But I still see a lot of analysts who say, “Look at how fast manufacturing is growing; manufacturing output is growing faster than GDP. There’s nothing wrong; manufacturing is doing great.” But we find that without the computer industry, growth in manufacturing real value added falls by two-thirds and productivity growth falls by almost half. It doesn’t look like a strong sector without computers. That’s the first point.

The second point, which was the focus of the 2010 paper, is that there’s been a lot of growth in manufacturers’ use of foreign intermediate inputs since the 1990s, and most of those inputs come from developing and low-wage countries where costs are lower. We point out that those lower costs aren’t being captured by statistical agencies, and so, as a result, the growth of those imported inputs is being undercounted.

fedgazette: How is it that lower-cost manufacturing in other countries influences U.S. productivity statistics and results in incorrect measurements?

Houseman: It is hard to get your teeth into the problem, which fundamentally has to do with price index theory and how things are deflated. But let me illustrate with a hypothetical example.

Suppose an auto manufacturer used to buy tires from a domestic tire manufacturer. Then it outsources the purchase of its tires to, say, Mexico, and the Mexicans sell the tires for half the price. That price drop—when the auto manufacturer switches to the low-cost Mexican supplier—isn’t caught in our statistics. And if you don’t capture that price drop, it’s going to look like, in some statistical sense, the manufacturer can make the same car but only needs two tires.

fedgazette: So the important part is to measure the changing value of inputs better.

Houseman: Yes, exactly. We have pretty good measures of the value of inputs. But if, say, the dollar value of inputs falls, that could be because manufacturers are using fewer inputs or because the price of the inputs dropped. Our statistical agencies try to measure price changes, but they miss them when the price drops because companies have shifted to a low-cost supplier. So because we don’t catch the price drop associated with offshoring, it looks like we can produce the same thing with fewer inputs—productivity growth. It also looks like we are creating more value here in the United States than we really are.

fedgazette: You said that the growth in productivity in manufacturing is not that large if you take out computers. The corollary is that productivity growth in the computer and electronics industry has been pretty strong. Are you suggesting that it is also mismeasured? Does the logic you’ve spelled out in the example with automobile tires also apply to the computer and electronics industry?

Houseman: Yes, it applies to the computer industry too, and we include estimates of the bias to productivity growth in the computer industry in our paper. But because actual productivity growth is so high in that industry, these [bias] corrections account for a relatively small percent of the growth in that industry.

The standard argument is that the rapid productivity growth in computers is coming from product innovation. This year’s computers and semiconductors are faster and do more than last year’s models. And that product innovation essentially gets captured in the price indexes the government uses to deflate computer and semiconductor shipments. The price indexes for most products increase over time—that’s inflation. But, for example, the price indexes used to deflate computer shipments have actually fallen by a whopping 21 percent per year since the late 1990s. Those rapid price declines largely reflect adjustments for the growing power of computers. And that extraordinary decline in computer price indexes translates into extraordinary growth in real value added and productivity in the computer industry as measured in government statistics.

So, in some statistical sense, today’s computer may be the equivalent of, say, 13 computers in 1998. But that doesn’t by itself mean fewer workers are needed to manufacture a computer today than in the past. Product innovation doesn’t displace workers; we’re not buying fewer computers because they’re more powerful. If anything we’re buying more of them.

Could there be other measurement issues in the computer industry? Sure. It’s a really hard sector to measure for various reasons. Global supply chains are complex and rapidly changing, and there’s a big lag in the collection of data the government needs to get the industry structure right. It’s also really important that imported IT products are deflated the same way domestic ones are.

So there could be a lot of errors, but it’s hard to say how big they might be or even the direction of any bias. The point is that when you have an industry where you are aggressively adjusting prices for quality changes the way the government is, an error can really swing the numbers not only in that industry, but also in the manufacturing sector and even in GDP. So we have to be, in my view, very cautious in interpreting aggregate numbers when one industry is dominating the data.

fedgazette: It has been considered something of a puzzle that as productivity in manufacturing has grown, employment in factories has declined and wages for existing workers haven’t kept pace. Does your research suggest a resolution to this puzzle?

Houseman: We do argue that productivity is overstated. So that’s one piece, but it’s not the only piece of the puzzle.

Another piece of it is that the rapid growth in manufacturing productivity is being driven by one industry—computers—and what’s driving productivity growth in computers is improvements in quality of the product, which doesn’t have any implications per se for jobs or workers’ wages. The reason jobs in computers have been lost is not because productivity growth has crowded them out; not at all. It’s because much of the production has gone overseas.

So there’s that. And then another standard story has to do with automation. Basically, capital is substituting for labor. Automation can lead to job losses. And the returns from automation, or higher capital use, won’t necessarily be shared with workers.

Then, finally, there’s probably been some shifting in the sorts of production that occur here. In particular, less of the labor-intensive production is done in the United States, and that would result in job losses and higher labor productivity. Again, the gains from that productivity growth aren’t necessarily going to be shared with remaining workers. So part of the answer to the puzzle is that even if productivity gains are real, there’s really nothing that guarantees those gains will be broadly shared by workers. Certainly some people have done very well in the economy, but those individuals typically haven’t been production workers.

fedgazette: So what is the “right” way to measure manufacturing productivity, if that’s even possible? You wrote your paper in 2010. Has any progress been made since then?

Houseman: For a start, it’s important to catch the kind of price drops that we talked about in our paper—price drops associated with rapid shifts from high- to low-cost—often foreign—suppliers. It’s fair to say that for the most part, the way price indexes are constructed in the United States, the “law of one price” is assumed to hold all the time. That is, it’s assumed there are no price differences among stores or suppliers to businesses once differences in quality of the products they sell are taken into account.

But a point we try to make clearly in our 2010 paper is that a lot of the price changes occur because new suppliers enter the market, offer lower prices for similar products and drive out old suppliers. There’s a lot of evidence both domestically and internationally to suggest that this is an important piece of price dynamics that just isn’t captured in the way we collect price statistics.

So the Bureau of Labor Statistics is considering whether it would be worthwhile to change the way price data are collected to better capture price movements. The idea that BLS has is to collect price data from the purchaser rather than the seller.

There’s a bigger question, though, about how to think about productivity in a national sense given the extensive global operations of multinational companies. Where do you “book” their value added? The more value added booked in a country, the higher its measured productivity.

That’s a really big question, and something that the measurement community is just beginning to grapple with.

The Quick Take: The trend in “reshoring”—bringing previously offshored manufacturing production and jobs back home—is widely heralded, but poorly documented. A growing number of anecdotes and other evidence suggest that some reshoring is occurring, particularly for items destined for domestic markets, the result of rising overseas production costs and better recognition of hidden costs and logistics issues. But reshoring’s effect on manufacturing employment in the district is likely very modest given the high-automation, low-labor demands of most reshored products.

The small community of Jackson, Minn., might not be the first place you look to see global manufacturing trends at work.

Tucked along the bottom of the state near Interstate 90, the community of 2,800 people might be more renowned for an odd pairing of American artifacts: Fort Belmont, one of only two civilian-built 19th century forts ever constructed in the Midwest, and Jackson Speedway, where all varieties of hobby and modified stock cars and other vehicles race around a half-mile dirt oval for purses of up to $10,000.

But in the northwestern part of town, in the city’s industrial park, sits a new addition to a heavy manufacturing and assembly plant owned by AGCO, an ag-equipment giant with worldwide operations, headquartered in Duluth, Ga. The 600,000-square-foot facility has traditionally made self-propelled field sprayers and a variety of track- and center-pivot tractors. Some production has come through consolidation, as AGCO acquired other ag-related companies over the past two decades and brought that production to Jackson, eliminating jobs in other Minnesota communities along the way.

But earlier this year, about 100 new workers started assembling high-horsepower Massey Ferguson and Challenger wheeled tractors—products the company had been making in Beauvais, France. Tractor components—almost everything short of the wheels and batteries—are mostly still made in France or elsewhere and then put in a kit and shipped to Jackson for assembly.

That might not sound like a particularly economical way to build tractors, but Greg Peterson, the company’s director of investor relations, explained that these tractors were destined for U.S. farmers anyway, and “it’s cheaper to ship parts because you can put them in a container,” which takes up less space than a fully assembled tractor. Peterson said there are also savings in wages and benefits; workers in Jackson receive about 10 percent to 15 percent less in total compensation than workers in France.

“After all the puts and takes in a financial sense, [the production transition] is a wash,” he said. The company expects to reap additional financial benefits over the next few years as it looks to produce many components in the United States, possibly even in Jackson.

Welcome to manufacturing’s updated math, which is generating a growing number of anecdotes about firms like AGCO bringing manufacturing back to the United States. The phenomenon goes by a variety of names—reshoring, homeshoring, inshoring, insourcing—and happens in different ways. Corporations can return in-house production from international plants to domestic ones; or they might source such production to outside firms, giving contracts to U.S. vendors rather than those in other countries.

There are myriad reasons for doing so, but most center on the narrowing gap in labor costs between domestic and international locations, better recognition of indirect costs and logistics issues with overseas production and even the marketing opportunity to stamp “made in the USA” on products.

The extent of reshoring is guesswork because hard data are nonexistent. There are enough anecdotes to suggest that reshoring is occurring, giving rise to the hope of renewed manufacturing growth across the Ninth District and the nation. But reshoring is likely to have a limited effect, especially on employment, because factors that made offshoring a global phenomenon are still present, especially for low-value products requiring lots of labor.

However, a shrinking gap in labor costs combined with other considerations—transportation costs, customer service needs, supply chain logistics—have made it feasible for manufacturers to produce more goods domestically, especially those with a high level of specialization and automation.

Workers readying an engine at the AGCO plant in Jackson, Minn.

Manufacturing boom(erang)

A host of private surveys suggest that many companies are giving reshoring some consideration. Last April, the Boston Consulting Group found that more than one-third of U.S.-based manufacturing executives at companies with sales greater than $1 billion are either planning or considering reshoring some production back from China.

Another survey released in July by CoreNet Global, an association of corporate real estate executives, reported that 51 percent of corporate real estate asset managers expected a rebound in domestic manufacturing from offshore locations. This recovery will be driven both by companies bringing manufacturing plants and jobs back to the United States or by choosing not to offshore in the first place, according to the report—a trend it said “will continue strongly through the year 2020.”

MFG.com, an online marketplace for manufacturers, found that 40 percent of almost 260 small manufacturers surveyed said they had received a contract that was previously sourced to a foreign supplier. In earlier research by the organization, 22 percent of product manufacturers reported returning a portion of their production back to North America, and 33 percent were researching such a move.

But the full extent of reshoring is hard to put your finger on. There are no reliable counts of reshoring activity at virtually any scale, not even back-of-the-envelope estimates to quibble over. “We’ve been asked that question a lot in the last year or two, but I’m not aware of any numerical studies,” said Neal Young, director of economic analysis at the Minnesota Department of Employment and Economic Development. “Everything we’ve seen has been anecdotal.”

And there are plenty of reshoring examples. You can’t get any more American than softball, the “ting” of batted balls echoing across virtually every community in the country—and sometimes all the way to China. That’s where bats from Miken, based in Caledonia, Minn., were outsourced about eight years ago. But last year, the company decided to return production to Caledonia.

The company declined to be interviewed and hasn’t disclosed employment changes in Caledonia, but said via email that it “regularly reviews its supply chain and manufacturing costs, and in doing so, we made the decision to move some of our manufacturing back to the U.S. from China.” Specifically, costs had risen in China, and the return to local production allowed the company “to tap into a high-quality labor market, while improving our supply chain logistics at lower manufacturing costs.”

Miken’s experience underlies a fundamental driver of reshoring activity. Overseas manufacturing costs—especially in China—have been rising. Boston Consulting Group estimated that Chinese factories were seeing wage and benefit increases of 15 percent to 20 percent per year, one reason it believes the United States will be “in a strong position” to gain 2 million to 3 million manufacturing jobs by the end of the decade.

As overseas costs rise, the gap between domestic and international production has been closing. A study by the Hackett Group projected that the wage gap between the United States and China will fall from 51 percent in 2005 to 30 percent in 2013 (see chart, reprinted with Hackett’s permission).

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But wages are only part of the story. Among other reports on the matter, Hackett’s study found that the gap in total landed costs—raw materials, component costs, transportation and logistics, inventory carrying costs, taxes and duties—have been halved from 31 percent to 16 percent, and similar cost reductions were also seen in comparison with other emerging, low-cost countries (see chart). These structural changes “are definitely permanent” under the most likely scenarios imagined by the companies tracked by Hackett, said Michael Janssen, the firm’s chief research officer, in an interview. “They expect the gap to shrink further. The only thing that changes is the time frame” in terms of how quickly things might occur.

District reshoring

Manufacturers in the district are seeing the cost-gap phenomenon firsthand. Jim Haglund, president of Central Container in Brooklyn Park, Minn., said he’s been going to China for 30 years. He’s watched productivity there steadily improve, but lately he’s seeing costs rise. “Inflation is hitting them, and workers are demanding more money.” Combined with higher transportation and other costs, the price gap is now closer to about 20 percent, Haglund believed. “Once you put pen to paper, it costs more” to be in China than many first realized.

Add in customer service needs—like quicker product adjustments—and more manufacturers have started to rethink their offshoring strategy. Haglund said Central Container is seeing business increase for contracts with medium- to lower-quantity volumes, where cost isn’t necessarily the overriding factor. His company now does more business with a high-tech stamping company (which Haglund couldn’t name for privacy reasons) that wanted better quality and quicker turnaround. “Where quality and inventory [control] and service are concerned, that’s where it’s coming back. Items that we lost eight or nine years ago, we’re getting back.”

It’s a similar story at OEM Fabricators, a Woodville, Wis., heavy-industry contract manufacturer. Customers are looking more closely at “time to market” from the prototype stage to final product rollout, and “many of our customers are accepting the concept that there are other important considerations beyond simply the price,” said President Mark Tyler. Supply chain control is also becoming more important, “and closer [proximity] typically means more opportunities to reduce supply chain costs,” he said.

Nicolet Plastics, a plastics injection molding company in Mountain, Wis., has also seen an increase in domestically sourced products, said President and CEO Bob MacIntosh. The company has embraced so-called quick response manufacturing to reduce the cost of producing low-volume, customized products. Along with immediate product savings, lower volumes mean less inventory for customers “as well as less chance of [product] obsolescence. If a customer is buying container loads of product from overseas, it had better be right when it arrives.”

Newly assembled field sprayers lined up at the AGCO plant in Jackson, Minn.

Producing goods closer to their final sales market offers obvious logistics advantages. It has the added perk of capitalizing on rising buyer preferences for goods made here. Peterson, from AGCO, said, “In marketing, there is a big advantage” to bringing the new tractor production to its Minnesota plant in Jackson. The company built a 17,000-square-foot visitors center in Jackson where, along with historical company and agricultural artifacts, visitors can get a glimpse of the assembly line so that “farmers can come in and see their tractor roll off the assembly line.”

A “positive” net zero?

Despite these positive developments for district manufacturers, the impact of reshoring is likely to be more muted than all of the anecdotes might imply, especially in terms of employment.

For one, the Chinese manufacturing dragon is far from dead. In June alone, the United States carried a $27 billion trade deficit in manufactured goods. Outsourcing to China and other low-cost countries will still be the way to go for many U.S. manufacturers producing goods that are even moderately labor intensive. “The advantage in China is still labor. … Its labor scale is unbelievable,” said Janssen. Apple, for example, is famous for employing huge numbers of foreign workers for manual tasks, like putting stickers on an iPad or putting it in a box. Such jobs are simply impractical in the United States, he said. “There’s not enough people in the U.S.” willing to do similar work for a comparable wage.

But Janssen noted that cost increases in China are real and not likely to go away soon. As factories there continue to pump out goods and earn profit, Chinese workers are asking for something in return—a normal transition in any growing economy. Workers there, Janssen said, “don’t want to live like peasants any more. They want the things we want,” like better living conditions and material goods. This leaves U.S. companies with three options: Increase labor productivity at Chinese plants, move production to lower-wage countries or bring it closer to developed markets.

But a lost job in China—or other low-cost country—does not equal a new job here. A plant in China with 100 workers might employ only 10 workers if it were located in the United States because the domestic plant—by necessity—would be highly automated to offset much higher wage and benefit costs, according to Janssen. Such capital investments are also easier today because of the low cost of capital.

Hackett’s research suggests something of a rebalancing in manufacturing production, rather than a reshoring stampede. A May report by the group found that companies are exploring reshoring for nearly 20 percent of their offshore manufacturing capacity between 2012 and 2014. While that’s a positive development for U.S. producers and their workers, this repatriated production would only “roughly offset the jobs that will otherwise move offshore, indicating that the great migration of manufacturing offshore over the past several decades is stabilizing.”

In other words, “the good news is that we’ve gotten to net-zero jobs. We’ve finally reached an equilibrium,” said Janssen. “That’s bad news for China. But unfortunately, [the resulting job growth here] is not as much as politicians would like.”

Video: fedgazette Editor Ron Wirtz on manufacturing

On a sunny day in May of last year, workers at OEM Fabricators, a heavy-industry fabrication shop in Woodville, Wis., did not come dressed in the work clothes they normally wear to weld, machine, paint and assemble products for customers. Instead, they came in suits and ties to pay distant respects to the deceased.

Despite coming off a strong year of growth, the company was hosting a funeral. Even the community showed up. Workers dug a hole and laid a wooden coffin to rest right there on company grounds. And then they celebrated, ate and danced to a Dixieland band. For they had all shown up to bury the recession—literally, it was inscribed on the coffin—that was long past for the company, but still lingering on the minds of many.

OEM President Mark Tyler said the faux funeral was meant to change people’s mindset. Times were tough during the recession. “It dropped a piano on our head” in terms of sales, and employment was more than halved to about 150 workers, Tyler said. The company’s fortunes soon turned around, but you wouldn’t have known or felt it around the company.

“You know the guy in [the comic strip] Li’l Abner that always had the black cloud over his head? Well that’s what it felt like for a long time, even within the company. We were growing; we were coming out of the [downturn]. And yet there was this feeling that things were bad,” said Tyler. “But things weren’t bad. Things were good—we’re riding this rocket ship in terms of revenue growth, and earnings are strong. And so we thought, ‘How do we break this attitude? And we said, ‘Let’s bury it,’ and thought a New Orleans-style funeral might be appropriate.”

OEM hasn’t looked back on the dark days. Last year, revenues grew 75 percent and are on a similar pace this year, Tyler said. The company expanded its Woodville site, and it expects to move into its biggest facility yet in neighboring Baldwin. The company’s current workforce of 500 is 50 percent larger than its prerecession peak.

OEM Fabricators is a heavy-industry fabrication shop in Woodville, Wis., that serves the robust energy and agricultural markets, and other customers of machinery and durable goods.

Not all manufacturers are experiencing the same success as OEM, but the sector in general has been a bright spot in an otherwise sluggish recovery. Output has recovered, and many firms are seeing revenues, particularly sales of durable goods, return to and often exceed prerecession levels. Even manufacturing employment has risen in district states, reversing many years of decline.

Many factors are involved, including a bounce-back in orders stemming from steep inventory cutbacks during the recession, strong exports and some evidence that more orders are being filled in the United States rather than elsewhere—all of it facilitated by a seemingly manic focus on productivity and adding value to products, courtesy of the recession. Firms that managed to hang on through the recession have been forged stronger by the need to reevaluate products, processes and personnel from top to bottom. The experience made companies leaner and more efficient, and their products more competitive.

Many hope for a manufacturing renaissance that might return the industry to its former prominence in the national economy—creating jobs, vacuuming up unemployed workers and making “Made in the USA” more than an economic wish or election slogan. Manufacturing output is doing its part, rebounding past prerecession levels. But manufacturing employment—while growing of late—is still far below prerecession levels, and the long-term job trend since the 1970s is decidedly downward.

But maybe counterintuitively, given the public’s preoccupation with job growth, the dual trend of rising output and modest job growth is itself a positive development for manufacturing because it signals rising productivity, a key to long-term health and survival for firms and their workers.

Recession: R.I.P.

The manufacturing industry had a forgettable past decade, thanks mostly to bookend recessions. After mostly treading water in the middle of the decade, manufacturing establishments and related employment in the Ninth District were pummeled by the Great Recession of 2007. District states lost more than 1,300 (net) manufacturing firms, countless others saw cutbacks and 150,000 manufacturing jobs were eliminated (see Chart 1).

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But things started turning around for many manufacturers by about the middle of 2009, when the recession officially ended. Some, even much, of the early rebound was simply rebuilding inventories, which fell dramatically during the recession as businesses across the economy cut orders in light of the financial crisis and simply used what they had on hand. Manufacturers responded in kind; shipments sank during the recession, then steadily rebounded.

Daniel Berdass is president of Bermo Inc., a manufacturer of metal components in Circle Pines, Minn. During the last recession, “we dropped tremendously,” he said, and employment shrunk by about half. But business started rebounding within two years, “and it’s been a snowball ever since.”

Bermo sales since the recession’s nadir are up 300 percent—from the “teens to the sixties [million],” according to Berdass—and are now above prerecession levels. Employment has grown on par with revenues as well, he said, and the company now employs over 200 people at its 286,000-square-foot headquarters facility.

Similar stories of transition, rebound and growth are easy to find around the Ninth District. Bus maker Motor Coach Industries is adding about 80 jobs in Pembina, N.D., a community of just 600 on the Canadian border. In the Twin Cities, steel-maker Gerdau is investing $50 million to significantly increase capacity at its St. Paul plant. Just to the east, Polaris Industries, a maker of all-terrain and other recreational vehicles, is adding 89 jobs at a 140-worker plant in Osceola, Wis., a partial reprieve from its 2010 announcement that it would close the plant entirely and eliminate more than 500 jobs. In Sioux Falls, S.D., Twin City Fan & Blower is building a new 50,000-square-foot facility and expects to hire more than 50 employees.

Not everyone’s a winner in the sector’s recovery, of course. Agribusiness giant ADM closed its ethanol plant in Walhalla, N.D., this summer, eliminating 61 jobs. In Sartell, Minn., a Verso Paper plant that employed 259 workers was destroyed by fire in May and will not be rebuilt given high operating costs and sluggish paper markets. At the end of last year, Ford Motor Co. closed its 86-year-old truck facility in St. Paul, putting 800 people out of work. At its zenith in the 1970s, the plant employed more than 2,000.

Though some manufacturing indicators softened over the summer, most macro measures suggest that the industry needle has moved to the positive side overall. For example, the number of manufacturing job vacancies has been on the steady uptick, from fewer than 2,000 in the fourth quarter of 2009 to 4,900 two years later, according to surveys by the Minnesota Department of Employment and Economic Development (DEED). The Mid-America Manufacturing Index, which regularly surveys producers in Minnesota and the Dakotas, has indicated expansion among district manufacturers since the summer of 2009. (See Chart 2; this summer, however, producers started reporting some softness. More on current conditions later in the article.) That optimism was validated by steep increases in manufacturing output in district states since 2009, which outpaced the sector’s recovery nationwide, according to the federal Bureau of Economic Analysis (see Chart 3).

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Strong optimism and output have led to recent hiring—a notable reversal for the sector—starting in 2010 (see Chart 1). From June of that year to June 2012, manufacturing employment grew by 5 percent among all district states, or about 41,000 jobs. Though the manufacturing base in the Dakotas is still quite small—fewer than 70,000 jobs combined—the two states saw sector employment expand by nearly twice the district rate (see Chart 4).

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But not all manufacturing jobs are created equal, and statewide data obscure a large amount of industrial variation. For example, employment has grown significantly faster among makers of durable goods—things like machinery, transportation equipment, metal fabrication—compared with nondurable goods (see Chart 5).

Even within durable goods, some sectors have not recovered. In 2005, wood products employed 52,000 workers across district states, many of them making lumber and other products for the housing industry. The subsequent housing bust sawed off about 40 percent of jobs—some 20,000—by 2010. Since then, employment levels have been merely flat. Responding to a fedgazette online survey, the owner of a western Montana lumber company said it has had to cut payroll significantly, adding that any “sunny spot” in manufacturing seen elsewhere “doesn’t exist here. … I honestly don’t believe we’ve hit bottom. Public confidence in our area is as bad as I have seen it in 37 years.”

Energy and ag

For those industries seeing growth, there are many sources, but a few seem to stand out. Robust energy and agricultural sectors are big consumers of machinery and other durable goods, and manufacturers serving these markets have seen little downside in recent years, according to Andy Peterson, head of the North Dakota Chamber of Commerce. “Those two sectors have been blown out of the water, and companies can’t keep up.”

With strong crop prices for several years running, farmers are taking the opportunity to invest in their operations. That translates into more tractors and other farm equipment purchased from the likes of Bobcat, a Bismarck, N.D., maker of compact loaders, excavators and other farm equipment. The firm announced in April that it was expanding and adding about 200 jobs in partnership with Menlo Worldwide Logistics.

International companies are also looking to bring products closer to their final markets. Last month, German-based Geringhoff announced plans to invest over $20 million in a new plant in St. Cloud, Minn.—its first manufacturing facility in the United States, which will make corn-harvesting and other farm machinery. The move will create 100 jobs initially, with significantly more anticipated in the future.

A strong ag sector also trickles to niche markets like drainage tile for farmland. In February of last year, Willmar, Minn.-based Prinsco opened a tile production facility in Beresford, S.D., and broke ground on a second district facility this year in Fargo, N.D. But that’s only the half of it. Advanced Drainage Systems also opened a production facility in Buxton, N.D., in early 2011 and this summer announced plans for a new multimillion-dollar facility in Watertown, S.D.

The nationwide oil and gas boom, including intensive drilling of the Bakken oil shale formation in western North Dakota and eastern Montana, has been another obvious source of demand for manufacturers. Mark Oelke owns M & W Machine, a small machining interest in Three Forks, Mont. Via email, Oelke said 2008 and 2009 “were rough years. … I came real close to laying off a very seasoned employee.”

So in 2011, “as a means of survival,” Oelke started traveling to the Bakken, about 400 miles away. It worked. Oelke found business for its boring, milling, welding and other machines, and the company also bought two computer numerical control machines “to cater to what some of the companies were asking for.” That year, business grew by 30 percent and has leapt by 150 percent so far this year—90 percent of which was oil-patch-related—allowing M & W to add three employees. Now, he said, “There’s no downturn in sight.”

Last year, revenues at OEM Fabricators grew 75 percent and are on a similar pace this year. The company’s current workforce is 50 percent larger than its prerecession peak.

OEM Fabricators—remember the funeral in western Wisconsin?—derives more than 40 percent of its current business from oil- and gas-related products, including items like large engine manifolds, stator frames for motors and generators, mixing tanks and myriad other mechanical components. The company has a history of serving others in the energy sector. But as companies have become active in the Bakken, “we have seen increased activity from nearly all of them. … It’s just been an accelerator,” said Tyler, company president.

Prospects also look good for steady business going forward, according to Tyler. “We have been watching the energy sector outlook and have gotten the sense that we are in a level of activity that is sustainable for many years.”

Forged by fire

Many other factors have helped the manufacturing sector. Exports, for example, have grown at exceptional rates since the recession (see Exporting growth). Employer costs also haven’t risen much—workers’ wages have been held in check by the downward pressure of widespread unemployment. From 2007 to 2011, unadjusted average weekly manufacturing wages in district states rose between 7 percent (Montana) and 12 percent (North Dakota)—barely ahead of the rate of inflation only because inflation has been so low.

But in the most fundamental sense, the recession appears to have played an important, if unwelcome, role in the manufacturing rebound. Industry sources widely described the recession as a meet-your-maker event that put everything under the microscope. Those that survived can’t help but be leaner, more strategic and more productive for the experience.

“In this recession, very few companies didn’t get forced to think about their personnel,” said Bob Kill, CEO and president of Enterprise Minnesota, a state-chartered organization affiliated with the Department of Commerce that offers fee-based consulting services to manufacturing firms. But in this recession, he added, “more than in the previous two [recessions], companies have really had to invest.” And it’s not all capital investment. Increasingly, companies are investing in analytics—that’s where Enterprise Minnesota comes in—to see how processes can be more streamlined and efficient to cut labor, energy and other costs.

“Sometimes when you invest, you don’t spend money,” Kill said. “It means sometimes not investing in any new equipment, but improving production processes” or finding other efficiencies that get passed on to customers. As a result, “firms were better able to weather the storm. … What we have left are firms that can compete.”

At OEM Fabricators, “there is no doubt that the recession drove improvements in our operations,” said Tyler. The company looked at personnel and processes, and “many changes were made, leaning our operations.” Employment was slashed during the recession, and while it bounced back fairly quickly, it was done carefully “to retain the efficiencies gained during the recession,” he said. The company also hired some “outstanding, highly skilled” employees who were available as a result of the downturn.

As business increased coming out of the recession, the company also invested heavily in new equipment and technology, which Tyler said “drove even higher levels of productivity.” While OEM employment is 50 percent higher than before the recession, sales have more than doubled. The company is in the process of expanding to an 80,000-square-foot facility in Baldwin, Wis., its third and largest plant.

It’s the same story at Nicolet Plastics, a plastics injection molding company located in Mountain in the northeastern part of Wisconsin. President and CEO Bob MacIntosh said the company downsized its workforce by more than 20 percent in 2009. As business rebounded, “we were able to manage most of the growth with the remaining workforce and some added automation.” The company is doing about $2 million more in business—now at about $10 million—than it did in 2008, “and we still have not gotten back to the ’08 employment levels.”

Many sources also talked about “going up the value chain” to develop products whose competitive advantage is based on more than just low price. That’s the case even for seemingly mundane items like packaging and product containers. Thirty years ago, the container industry “was a brown box to get something to the end user,” said Jim Haglund, owner of Central Container of Minneapolis, which employs about 150 people throughout its 175,000 square feet of plant and generates about $30 million annually in revenue.

The container industry has evolved. Haglund said the company made a big commitment during the last decade to go “lean and green,” hiring the design and engineering talent to go after new, value-added product markets like medical supplies. This brought some growing pains. To package medical products, Haglund said, “it seems like we go through the same ropes as the stent you put in your body.” These companies, he added, “are very strenuous and demanding. But it forced us to get good in quality.”

Striving for quality brought the security of better margins. Haglund said that for a $5,000 medical device, “it’s not a big deal if the packaging is 50 cents more than a competitor. It is a big deal if the product is [worth] two dollars.”

During the recession, Central Container’s revenues dropped about 15 percent. Slowly, they rebounded. Last year was “not bad,” Haglund said, and this year the company’s revenues are up 10 percent, moving it above prerecession levels. “I’m pretty positive,” he said, evident in the fact that the company expected to add 13 workers by year’s end.

Central Container of Minneapolis employs about 150 people throughout its 175,000 square feet of plant and generates about $30 million annually in revenue.

These anecdotes give life to the macro data, which show that productivity is rising among manufacturing firms—and particularly among those producing durable goods. Productivity has also been rising faster in manufacturing than in all other nonfarm businesses (see Chart 6). (There is, however, some debate about how to measure manufacturing productivity. See interview with Susan Houseman, a labor economist with the W.E. Upjohn Institute.)

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Big challenges remain

But none of this is to suggest that district manufacturers have found refuge from the tempest of global competition. Challenges are omnipresent, from Chinese competition to the need to constantly innovate to satisfy finicky, fickle buyers.

Kill, from Enterprise Minnesota, said the optimism of manufacturing CEOs is “tinged with caution.” The European debt crisis, America’s own debt problem, a slow national economy, health care reform and other economic concerns “get in the minds of people, and they get more conservative,” said Kill, adding that order backlogs “are good, but future visibility is still very short range.”

This summer various manufacturing indicators were starting to soften. The Institute for Supply Management’s factory index saw three consecutive months below 50 (the benchmark for industry expansion). The Mid-America Manufacturing Index, a regional subset of the Institute’s survey, also dipped into negative territory (see Chart 2).

If that weren’t enough, firms fortunate enough to be doing good business are having difficulty finding qualified workers. A fedgazette survey of Montana manufacturers found that revenue increased over the past two years for half of the 55 respondents (one quarter had flat revenue and another quarter saw revenue decline). But two of three respondents said finding the necessary labor was difficult. In the past year, employers have expressed similar sentiment in surveys by the DEED and Enterprise Minnesota.

Skilled labor conditions are even tighter in North Dakota, which has the envious challenge of dealing with an oil boom and virtually uninterrupted economic growth over the past decade. Peterson, from the state chamber of commerce, said that an executive at Case New Holland told him: “Give me 50 trained welders, and I’ll hire them today. Give me 50 more, and I’ll hire them tomorrow. Give me 50 more, and I’ll hire them the day after.” Those stories abound in North Dakota. He noted that two other large manufacturers in the state had all the business they could handle, “and they can’t get enough workers. … Their greatest fear is not finding enough workers to grow in North Dakota.”

Randy Schwartz, director and CEO of the nonprofit Dakota Manufacturing Extension Partnership, pointed out that North Dakota manufacturers are looking for workers whose skill sets are similar to those working in the oil and gas industry, where wages “are roughly double what they are in many manufacturing companies.” With such hot competition for skilled labor, Schwartz said, “more manufacturers are going to have to avoid becoming the workforce feedstock for the energy industry.”

Is this different?

Despite these myriad challenges, many are cautiously optimistic about the future of manufacturing. Some are gaining confidence from an increasing number of anecdotes about manufacturers “reshoring” jobs back home, or giving contract work to domestic suppliers rather than sending the work abroad (see Made (again?) in the USA).

The encouraging thing about this manufacturing recovery is that sector employment has rebounded more quickly this time compared with the 2001 recession (see Chart 7) and to date is roughly in line with the recovery after the 1991 recession, which was subsequently followed by strong manufacturing growth for most of that decade. The Mid-America survey and others also continue to be upbeat regarding future employment.

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That’s good news for workers and policymakers fretting about continued high unemployment. But job gains in the sector will probably be comparatively modest; despite 41,000 new manufacturing jobs in district states since the upturn, the industry employs 100,000 fewer workers than it did before the recession, while output in most district states has generally equaled or surpassed prerecession levels.

There is little reason to believe manufacturing will significantly reverse the sector’s steadily sliding share of employment—from 25 percent 40 years ago to 10 percent—because manufacturing today simply requires less labor than it once did, thanks to new technology and rising worker skills. New manufacturing jobs often demand a range of mechanical and computer skills to run sophisticated machines that do most of the production work. “Mechatronics” has become something of a buzzword in some manufacturing circles. It represents a skill set—as well as a curriculum in some district technical colleges—that combines mechanics, electronics, software and other technology, according to Kill. It transitions the manufacturing worker from brawn to brains, but requires fewer workers to produce the same number of widgets.

Kill acknowledged the trade-offs. “Does it require as many employees? No. Is it skilled? Absolutely. Does it pay more? Absolutely,” said Kill. “This is where [manufacturing] is going.”

So while manufacturing in the Ninth District has made a solid recovery by many measures, there is just as much work ahead if manufacturers hope to remain competitive. As Central Container’s Haglund put it, “Status quo used to be status quo. Now status quo is regression.”

For a final tale of both promise and peril in manufacturing, gather around Daniel Berdass, from Bermo Inc., who is something of a celebrity within the industry. “Everyone wants to hear my horror stories. It makes them feel good,” said Berdass.

While Bermo is currently seeing strong growth in its metal components business, it’s been a volatile arc. It went through gut-wrenching upheaval in the last two recessions. In 2001, the company was an international supplier to computer and electronics firms like Dell during the high-flying 1990s. The collapse of the Internet and telecomm bubble with the 2001 recession saw the “loss of 90 percent of our business in 45 days.” The company shut down six plants abroad, leaving only its Twin Cities facility, and employment shrank from 1,200 to just 110. That period “was probably the most difficult thing I ever experienced. You wouldn’t believe the trauma,” Berdass said.

So the company decided that the only feasible, yet risky, move was to shift into heavy equipment prototyping, fabricating and stamping. The thinking, according to Berdass, was that “the bigger and the heavier, the better a chance [production] has to stay” in the United States at which point the company could expect to compete for business.

Berdass said that retrenchment finally took hold after about five years, just in time for a smackdown by the 2007 recession. Revenues dropped and employment got cut in half. But while the firm struggled, “we were used to this. We knew how to shrink.” Recovery took a couple of years, but today “things look very good, very strong,” said Berdass. Even among his competitors, “95 percent of us are doing very well.”

But none of the recent success is much comfort to Berdass because he knows how fast things can change. “It’s very scary. Certainly the next six months look strong … but we’re very cautious.”

Whether the current upturn in manufacturing is merely a temporary sunny spot or something more long lasting is “a question I ask myself every day, and I have no idea,” said Berdass. “You get whacked twice in eight years, it’s very hard. I’m scared. From here it looks strong. But we could get [contracts] canceled tomorrow and things will look terrible. It’s happened before.”

Measuring dead zones is an imprecise exercise, but the federal government has made substantial investments in tracking them, mostly via federal economic stimulus funding, to better understand and expand the nation’s broadband capacity.

What can be gleaned from existing data and various research efforts is that broadband is more widely available than conventional wisdom and the public debate over the “digital divide” might suggest. Sizable geographic dead zones exist in the district even today, but they tend to affect comparatively few residents. At the same time, federal standards for broadband access are a bit outdated, and a narrow focus on access ignores other important issues such as speed, affordability and, maybe most important, consumer demand.

Got broadband?

Broadband is an umbrella term for telecommunications pipelines that offer more bandwidth, or speed, than the dial-up modems that were prevalent in the 1990s. The Federal Communications Commission has adopted the stance that broadband Internet access, once a luxury, is an economic necessity today. The FCC and other federal agencies have launched programs to accelerate broadband deployment in underserved areas in hopes of not only driving economic growth in rural America, but also expanding the online marketplace nationwide, creating jobs and business opportunities across the country. 

Broadband availability became a federal priority in 2009, when the American Recovery and Reinvestment Act allocated billions of grant dollars to expansion efforts, including $320 million for a few dozen projects in six district states (some projects were outside the district in Michigan and Wisconsin). The stimulus program also funneled almost $300 million to states and U.S. territories to help them gather semiannual data on broadband geographic penetration, capacity and uptake.  

This information, the most granular and comprehensive available, is used by the federal National Telecommunications and Information Administration to publish nationwide data on broadband access. The NTIA has set a download speed of 768 kilobits per second (Kbps) as the minimum threshold for broadband. Measured by population, virtually everyone—about 99 percent of households across the United States and Ninth District—has access at this or higher speeds, according to the NTIA.

On a map, however, the picture looks a bit different. NTIA geographic data show that Ninth District states still have large areas devoid of broadband (see district map). Significant dead zones remain in northern Minnesota, the Upper Peninsula of Michigan, northwestern South Dakota, and central and western Montana.

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These large geographic not-spots stem from sparse population and rough terrain that increases the cost of broadband coverage; in relatively more populated western Montana, for example, mountains create considerable dead zones.

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Most of that faster throughput comes from mobile broadband, but wired and fixed wireless also play significant roles in every state (see Montana map for illustration).

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I’ll take the slow lane

While broadband access might be widespread, that doesn’t mean all states are created equal in terms of capacity. In Montana, rural and urban (see Chart 1) residents alike tend to lag those in other states in access to faster speeds, particularly at the top end, while South Dakotans have exceptionally good access, especially at higher speeds.

But broadband access does not equal usage, and here’s where the broadband picture becomes fuzzier, because not all states have looked beyond mere availability. Minnesota and Michigan are two district states that have investigated socioeconomic facets of broadband usage. While virtually all Minnesota households have broadband access, only 72 percent buy the service—though that’s higher than the national subscription level of 67 percent.  

Public debate over access often implies that cost limits broadband penetration.  But according to a 2011 survey by Connect Minnesota, 60 percent of respondents who knew the price of their broadband service reported paying less than $50 a month; one in five paid less than $30.

There are 470,000 households in Minnesota that choose not to subscribe to broadband services. Cost is certainly a concern; the Connect Minnesota survey identified cost as a main barrier to broadband adoption for about one-quarter of respondents (see Chart 2). Those found most likely not to subscribe are senior citizens, racial minorities, people with disabilities and those with low income or little education.

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At the same time, even more people declined to subscribe because they didn’t view broadband as a relevant service for them. So in the midst of the debate over the need for speedy Internet access, a significant share of households in Minnesota—and probably in other district states as well—prefers to remain in the Internet slow lane.