October 27, 2005
Chicago's Exchanges Look to the Future
Last week, the Chicago Board of Trade (CBOT) became a publicly traded company. On the first day after offering its stock, its share price ended the day above $80, well above forecasts of a $45-50 value per share.
The CBOT development was one of many suggesting that the prospects of Chicago area’s futures exchanges have improved in recent years. But to what extent is the turnaround sustainable, and will this growth and success continue for one of Chicago’s hallmark industries?
Chicago’s importance as a financial center is defined by its exchanges and associated dealers and brokers. The Chicago exchanges can claim close to two-thirds of the volume of exchange-traded contracts in the U.S. A major assessment of the exchanges’ importance to the Chicago economy has not been conducted since 1997. (See Civic Committee of The Commercial Club of Chicago’s Report by the Risk Management Center, “Study of Financial Markets & Financial Services in Chicago,” 1997.) That study reported that 150,000 Chicago-area jobs could be attributed to the exchanges, and $35 billion in funds were on deposit at local banks to support Chicago’s exchange products. Many other linkages to Chicago’s economy, such as the needs of large local companies to balance their financial risks and risk exchanges’ ties with other financial and legal services firms and universities, were articulated in that report.
Chicago’s exchanges had long dominated global trading activity in futures and derivatives. But throughout the 1990s, the Chicago exchange community lost global market share. The figure below shows the growth in volumes of futures and options contracts traded on exchanges from 1987 to 2004. Trading volume at U.S. exchanges languished in the mid-1990s, even while growing rapidly throughout the rest of the world.
In the 1990s, competing exchanges in Europe and Asia made strong gains in market share. Electronic or computerized exchange facilitated overseas market locations partly by offering trading activity during hours when Chicago floor trading was not active. Ultimately, electronic trading also offered cost advantages for some existing products, while preserving important liquidity, clearing, and price-discovery properties as well. Overseas competitors adapted to and innovated electronic or computer-generated trading more successfully, and therefore captured markets that the Chicago exchanges might otherwise have claimed.
The Chicago exchanges also innovated and implemented systems of electronic trading, but their strong prior commitment to the open outcry or pit trading method of trading and price discovery perhaps impeded their success. So too, globalization of capital markets enhanced the demand for futures products overseas, along with a desire to trade around the clock. And so, electronic trading and the competitors who used it effectively were more successful in capturing growth in global demand.
But in recent years, Chicago’s two major exchanges, the Chicago Mercantile Exchange (CME) and the CBOT (CBOT), have rebounded strongly. Not only are contract volumes up markedly, but both exchanges have gained market share on their global competitors over the past two years. The CME reorganized from a mutual or member ownership structure to incorporation and public ownership, with an IPO in late 2002. Since that time, product and market expansion, enhanced services, and cost savings and price reductions on trades have boosted the CME’s market shares and sales. As of mid-October, the CME share price had increased ninefold since its IPO.
How did the Chicago exchanges turn it all around and what are their prospects? The answers are central to the future of the Chicago area’s economy. On October, 13, 2005, I participated on a panel convened by Bob DeYoung of the Chicago Fed at the Financial Management Association meetings. At the session, I noted that the exchanges’ success in recent years seems to parallel an unprecedented explosion of exchange-traded contracts worldwide. For example (as shown in the chart above), the volume of contracts expanded five times from 1999 to 2004. Much of this growth can be attributed to the continued deepening of capital markets and expanded funds flows as markets and firms continue to extend their global reach, along with heightened global uncertainty and economic upheaval. Have Chicago’s exchanges merely been riding the crest of the rising market, which would ultimately make it vulnerable to a worldwide slowing of exchange-traded contract growth?
The fact that Chicago’s exchange community has been gaining market share in recent years somewhat belies that interpretation. Furthermore, Kim Taylor, managing director & president, MERC Clearing House, showed that the CBOT’s market share among the four major global exchanges had risen from 19% in the second quarter of 2005 to 22% in the same quarter of 2006; the CME’s share rose from 27% to 33%. Taylor offered an alternative interpretation of the global growth of exchange-traded contracts. She argued that, far from riding the wave, the Chicago exchanges were partly responsible for the expanded demand for exchange-traded contracts worldwide through their own product and training innovations—especially at the CME. These efforts include expanded overseas trading capabilities in Europe and Asia, the consolidation of clearing operations for both of Chicago’s largest exchanges in 2003, enhanced electronic trading platforms, and new products. Bryan Durken, executive vice president and COO, CBOT, further explained that the CBOT’s success was hard won by “listening closely to the needs of their customers and acting quickly and creatively.”
But what was the source of the recent inspirations? Chicago’s exchanges had suffered through some rough periods when their traditional “membership” mode of organization, coupled with deep-seated cross-town rivalry, seemed to impede their transition toward computerized trading and other innovations. Chicago’s dominance was challenged to such an extent that Eurex US, an arm of a major European exchange, won approval to operate in Chicago in an attempt to topple CBOT’s market dominance of U.S. Treasury futures contracts. This attempt ultimately failed. And both the CME and the CBOT are now publicly traded companies, with the third major Chicago exchange, the Chicago Board Options Exchange, also moving toward de-mutualization.
In talking about Chicago’s recent success and its prospects, I also offered the idea of an “economic cluster” at the session. Economists such as Gerald Carlino describe the spatial concentration of some industries as being highly productive and often a formidable barrier to competition from market challengers. In this instance, over the course of its long and successful life, Chicago’s risk exchange community developed local assets like a deep pool of talent and supportive service firms, including local banks that understand their businesses, legal/consulting firms with specialized knowledge to service them, and local universities that produce new workers and new product ideas from finance professors. Might such a clustering of firms and assets have carried Chicago’s exchanges through a period when they were otherwise hobbled by their own outdated organizational structures?
Mike Cahill, CEO of The Options Clearing Corporation, noted that the specialized workers and other local personnel have been critical in maintaining Chicago’s exchanges. In particular, in areas such as contract product innovation, there is no question that Chicago’s historical role continues to provide the exchanges with striking advantages. However, Cahill also explained that Chicago’s strength and local assets have been weakened by technological changes that have lessened the need for “back office” activities to be located near the trading floor. Such operations have begun to move closer to far-away customers or where processing costs are cheaper. And as data manipulation and trading systems become more technical in nature, clearing operations and back office support are drawn to the technical workforce and technology firms of other regions.
Bob DeYoung asked whether the exchanges’ access to credit had been diminished with the loss of several major banks from Chicago. All of the industry panelists agreed that the loss of some major banks in Chicago had weakened the “cluster” of mutually dependent relationships among the exchanges, brokers, dealers, and banking community. It is not the case that the existing Chicago area lenders are not savvy and responsive partners. However, the choice spectrum of lenders is somewhat diminished, and with it some of the former willingness to fund and finance the small start-up companies.
The risk exchanges are a bright spot for Chicago and the Midwest even as many of its other industries are not sharing this luster. Local public policy is not a dominant force in determining the success of a local cluster such as this. Yet, it seems to me that it is worthwhile for us to understand our local industry clusters so that we continue to support—as appropriate—their supporting industries, their work force requirements, and their public service needs.
October 20, 2005
Delphi and Midwest Auto Parts
Midwestern communities that host automotive plants are especially concerned at the recent bankruptcy actions of Delphi Corporation. Such concerns are not misplaced, since the geography and problems of Delphi’s operations are similar to those of some other automotive plants.
Delphi, the nation’s largest auto parts supplier, filed for Chapter 11 bankruptcy on October 8. The bankruptcy covers only its U.S. plants; non-U.S. subsidiaries are not included. The company, which had 2004 revenues of $28.6 billion, is looking to the courts to allow it to cut costs by rewriting its contracts with its UAW-represented work force, closing plants, and restructuring its legacy-cost obligations for retirement and health care.
Delphi is a global company. It employs 185,000 people around the world. Of these, about 50,000 are employed in the U.S. Delphi makes a wide range of auto parts, including dashboards, air conditioning systems, electronics, and batteries.
Drawing from a variety of data sources, my colleague Thomas Klier and his research assistant, Cole Bolton, have put together a map of Delphi’s Midwest operations that displays current employment (figure 1). The Midwest is home to about 70% of Delphi’s U.S. employment. The two states with the highest concentration of Delphi employment are Michigan (just under 15,000) and Ohio (just over 13,000).
Delphi’s Midwest footprint is very typical of the overall auto supplier industry; the Midwest is home to 61% of auto supplier plants located in the U.S. (figure 2) with other plant concentrations in the southern states, Ontario, and Mexico.
This remarkable concentration in the Midwest has historically been lucrative for the region. But now, the traditional hub of the auto industry is facing some serious challenges, and Delphi is something of a bellwether.
Challenges to U.S.-produced automotive parts are either directly or indirectly linked to international trade and investment, though ongoing shifts in the domestic geography of parts production also play a role. First, the sales of the traditional “Big 3” domestic auto assembly companies have been giving way to transplant sales. Transplant vehicles are produced in the U.S. by foreign companies and, in some cases, their supply chain of parts reaches overseas to a greater extent than Big 3 auto production. The U.S. light vehicle sales share accounted for by these foreign nameplates has risen from a 15% share to a 22% share during the past decade.
In addition to having global supply chains, this sales shift threatens Midwest parts plants because the transplants and their parts suppliers tend to be located south of the traditional auto states of Michigan, Indiana, and Ohio.
At the same time, imports into the U.S. of light vehicles produced in countries other than Mexico and Canada have increased their market share by 8 percentage points (to 19%) over the past decade. Imported cars do not usually contain U.S. produced automotive parts.
And finally, parts for domestic vehicles—including those produced by the Big 3—are increasingly sourced overseas, with China’s share growing fast, albeit off a small base.
These international developments and regional shifts will be analyzed further by Thomas Klier in a Chicago Fed Letter to be released later this fall. (The CFL is now available -- link.) In addition, Klier is organizing a conference in the Detroit area to further assess the directions and challenges of domestic automotive parts producers.
To be sure, Delphi has some unique characteristics concerning its relative wage and benefit costs that are not mimicked by other domestic parts operations. But the scale and geography of struggling Delphi are enough to focus Midwest attention on both the similarities and the differences.
October 18, 2005
How Much Are Headquarters Worth?
Earlier this month, Mittal Steel USA announced it will locate its headquarters in downtown Chicago rather than in Northwest Indiana. Mittal USA employs 21,000 workers in 14 states. The parent company, Mittal, headquartered in London, is the largest steel maker in the world.
Mittal’s U.S. headquarters will employ only about 200 people. Even so, the company will reportedly receive $7.5 million in tax credits from the State of Illinois for job training and infrastructure, and the City of Chicago will contribute $2 million toward equipment, furniture, and fixtures. At a cost (undiscounted) of $40,000-$50,000 per job in tax incentives, why are public officials so pleased to have the Mittal headquarters?
For one reason, the Chicago area economy, along with the rest of the Midwest, is lagging the nation in this first decade of the millenium. Moreover, an intense matter of pride and branding of Chicago’s economy is at stake. The Chicago area ranks second only to the New York metro area as a headquarters city (figure 1). And, as reported by Lyssa Jenkens, chief economist of the Greater Dallas Chamber, even Sun Belt cities that are gaining headquarters admire Chicago and New York(Chicago Fed Letter). Yet, although Chicago snagged a big prize with Boeing’s move from Seattle in 2000, the city has lost other headquarters in recent years, such as Ameritech, BankOne, Quaker Oats, and Amoco.
Such concerns may lie behind the willingness of Chicago and Illinois to court relocating headquarters with tax incentives. So too, city and state development officials believe that the “ripple” effects of the headquarters will greatly augment the economic impact of the 200 direct jobs that the headquarters will bring. Part of these expected ripple effects are based on the tendencies of headquarters operations to purchase local business services, such as accounting, legal and financial, not only for their local operations but often for their entire organization.
This idea is borne out in a recent study by Yukako Ono (2002 Working Paper). In a statistical study using the 1992 plant-level data from the 1992 Annual Survey of Manufactures, Ono examines manufacturing plants’ outsourcing of advertising, bookkeeping, accounting, and legal services, and how the degree of plant outsourcing changes with the location of their headquarters. She finds that plants rely more on headquarters if their headquarters location offers a greater supply of such business services. And so, if business services in areas of accounting, legal, and finance are cheaper or more accessible in larger cities, headquarters operations will be motivated to locate there. Indeed, the CEO of Mittal USA cited the availability of support services such as accountants and lawyers in the company’s decision to locate in Chicago (Crain’s article).
In courting Mittal, Chicago may also be anxious to put back together the clustering of business functions that propelled its economy during the 1990s. Back then, business service employment expanded rapidly (previous blog), along with corporate and organizational headquarters. At the same time, both headquarters and business service establishments brought customers in, and sent company execs out, via booming O’Hare airport. Local business meetings and conventions added to the allure for those same customers and local execs, and Chicago’s diverse economy enhanced its reputation as a business capital city for the mid-continent and as an emerging global city.
From this perspective, the tax incentive package to Mittal appears to be thoughtful and stragetic. Still, in the aftermath of business relocations like this one, the question always lingers as to whether Mittal would have chosen Chicago anyway and paid full freight to boot. Even if Mittal had chosen Northwest Indiana in the absence of any incentive offer, it would not have greatly limited the company’s ability to purchase high-level business services from Chicago.
But apparently, Chicago is taking no chances. Tax sweeteners have become a signal to footloose firms that they are welcome, and that local government and civic organizations will partner with them in the future as the business environment changes. Chicago would like to see other headquarters follow Mittal’s lead.
October 6, 2005
Hurricane Impacts and Energy Prices
As the water recedes and the human toll accumulates in the hurricane-impacted Coastal regions, discussion has turned to the economic impact. Many areas and communities immediately surrounding the Gulf Coast are experiencing increased business and real estate activity as evacuees try to refocus their lives and homes, even as local governments and charitable organizations struggle mightily to lend assistance and resettle evacuees. Midwest economic activity will pick up in several ways during the coming months, but these will likely be outweighed by rising energy prices—-especially for natural gas, which is used to heat Midwest homes.
Hurricanes and other natural disasters are often accompanied by interruptions in economic activity and are followed by upswings and regional diversions in economic activity. Parts of the Midwest have felt the disruption through our ties to the Gulf Coast economy. Shipment delays and sharp price spikes for petroleum-based chemicals have slowed production for Midwest manufacturers of tires and furniture. Midwest grain shipments down the Mississippi were delayed and diverted by Hurricane Katrina, though they have now largely resumed or been diverted in other directions.
In other ways, the hurricane impacts are boosting Midwest economic activity. Some evacuees have taken refuge in Midwest communities, and now reside with relatives or in donated facilities. In response, government operations such as schools must bolster their payrolls. The added spending of the new families will be an infusion into Midwest income and spending streams.
As for “export” industries, mobile and trailer home construction in northern Indiana and other areas of the Midwest have been called into hot demand by FEMA. Emergency workers, evacuees, and homeowners who are in the process of rebuilding their properties must have housing—-at least temporarily. And the region’s manufacturers of earth-moving and construction equipment, such as Caterpillar, and makers of other rebuilding tools, such as electric equipment and generators, will experience some added sales. And of course, flood-damaged autos and homes will require such Midwest staples as motor vehicles and home appliances. Chicago also has gained several upcoming conventions dropped from the New Orleans calendar.
But rising natural gas prices loom large as the Midwest approaches the home-heating season, due to supply disruptions from the Gulf. Other cold-weather regions, such as New England, burn home heating oil. The Midwest enjoyed low home heating bills from the late 1980s to the mid-1990s when natural gas prices were very low and gas utilities were paying about $2 to $3 per thousand cubic feet of natural gas (mcf). But in recent years, natural gas prices have been rising because of higher demand for gas from electricity utilities and from its use as a substitute for petroleum.
In the regional newsletter of the Federal Reserve Bank of Dallas, veteran energy economist Steve Brown investigates the relationship between petroleum prices and natural gas prices (Southwest Economy July/August 2005). Although the two fuels are no longer common substitutes in electric generation, Steve finds that the two fuel prices continue to move in tandem—-with two exceptions. Natural gas prices are higher in the winter, and they also depend on how much is stored during the summer for use in the winter. In the Midwest, natural gas is stored in the summer in underground aquifers, salt caverns, and abandoned gas wells. According to Brown, if 10 percent less gas is stored now than the average in the previous five years, natural gas price prices will go up 23 cents nationally.
What can cause these shortfalls in stored volumes? Winter cold snaps for one, whereby vendors drain their stored reserves to meet demand. Cold snaps contributed to price spikes during the winter of 2000-2001 and 2002-2003 when the spot price approached $10 and $12 per mcf. Abnormally hot weather during the summer can also contribute to a shortfall. The hot spell in the Midwest this past summer increased natural gas prices and slowed storage as some electric power generators fired up on natural gas to feed air conditioning units. And finally, of course, supply interruptions such as those from Hurricanes Katrina and Rita can slow the pace of storage. This is a particular problem for the Midwest since most of our natural gas supplies come from the Gulf Coast area.
How much will natural gas prices rise this winter as a result of the Gulf hurricanes? Not quite as much as current rises in spot market prices and contract prices for future delivery suggest. During the heating season, gas distributors blend new spot market purchases with the natural gas already purchased and stored or pre-contracted. Likewise, the delivered price to homes reflects a price blend of the stored gas, as well as gas purchased under long-term contract, with augmented or spot market purchases. A colder-than-normal winter, or low volumes of stored or pre-contracted gas, would tend to tilt the blend toward higher-priced spot market purchases, which could deliver a ruder heating bill shock to Midwest households.
The figure below shows that reported spot prices do follow the acquisition, or “city gate,” prices that gas distribution utilities pay for natural gas. This past summer, and intermittently since 2000, the measure of spot price was running roughly double that of the 1990s. Due to the current supply disruptions, the prices for delivery under futures prices on the NYMEX were running double that of this past summer at over $14 for December 2005 and January 2006 delivery, though falling in the years thereafter.
Rising gas city gate prices push up home heating bills, though less than proportionately because home heating bills also include distribution and delivery costs, which are more stable. The figure below compares past city gate prices in the Midwest to home heating bills. Heating bills rise only moderately less steeply than city gate prices. Natural gas expenses per household in the Midwest for the November–March heating season averaged $445 from 1996-97 through the 1999-2000, but had climbed to an estimated $732 last winter (which was a mild winter). In its recent “Short Term Energy Outlook,” published just after the Katrina and before the Rita disruptions, the U.S. Department of Energy estimated that home heating bills in the broader Midwest, under normal heating circumstances, will be 71 percent above last year.
The U.S. Department of Energy (DOE) does not include any measurement of uncertainty in its model forecasts, so these estimates should be taken as nothing more than a rough guess … not only because of the vagaries of the weather, but because little is known about the amount of gas stored at Midwest utilities or purchased under long-term contracts for later delivery. The extent of damage to production of natural gas in the Gulf region is only now being assessed, but early indications are that Rita was less damaging than the initial assessment. Until we know how long it will take to restore lost production, and its effects on spot price, winter heating costs remain a big question mark.
In any event, despite some possible benefits from the hurricanes for the regional economy, most Midwest households will wish they had never heard the names Katrina and Rita as they feel the frosts and pull out their checkbooks to pay the bills this winter. In our 2001 Chicago Fed Letter, Thomas Klier and I found that the cold weather snap took a 1.74 percent bite out of Midwest disposable income (versus 1.01 percent for the U.S.) during the winter of 2000-01, up from 1.05 percent the previous winter (Chicago Fed Letter). And gasoline prices, though up sharply that year, averaged $1.40 in the Midwest in 2001. They’ve averaged $2.19 so far this year in the Midwest, with a 40 cent jump after Hurricane Katrina. Who said that hurricanes could only damage coastal regions?
October 4, 2005
Michigan Auto Woes
Michigan’s traditional heavy reliance on the domestic auto industry has been troubling its economy over the past five years. While GM and the other domestic auto makers have “kept America rolling” with continued auto sales and sales/finance incentives, the state of Michigan has shown the worst performance among the states. Michigan’s unemployment is the second highest at 6.7 %; and it holds the bottom spot for year-over-year payroll job performance with a 1.1 percent loss as of August. It is the only state to have lost jobs over this period. What are policy makers to do? The state’s heavy reliance on the automotive sector makes efforts to diversify a long-term and risky proposition at best. In the short term, hopes ride on a turnaround for the domestic auto makers and their upstream auto parts manufacturers, while long-term bets are being placed on new industries.
Light vehicle production in the U.S. has continued to average around 12 million vehicles since 2000. However, as discussed by Thomas Klier (Chicago Fed Letter) earlier this year, it is the geographic shift of production from Michigan and other parts of the upper Midwest southward that is adversely affecting Michigan’s economy. A shift southward has accompanied the slippage in sales share of the domestic nameplate automakers—GM, Ford and Chrysler, which has fallen from a 65% share of domestic sales in 2000 to 58% in August, 2005. Rising imports into the U.S. have contributed to this slippage, with the import share rising from 17% to 20% percent of domestic sales. And so-called “transplants,” which are foreign nameplate companies producing vehicles in the U.S., have captured the rest of the rising share from Big 3 auto makers. Transplant production largely takes place in the South. Michigan hosts only a single transplant(Mazda), which is partly owned by Ford, whereas it hosts 17 domestic assembly plants. Ohio is also laden with domestic assembly and parts makers, but it has two Honda plants as an offset. Indiana is the third state in the Midwest auto troika, and it hosts an Isuzu plant in Lafayette and a recent Toyota plant in Princeton in the southwest part of the state.
As a result, from 2000 through July, 2005 year-to-date, Michigan lost 42% of its auto assembly jobs versus a 14% loss in the U.S. located outside of the three Midwest auto-intensive states. Ohio assembly jobs are down 25% over the same period, while Indiana is actually up one-third.
Auto parts are a larger part of the story, since there are four times as many jobs in parts as assembly operations. Parts makers tend to be located near the assembly plants for historical reasons, and more recently because “just-in-time” production requires proximity for many parts such as seats and sub-assemblies. Michigan’s parts employment is down 34 percent since year 2000, versus 19 percent in the rest of the U.S.
These job losses are felt more keenly in Michigan since, even among the Midwest troika of auto states, Michigan is by far the most dependent on automotive. Michigan’s job base is 7 times more concentrated than the nation in automotive parts, versus 5 and 3 for Indiana and Ohio.
Policy makers in Michigan have long recognized the state’s heavy reliance on this cyclical and competitively-challenged industry. In response, state government is weighing large expenditures to fund life sciences research and is also promoting new company formation in advanced manufacturing and homeland security. Local communities such as Kalamazoo and Grand Rapids are also trying hard to move life sciences activities along. But such efforts to encourage diversification through public support are not without risk, and even if successful, the results often take a very long time. At times like these, many possible avenues of growth and adjustments to public policy will be considered in Michigan. Meanwhile, any signs of a Big 3 turn-around will be enthusiastically cheered.