is hunkering down to protect New Mexico’s permanent funds.
The total value of the funds fell by 1.2 percent in 2015, from $20.2 billion in 2014 to $19.95 billion as of Dec. 31, according to preliminary estimates by the SIC. That marks the first decline since 2011.
And unlike the 2011 decline – when stock markets quickly bounced back and oil prices remained at record levels – today’s challenge could linger for years.
“We’re seeing very high volatility,” said SIC spokesman Charles Wollmann. “The outlook now is for a depressed or low-return environment for quite a while.”
New Mexico’s oil production is also expected to drop this year for the first time since 2008, when high prices helped fuel a prolonged boom in the Oil Patch in southeastern New Mexico. As of November, output had continued to grow despite the crash in prices. But as oil prices hit new lows, production will likely slow down as well, creating double trouble for state funds.
Those declines have a direct impact on the state’s land grant and severance tax funds, which together account for about 95 percent of New Mexico’s permanent funds. That’s because income from leases, royalties and taxes on oil and gas production feed the funds, while SIC investments in stocks, bonds and other assets provide additional benefits.
With production declines on the horizon, the state funds face prolonged pain because, once output drops, it can take a long time to recover as prices slowly rebound, said SIC member Harold Lavender.
“I think it will take potentially years for oil to recover,” Lavender said. “It won’t be a quick recovery like a ‘V,’ but more like an ‘L,’ where it drops and stays that way for awhile.”
Buffering the impact
Diversification in SIC investments in recent years away from volatile stocks and bonds may help buffer the impact of sluggish markets. But as income from oil and gas production falls, the council has less money to invest to mitigate the decline.
On the plus side, the permanent funds are coming off a prolonged run-up in value from the oil boom and from previously robust stock markets that helped drive up total assets to all-time records.
The financial crash in 2008 had cut the state’s funds by nearly a third, from $16.1 billion in 2007 to $11.68 billion. But, with the exception of 2011, when stock markets briefly dipped, the permanent funds have steadily grown in value since the recession ended. Today, the permanent funds are 24 percent higher than before the recession.
That growth has helped fuel state spending in recent years, since the permanent funds generally contribute about 15 percent of the government’s annual budget. In the new fiscal year, which begins next July, the funds will provide about $839 million, or about $229 million more than before the recession.
Fund distributions help finance public schools, universities, specialty schools and other state institutions.
But, with declining oil earnings, the council will be hard pressed to maintain current values, particularly in the land grant fund, which has ballooned alongside the oil boom.
“With the drop in oil prices, our monthly inflows last year shrank considerably,” Wollmann said. “During the boom years, it wasn’t unusual to see up to $70 million or more flow into the land grant fund in one month. But today it’s the opposite, as more money leaves the land grant fund than what’s coming in. We now have like $30 million in monthly inflows and like $50 million being paid out through distributions each month.”
Today’s stock market volatility, which gained momentum last summer, compounds the problems.
“We’re running a deficit in the land grant fund at a time when investment returns are slowing,” Wollmann said. “It’s a double hit.”
Total returns from SIC investments fell by 1.9 percent in the second half of 2015, from July-December, according to preliminary estimates from J.P. Morgan. That compares with 1.24 percent growth in the same period in 2014 and 9.8 percent in 2013.
Full calendar year returns flatlined in 2015 to just 0.37 percent from 6.84 percent in 2014. Returns for three and five years fell to just above 7 percent as of Dec. 31, compared with double-digit growth in 2014.
As a result, in late fall, the SIC lowered its return targets for land grant and severance tax fund investments from 7.5 percent to 7 percent and 6.75 percent, respectively. That eases the pressure to offset low-performing equities with risky, higher-yield investments.
“We thought it was the prudent thing to do,” Wollmann said. “It makes it less likely that additional risky assets will be pushed to overreach for unrealistic rates of return.”
The SIC is counting on investment diversity to buffer stock market volatility and low-yielding bonds, a strategy it has pursued since the recession.
Over the past five years, the council lowered its holdings in public equities from 62 percent of total investments to 47 percent, with a long-term target of just 40 percent. It redirected investments toward income-producing assets, such as real estate, timber, infrastructure and energy, which earn lower returns during bull markets, but provide more long-term stability against the constant ups and downs of stock markets.
That includes holdings in such iconic real estate as One Times Square and Chelsea Market in New York, infrastructure like Scotland’s Edinburgh Airport and diverse businesses such as the Detroit Pistons basketball team.
“We’ve given up some gains from stock markets during upturns in order to protect the funds in downturns like we’re seeing now,” Lavender said. “That helps us keep the funds on an even keel over time.”
Diversification could shore up overall fund resilience in the current downturn.
“I believe we’re very well situated now,” said council member Linda Eitzen. “It doesn’t mean we won’t see the value of the funds go down, but we can now buffer the amount it goes down.”
Middle of the pack
More stable, albeit lower, returns have improved SIC performance compared with peer funds nationwide. The SIC now generally ranks about the middle of the pack for returns over one, three and five years, according to the Wilshire Trust Universe Comparison Service, which tracks more than 75 public funds. That’s up from near last-place rankings during the recession.
For now, the SIC projects annual fund contributions to the state to continue growing in coming years.
The SIC currently pays out 5.5 percent of the land grant fund and 4.7 percent of the severance tax fund each year. Those amounts are based on the average value of each fund over five years to provide more stability by ironing out annual ups and downs in value.
The land grant distribution will drop to 5 percent in July when a constitutional amendment that had temporarily increased land grant payouts over the past decade expires. That will cut total state distributions in FY 2017 by about $11 million. But, starting in FY 2018, the SIC expects payouts to start growing again, by an average of about $50 million per year through FY 2020.
That, however, depends on the oil and gas industry.
“The problem is, we just don’t know what the markets will do or how low oil and gas will go,” Wollmann said.
And, in the meantime, some state legislators and civic groups are seeking a permanent increase in land grant distributions for education, something council members and some lawmakers caution strongly against.
Legislative Finance Committee Chairman Sen. John Arthur Smith, D-Deming, said most large institutional funds around the country limit distributions to just 4.7 percent to buffer market downturns.
“When you get much above that, the funds can’t sustain themselves in down periods,” Smith said. “Accelerating the withdrawals will put the funds in the danger zone.”
Performance of state permanent funds
New Mexico’s land grant and permanent funds together account for about 95 percent of all funds managed by the State Investment Council. The other 5 percent comes from the state’s tobacco, water and client funds.
The land grant fund, created at statehood in 1912, receives its money from leases and royalty payments on state land, primarily from oil and gas operations. It allocates money annually to the general fund to help finance public schools, universities, specialty schools and other state institutions. For fiscal year 2017, it will provide about $638.1 million to the general fund.
The severance tax fund, formed in 1973, receives its money from taxes on oil, gas and mineral extraction on state lands. Allocations from the fund help finance public school operation budgets, with about $200.3 million going to the general fund in FY 2017.
Allocations from the land grant and severance tax funds combined will account for about 13 percent of the total state budget in FY 2017.
Returns from severance tax fund investments are generally lower than the land grant because the SIC earmarks some severance tax money for “economically targeted” investments that earn lower returns but that produce significant economic development benefits. That accounts for the lower performance rankings for the severance tax fund compared with peers nationwide.