July 27, 2005

Eleventh District economic activity strengthened from late May to early July, driven by strong construction- and energy-related activity. Many contacts expressed increased optimism about the economic outlook, noting surprise that activity had strengthened more than they had expected. Manufacturing and service sector activity was up. Retail sales increased. Contacts say real estate investment is very strong. There has been a pickup in all types of construction and real estate activity, leading to a very hot housing market and construction of speculative office space in the Dallas area. The financial sector continued to report solid loan growth and good credit quality. Hot, dry weather hurt agricultural conditions.

Prices
Energy prices were higher than during the last survey period. Strong demand pushed up crude oil prices. Pump prices for gasoline and diesel fuel were also higher. Exceptionally strong demand for diesel raised concern about the refinery system's ability to build inventories for next winter. Natural gas prices have risen along with crude prices, helped by warmer-than-normal temperatures in the South. Despite high temperatures, natural gas inventories remained 12 percent above normal for this time of year. Refinery margins on the Gulf Coast remained very strong throughout June, about the same as May and better than $3.50 per barrel higher than last June. Prices for energy services were sharply higher.

Most contacts expressed concerns about rising freight, fuel and utility costs. Transportation firms said they are passing these costs on to customers as much as possible, and even airlines have been able to raise fares. The ability of manufacturers and retailers to push through price increases remained mixed, however.

Strong demand pushed up prices for cement and most other construction-related materials. Selling prices were lower for scrap steel, nickel, and aluminum. Excess inventory led to price declines for a variety of basic chemical and plastics products, but increased orders and unplanned outages were helping inventories adjust and prices stabilize.

Labor Market
The labor market continued to strengthen, with more reports of hiring, employees being bid away and scattered problems hiring skilled workers. Only a few industries noted any significant wage pressures, notably accounting firms and the energy industry.

Manufacturing
Manufacturing activity increased, with very strong demand for most construction-related and energy-related manufactured products. Very strong demand for cement has led to shortages in Texas, and inventories are rapidly depleting—despite manufacturing plants working at capacity. Some producers said they imported cement from abroad to keep up with demand. Producers of clay, brick and glass continued to report robust demand. Demand for fabricated metals has been good and steadily improving, spurred by particularly strong sales for highway and commercial construction. Demand for lumber was above last year's pace.

Respondents in high-tech manufacturing said sales and orders continued to grow at healthy rates since the last survey. Industrial demand for semiconductors has picked up in the past six weeks. Apparel producers say demand has been decreasing due to import competition, which has resulted in another plant closure. Sales of primary metals have cooled from very strong growth earlier this year, and producers continued to report increased import competition. Inventories are higher than desired for some metals but are being pared down.

Chemical producers continued to struggle through a patch of weak demand. Sales to Asia have slowed. There was some improvement in orders in late June, which contacts said was an early indication that demand was stabilizing. Refinery capacity utilization averaged rates near 98 percent in the District, higher than the U.S. average.

Services
Activity in the service sector picked up slightly. Temporary staffing firms said demand edged up over the past six weeks. Transportation firms also reported an increase in demand. Legal firms reported no change in demand. Demand continues to be strong in the accounting sector, keeping pace with last year's strong growth.

Retail Sales
Retailers report that sales growth has been stronger than expected, and early signals suggest a healthy back-to-school season. Contacts thought high oil and gasoline prices would restrain growth, but reported that consumers have kept spending, and there has been no deterioration in bad debt portfolios. Auto dealers also reported a pick up in sales growth. Contacts noted some uncertainty because they said sales were being stimulated by manufacturer price reductions, and the underlying market is not strong.

Construction and Real Estate
Contacts say real estate investment is extremely high in part because the District's competitively-priced markets are attracting investment capital from more expensive coastal markets. Construction of new homes picked up over the past six weeks. Demand is strong, and sales are ahead of this time last year. With few regulatory or land development constraints, the supply of new homes has been sufficient to meet demand, and prices are not increasing faster than inflation. Existing home sales in major metropolitan areas remained above last year's record levels, but sales growth was less robust than earlier this year and some contacts expressed concerns about rising inventories.

Demand for apartments rose over the past six weeks. Contacts noted an upturn in market conditions with occupancies tightening in Dallas and Austin, and rents rising modestly. Apartment construction continued to be at high levels in Dallas, Houston and San Antonio, and developers remained optimistic that conditions will continue to improve. Several high-end condo and town-home projects are slated to break ground in Dallas, and contacts noted that most are at least 60 to 70 percent pre-leased.

Office markets also continued to improve. Occupancy rates increased, although they are still low in comparison with other parts of the country. Contacts say rents are "firm" to "rising." There is limited office construction activity in Houston and Austin, but speculative space is being developed in the Dallas area. Industrial activity is also picking up, especially near the Port of Houston. Hotel markets are "hot."

Financial Services
Loan growth remained solid, according to contacts, who said that there has been a pickup in consumer auto loans as a result of an increase in purchase incentives. Credit quality was still good. The banking environment is very competitive, they said, particularly for large, commercial loans.

Energy
Drilling activity continued to expand. The rig count increased, and contacts say the outlook for future drilling activity has picked up. Oil service companies reported extremely strong demand, limited capacity, and strong pricing power. Service firms say they are turning down work and have expressed more willingness to expand capacity, given current pricing and the potential durability of this drilling cycle. Expanding manufacturing capacity for oil field equipment poses few barriers, but finding qualified engineers and training crews is difficult and time consuming. Technical skills will increasingly have to be found abroad, they say.

Agriculture
Dry weather has reduced yields and increased the cost of production. Irrigated land crops remained in fair condition but the outlook for dry land crop yields worsened. Range and pasture conditions also deteriorated substantially since the last report, and hay production has been very limited. Corn producers expressed concern about aflatoxin.