October 12, 2006

The Eleventh District economy continued to cool from high levels in September. Falling fuel prices increased profits and optimism for some firms, but increased caution has crept into the residential construction and energy industries. Energy activity is still robust, but drilling has paused amid growing concern about a glut of natural gas in storage. Nonresidential construction is vigorous, and residential building is strong but continuing to cool. Manufacturing activity is also quite strong, despite slowing demand from residential builders. Retail sales were up, and demand in the service sector is still very good, but there continue to be pockets of softness. Financial service firms reported slower consumer lending, but commercial lending remained strong. Rain has slightly improved agricultural conditions.

Prices
Energy costs have fallen, relieving upward pressure on prices. Selling prices have fallen for some products where demand has fallen precipitously, such as for lumber. But in most instances, lower energy costs have halted the rise in selling prices and not yet resulted in price declines. Some firms say lower energy and commodity prices have boosted profits to offset recent sales declines.

After peaking near $78 in July, crude oil prices fell to near $60 in September. Demand for crude oil has been strong, but inventories are well above last year's level and the 5-year average. Wholesale gasoline prices fell about 50 cents per gallon in September, and the pump price fell further. Distillate prices fell less rapidly than gasoline because the winter heating season is approaching. Spot natural gas prices dipped from about $6 to just over $4 per million Btu at Henry Hub. Natural gas in storage is roughly 12 percent higher than the 5-year average. Some producers say they are holding natural gas off of the market in anticipation of the higher prices the futures market shows for winter. Other producers are preparing but not perforating their natural gas wells, so they can sell forward the initial surge of production at a higher price.

Home prices continued to rise in Houston, but in other cities softer demand has led builders to add incentives. Apartment rental rates are edging up, but at a slower pace than was expected earlier this year. Commercial builders reported higher construction costs.

Labor Market
While there were scattered reports of hiring freezes or layoffs, the labor market remains tight. Contacts across many sectors are still reporting problems finding skilled labor. Skills in short supply include high-tech engineers, automobile mechanics, truckers, accountants and workers for the energy and commercial construction industries. Wages have increased for most of these types of employees.

Manufacturing
Manufacturing activity continued to expand at a strong pace, boosted by commercial construction and a backlog of orders from the energy industry. Sales of food products were very strong and accelerated this month, which contacts attribute to lower gasoline prices boosting restaurant activity. Demand has slowed for corrugated boxes, and contacts in this industry have become less positive about the outlook. High-tech manufacturers said shipments were still strong, but there is continued uncertainty about the outlook.

Demand continued to slow for products used in residential construction, but some firms said recent slowing may have been partially weather-related. Producers of stone, clay and glass reported sales declines of as much as 20 percent from a year ago, and inventories are up for some products. Lumber producers reported a significant drop in demand and increase in inventory over the past month, mostly because of reduced demand from national markets, although sales in Texas were also weaker. Producers of wood products, such as cabinets, say demand is unchanged. A few producers of construction-related products report that some large publicly-traded builders have sent letters asking for price reductions to help them achieve quarterly income projections. This has led producers to become wary about doing business with these builders.

Fabricated metals producers report no change in sales volume but had become more optimistic. Demand for residential construction products has been soft, but sales to the energy industry remain strong. Primary metals producers reported little change in demand overall, with strong demand for commercial building helping compensate for slowing activity from the residential sector.

Gulf Coast refineries continued to operate at very high levels, near 97 percent in recent weeks. Gasoline demand fell seasonally but is still 4 percent stronger than last year. Demand softened for synthetic rubber and ethylene. Plant outages temporarily boosted ethylene prices, and contacts suggested recent weakness in sales is a result of customers using inventory in anticipation of lower prices in the weeks ahead.

Services
Activity continued to increase for some temporary service firms, particularly in Houston and East Texas, but demand dropped unexpectedly at some companies, leading these contacts to be less optimistic. Accounting firms say demand growth has slowed from last year, mostly due to a slow down in Sarbanes-Oxley related work. Most law firms reported continued strong demand and are optimistic about the outlook.

Overall cargo shipping continued to increase, with some contacts noting particularly strong international activity. Railroads reported strong demand, but there has been a modest decline in trucking volume. Airlines reported a rebound in passenger traffic, with good loads and bookings for long-haul and international flights. Demand was reported as slower for short hops that are more affected by the increased hassle of increased security restrictions.

Retail Sales
Retail sales improved in September after weakness over the summer. Sales growth was better than expected but lower than earlier this year. Contacts mostly attribute the pickup to lower gasoline prices, but other factors were mentioned. Auto sales continued to be soft according to dealers, who say imported fuel-efficient vehicles are selling well but sales of domestic vehicles remain poor. Sales are strong for luxury vehicles, both domestic and imported.

Construction and Real Estate
The housing market continues to soften but remains quite strong. Sales are particularly strong in Houston, Austin and El Paso. Dallas real estate agents say the "buying fervor" is a little slower, but relocations and healthy job growth are still boosting activity. New home inventories have inched up, despite strong demand in some markets. Building is expected to slow from the rapid pace of growth seen earlier this year. While the market remains strong, contacts have become "more nervous and anxious" in their outlook, especially given recent reports of a decline in housing sales and prices at the national level.

Apartment construction remains strong, and occupancies are still near or above 90 percent in most areas. In Dallas, demand for apartments picked up robustly over the past couple of months, boosting occupancies and rents. Houston contacts attribute some recent softness to the "Katrina effect" as evacuees leave apartments for permanent residences. With many Houston projects in the works, some contacts were concerned with the possibility of overbuilding.

Construction and demand for office space is still increasing. Contacts characterize the Houston market as "the healthiest we've seen in a long time." Dallas contacts say the large blocks of space have become more limited, shifting pricing power to landlords.

Financial Services
Commercial loan demand remained strong. The market remains very competitive, but firms say there is no apparent credit quality deterioration. Deposit growth is steady, but deposits are increasingly difficult to get. Consumer lending slowed further, which was attributed to borrowers paying down existing debt. Automobile lending has softened.

Energy
After increasing strongly for months, the Texas and U.S. rig counts were virtually unchanged in September. Low natural gas prices have raised caution in the industry. Demand for oil-field equipment and energy services is still strong, stimulated in part by international activity, where the rig count continues to rise.

Heavy supplies of natural gas have increased pipeline pressure in parts of the country. Concern is rapidly growing about the possibility that a warm winter would sustain lower prices. Drilling has not yet been cut, which contacts say is partly because of the backlog of equipment and workers in the industry. Firms are hesitant to give up a rig or their place in line for oilfield equipment or services. While oil prices have fallen, this drilling is expected to be more immune from a price downturn because oil projects are larger and based on conservative outlooks for oil prices, have long-term horizons and deeper pockets behind them.

Agriculture
Most of the District continues to suffer from severe or extreme drought, but September rain brought some relief. The moisture helped the wheat crop get off to a good start, improved range and pasture conditions and eased pressure on livestock producers to liquidate herds. Cotton harvesting is under way in some parts of the District, and contacts say production will be 35 percent less than last year. Contacts remain concerned that low crop production and rising costs will make it difficult for producers to repay farm loans. Federal grants recently made available under the livestock assistance program are expected to ease the cash flow situation for some producers.