November 29, 2006

In October and the first half of November, the Eleventh District economy continued to decelerate from high levels. While there remains strength in the manufacturing, construction, finance and service sectors, there are also areas of softness. Many industries reported increased caution about the outlook. Energy activity was strong overall, but there was still little change in the rig count. Retail sales were weaker than expected. Manufacturing activity remained strong to supply the energy industry but continued to report slowing sales to residential building. Service sector activity was also mixed, with a dip in demand for temporary workers. Nonresidential building is strong, but home sales and home building weakened further. Financial service firms reported softer consumer lending, but credit quality is healthy and commercial lending is good. Agricultural conditions improved over the past six weeks.

Prices
Energy prices have stabilized at relatively high levels. West Texas Intermediate crude oil prices have floated between $57 and $61 in recent weeks. U.S. demand for crude oil has risen as refiners return from seasonal maintenance, but crude oil inventories remain high. Gasoline prices at the pump fell sharply, boosting gasoline consumption and reducing inventories. Demand for heating oil and diesel has been strong, but inventories have built up with mild weather, while pump prices have stayed near $2.50 per gallon as the result of reduced sulfur requirements. Natural gas prices strengthened seasonally during the period, from $6 to $8 per million Btu at Henry Hub. Inventories are at very high levels and a mild winter is expected, which has some contacts raising the possibility that natural gas prices might take a downward bounce.

Other prices were mixed. Overall home prices are unchanged, but prices have declined in some metropolitan areas, particularly in Dallas and Fort Worth. Building costs to supply nonresidential construction are unchanged, but prices are lower for products supplying home building. Paper prices were unchanged, but prices of corrugated boxes were lower. Accounting firms raised fees to cover rising salaries. Prices for corn, grain sorghum and wheat were up sharply.

Labor Market
The labor market remains very tight, and wages were rising in many industries. Workers shortages were reported by service, manufacturing, finance and energy firms. A lack of labor is a capacity constraint for some firms and, in some areas, companies have resorted to using billboards in an attempt to attract workers. While the shortage extends to many types of skilled and semi-skilled workers, of particular note in this survey were reports of difficulty finding engineers, electricians, high-tech technicians, certified mechanics and accountants. Some firms have reached out to community colleges in an attempt to boost the supply of qualified workers.

While the labor market remains tight, softening sales have led some manufacturers to slow hiring as a precaution. The shortage of qualified truck drivers seems to have eased some.

Manufacturing
Manufacturing activity continued to cool. Demand remained strong for refining, some chemicals, and for products to supply commercial construction and oil and gas drilling. However, sales to homebuilders slowed further, pushing up inventories for some products and causing some firms to reduce production. Food producers report an increase in demand. Sales of paper products increased slightly, but demand for corrugated boxes softened some. High-tech manufacturers reported generally good growth in production and orders, although there were a few firms that reported some recent softening in orders.

Gulf Coast refineries are now operating at high levels. The return from maintenance was delayed in some cases by labor and construction shortages or by relatively weak margins that offered less incentive to produce. Refining margins have been strong by historical standards, but are only half to one-third of the high margins enjoyed over the summer.

Petrochemicals were mixed. Ethylene production was affected by a series of planned and unplanned outages that have supported prices and kept profit margins high. There was a sharp seasonal decline in demand for polyethylene, and the decline in homebuilding has hurt demand for PVC pipe. In contrast, demand for synthetic rubber is very strong. Prices are high, and margins are excellent. Demand for isobutylene, used in many consumer products, weakened in September and October but returned strongly and has been pushing capacity limits in early November.

Services
Temporary staffing firms say activity slowed earlier than expected and the volume of new orders was below last year levels. The slowdown was concentrated in manufacturing; however, contacts noted that they had seen a fall off in demand in other industries as well. Demand for legal services held steady over the past month but activity was up compared with a year ago. Accounting firms saw no change in activity.

Shipping firms report good demand but anticipate slower growth in coming months. Cargo volumes remained flat and continued to be buoyed by domestic demand for nondurable goods. Container trade activity rose sharply, with growth partly coming from an increase in steel imports. Railroads indicated no change in overall volumes but noted that shipments of lumber, wood and other building products were down substantially over the past month. Trucking firms said demand softened further which, according to contacts, helped ease the shortage of truck drivers in the industry. Airlines report continued good demand overall.

Retail Sales
Retail sales growth has been weaker than expected. Some contacts had expected a greater pick up in sales following the drop in gasoline prices. Sales continue to be weakest to lower income customers who were more affected by high energy costs. Sales were weakest for home items, particularly for furniture. Respondents have become more cautious about the outlook for holiday sales, which they say will be very competitive. Inventories are in good shape, although retailers say they are watching them closely.

Demand for autos remains soft, although lower gasoline prices have resuscitated sales of some domestic vehicles. There were reports of higher than desired inventories.

Construction and Real Estate
District home sales continued to slow, but activity has been mixed. Sales are still strong in some areas, such as Houston, but sales and traffic are down significantly in the Dallas/Fort Worth area. Cancellations have edged up, especially for lower priced homes. Homebuilders and real estate agents noted increased uncertainty and uneasiness among buyers that they blamed partly on reports of weakness in other parts of the country. Builders have pulled back on starts and increased buyer incentives in an attempt to manage rising inventories.

Apartment demand remained solid, and rents are rising. Despite the departure of Katrina evacuees, apartment occupancies are at or above 90 percent in most Texas metros. Multifamily construction activity was still strong, but contacts said a shortage of building sites and high construction costs have held back construction of Dallas-area apartments.

Demand for office space remains strong, and rents continue to increase. Contacts say investor interest remains high. Occupancy rates are edging up--and in Austin have reached a five-year high. A Houston respondent said rents were up dramatically in some areas. Office construction continues in all major metros. Dallas contacts remain optimistic that demand will be sufficient to absorb the increased volume of speculative projects currently under construction.

Financial Services
Consumer lending continued to slow for all types of products, including mortgages, credit cards, personal and auto loans. Credit quality is still good, and mortgage delinquencies do not appear to be a problem for District lenders. Commercial lending is very good, although contacts expect activity to slow. Competition for experienced and talented lenders continues to be intense.

Energy
Energy activity remained generally strong, but the rig counts continued to be mostly unchanged in the United States and Texas. Oil service companies are working through an extensive backlog of orders, and there are still shortages of people and equipment. Day rates continue to rise but more slowly than earlier in the year. International activity continued to grow strongly.

Contacts are cautious about weak natural gas prices and rising drilling costs, and say that drilling for natural gas in high cost areas is the most vulnerable. Firms have completed extensive hiring and training of new employees and made large commitments to internal capital expansion and R&D. Companies say they can shift crews and equipment across basins or around the world, wherever backlogs continue.

Agriculture
Recent rains boosted cattle grazing conditions, and many producers are optimistic they will get a good cutting of hay before the first freeze. Still, supplemental feeding of herds continues in the driest regions, and rapidly rising feed costs--particularly for corn--have substantially lowered calf prices. Rain has helped wheat and oat crops get off to a good start, but were too late for cotton, pecan, peanut, soybean and sorghum. Harvest of these crops is underway, and yields are better than expected but below last year's levels.