January 17, 2007

The Eleventh District economy continued to decelerate from mid-November to early January. Activity in the energy sector remained at high levels, but growth was slowing. Manufacturing activity softened. While still strong, service sector activity slowed some. Retail sales growth was weaker than expected, but contacts said growth improved in late December and early January. Overall construction and real estate activity was quite strong but continued slowing. Consumer lending moderated. Commercial lending was strong but expected to slow. Rain improved agricultural conditions, but high costs and low yields have reduced profitability.

Contacts in a number of industries were more optimistic about the outlook than at the time of the last Beige Book--partly because sales growth has not deteriorated as much as they feared.

Prices
Price pressures were mixed. Prices were lower for some raw materials, including petrochemicals, primary metals, copper and aluminum. Competition put downward pressure on selling prices for a number of products, including high tech and retail. Transportation costs are up. Some contacts reported price increases for imported goods because of high shipping costs and declines in the value of the dollar. Others reported declines in the dollar reduced competitive pressures by raising the cost of imports. Real estate prices and rents were mostly higher.

After strengthening in December, energy prices declined in early January but remained relatively high and a concern for many firms. Henry Hub prices for natural gas fell from $8 to about $6 per million Btu.

A major inventory adjustment led many chemicals derived from natural gas to see rapid price declines, including record drops for ethylene and propylene. There were large price declines for polyethylene and polypropylene. Inventories had been built up last summer to protect against any shortages that might be caused by hurricanes and ensuing major plant outages. The inventories were cost effective while natural gas prices were rising, but the recent decline in natural gas prices prompted a rapid reduction of inventory that pushed petrochemical prices down sharply. Weak demand also contributed to price declines for polycarbonate, polystyrene, PET bottle resin, and PVC. In contrast, some oil-based petrochemicals, such as synthetic rubber saw excellent demand, low inventories, good pricing, and solid margins.

Labor Market
The labor market remains very tight, with numerous firms continuing to report difficulty finding skilled and unskilled workers. Many contacts say high and rising labor costs, including the cost of health insurance, top their list of concerns for the coming year. Shortages of skilled labor continued to restrain nonresidential construction. Energy service contacts said workers must be kept "inside the fence" to keep other firms from hiring them off the job. While hiring continued to increase for some manufacturing firms, weak demand led others to slow hiring, eliminate shifts and/or lay off some workers.

Manufacturing
Overall manufacturing activity was weaker. Demand remains weak for products used in residential construction, such as stone, brick, clay, glass, lumber and metals. Inventories have increased for many of these products, leading to reductions in production and scattered layoffs. There was little change in demand for fabricated metals--with most orders supplying commercial and industrial customers.

The paper industry continues to struggle with weakening demand, high inventories and input costs that are rising faster than selling prices. Sales have been weaker than expected for producers of automobiles and high-tech products, causing some of these manufacturers to temporarily shut down factories during the holidays and/or slow hiring.

High-tech firms say that there is uncertainty about the outlook for sales growth. Most contacts believe sales will pick up after a slow first half of 2007, but some fear there may be a more serious downturn. Inventories are mostly in good shape, according to firms, who report some build up and uncertainty about how much stock is being held by distributors and retailers. There was optimism that the finalizing of telecommunications mergers will free up capital spending in the coming year.

Sales of food products unexpectedly rose more than the typical December gain. Producers supplying equipment to the energy industry continue to report strong demand and backlogs. Petrochemical exports increased strongly, with shipments of some products jumping 30 percent. Strong Asian demand was stimulated by declines in product prices and the value of the dollar. The rush to export resulted in a logjam of railcars at the Port of Houston, and railroads imposed embargoes and rationed capacity.

Refinery production on the Gulf Coast sagged in late November and early December, but utilization rates returned to high levels by year-end. A prolonged fall turnaround season was responsible for the slack in December production, and a heavier than normal schedule of maintenance is expected this spring. Refiners have run plants hard in response to high margins and are using the turnaround period to improve plant performance, but delays are expected because engineering and construction firms are stretched thin, and craft skills are scarce.

Services
Activity slowed a little in the service sector, but there remains a good deal of strength. Temporary staffing firms reported weak demand to supply workers to manufacturing, warehousing and distribution, but continued high demand for professionals with experience and technical skills, especially in the accounting, financial services and IT services industries.

Law firms said demand had improved over the past six weeks, driven by mergers and acquisitions and real estate transactional work. Accounting firms reported little change in demand. Accounting companies are still hiring, and say that it is increasingly difficult to find both experienced accountants and new college graduates.

Demand for rail transportation was strong and increased slightly, with particularly high shipments of grain, chemicals and petroleum products. Trucking activity picked up robustly in December after an unusually weak November. Shipping firms reported good volume growth in both their freight cargo and domestic small parcel business, and indicated that shipping rates were likely to increase in coming months. Airlines reported a weak start to December but a good sales pickup over the holiday season and good bookings into January.

Retail Sales
Retail sales growth was good but not great, according to contacts. Sales were weaker than expected in early December, but picked up strongly as Christmas approached, which increased the optimism about sales growth in 2007. National retailers reported stronger sales growth in Texas than in other parts of the country. Auto sales picked up near the end of 2006. Contacts said inventory remains too high for some types of vehicles, and prices have been falling.

Construction and Real Estate
Residential real estate markets continued to adjust to cooler demand. Home sales have moderated from the vigorous growth experienced throughout most of 2006, and inventories inched up. Builders report an increase in cancellations, leading some to pull back on starts. The market was much weaker for lower-priced homes than for homes at higher price points, and the Dallas/Fort Worth market was weaker than the other major metropolitan areas, some of which were still quite hot. Home prices continued to rise at a modest pace.

Apartment occupancies declined in Dallas and Houston over the past six weeks, but contacts said the decline was expected as Hurricane Katrina evacuees continued to move out. Despite the decline, overall occupancy rates remain above 90 percent. Austin's apartment market was performing better than most--with an occupancy rate of 96 percent and rising rental rate.

Office demand remained strong. Landlords saw multiple tenants compete for unoccupied blocks of space in Dallas. The Houston office absorption rate in 2006 was three times that of 2005. Rent continued increasing at a strong pace. Contacts are optimistic that demand will remain positive in 2007.

Financial Services
Consumer lending moderated--with some softness showing in all types of consumer products: credit cards, personal loans, auto loans, and mortgages. Bankers say the moderation appears to be the result of more careful consumer spending and payback of existing debt. Demand for commercial loans remains steady, but contacts expect commercial activity to slow somewhat in 2007.

Deposit growth has slowed, and contacts say deposits are increasingly difficult to obtain from both consumer and commercial customers. Pricing of all types of loans is still aggressive, but credit quality remains solid.

Energy
The U.S. and Texas rig counts fell slightly over the past few weeks. Demand for energy services remained strong, however, and contacts said their order books have very long and increasing backlogs. Producers will reduce exploration if low natural gas prices hurt their cash flow, but many producers have sold their production forward, which will allow them to keep drilling through any short-lived weakness in prices. Drilling activity is expected to increase in 2007, but growth is projected well below the increases of the last two years. Some contacts say exploration expenditures will shift away from domestic natural gas to finding oil in international markets.

Agriculture
Rainfall improved conditions by replenishing livestock ponds, boosting subsoil moisture and stimulating pasture growth. Still, supplemental feeding of livestock continued, and hay was difficult to locate in many areas. Producers continue to harvest cotton, vegetables and some remaining summer crops. Cotton yields are below last year levels. Contacts say high prices of corn and grain sorghum have reduced prices for stock and feeder cattle.