September 8, 2004

Eleventh District economic activity continued to expand from mid-July to late August. Manufacturing activity was mixed, but demand for business services continues to increase modestly. Retail sales softened some. There was little change in construction or financial services activity. There was only a slight increase in energy activity, a much weaker response than might be expected given the high energy prices. Agricultural conditions continue to be favorable.

Contacts remain optimistic about the outlook for the rest of the year, but many are less enthusiastically optimistic than they were a few weeks ago. Many contacts said they are looking forward to getting past the Presidential election, hoping for reduced uncertainty.

Prices
There continue to be reports of price increases for manufactured products, such as paper and processed food. Some energy prices were also higher. A number of factors pushed up crude oil prices over the past few weeks but gasoline and natural gas prices have softened some.

Demand for crude oil has been strong from both the U.S. and China; Chinese oil imports are up 40 percent over a year ago. The International Energy Agency made a sweeping revision of its energy consumption statistics, revising upward both recent and forecast figures. With OPEC near full capacity, fears of potential supply disruptions also played a role in pushing up oil prices, with various estimates of the "fear premium" placed at $10 to $15 per barrel. Fighting in Iraq, sabotage of Iraqi oil facilities, bankruptcy of Russian oil giant Yukos, recall elections in Venezuela, and severe tropical weather all added to uncertainty in the market about oil deliveries in a tight market.

Gasoline prices peaked in mid-July at both the wholesale and retail levels. Heating oil prices have begun a normal seasonal rise, but are about 20 cents per gallon above year ago values. Inventories of distillates--including heating oil--have now risen back to near normal levels over the summer.

Natural gas prices were near $6 per million Btu in mid-July, but have trended downward to near $5.25. Mild summer weather has kept air conditioning loads at low levels, and the forecast is for continued mild weather through September. Inventories have been filling ahead of schedule, and will easily refill to capacity for the winter heating season. The futures market has built in a potential seasonal increase to $7 natural gas over the winter.

Manufacturing contacts are concerned about high fuel prices driving up the cost of raw materials, production and shipping. Manufacturers' ability to pass on cost increases remains limited, cutting into profits. Some manufacturers also expressed concern that continued high energy prices would cut into demand for their products because customers would be forced to spend more on fuel.

Labor Market
The labor market continues to strengthen with scattered reports of hiring in both manufacturing and the service sector. Some firms reported upward wage pressure, and a few reported difficulty finding qualified workers. For example, the trucking industry reports a shortage of qualified drivers. Many firms expressed concerns about rising medical costs, but some noted that the rate of increase is slower than it was a year ago.

Manufacturing
Manufacturing activity was mixed. Sales for food products have weakened over the last several months, which contacts attribute to higher prices for food and gasoline. Manufacturers of stone, clay and glass continue to report steady demand. Demand for lumber is unchanged. Paper producers say there has been some softening in sales because their customers built up their inventory of boxes and packaging in anticipation of higher prices.

Respondents in high-tech manufacturing report that orders picked up slightly in the second half of August after slowing in the previous six weeks. The increase was due mainly to a rise in commercial and industrial demand as companies increased orders for computers and other electronic equipment. Contacts say that products inventories are lean, with the exception of those in China. Telecomm manufacturers say demand is unchanged. Prices continue to decline, although at a slightly slower pace.

Demand is unchanged for primary and fabricated metals. Input prices are rising because the Chinese are buying up a lot of scrap metal, the dollar is weaker and energy costs are higher. Cost pressures are being pushed through to selling prices for some products.

Chemical demand remains very strong for most products, and price increases are widespread. Nitrogen, polypropylene, PET bottle resin and caustic soda are among products with notable price increases driven by strong demand. Prices for other products, such as for benzene, are rising due to higher feedstock costs. Suppliers to the industry report high levels of capacity utilization and, for the first time in several years, an interest in expanding capacity along the Texas Gulf Coast.

Gasoline consumption has slowed with higher prices over the summer. Imports of gasoline have surged over the summer, and gasoline inventories moved from the bottom of the 5-year range to the top. Refiners now report that falling gasoline prices and rising crude prices have squeezed once sizable margins, cutting them in half since mid-May along the Gulf Coast.

Services
Accounting firms report that demand has not changed from its high levels. Contacts say firms are swamped with work related to new regulations put in place by the Sarbanes-Oxley Act and the SEC. Salaries are up 3 percent to 5 percent.

Temporary staffing firms say activity has softened some, but demand remains above a year ago. Demand is strongest for temporary manufacturing workers. Higher costs and stiff competition continue to erode profit margins. Demand for legal services is still strong and increased slightly in the last month, driven mostly by demand from corporate customers.

Transportation firms report strong activity. Airlines report high load factors but an inability to earn profits because of industry-wide overcapacity, stiff competition, and high fuel prices. Railroad transportation hit record levels in August, leading to some additional congestion and capacity issues. Railroads have increased prices and demand continues to rise. Future expansion plans include purchasing more locomotives and bigger railcars to meet demand. Trucking activity remains strong, but companies continue to voice concerns about higher fuel costs.

Retail Sales
Retail sales have been mixed, with some respondents being disappointed by the pace of sales growth over the past few weeks. Sales were weakest for retailers that serve lower income customers, and contacts conclude that high energy prices are impacting these consumers the most. High energy costs are also a concern for retailers, and some say they are making investments to control and reduce their energy consumption. Automobile sales in the District continue to slip, particularly for SUVs and less fuel-efficient vehicles.

Construction and Real Estate
Homebuilding remained steady, with the exception of a normal back-to-school-lull. Strong competition and rising costs continue to squeeze margins. Existing home markets in most major Texas metros remained lively in August, following record-breaking sales in June and July. Still, median home prices have not appreciated much this year. Contacts in the residential sector are cautious about the outlook, hoping that a pickup in job growth will buoy housing demand if mortgage rates edge up. Apartment markets continue to suffer as construction slightly outpaces the growth of demand.

Commercial construction continues to be driven by public works. High office vacancies have put a lid on private office construction, but there are some signs of recovery in hotel construction, according to respondents. Demand for office space is picking up slowly, and contacts noted that tenants were expanding their leases in expectations of an improved economy. Retail space remains the healthiest market segment for most real estate contacts.

Financial Services
Financial services activity continues to improve steadily. Demand for consumer and commercial loans remains good, but there is beginning to be slowing for home financing. Deposit growth remains flat, and contacts hope eventual interest rate increases will lead to more deposits. Most respondents say that, while lending is strengthening, it is not to a level that would squeeze current funds availability. Competition for loans and deposits remains stiff. Contacts say that the Texas retail market is underserved and expect the rapid expansion of branches and new bank entry to continue.

Energy
Higher energy prices moderately pushed up drilling activity but there was little change in demand for oil services and machinery. Contacts continue to report that higher oil and gas prices are adding to cash flow for producers but are not leading to a significant increase in exploration budgets. The Texas rig count is up about 20 rigs over the past six weeks, after having remained at about 500 working rigs since last April. Activity in the Gulf of Mexico is unchanged. The international rig count fell sharply in July, but contacts say the drop was an anomaly and did not reflect a fundamental change in the outlook.

Oil service companies report that business is busy and profitable but subdued given current energy prices. Prices for oil field equipment and services were up in the second quarter, but most of the increase was tied to higher costs for steel and copper, rather than capacity limitations in producing the equipment.

Agriculture
Overall crop conditions for corn, cotton, peanuts and sorghum are better than a year ago. Rangeland and pastures are in fair condition, with supplemental feeding unnecessary. Wet weather conditions in some parts of the district disrupted harvest, slowed crop progress and delayed hay cutting and bailing activity. There were some reports of cotton crop loses and damage due to hail in the South Plains.

Feeder cattle markets have been a little sluggish in recent weeks; a drop in the price for imported chicken has reduced beef demand, according to contacts. Prices of feeder cattle are expected to remain soft until the end of September 2004.