July 26, 2006

Eleventh District economic activity continued to expand at a strong pace from early June to mid-July, but there were some signs of cooling. Energy activity remained robust, and activity was still quite strong in the manufacturing and service sectors. Retail sales reports continued to weaken, with high gasoline costs squeezing other consumer spending. Nonresidential construction strengthened, and the level of new home and apartment building was unchanged, but there was a noticeable softening of demand for homes and apartments. Financial service firms reported favorable conditions, although there was some weakening of demand for consumer loans. Agricultural conditions remained dry.

Prices
Price pressures were mixed. High energy costs continued to be reported, and prices were rising for many products that contain oil or one of its derivatives. Transportation costs were also up. Still, natural gas prices are lower, and a few industries reported that weakening demand was making it more difficult to raise selling prices. After increasing for several months, some product prices declined slightly in recent weeks, such as those for lumber and most petrochemicals made with natural gas.

Surging demand for gasoline and geopolitical tensions pushed oil prices to record levels in current dollars--rising briefly above $78 per barrel. Crude inventories are 11 percent above the 5-year average. Weak demand throughout most of the period pushed natural gas prices down to $5.60 per million Btu at Henry Hub. Natural gas in storage is 20 percent above normal and at the highest level in 8 years for this time of the year, but rising crude prices and the threat of tropical weather provide some support for prices.

Labor Market
All sectors of the economy report growing difficulty finding qualified workers, and in some instances, the challenge to obtain workers with particular skills has become intense. Wages are increasing for some positions. Temporary service firms say pay rates have finally increased--as much as 5 to 10 percent--and it has become harder to find workers. Some contacts, particularly those in the restaurant industry, expressed concern that tightening immigration enforcement will make it even more difficult to find and retain workers, pushing up employment costs.

Manufacturing
Manufacturing activity expanded at a solid pace, but there was some cooling, particularly for materials used in home construction. Food and apparel manufacturers reported continued solid demand. Sales of paper products were unchanged, but contacts said insufficient capacity had pushed up prices.

Reports from construction-related manufacturers were mostly still strong. Some contacts noted recent softening which they attribute to weather disruptions and a decline in demand from builders. Primary metals producers said a rebound in nonresidential construction nearly offset cooling in the housing market. Producers of stone, clay and glass said demand mostly held steady at high levels. Lumber and fabricated metals manufacturing was unchanged.

Overall high-tech manufacturers say production continued to grow at a good pace since the last survey. Demand is strong for most devices, particularly cell phones, but weaker sales of PCs led to excess capacity and a build up of inventory for some chips. Sales of semiconductor manufacturing equipment have been lower than expected, with some orders being cancelled or delayed. Industry executives say this cooling demand will not necessarily lead to a downturn in the semiconductor cycle because PCs are a smaller percentage of the market than in previous years.

There was little change in the demand for chemicals, except for PVC, where demand has weakened with slowing housing construction nationwide. Refining utilization on the Gulf Coast pushed up to 95 percent, the highest levels since the hurricanes last year. However, utilization rates remain below normal for late June and early July. Mechanical problems are common, and refiners are delaying maintenance due to high cost, labor shortages, or inability to schedule needed work. Refiners also are earning strong margins of $15-$20 per barrel, making them reluctant to reduce runs.

Services
Temporary service firms report that activity levels remain high and revenues are up significantly compared with last year. Legal firms report continued strong demand, particularly from the business sector. Accounting firms report steady activity with some signs of growth.

The railroad industry continues to operate near full capacity and expects to set record volume levels this fall. Recent increases in traffic volumes were observed for coal, metals, petroleum products, grain and crushed stone for highway construction. Traffic volumes declined for products supplying home building, such as metallic ores, lumber and non-metallic minerals.

Trucking cargo volumes continue to rise, but contacts say the rate of growth is slightly slower than a year ago. Shipping firms say cargo volume has increased modestly over the past month. Demand was led by durables in wholesale, manufacturing, and retail areas. International traffic continued expanding strongly. The airline industry reports very strong demand and growing domestic capacity.

Retail Sales
Retail sales continued cooling. Reports remain very mixed, and contacts say customers are still modifying purchasing patterns because high energy costs are taking a larger share of their paycheck. For example, a food retailer noted increased sales which he attributes to lower income customers cooking at home instead of eating at restaurants. National retailers say that sales to stores in Texas are stronger than in the country as a whole.

Auto sales have been soft, according to dealers, who say high gasoline prices are dampening sales of SUVs and other vehicles that obtain relatively poor gas mileage. Inventories and inventory costs are high at dealerships and factories.

Construction and Real Estate
Home demand remains strong, according to contacts who say there has been an acceleration in relocations. Demand is particularly strong for homes priced over $200,000, but sales to first-time buyers continued falling. The market is showing more signs of cooling--buyers are taking longer to make decisions, and inventories are rising. Building continues to be robust, and there has been an increase in builder incentives, especially in Austin, Dallas and Fort Worth. Apartment leasing slowed over the past six weeks, which contacts blame partly on the increase in builder incentives luring renters away from apartments. Office markets continued to improve over the past six weeks. Occupancy rates are edging up, and rents are up significantly. Commercial construction activity is rising, especially in Dallas.

Financial Services
The financial services industry continues to report favorable conditions. Demand for commercial loans has been very strong, but there has been some softening in demand for loans from consumers, particularly for automobiles and mortgages. Deposit growth has been "pretty good," which one contact attributed to a "flight-to-safety" because of recent stock market volatility. Credit quality is good, with few past due or problem loans. Some contacts say there has been some weakening of credit structures, with bankers cutting corners, weakening loan covenants or using "air ball" financing, where a portion of the loan is backed by expectations of business growth rather than hard assets.

Competition for commercial loans is intense, according to respondents, who say it is affecting pricing but not credit quality. One firm reports exceeding their latest monthly goal by a factor of three times and said there appears to be a lot of momentum for future growth. Rising interest rates have caused some clients to rethink deals but none have fallen through. One contact referred to activity as "scary good" because loan quality is better than expected but he fears lenders might be missing something important as they continue to aggressively compete for new loans.

Energy
The rig count continues to rise. Weaker natural gas prices have led some drilling to switch from natural gas to oil, although producers generally believe the recent the price decline is mostly weather-related and temporary. The recent cooling in activity has caused day-rates for land rigs and the price of some other services to rise more slowly after a long period of sustained increases. Demand for oil services remains strong, with continued heavy backlogs and labor shortages.

As hurricane season approaches, a few rigs are leaving the Gulf of Mexico in search of higher rates or lower insurance premiums. Hurricanes are causing a general rethinking of drilling activity in the shallow waters of the Gulf of Mexico. Insurance costs have skyrocketed in the Gulf as a result of last year's hurricanes.

Agriculture
Rain in early July improved soil moisture conditions in a few areas, but drought continues to stress crops and forage across much of the District. Dryland corn, sorghum and pecan acreage production is "way off" normal levels, and most of the corn harvested in North Central Texas is being made into silage. The cotton crop is expected to yield 3.2 million fewer bales than last year. Irrigated crops were mostly in fair shape.

Range and pasture conditions are poor. Hay supplies remain short, and stock tanks are low. As a result, livestock producers continue to liquidate herds, and some have completely sold out. Good demand for dairy products and solid cattle prices are helping ranchers and dairy farmers.

Bankers expressed concern about the financial condition of producers because of drought, high fuel prices and rising borrowing costs.