Prepared by David G. Sowerby, CFA
Loomis, Sayles & Company, LP

In the first nine months of 2006, local area business activity was marginally higher from levels recorded in the fourth quarter of 2005. The Greater Lansing Business Index was up approximately eight points from December 2005 for a 7 percent gain, rising from 105.1 to 113.5 at the end of September 2006. On a year-over-year basis, the index is roughly flat using a six-month smoothing basis to remove the monthly volatility associated with local business activity.

Among the individual components slightly better gains have most notably prevailed in the hotel occupancy and local area stock prices. Weakness continues in residential real estate markets and local motor vehicle production. Production should increase in the future with the opening of GM’s new Delta Township assembly plant.

Much of the overall business outlook has naturally focused on the turbulence of the energy markets. During the last five years, the world has experienced a massive energy price surge. At the end of 2001, the price of crude oil was close to $19 per barrel and the national average price for regular gasoline was $1.10 per gallon. Just three years earlier in 1998, crude oil prices were close to $12 per barrel and gasoline was 92 cents per gallon. Something changed! Between April and August of this year, crude hovered around $70 per barrel, touching a record high of $77 per barrel on July 14. Gasoline prices soared accordingly, exceeding $3 per gallon. In less than five years, the real price of motor fuels more than doubled, edging out the previous record highs of March 1981 (after the Iranian revolution and the start of the Iran – Iraq war) and September 2005 (after the upheaval caused by Hurricane Katrina).

Not only has the pace of global growth accelerated, but the nature of that growth has changed. China and India have experienced GDP growth rates of at least 7 percent per year for the past three years. These two countries alone account for nearly 40 percent of the world’s population. The rapid growth in manufacturing in China and other developing countries has provided a disproportionate boost to energy demand because manufacturing is so energy-intensive.

Demand may have risen rapidly, but capacity has not. Years of low prices and low profit margins, compounded by environmental restrictions in some places, discouraged activity in oil exploration/drilling, construction of new pipelines and tankers, and investment in refineries. To make matters worse—much worse—most of the world’s proven and probable oil reserves are located in regions with difficult governments. Consider this list of major oil producers: Putin in Russia has nationalized the oil sector; Iraq’s situation is chaotic and suffers attacks on its oil infrastructure; Iran is under the control of autocrats seeking nuclear weapons; Venezuela’s dictatorial Hugo Chavez is fanatically anti-American; Saudi Arabia is threatened by a home-grown terrorist movement; and important African oil producers such as Nigeria, Angola and Sudan are plagued by domestic strife or labor unrest. As oil consumption increased faster than new capacity, the amount of spare capacity in the global oil sector grew lean, making the oil market vulnerable to seemingly small shocks to demand or supply.

U.S. growth has slowed, to be sure, but there are no signs of recession at this time. How is it oil prices have gone up as much as they have without causing a U.S. recession? What is different this time? The Michigan economy has done a better job of rolling with the energy punches of the past five years for the following reasons:

1) The percentage of GDP and consumer income involved in oil-related purchases has trended down for over 30 years.

2) American consumers and businesses have learned from hard experience how to cope better with fluctuating oil prices.

3) The Michigan economy is more flexible and less regulated than it was 30 years ago.

4) Since the turbulent 1970s, the Fed has pushed inflation down and kept it down. That is important since some of the apparent damage from oil spikes in past decades resulted more from high inflation than high oil prices.

To create a comprehensive barometer for local business activity, the Greater Lansing Business Index combines six local economic variables:

1) Residential housing units built (seasonally adjusted)

2) Motor vehicle productions (seasonally adjusted)

3) Hotel occupancy rates (seasonally adjusted)

4) Kilowatt per hour usage (seasonally adjusted)

5) Ingham County employment

6) Local area stock prices

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