The bogeyman of Internet advertising in recent months has been the incredibly shrinking demand. But to get a clearer picture of the market's future, pay attention to the supply.

If you do, according to one analyst's assessment, you end up with both good and bad news. The good news is that a viable, stable and even growing Internet advertising market could be just a few months away. But the bad news is that before that happens, online ad businesses will have to undergo further consolidation, layoffs and shutdowns on a billion-dollar scale. And certain segments of the market, such as search engines and targeted marketing companies, are especially and obviously vulnerable, the analyst says.

That mixed outlook comes from

Lanny Baker,

Salomon Smith Barney's

online media analyst who, in a recent report, takes time to study the supply side of Net advertising, rather than well-trod issues such as online advertising effectiveness, click-through rates and other elements affecting demand.

To understand what's happening to new media, Baker makes an intriguing comparison to a very old-line industry: the oil and gas business. You know, all those oil rigs out there, anywhere from Texas to the North Sea to the Arabian Peninsula, drilling for oil to sell at $30 a barrel, or whatever it happens to be. That business, writes Baker, is essentially a continually shifting balance between demand, supply and resource management.

How It Works

Strong demand for fuel leads to rising prices for oil and gas, which leads to increased production -- more aggressive drilling and exploration activity. But as new reserves find their way to the market, supply catches up to demand, prices fall, and production, drilling and exploration are curtailed. Those cutbacks eventually translate into stronger demand for the available supply, and the cycle starts all over again.

That's not much different from what's happening with the Internet advertising business, writes Baker in a March 28 report titled

Crude Thoughts on Supply

. As corporate interest in the Internet rose during the late 1990s, demand skyrocketed, with the total online advertising market tripling in 1997, doubling in 1998 and doubling again in 1999. Internet ad prices, as judged by the standard industry yardstick of CPMs -- essentially, the cost to display an ad to 1,000 different users -- rose, too.

But in March of last year, the cruelly fickle capital markets began the process of vaporizing a significant portion of the demand side of the equation -- dot-com advertisers. A slowing economy is erasing more demand. The result is lower ad revenues and CPMs that have slid, on average, to less than $7 from $30, by Baker's estimate.

Though some people see lower CPMs as evidence that Internet advertising just doesn't generate an effective return on investment for advertisers, Baker disagrees. "Just as oil price information does not reveal anything about gas mileage or the ability of natural gas to heat your house," he writes, "we believe falling online CPMs do not directly reveal anything about the effectiveness of the medium or its ability to generate a return for advertisers. Instead, we believe falling Internet CPMs merely indicate that supply currently outstrips demand."

Big Numbers

By how much does supply outstrip demand? In a conversation with

TheStreet.com

, Baker hazards a rough guess. Back in June 2000, he says, the expectation was that the online advertising market would be $11 billion to $12 billion in 2001. But now, it looks as if the market will amount to $5 billion or $6 billion. Doing some back-of-the-envelope calculations -- based on his estimates of how many ad salespeople have been laid off from Internet media companies since last June, and how many ad dollars each salesperson generated -- Baker concludes that those layoffs have eliminated up to $2.5 billion of the roughly $5 billion in excess supply in the system -- that is, the difference between the expected 2001 market last year and the actual sales numbers that are shaking out. In other words, as far as getting supply in sync with demand, "We're probably only halfway there," Baker says.

We get there, Baker says, the same way we got this far: eliminating supply by eliminating infrastructure associated with advertising sales. (For Baker, supply isn't defined by Internet usage, or page views on which Internet advertising

could

be sold, but by inventory "which is acceptable to advertisers and which is actively packaged and marketed to them," he writes. (In other words, a page in

Yahoo!'s

(YHOO)

finance section qualifies as supply, but a page on

BuffySearch doesn't.)

Supply is eliminated through online media company closings, mergers and acquisition activity, reduced investment by traditional media companies and, ultimately, the above-mentioned layoffs of sales personnel.

As for what areas of online advertising the further $2.5 billion supply correction will come from, Baker has some ideas. Look for the most competitive pockets of the Net ad market, he says. For example, supply already has exited the system in the once hotly competitive ad-supported free access market; casualties in that sector include

Spinway

and

1stUp.com

.

Capacity

Currently, Baker sees excess capacity in several other areas. One is in search engines and portals: "There are too many second-rate search engines out there," he says.

Baker sees oversupply, too, among companies specializing in helping marketers target consumers by demographics or other criteria. These include firms like

Lifeminders

(LFMN)

,

MyPoints.com

(MYPT)

,

Digital Impact

(DIGI)

and

Mediaplex

(MPLX) - Get Report

.

"It's so easy to think of companies that are stacked on top of each other," says Baker, adding that it's overcapacity even if some of these companies don't sell ads themselves, but supply other companies that do. "Whether they are actually getting paid media dollars or getting paid infrastructure dollars, it's all part of the same pie." (Baker rates MyPoints.com, for which his firm has done investment banking, a hold; he doesn't follow the other firms.)

Other areas with excess capacity include the online financial news and information segment, and online sites targeted at women, a segment in which

iVillage

(IVIL)

is about to acquire

Women.com Networks

(WOMN) - Get Report

. (Baker's firm has done underwriting for Women.com.) A rule of thumb for overcapacity, says Baker, is a segment with sufficient revenues to fund a profitable company -- say, $50 million in sales per quarter -- but a business "where only one of, or zero of a bunch of competitors are profitable."

CNet Stands Tall

In contrast to the other areas, Baker doesn't see much further consolidation in the online technology area dominated by

CNet Networks

(CNET) - Get Report

. Following CNet's acquisition of rival

ZDNet

, "it's not as if they have a competitive problem in that category," Baker says. "You try to write a list of CNet's competitors, and it's hard to do." (Baker has a buy rating, his firm's highest, on CNet; Salomon has done banking for the company.)

How long will this supply-side shrinkage last? At least nine months, says Baker, because he doesn't see demand picking up until the fourth quarter, and the longer the demand is weak, the longer the supply needs to correct. "This summer's going to be very tough," Baker says.

But hey, oil has come out of slumps like the one net advertising faces. In late 1998, oil traded for less than $11 a barrel; now it's around $27. Sooner or later, ad supply will find its own level.