Many applauded the strength of our economy that had withstood the assault of high oil price in 2005. But the reason oil price hasn't dispatched our economy, and the world economy, into recession is that the impact of high oil price is equalized by cheap money induced capital gains in real estate and consumer spending spree. What we paid for oil in 2005 was less than 5% of the increase in residential housing value.

In part 1 of this discussion, we've checked out the data that indicated the beginning of a downtrend in both home prices and home selling activities, and we've gone over the housing market's impact on the employment, the consumer spending, and our economy. With the housing market in trouble, the high energy cost will surely be felt by consumers, more so this year than ever. And, unfortunately, our infrastructure doesn't leave us with many options to become less dependent on oil. When the average regular gasoline price, for example, rose 24.56% between June and August 2005, our demand for gasoline didn't even flinch (see blue box on Chart 1); demand remained at approx. 9.4 million barrels (thick black horizontal line) during this period. Incidentally and coincidentally, the 9.4 million-barrel level is the mean between the average gasoline supply and average gasoline demand over the past 12 months.

You can also see on Chart 1 that the demand has been rising steadfastly (thick black arrow) since it hit the bottom in the beginning of September, and it's quickly approaching the 9.4 million-barrel mark. This clearly tells us the interruptions caused by hurricanes were temporary. And, barring natural disasters or economic conditions that permanently prohibit us from consuming energy, demand will continue to rise despite occasional disruptions.

In addition, while price gauging might've been a possibility, the big divergence between gasoline price and demand (blue double arrow) appeared to be more of a reality of supply shortage.

Chart 1

Chart 2 shows the supply shortage after hurricane Katrina hit the Gulf Coast. In September 2005, the total gasoline supply (import plus production) took a nose dive (black circle). It dropped way below the 12-month average supply of 9.7 million barrels per day (purple horizontal line). This, I believe, contributed to the spike in gasoline price during that period.

And, with the exception of a sharp demand decline due to hurricane Katrina, the demand for gasoline had been in an uptrend throughout 2005. Rising demand requires supply to remain high in order to stabilize gasoline prices. But the price went up anyway. Last year, gasoline price increased 25.84%, from $1.78 per gallon in the beginning of January to $2.24 in December 2005 (see Chart 1 above). As mentioned earlier, the biggest jump in price started in the beginning of June 2005 when demand surged past 9.4 million-barrel mark. This coincides with the time when supply fell below 10 million barrels.

Chart 2

Therefore, it's safe to assume that when demand rises above 9.4 million barrels (orange horizontal line), supply MUST sustain above 10 million barrels per day in order to keep a lid on gasoline price. As soon as supply slips below 10 million barrels, as it did in June and July (red rectangular box on Chart 3), gasoline price rises sharply.

Here we are seeing the rising demand for gasoline that's quickly approaching the 9.4 million-barrel magic marker once again while supply appears to be getting tighter and moving lower (red arrows). Unless either the production or the imports can pick up rapidly, this chart is basically forecasting higher gasoline price ahead. And we all know that higher gasoline price and overall energy cost would slow down consumer spending. But, high oil price does more than just impeding consumer spending.

Chart 3

Higher oil and commodity prices create higher inflation expectations, which will leave the Fed with little margin for interest rate cuts. As controversial as it may be, CPI does give us a good glimpse of the price movement. CPI chart below (Chart 4) shows that inflation topped out in 2000 and started to decline in 2001. Unless desperation kicks in, with rising inflation and record-breaking government budget deficit today, it's unlikely for the Fed to repeat similar 2000-2003 rate cut cycle to bail out homeowners again. This then takes us right back to our theme of 2006 being the year of living dangerously for American consumers.

Chart 4

I continue to believe gasoline price shock at the pump in September 2005 marked an important pivot point for American consumers. It has alerted them to start paying attention to their balance sheets. A lukewarm 2005 holiday shopping season was a good indication of that. And, from poor performing stock charts of high-end stores such as Tiffany, Zale, and Saks, it would seem that those who can afford luxuries have already become more cautious about their spending.

Corporate sector has already shifted from being a net borrower to a net saver in 2003, leading to a sharp decline in the supply of non-financial corporate sector bonds. Once consumers start repairing their balance sheets too, everyone would be doing the "right" thing at the same time. But this "Fallacy of Composition" may turn out to be the wrong thing for our economy. Of course, our current big, tall, and expanding government can keep its spending spree going, but it'd be hard pressed for the government to spend enough to fill the void of consumer spending, which represent 70.2% of our economy.

Thus, it's not inconceivable for our economy to begin showing signs of slowing down in 2006. And, when we slow down, we'd take the rest of the world down with us. On top of that, we'll continue to have, among other things, possible breakout of civil war in Iraq, Sinophobia, nuclear brinkmanship in Iran and North Korea, and potential bird flu pandemic to deal with.