Why oil continued to drop on government shutdown and inventories

Market Realist

Oil prices are a major valuation driver for energy stocks

West Texas Intermediate (or WTI) crude (priced at Cushing, Oklahoma) is the benchmark crude for US oil. So movements in WTI oil prices are a major driver in the valuation of domestic oil producers. Higher oil prices also incentivize producers to spend more money on drilling, which results in increased revenues for oilfield service companies (companies that provide services such as drilling, fracking, and well servicing). Consequently, WTI prices are an important indicator to watch for investors who own domestic energy stocks.

WTI crude dropped on the week due to inventory builds and the continued government shutdown

Last week, WTI crude oil prices were lower, as WTI finished at $102.02 per barrel on Friday, October 11, compared to $103.74 per barrel a week earlier. Oil slid on the week, as the builds in oil inventories far exceeded analysts’ expectations (see Why oil prices fell to lowest point since July on inventory surge). Plus, the US government shutdown continued, and markets feared that this could hamper crude demand, primarily due to less gasoline demand from workers remaining at home, which had a negative pull on oil prices.

Note that WTI more represents the price producers receive in the US and there’s another benchmark for crude called Brent, which more represents the price producers receive internationally. For more on the price difference between the two benchmarks, please see WTI spread to Brent crude reaches widest level since June. As the domestic benchmark, WTI prices matter more for domestic companies such as Chesapeake Energy (CHK), Range Resources (RRC), EOG Resources (EOG), and Pioneer Natural Resources (PXD) than for companies with significant international exposure, where Brent prices might be more relevant to watch.

Oil prices have remained relatively high and stable, supporting energy company valuations

For most of this past year, WTI crude oil has been range-bound between ~$85 per barrel and ~$110 per barrel. As we’ve seen, higher crude prices generally have a positive effect on stocks in the energy sector. The below graph shows WTI crude oil price movements compared to XLE and EOG on a percentage change basis from January 2007 onward. You can see that crude oil, the XLE ETF, and EOG (one of the largest US-concentrated companies in the energy space) have largely moved in the same direction over the past several years.

As the graph above shows, crude oil prices are a major driver in the valuation of many energy investments. Oil prices affect the revenues of oil producers, and consequently affect the amount of money oil producers are incentivized to spend on oilfield services.

So this past week’s downward movement in prices was a negative for the sector. However, oil prices over the past few months have remained elevated above $100 per barrel, which is a medium-term positive. Lastly, the longer-term stable and elevated price of oil has been positive. Investors with domestic energy holdings in names such as CHK, EOG, RRC, or PXD may find it prudent to track the movements of benchmarks such as WTI crude.

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