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Why the plunge in oil is crushing all stocks

Crude oil had rallied nearly 6% earlier Wednesday morning after dipping below $30 per barrel Tuesday. But a report by the Energy Information Administration released at 10:30 a.m. indicated supplies had increased over the past week, and all the price gains were erased in minutes. The current bear market in crude oil, which is the longest since the 1970s, is having ripple effects throughout all markets, including U.S. stocks.

Source: TradeStation, Yahoo Finance

Oil drilling is a capital-intensive business. Companies must spend substantial money to operate an oil well that has only a finite lifetime. Shale oil wells, in particular, may only yield crude for a few years, which requires those companies to issue large amounts of debt and stock to raise funds for operations.

Bankruptcy fears

Few wells are profitable at current crude prices, but companies must continue to pump oil to generate revenues—or, face the prospect of simply going out of business. This exacerbates the supply glut that skyrocketed to record levels in early 2015. Current supplies are 25% higher than the prevailing average in years prior to 2015.

Source: TradeStation, Yahoo Finance

While the break-even price for an oil well varies according to several factors, a Wolfe Research report estimates that if crude does not quickly climb to $50 or more, one-third of all oil-and-gas producers could face the prospect of bankruptcy by mid-2017.

According to data compiled by Yahoo Finance, of 559 oil-and-gas companies, only 5 are not in a bear market, which is commonly defined as a stock being down 20% or more from its high. Over one-third of oil-and-gas companies are down 90% or more from their highs, which is a leading indicator of potential bankruptcy problems down the road.

Source: TradeStation, Yahoo Finance

Contagion spreads

The issues in the oil-and-gas industry are making it more difficult for companies across the energy sector.

Monday, Arch Coal filed for bankruptcy protection as it struggled to meet interest payments on over $4.5 billion in debt. It is an indication that the contagion in credit markets caused by depressed oil prices has spread.

According to the Wall Street Journal, over 30 companies in a wide variety of sectors have filed for bankruptcy protection since the stock market peak last year.

Mutual fund woes

In December 2015, the manager of Third Avenue Focused Credit Fund announced that investors would not get their money back for at least one year. The fund could not sell its portfolio of risky, illiquid assets fast enough to meet investor redemptions.

Funds that invest in both safe and risky companies are facing increasing pressure industry-wide, as mutual funds suffered record redemptions into 2015 year-end. When funds scramble to sell assets at fire-sale prices, they must sell safe assets as well. This tends to depress all prices at the same time, which provides the fuel for a market panic.

Until crude oil rebounds, roiled credit markets will continue to lead stock prices down. Unfortunately, analysts are increasingly targeting $20 per barrel for crude, which is a further 33% down. If that occurs, U.S. stock indices will likely enter bear market territory in 2016.