Oil’s Drop Spells Disaster for Drillers

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In an explosive reversal, the commodity markets are plunging further downward.  Oil dropped on Wednesday for its third day in a row, marking its largest one-day drop since July 23.  Oil traded as high as $100 the week of September 10, only to take an 8% haircut this week.

Analysts were caught off guard by the major jump in the number of barrels of oil stored.  Analysts expected supply to increase by 500,000 barrels, but the number was 17 times higher at 8.5 million barrels

Imports played a role in the increase, ramping up from 1.28 million barrels per day ending September 14, to 9.8 barrels per day this past week.  The oversupply comes at a delicate time for the U.S., which is seeing its lowest demand since June 1 – just 18.3 million barrels per day.  Also, oil refineries and import facilities appear to have fully recovered from August’s Hurricane Isaac, further prompting supply.

Finally, Saudi Arabia insists that it wants to prop up supply to meet rising demand.  In effect, the country, which is the world’s largest oil producer, pushed prices downward.

Oil’s price move has had a major effect across oil and gas ETFs and stocks.  United States Oil ETF (NYSEMKT: USO), for example, has seen a price decline.  The ETF, which tracks West Texas Intermediate oil using futures, has slid down to just above the $34 mark, despite trading around $37 right before oil’s dip.

Investors long the iPath S&P Crude Oil ETN (NYSEMKT: OIL) also lost out.  The fund, which has approximately $454 million in assets and also tracks WTI, has seen a significant price drop.  The fund traded just under $25 before the pullback, but trades in the mid- $22 region now.

Aside from ETFs, investors long oil and gas stocks can also be hit hard by a reduction in crude prices.

Chesapeake Energy (NYSE: CHK), for example, has ditched natural gas drilling in favor of oil drilling.  Chesapeake, which faced a multi-billion budget shortfall before planning $13 – $14 billion in asset sales, has sunk billions in capital expenditures into oil drilling. 

The move to oil comes at a time when natural gas prices have seen decade-low levels and tremendous oversupply. Chesapeake, which is already over-leveraged, could see huge downside if it earns significantly less per barrel of oil than it expected.

Like Chesapeake, ExxonMobil (NYSE: XOM) would also be hampered if oil prices continue downward.  Exxon has shifted production towards oil as prices rose from the high 70s to breach $100. 

However, Exxon remains more diversified than competitors.  Exxon is the largest producer of natural gas in the U.S., and it is using natural gas’ price pullback to scoop up additional natural gas properties.  Exxon just announced that it would buy Denbury Resources’ Bakken assets, giving Exxon more shale properties.

Unlike Exxon, Plains Exploration and Production (NYSE: PXP) is shifting hard into oil assets.  The company just sold off a large chunk of natural gas holdings in order to fund its $5.5 billion acquisition from BP in the Gulf of Mexico.  The move is a risky one for Plains, which is selling natural gas assets at an incredible low in order to jump into oil when assets are more expensive.

Plains explains the acquisition as an opportunity to delve into offshore deep water drilling, exploration that is normally reserved for only the biggest players.  However, Plains is attempting to hedge itself.  The company is locking in oil prices that should cover 90% of its production between 2013 and 2015, the company says.

After months of rising, the oil market is taking a nosedive.  Hampered from oversupply and Saudi Arabia’s pricing influence, the commodity’s price drop has hurt investors who are long ETFs and oil and gas companies.

If oil continues its downward spiral, oil companies will see large losses, especially because their natural gas assets are dropping in value as natural gas prices sit near lows.  If you plan to scoop up oil and gas stocks, two plans could work well. 

First, ensure that the company is adequately hedged, meaning that it has sold futures to lock in its sale price.  Second, wait to buy.  Buying shares after oil has just dropped considerably is typically a good time to enter, considering oil’s volatile price movement.  The volatility that just caused investor losses could also bring you large profits.

ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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