Dropping Oil Prices Send Shockwaves Through Energy Sector

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Energy stocks have taken a beating so far in October as commodity prices continue to deteriorate.

A wave of bad news has hit the commodities sector. A weakening global economy, a surplus in oil supplies and a strengthening U.S. dollar have combined to send oil prices lower in recent weeks.

On Oct. 9, the slide continued when Brent crude dropped below $90 per barrel for the first time in more than two years.

Poor economic data from Germany raised fears that a renewed European recession could be on the horizon. The S&P 500 lost 2 percent on Oct. 9, and the markets have experienced some of the worst volatility so far this year. The International Monetary Fund (IMF) also revised downwards its projection for global economic growth in 2014 and 2015, warning that "global growth is still mediocre."

China's oil demand remains weaker than it has been in years. To a certain extent, China's oil imports have been artificially elevated as it has diverted oil into its strategic stockpile. Oil imports could soften as stockpiles fill up. China even posted a decline in oil imports for the month of July.

Elsewhere in Asia, demand is also tepid. Driven by a desire to boost budgets by cutting spending, countries like Indonesia, Vietnam, Thailand, India and Malaysia are all trimming fuel subsidies, according to The Wall Street Journal. That has sent fuel prices up 10 percent in Malaysia and 23 percent in Indonesia, for example. India's decision to reduce subsidies has pushed demand growth for diesel to near zero for the year, after annual growth rates of 6 to 11 percent in the past.

Meanwhile, oil supplies continue to rise. OPEC production for September hit its highest level in almost two years. Libya has lifted its oil production to 900,000 barrels per day, up from just 200,000 barrels per day in June. And Saudi Arabia has yet to significantly cut production.

Separately, the U.S. Energy Information Administration (EIA) reported higher than expected crude oil in inventories as refineries cut purchases and close for maintenance. Higher global supplies are pushing down prices.

The U.S. dollar also continues to strengthen, with the currency recently hitting a two-year high with the euro. A stronger dollar tends to weaken oil prices.

With oil prices hitting multi-year lows, the markets wiped out energy stocks. On Oct. 9, ExxonMobil lost 2.95 percent; Chevron lost 2.92 percent; BP was down 2.69 percent, and ConocoPhillips was off 3.20 percent.

But it wasn't just oil companies. The markets continue to wallop the coal sector. Arch Coal lost 7.23 percent of its value; Alpha Natural Resources lost 11.11 percent, and Peabody lost 9.22 percent. In addition to the broader economic malaise, the coal sector got an extra bit of bad news on Oct. 9 when China declared that it would reinstate tariffs on certain types of imported coal that were scrapped a decade ago. The tariffs threaten to slash coal imports and boost China's domestic coal industry.

The one-day sell off was the stock market's worst performance of 2014. It is unclear where the markets will go from here as there are no signs that the supply and demand picture will change significantly anytime soon.

But if oil prices drop any further, the bite will really set in. Although specifics differ across companies and regions, some oil companies could begin to trim spending on exploration if oil prices drop below $85 per barrel. That would eventually lead to lower oil production and bring prices back up to some equilibrium.

Alternatively, prices may soon drop lower than Saudi Arabia is willing to tolerate. In such a scenario, the world's only real swing producer would accept lower output in order to see prices increase to its desired range - somewhere between $95 and $110 per barrel.

However, Riyadh has remained silent thus far on its next steps.

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