Oil Plunge Accelerates As OPEC Floods Market

Led by Saudi Arabia, the cartel doubles down on its strategy to preserve market share and hurt U.S. producers.

Energy ETFs were crushed early this week as oil continued to reel from Friday's OPEC decision to stay the course in its price war. WTI crude oil prices dipped as low as $37.50 on Monday, the lowest level since early 2009.

Far from cutting production as some had hoped, OPEC didn't even specify a production target, the first time that's happened since 1982, according to Bloomberg.

Summing up the decision, the Iranian oil minister said, "Effectively, [production] is ceiling-less ... everyone does whatever they want."

That means that OPEC will continue to pump full throttle, while hoping that rising demand and lower production outside of the cartel eventually balances the market.

Crude Oil Price

OPEC Oil Flooding The Market

In many ways, OPEC is competing not only with other oil producers such as the U.S., but with itself. The cartel is irrelevant and has been since its November 2014 decision to refrain from cutting output to prop up prices.

Now each member country is on its own to try to weather the oil industry storm. The haves―such as Saudi Arabia and Iraq―are rapidly expanding their production in an attempt to capture market share and offset the drop in oil prices. Since the middle of last year, Saudi Arabia and Iraq have added a whopping 2 million barrels per day of supplies onto the market.

On the other hand, the have-nots―such as Venezuela and Nigeria―are struggling to merely hold output steady.

Then there's Iran, which hopes to re-establish itself as a major oil exporter by muscling its way back into the market in 2016. Once sanctions are lifted on the back of this year's nuclear accord, the country could add 500,000 barrels per day to 1 million barrels per day of production to the already-oversupplied oil market.

Friday's OPEC inaction didn't change anything, but it underscored the idea that member countries would continue to export as much oil as they can, offsetting the production declines in the U.S. and the big jump in global oil demand.

Goldman: 50% Crash From Here Possible

That may leave the market oversupplied for longer than many analysts had envisioned. Moreover, the longer the market stays out of balance, the more bloated inventories will grow, leaving little room to store excess supplies.

Source: International Energy Agency

Suddenly, the prospect of a "full storage" scenario is back in the cards, where oil craters to severely low levels because there is simply nowhere left to store it. This is a risk outlined recently by analysts at Goldman Sachs.

"The rising probability that markets may need to adjust through "operational stress," when surpluses breach [inventory] capacity, leaves risks to our forecast as skewed to the downside in coming months, with cash costs near $20/bbl," they said.

Energy ETFs Approach 2015 Lows

Twenty dollars a barrel is a long way down from current levels of around $38. If that happens―or even if oil stays at current levels for another year―high-cost U.S. shale oil producers will be hit particularly hard.

The fact that natural gas is also tumbling doesn't help matters as energy companies often produce both types of fuel.

Share prices for some of the big exploration and production companies such as Chesapeake Energy, Whiting Petroleum and others have been downright crashing in recent days, signaling danger. Investors are openly talking about bankruptcy for some of these firms.

That's sent energy exchange-traded funds, which hold shares in many of these companies, tanking also.

The largest energy ETF, the Energy Select SPDR (XLE | A-90), which is heavily tilted toward behemoths with strong balance sheets—like Exxon and Chevron—has fared better than most amidst the bloodbath. It's down "only" 20 % year-to-date, though it’s quickly approaching its 2015 lows.

The SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-59) has done worse, losing nearly 32%, while the First Trust ISE-Revere Natural Gas ETF (FCG | B-98), focused on natural gas producers, has done abysmally, dropping 56% so far this year.

YTD Returns For XLE, XOP, FCG

Market Repercussions

The repercussions of oil's demise are widespread. The U.S. oil industry will continue to be ravaged, and producers will need to cut back on drilling even more. Dozens of companies could go bankrupt, and defaults on energy-related high-yield bonds could skyrocket.

The aforementioned XLE, XOP and FCG will certainly continue to tumble in a $20/barrel scenario. Junk bond ETFs, which have heavy weights in energy sector debt, would likely follow suit. The SPDR Barclays High Yield Bond ETF (JNK | B-68) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) have fallen all year long, trading at their lowest levels since 2011.

Even the broader stock market could be hurt if the energy downturn intensifies significantly. The SPDR S&P 500 (SPY | A-98) has frequently traded lower on days that oil and oil stocks plunged.

That said, the energy sector's weighting in the broad S&P 500 has diminished notably in the last few years. The sector now accounts for only 6.7% of the S&P 500's total market capitalization, down from 10.3% two years ago and 11.6% five years ago.

Geopolitical Risks

On the geopolitical front, oil-producing countries such as Saudi Arabia, Russia and Venezuela could face stress the longer prices stay down.

Analysts say Venezuela is the most vulnerable in the short term. Large foreign exchange reserves are insulating Saudi Arabia and Russia for now, but if those dry up, those countries could see dramatic instability in their economies and social order.

The Aftermath

At a certain point, oil will rebound. The ingredients are certainly in place to see that, but the industry could see more pain before that happens.

In fact, the more companies that go bankrupt, the better it will be down the road for the survivors. Lower prices also boost demand, which is a key element for balancing the market.

Investors who buy energy-related ETFs before the rebound will surely profit, but of course, there could be more downside ahead in the short term, particularly if Goldman Sachs turns out to be right with its $20 call.

Contact Sumit Roy at [email protected].