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Must-know: Why oil prices tumbled sharply on the week

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Oil prices are a major valuation driver for energy stocks

West Texas Intermediate (WTI) crude (priced at Cushing, Oklahoma) is the benchmark crude for U.S. 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 oil prices fell on the week

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Last week, WTI crude oil prices finished at $93.96 per barrel, compared to $100.32 per barrel the week prior. Last Friday, a report from the U.S. Energy Information Administration (the EIA) showed greater-than-expected increases distillate, which is a refined product of crude oil. The large build compared to expectations could signal that less crude will be needed at refineries to produce distillate, which was bearish for crude prices. For more on crude oil inventories, see Why oil prices sank despite seemingly positive inventory figures.

Plus, crude prices also may have fallen as markets priced in a further tapering from the Fed on positive U.S. economic data.

Note that WTI more represents the price producers receive in the U.S., 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 Part 4 of this series. 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

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For most of this past year, WTI crude oil has been range-bound between ~$85 per barrel and ~$110 per barrel. As previously mentioned, 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 U.S.-concentrated companies in the energy space) have largely moved in the same direction over the past several years.

2014.01.06-WTI Crude Oil vs. XLE vs. EOG

As shown in the graph above, 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.

This past week’s downward movement in prices was a short-term negative for the sector. The longer-term stable and elevated price of oil has been positive, as crude prices have largely remained above $80 per barrel since late 2010. 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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