What happened
The price of crude oil initially spiked overnight after Iran retaliated against the U.S. for a drone strike that killed one of its key military leaders in Iraq last week. The U.S. oil benchmark, WTI, which spiked 4% after the drone strike to more than $63 a barrel, initially popped another 4% last night to more than $65 a barrel.
However, crude gave back those gains and then some after President Trump said that Iran "appears to be standing down," following a retaliatory attack against U.S. forces in Iraq. That eased fears of an escalating conflict that could have had a major impact on oil prices.
With those concerns dissipating -- taking with them the prospect of higher crude prices -- shares of energy companies tumbled. Leading the decliners were oil and gas producers EQT (EQT +3.05%), Whiting Petroleum (WLL +0.00%), California Resources (CRC +0.00%), Denbury Resources (DNR +0.00%), and Baytex Energy (BTE +3.23%). Each one slumped more than 10% at one point on Wednesday.
Image source: Getty Images.
So what
The reason the decline in crude prices hit these stocks the hardest is that they have weaker financial profiles. Because of that, they would have benefited from the extra cash they could have produced at higher prices.
California Resources and Denbury Resources both have leverage ratios above 4 times debt to earnings before interest, taxes, depreciation, and amortization (EBITDA), which is more than double the comfort level of most oil producers. Because of that, they've been using the excess cash they produce to pay off debt. As such, higher oil prices would have given them more money to shore up their balance sheets. However, with tensions in the Middle East easing, the prospect of higher prices is fading, taking with it the potential for accelerated debt reduction at these drillers.
Whiting Petroleum and Baytex Energy, meanwhile, both also have elevated leverage levels, though they're much closer to their targeted levels. Because of that, both companies have focused on generating free cash so that they can retire additional debt. They could have produced more money to use toward their debt-reduction efforts if crude kept rising amid an escalating conflict in the Middle East. However, with tensions easing and oil prices falling, it will slow their progress.
Meanwhile, EQT, which is the largest gas producer in the country, is also falling along with oil prices, even though it doesn't produce much crude. That's because natural gas liquids, which derive their value from oil, provide about 6% of its revenue. That's down from about 11% in 2018 due to weaker pricing. As such, slumping oil will keep a lid on a recovery in EQT's liquids-related revenue.
Now what
The U.S. drone strike against an Iranian general rocked the markets last week, sparking fears that tensions could escalate into an all-out war. However, Iran's retaliation appeared to be more symbolic, which led President Trump to impose additional economic sanctions instead of responding militarily.
Because of that, the situation seems to be quickly de-escalating, reducing the risk of a disruption to the oil market. As a result, investors who were hoping that higher prices would prop up financially weaker oil stocks are finding the opposite to be true.
