What happened

The bottom fell out of the oil market on Monday. At one point in overnight trading, crude oil prices were down more than 30%. They've recovered somewhat, with WTI, the U.S. oil benchmark, down more than 16% at 10:45 a.m. EDT on Monday, and below $35 a barrel. 

The shellacking in the oil market has eviscerated energy stocks. Nearly the entire sector has cratered today, with some of the most significant moves coming from oil producers focused on the Permian Basin. U.S. oil giants ConocoPhillips (NYSE:COP)EOG Resources (NYSE:EOG), and Occidental Petroleum (NYSE:OXY) had tumbled 22%, 29%, and 32%, respectively, by 10:45 a.m. EDT. Meanwhile, smaller Permian Basin-focused drillers like Diamondback Energy (NASDAQ:FANG) and Parsley Energy (NYSE:PE) were down more than 40%. 

Oil pumps with a downward sloping chart in the background.

Image source: Getty Images.

So what

Crude prices crashed after talks between OPEC and Russia broke down last Friday when Russia wouldn't agree to additional production cuts amid the COVID-19 outbreak. Saudi Arabia is now retaliating by pledging to increase its production, with the potential to go from 9.7 million barrels per day to its maximum capacity of roughly 12.5 million barrels. That would flood an already saturated oil market with more supply at a time when demand is under pressure due to the outbreak.  

The sell-off in the oil market has upended the drilling plans of large low-cost oil producers. Both ConocoPhillips and EOG Resources, for example, used $50 oil as their baseline level for 2020. But with crude prices crashing well below that breakeven point, it will put pressure on these producers to reduce their activity levels so they don't outspend their cash flow.

Occidental is in an even worse position because it made a bold bet to buy Anadarko Petroleum last year for $55 billion. It took on a significant amount of debt to finance the transaction so that it didn't need to put the deal before a shareholder vote. That decision has come back to bite the company big time, with investors growing gravely concerned that it won't be able to maintain its hefty debt load. It seems likely that the company will need to slash its dividend (which spiked to a yield of 17% after its shares cratered today) as well as its capital spending. 

Several drillers have already announced budget cuts, including both Diamondback Energy and Parsley Energy. Diamondback said that it would immediately cut its activity level, dropping from nine well-completion crews to six while also cutting two rigs in April and another later in the third quarter. Diamondback said it is making these moves so that it can "maintain positive cash flow and protect our balance sheet and dividend." 

Parsley Energy followed with a similar move as it revised its baseline capital budget from a $50 oil price assumption to a range of $30 to $35 for the rest of the year. That revised outlook led Parsley to cut two of its five well-completion crews while planning to drop three of its 15 rigs as soon as practical. This activity reduction would enable Parsley Energy to generate an estimated $85 million in free cash flow this year, assuming $30 to $35 oil, which is down from its estimation that it would produce $200 million if oil averaged $50 a barrel. 

Now what

The oil market is in a state of shock. Saudi Arabia went from supporting the price of oil to engaging in an all-out price war with Russia to force that country back to the bargaining table. It's unclear how long this price war will last or how much impact the COVID-19 outbreak will have on oil demand. Because of that, oil could head even lower in the near term until the market stabilizes.

The likelihood of lower oil prices will almost certainly force other drillers to slash their activity levels and spending plans. It could also cause another round of dividend reductions and a wave of bankruptcies among the sector's financially weakest players. These issues will likely keep the pressure on oil stocks in the near term.