While the short-term path of oil prices followed a steady downward trajectory in the third quarter, giving up more than 13% to close out September at a West Texas Intermediate (WTI) price of just over $91 per barrel (bbl), energy equities did even worse. By quarter-end, the EPX index was down around 18% and losing further ground as October got underway.

During these more painful periods for energy investors, the sometimes routine reports of what long-term commodity prices are being discounted by energy equities tend to attract more attention. So what kind of oil and gas prices are baked into the stocks?

According to J.P. Morgan, its coverage universe is discounting a flat WTI and Henry Hub price deck of around $83.50/bbl and $4.13 per thousand cubic feet (Mcf). RBC Capital markets provides an analysis by market capitalization, with the major/large capitalization stocks said to be discounting $84 oil and $4.20 gas, while small cap stocks are discounting $82 and $4.40. Bringing up the rear are the mid-caps, discounting just $79 oil and $4.40 gas.

As compared to the broader market, the energy sector’s relative underperformance vs. the Standard & Poor's (S&P) Index picked up speed as the quarter unfolded. Since Labor Day, E&P stocks have pulled back 10.4%, underperforming the S&P by 7.3%, with small-cap names hit the hardest and underperforming the S&P by 11.9%, according to RBC.

In the mid-cap sector, Morgan Stanley noted E&P stocks had been “under severe pressure” for the past three months, with stocks underperforming oil prices on heightened concerns of further oil weakness in the wake of September OPEC production data.

Although not yet ready to call a floor on the sector, analyst Drew Venker indicated that—assuming oil prices stabilize—the mid-cap stocks should be bottoming based on recent multiples of enterprise value to next 12-month EBITDA. Going back to 2010, the lowest median valuation has been a 6.5x multiple of EV to NTM EBITDA, set in the second quarter of 2013. At 5.7x EV/NTM EBITDA, using consensus 2015 estimates, the recent mid-cap valuation was 13% below the prior trough, Venker said.

But, as noted, making a bottom in the stocks requires some stabilization in the commodities. What’s pushing oil lower?

Concerns include non-OPEC (i.e. North American) supply growth potentially overwhelming demand growth that has been sub-par amidst a faltering global economy, particularly in Europe. Higher output from restored Libyan production has also added pressure. And historically strong Chinese demand is viewed as more questionable as GDP targets are trimmed.

An interesting perspective from Global Hunter Securities focuses on the changing spread between key Chinese demand and rising U.S. oil production. In November of 2010, China’s oil consumption exceeded U.S. production by as much as 5.05 MMbbl/d. By September of 2014, the spread had narrowed to 2.57 MMbbl/d, essentially cutting the differential in half in less than four years. “The oil markets have to meander through a phase of lagging China oil consumption growth concurrent with a period of unusually fast growth in U.S. oil output,” said the report.

With the U.S. a less accommodating—and fast shrinking—export market for overseas producers, competition for Asian markets has intensified among traditional Middle Eastern and West African suppliers re-directing supplies away from North America.

But also roiling commodity markets has been the impact of foreign exchange movements, with dollar strength tending to put downward pressure on commodities in general, including crude.

With the European Central Bank easing while the Federal Reserve Bank signals future tightening, the opposing policies have resulted in a strengthening of the dollar in foreign exchange markets. The ICE Dollar Index posted 12 consecutively weekly gains through early October, its longest such streak in years.

“U.S. dollar strength drove systematic selling across many commodities,” said a Morgan Stanley report after a stronger government jobs report last month.

So the good news of fast-growing U.S. production in the oil sector—one of the few drivers of higher employment in the country—faces the prospect of a rising currency weighing on crude oil prices during the unique circumstance of the Fed trying to gradually exit from quantitative easing ahead of central banks in Europe and Japan.

How long will dollar strength continue?

As if calling crude prices wasn’t enough ... try making a dollar call, too!

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