What happened

A surging stock market and a little bit of optimism had prices jumping on Dec. 26, with Brent crude futures gaining almost 8% on the day as investors take a step back from recent negativity on oil heading into 2019. The day's performance had a big impact on investor's hopes for a lot of oil stocks, with the following dozen having banner days: 

Company Name Stock Price Daily Change
Baytex Energy (OTC:BTEG.F) 14.1%
California Resources (OTC:CRC) 21.7%
Carrizo Oil & Gas (NASDAQ:CRZO) 13.7%
Chesapeake Energy (OTC:CHKA.Q) 27.3%
Denbury Resources (NYSE:DNR) 23.8%
Extraction Oil & Gas (NASDAQ:XOG) 13.4%
HighPoint Resources (NYSE:HPR) 19.4%
Laredo Petroleum (NYSE:LPI) 20.1%
Noble (OTC:NEBLQ) 13.4%
Northern Oil & Gas (NYSEMKT:NOG) 18.5%
Oasis Petroleum (NYSE:OAS) 13.5%
Whiting Petroleum (NYSE:WLL) 15.6%

Data source: Yahoo! Finance.

This sharp reversal breaks -- at least for a day -- the ugly decline in crude prices that started in early October and saw prices fall more than 35% at one point, including the biggest single-day drop in crude prices since 2014. 

So what

Both stocks and oil started falling sharply in October, with recent weeks including some of the worst days for both the S&P 500 and crude futures in years. While stocks haven't fallen as sharply as oil this year, at the low point on Christmas Eve, stocks had sold off more than 17% from the all-time high from a few months ago. That marks the biggest short-term decline in stocks since the market started recovering from the global financial crisis. 

At some point, all the recent selling would have eventually started to reverse. The overall health of the U.S. economy remains solid, and while there are some valid reasons to be concerned about global economic growth, particularly with less transparent parts of the world, including China, there's a good argument to be made that both oil and stocks have been a bit oversold -- hence today's super-surge in these stocks, particularly the oil producers, which benefit from higher oil prices when they sell their production.

The benefit is more indirect for service providers such as Noble, which operates offshore drilling equipment it leases to oil producers, but the general idea is that higher prices make it more economic to develop offshore reserves, which can take many years to move from exploration to commercial production. 

Now what

Instead of doing a deep dive here on these companies, suffice it to say that for the most part, this is a collection of small, independent producers that want, and in some cases need, oil prices to rise higher from here. And the uncertainty around oil prices will continue to weigh on their prospects, particularly with West Texas intermediate crude, the benchmark that's closer to what most of these producers realize, still sitting nearly $10 per barrel below Brent and not much above $46 per barrel today. 

I'm not saying there's no money to be made in these small, independent producers, but I am absolutely saying that their prospects -- and that of their shareholders -- is heavily weighted to what oil prices do. And as we have seen over 2018, predicting what oil prices will do in the next year or two is nigh-on impossible to do. But if you're still interested in this segment of the oil business, my suggestion is to identify the ones with the best combination of balance-sheet strength and low production costs. 

Frankly, this group, as a whole, has substantial debt leverage: 

CHK Debt to Assets (Quarterly) Chart

CHK Debt to Assets (Quarterly) data by YCharts

That means any future shocks to the oil market -- which could still happen -- would potentially wreak havoc on their cash flows, and with already-high debt levels, many of these producers would struggle under the weight of their debt if that were to happen. One look at what their stock prices have done over the past year is all the evidence you should need:

CHK Chart

CHK data by YCharts

Oil prices drive these oil stocks. And unless you can reliably predict oil prices (spoiler: you can't), then it's probably best to avoid this group of stocks. I've learned the hard way with Chesapeake Energy. Offshore driller Noble is interesting, with what looks like a very cheap valuation by at least one metric, but it's far from foolproof

My advice: There are other subsectors of the oil and gas industry which have proved to be far better places to invest, particularly the midstream segment. Most retail investors would do far better to put their money there than in independent producer stocks. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.