What happened

This week has been a volatile one for the oil sector. Oil stocks started the week on fire after OPEC and its partners agreed to extend their initial supply reduction rate until the end of July. However, the sector has cooled off since then after oil storage levels rose, and COVID-19 cases started spiking, causing concerns that demand might weaken. Those fears seem to be fading today, which is fueling another rally in the oil sector. 

Shares of several oil producers were up by more than 10% by 12:30 p.m. EDT. Among the leaders were financially challenged shale drillers Chesapeake Energy (OTC:CHKA.Q)Callon Petroleum (NYSE:CPE)SM Energy (NYSE:SM)Centennial Resource Development (NASDAQ:CDEV), and QEP Resources (NYSE:QEP)

Several oil pumps in a row at dusk.

Image source: Getty Images.

So what

Many stocks are trading based more on hope than reality these days. That certainly describes the moves in many deeply indebted oil companies. When the market or oil prices rise, these stocks seem to soar, with the inverse occurring when prices take a breather. Today, some optimism has returned following a nasty marketwide sell-off yesterday on concerns that COVID-19 cases are on the rise in the U.S., which could cause renewed government lockdowns. 

Unfortunately, most oil companies need more than hope, given their dire financial situations. For example, Chesapeake Energy is on the brink of filing for bankruptcy. Despite that risk, shares of the oil and gas producer have gone on a wild ride this week on the insane gamble that it might be able to make it through the downturn in one piece. 

Meanwhile, several other shale drillers have been so financially weakened by the decline in crude prices that they might need to restructure their debt in bankruptcy in the coming months. In Callon Petroleum's case, its banks recently reduced the borrowing base on its credit facility from $2 billion to $1.7 billion. That put it in a tight spot since it has drawn $1.35 billion on that facility, leaving it with much less liquidity. Another borrowing-base reduction by Callon's banks this fall could force it to file for bankruptcy. 

QEP Resources is also in a tight spot, though it did get some good news earlier this month. Its creditors amended its facility, which boosted its liquidity by $500 million. However, the company needs a much stronger oil market before its finances will be back on a sustainable level. 

SM Energy and Centennial Resource Development are also in less-than-ideal financial positions. Because of that, SM Energy recently had to issue senior secured notes paying 10%, so that it could exchange some of its other debt to gain more breathing room. Meanwhile, Centennial Resource Development had a $225 million asset sale fall through, which will adversely affect its business and financial condition, according to the company. That's because its liquidity is drying up after its banks cut the borrowing base on its credit facility from $1.2 billion to $700 million. With $235 million drawn, the company has less than $500 million of breathing room, which could further erode this fall if its banks cut its borrowing base again. 

Now what

Speculators continue to gamble that financially challenged oil stocks will make it through this downturn without needing to restructure via bankruptcy. While that's certainly possible, traders are making a risky bet that oil market conditions will continue improving. Meanwhile, even if these oil stocks survive, they'll remain financially weak, which will impact their ability to grow shareholder value over the long term.  

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.