What happened
Shares of U.S. energy driller Centennial Resource Development (PR -0.58%) fell as much as 13% in the first hour and a half of trading on Monday. Following close behind was fellow exploration and production (E&P) name QEP Resources (QEP), which dropped roughly 10.5%. Energy services name Core Laboratories (CLB) got in on the act as well, losing about 7.5% in early trading. The big news driving these declines were weak energy prices, with both crude oil and natural gas lower. But the real story here is bigger and perhaps even more important to understand.
So what
The top and bottom lines at Centennial and QEP are tied directly to the commodities they produce. So falling energy prices often lead investors to sell their stocks. This is pretty much the norm when it comes to commodity companies like these, especially in a sector that's known for being volatile.
It's particularly notable this year, however, because energy prices are historically low thanks to the economic shutdowns used to slow the spread of the coronavirus. In fact, oil actually fell below zero at one point in early 2020, which technically means that, for a short period, drillers were paying customers to take oil. Even though oil has rebounded from those frightening depths, it is still hard for many E&Ps to turn a profit. So the shares of drillers are, perhaps understandably, extra sensitive to energy prices today.
Image source: Getty Images
Complicating this industrywide dynamic for Centennial and QEP is that both companies also have heavily leveraged balance sheets. To put some numbers on that, Centennial's financial-debt-to-equity ratio is roughly 4.5 times; QEP's is even higher at around 6 times. Compare that with a company like energy sector giant Chevron, which has a ratio of just 0.2 times.
So energy price moves tend to have an even bigger impact on Centennial and QEP because of the financial situation they are in today. This was on clear display this morning, since falling energy prices will make it that much harder for this pair to carry the leverage they've taken on.
CDEV Financial Debt to Equity (Quarterly) data by YCharts.
Core Labs is also leveraged to oil and natural gas prices, but in a different way. While the company's financial-debt-to-equity ratio is a completely reasonable 0.3 times or so, its reservoir services are highly dependent on the capital spending plans of drillers. When energy prices are low, as they are today, E&P names tend to pull back on capital spending, thus reducing demand for Core Labs' services. Notably, demand can ramp up and fall off fairly quickly, so in its own way, Core Labs is also leveraged to price moves in the energy space. With both oil and gas lower today, Core Labs followed along for the ride. Investors, basically, are assuming that demand for Core Labs' services will continue to remain relatively weak, which is not at all unreasonable given the overall state of the energy sector.
Now what
The energy industry is working through a very difficult supply/demand imbalance today. Good news and bad news is leading investors to jump in and out of the sector, often switching directions on a day-to-day basis. Conservative long-term investors should probably stick to the largest and most financially secure names, like Chevron. Core Labs might interest more-aggressive investors, but volatility is likely to remain high for the foreseeable future.
