What happened
Shares of U.S. onshore oil and gas company Centennial Resource Development (CDEV 0.16%) hit a high of 13% on Oct. 8. Peer QEP Resources (QEP +0.00%) basically matched that, also rising as much as 13%. But both of these exploration and production names were easily outdone by Northern Oil and Gas (NOG 2.46%), which owns pieces of oil and natural gas properties but doesn't operate them itself. Northern rocketed to a nearly 21% gain at one point in the day.
Image source: Getty Images.
By the 4 p.m. EDT closing bell Thursday, Centennial was still holding on to nearly all of the day's gains. QEP closed the session with a 10.5% advance, a little off its highs. And Northern Oil and Gas was up by about 17.5%. The big news was related to oil prices, but there's a little more to understand here.
So what
Centennial Resource Development and QEP Resources are both oil and gas drillers, so their top and bottom lines are tied tightly to the ups and downs of energy prices. Northern is a bit different, in that it buys non-operating interests in oil and gas assets and, in return, gets some of the cash the operator generates from running the properties. It offers a way for exploration and production companies to raise operating cash without having to issue stock or sell debt. Its business is tied to oil and gas prices, just less directly. So, the basic story is that oil and natural gas prices rose. That, in turn, led investors to take a more upbeat view of this trio of U.S.-focused energy companies.-
But there's another little piece to the story that's relevant. Earlier in the year, oil prices in the United States fell to zero, meaning that drillers were basically paying customers to take oil off their hands. There were technical reasons for the drop and it was short lived, but it spooked a lot of investors and energy companies. The industry pulled back hard (and investors dumped energy stocks) in an attempt to fix a massive supply/demand imbalance. Supply and demand are still out of sorts, since much of the excess oil produced while COVID-19 had economies around the world shut ended up in storage. That excess supply has to be worked off before there's a sustained improvement. However, oil prices have begun to recover.
Along the way the $40-a-barrel price level for West Texas Intermediate (WTI) oil became an important signal. It's hard for drillers to make money at $40 a barrel, but it's really hard to turn a profit with oil below that point -- so when oil moves above and below that key price level, investors take notice. WTI started October below $40 but has been hovering around that number for the last couple of days. On Thursday, the price moved pretty strongly above it. Investors reacted by bidding up oil stocks.
QEP Financial Debt to Equity (Quarterly) data by YCharts
Unfortunately, the price move appears to be related to a weather event in the Gulf of Mexico. Hurricanes and tropical storms often lead to supply disruption, but usually only on a temporary basis. In fact, OPEC just announced more somber news, cutting its forecast for long-term oil demand. That would be an obvious negative for oil and the companies that drill for it.
Indeed, even if the Gulf of Mexico oil supply is disrupted for a little while, it is unlikely to materially improve the supply/demand dynamic currently playing out. To fix the problems the industry is facing will likely require both reduced supply and increased demand. That's problematic, because demand isn't likely to rebound until the world has a better handle on COVID-19.
Now what
This was just another in a series of volatile moves for oil and the companies that drill for it. In the case of Centennial, QEP, and Northern, meanwhile, volatility is exacerbated by a heavy use of leverage. Northern has the least leverage, ending the second quarter with a financial debt-to-equity ratio of 2.7 times, QEP sits at roughly 6 times, and Centennial is in the middle at 4.5 times. For reference, Industry heavyweight Chevron, one of the strongest names in the sector, has a financial debt-to-equity ratio of just 0.2 times.
With once-dominant U.S. oil drillers falling into bankruptcy, investors are concerned that other leveraged oil names, like the ones here, may follow. So good and bad news both tend to result in large oil price moves as investors vacillate between fear and greed. Don't read too much into the day's price move -- volatility is the norm lately, and it's highly likely to remain that way for some time. Thursday's news just happened to be of the good variety, lifting Mr. Market's spirits at least for a little while.
