What happened

Shares of U.S. energy company SM Energy (NYSE:SM) rose as much as 16% in early trading on Nov. 16. Close behind was offshore-focused Kosmos Energy (NYSE:KOS) with a 14% advance. And pulling up the rear was Callon Petroleum (NYSE:CPE) with a still notable 13% gain. At roughly 10:30 a.m. EST Callon Energy and Kosmos were up about 11% and SM Energy was higher by 13%. The driver here was oil.

So what

Key U.S. energy benchmark West Texas Intermediate (WTI) rose sharply in early trading on Monday, so it's little surprise that U.S. onshore exploration and production (E&P) companies SM Energy and Callon Petroleum both advanced sharply in early trading, as well. Kosmos, which is focused on offshore drilling, benefited from international benchmark Brent Crude's early advance. The big-picture story for oil is that investors are excited about the prospects that a successful vaccine will help get energy demand back to normal. That view was bolstered by another positive vaccine update this morning, this time from Moderna. Getting from testing to widespread availability is still a ways off, but Wall Street often gets ahead of itself on news like this.

Two women in the front seat of a roller coaster.

Image source: Getty Images.

That said, the big advances at SM Energy, Callon, and Kosmos are about more than just oil prices and vaccine hopes. Each of the E&Ps is a relatively small player in the energy sector. Kosmos is the largest of the three, with a market cap of around $580 million. SM Energy has a roughly $300 million market cap, with Callon sitting at $280 million. In addition to being small, all three are pretty heavily leveraged. Callon's financial debt-to-equity ratio is a huge 16 times, SM Energy comes in at around 13 times, and Kosmos is the most conservative at a still sizable six times or so. 

SM Market Cap Chart

SM Market Cap data by YCharts

For comparison, Chevron has a market cap of $167 billion and a financial debt-to-equity ratio of just 0.26 times. Not surprisingly the shares of SM Energy, Callon, and Kosmos tend to be a bit more volatile than industry giant Chevron, which makes complete sense. Rising and falling energy prices will have a bigger impact on the results of these heavily leveraged drillers. Effectively, they need higher oil prices to be sustainably profitable.

The problem is that oil and natural gas tend to be volatile. That's true even when times aren't as complex as they are today with a global pandemic upending the supply/demand balance. So the gains that Mr. Market awards today can easily turn into losses tomorrow and all it takes is a shift in the mood on Wall Street. Add COVID-19 to the mix and owning the shares of Callon, SM Energy, and Kosmos can feel like riding a roller coaster lately. 

Now what

Although it can be exciting to see stocks rack up huge gains in just a few minutes, most long-term investors should probably steer clear of small and heavily leveraged exploration and production companies. A much better play, if you want to invest in the energy sector, is to stick with the largest, most diversified, and financially strongest names. On that score, Chevron would be a good starting place, as its leverage sits toward the bottom of the energy sector. And that's after a material increase in debt during the pandemic to support its dividend and investment plans, which speaks volumes about the company's immense financial strength. 

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.