What happened
Shares of U.S. energy driller SM Energy (SM +8.36%) rose nearly 21% out of the gate on Nov. 18. QEP Resources (QEP +0.00%) jumped around 14%. And Centennial Resource Development (CDEV +0.55%) trailed a bit behind at a gain of 9%. The stocks of all three of these exploration and production (E&P) names cooled off quickly, however, with SM Energy up just 6% or so by 10:30 a.m. EST, Centennial 7%, and QEP Resources 11%. The big news was oil prices, but there's more to the picture than just that.
So what
Oil prices rose quickly on Nov. 18 and then started to cool off. So it makes sense that this was the rough price action seen in the stocks of SM Energy, QEP Resources, and Centennial Resource Development. They are, after all, E&P companies, and their top and bottom lines are highly influenced by the ups and downs in the prices of oil and natural gas.
Image source: Getty Images.
That said, it's also important to note that these three companies are small and heavily leveraged. To put some numbers on that, SM Energy is the biggest company here, and its market cap is only about $380 million or so. If that's the biggest of the trio, it's safe to say that they are hardly industry giants. On the leverage side of things, the least leveraged name is Centennial Resource Development with a financial debt-to-equity ratio of around 6.5 times. That's a pretty substantial number, but it's actually about half of SM Energy's nearly 13 times financial debt-to-equity ratio. When you consider that Chevron (CVX +0.14%), with a market cap of roughly $170 billion, has a financial debt-to-equity ratio of 0.26 times, you can see that this trio of tiny drillers aren't in the same league with the big boys.
All in, being small and heavily leveraged means that SM Energy, Centennial Resource Development, and QEP Resources are extra sensitive to oil price moves. That's not meant to suggest that there's any imminent danger, per se. For example, SM Energy's lenders just reaffirmed its borrowing base. So the company has around $880 million of liquidity to support its operations. It's also partnering on projects to help reduce its costs. So the companies here are clearly working hard to muddle through this rough patch. However, investors are rightly concerned about the scale and leverage issues inherent in these names.
SM Market Cap data by YCharts
But there's still more to unpack. One of the big problems facing the energy sector today is low oil prices because of a massive supply-demand imbalance. In fact, the demand decline from the economic shutdowns used to slow the global pandemic was so swift and severe that U.S. oil prices actually fell below zero at one point. Prices have since recovered, but they remain painfully low. Adding to the troubles, the industry couldn't adjust as quickly as demand declined, so excess oil found its way into storage. That has left an overhang over the industry that won't be easily resolved. There have been cutbacks throughout the energy sector, which is helping to rebalance supply and demand, but there's still a long way to go.
Today, industry watchers appear to believe that OPEC, which has been cutting production to help prop up prices, will continue to do so -- specifically to help offset still high U.S. inventory numbers. That's notable because the group's current round of cuts is set to roll off soon. So, if OPEC doesn't act, supply will increase. That would be bad news all around but specifically so for smaller drillers with heavy debt loads.
Now what
Investing in SM Energy, QEP Resources, and Centennial Resource Development is kind of like riding a seesaw lately. News is driving prices higher and lower in swift and often dramatic fashion. While that makes sense in many ways, that doesn't make the ride any smoother. Most investors interested in the energy sector would probably be better off with larger and financially stronger fare, like Chevron.
