What happened
Shares of U.S. exploration and production company Centennial Resource Development (PR 0.58%) rose as much as 18.5% in early trading on Nov. 23. Not far behind were fellow energy players QEP Resources (QEP) and SM Energy (SM 1.10%), up as much as 10% and 12.5%, respectively, in the first hour of trading. The big news was a rise in the price of oil, but there's so much more going on.
So what
Centennial Resource Development, QEP Resources, and SM Energy are all small U.S. oil and natural gas drillers, with market caps of roughly $300 million, $340 million, and $460 million, respectively. They are all also carrying a fairly significant amount of leverage, with financial debt-to-equity ratios of 6.5 times, 7.2 times, and nearly 13 times, respectively. Since energy prices are the main driver of top- and bottom-line performance here, rising oil prices have a positive effect on investor sentiment in general for these energy companies. But add in the size and debt issues, and rising energy prices tend to have an exaggerated influence.
Image source: Getty Images.
That said, the news behind oil's price move is equally important to understand. The oil and natural gas industry was facing a delicate supply/demand environment prior to the economic shutdowns being used to slow the spread of the coronavirus. When the shutdowns hit, however, demand fell off a cliff, leaving the world flooded with oil and gas. Supply and demand were so off-kilter that U.S. oil prices fell below zero at one point earlier in the year. Although oil prices have recovered, they remain stubbornly low because excess oil has found its way into storage. That excess needs to be worked off before oil can mount a sustained rally, and the ability to work it off is likely to be driven by economic activity.
CDEV Financial Debt to Equity (Quarterly) data by YCharts
Which brings the story to COVID-19 and OPEC. With more and more vaccines passing key development hurdles (there was another vaccine announced today, bringing the count to three in three weeks), investors are starting to think that the demand side of the equation could eventually begin to improve. Meanwhile, OPEC, which has been trimming supply to combat low prices, seems likely to keep supply cuts in place over the near term, which will also help to right the supply/demand imbalance. All in, the news does appear generally positive and, as you would expect, Centennial Resource Development, QEP Resources, and SM Energy shares moved sharply higher.
Now what
The really big takeaway here is that the move today was largely driven by investor sentiment as it relates to the oil industry. Mr. Market is notoriously fickle, with energy prices often moving higher and lower in swift and dramatic fashion. In other words, prices could move in the opposite direction just as easily as they moved higher today.
And that doesn't even take into consideration analyst calls, which can also have a big impact. For example, Stifel just increased SM Energy's target price 25%. The Wall Street firm believes the company can withstand the hit should oil prices fall again. Still, given the volatile backdrop here, most investors looking at the energy patch should probably stick to the largest, most diversified, and financially strongest names, such as Chevron.
