What happened

Shares of onshore U.S. exploration and production (E&P) company SM Energy (NYSE:SM) jumped just shy of 13% in early trading on Dec. 10. Following close behind was offshore driller Kosmos Energy (NYSE:KOS), which rose as much as 10.5% in the first hour or so on Wall Street. Energy services provider Core Laboratories (NYSE:CLB) advanced nearly 6.5%, tagging along for the ride, too, but to a lesser extent. The big story today was a rise in commodity prices, but there's so much more to the story than that when you look at the big picture.

So what

The energy sector has been a deep funk this year. It entered 2020 with supply slightly exceeding demand. Then the economic shutdowns being used to slow the spread of the coronavirus led to a massive decline in demand and drastically exacerbated the supply-demand imbalance. Energy prices declined, as you would expect. At one point key U.S. benchmark West Texas Intermediate crude fell below zero. There were some technical reasons for that drop, and it didn't last long, but the event shows just how badly out of balance the energy sector has been this year. 

A man and a woman on a seesaw

Image source: Getty Images.

That's had a particularly brutal impact on smaller drillers, like $700 million market cap SM Energy and $880 million market cap Kosmos Energy. Complicating things for this pair is the fact they are highly leveraged. Kosmos Energy's financial debt-to-equity ratio is nearly 6 times and SM Energy's is nearly 13 times. Those are troubling figures when you consider that industry giant Chevron has a financial debt-to-equity ratio of roughly 0.26 times. Put simply, higher energy prices will make it much easier for SM Energy and Kosmos to muddle through a downturn that has already pushed some of their peers into bankruptcy court. Mr. Market was accommodating on that front today, with oil and natural gas prices both rising notably in early trading. That said, also helping Kosmos Energy today was the completion of an asset sale to industry giant Royal Dutch Shell, with the proceeds set to be used to reduce leverage and support capital spending needs.   

Core Labs' story is roughly similar, but one step removed. The company provides largely digital well-enhancement services to E&P names. When energy prices started to fall, struggling drillers were forced to pull back. That led to reduced demand for Core Labs' services. Investors are bidding the stock up today on the hope that rising energy prices will reverse that trend. It may take a bit longer for Core Labs to benefit from rising energy prices, however, because there's a glut of supply still sitting in storage from the excess supply that glutted the market earlier in the year. That will need to be worked off before there's a sustained and material uptick in energy prices, and, following that, a sustained and material uptick in demand for energy services.

Now what

The energy sector is not in a good place right now. News from individual companies and the broader sector can have a material impact on investor emotions and daily stock prices. Investors are seeing that today. The impetus for big swings, meanwhile, can come from a variety of places, too, including coronavirus vaccine updates, OPEC negotiations, analyst calls, and the rise and fall of oil sitting in storage, among many others. Investors looking at this deeply out-of-favor sector need to tread with caution because, just like a child's seesaw goes up and down, one day's price gains can easily turn into the next day's price declines. 

In fact, most investors would likely be better off sticking to the largest and financially strongest names in the sector, such as integrated oil giant Chevron. It is simply better positioned to weather the ups and downs than smaller players, like SM Energy and Kosmos, and its diversified business model should provide more stability than highly focused services names, like Core Labs.

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.