What happened
Shares of onshore U.S. energy driller Centennial Resource Development (PR 0.53%) fell a quick 7.5% on May 19. That drop, however, was outdone by peer SM Energy (SM 1.58%), where the decline in the first hour was as deep as 11.5%. But it wasn't just onshore domestic names that took a hit -- offshore focused driller Kosmos Energy (KOS -1.84%) and even drilling services company Core Laboratories (CLB) felt the sting, too, falling just shy of 10% and 5%, respectively.
Roughly an hour into the trading day all three remained near their lows. There was some mixed news here, but the main culprit for the weak share performance was pretty much what you would expect.
Image source: Getty Images.
So what
Centennial and SM Energy are both relatively small drillers that have been dealing with heavy debt loads. That was a more material issue in 2020, when a key U.S. oil benchmark plunged to zero. And while that severe crisis has passed, with U.S. oil prices having recovered materially since they hit record-setting lows, the big-picture story for this pair has improved, but not completely changed. Notably, SM Energy's financial debt-to-trailing-EBITDA ratio, at nearly 13 times, is much worse than Centennial Resource Development's roughly 5.1 times. That partially helps to explain why SM Energy took the bigger hit today.
SM Market Cap data by YCharts
Which brings the story to the real reason for today's price declines: An early drop in oil and natural gas prices. The big headache today appears to be a mixture of COVID-19 worries and economic concerns. Falling energy prices just had a disproportionate impact on Centennial and SM Energy because of the company-specific factors involved. For example, industry giants Chevron and ExxonMobil also fell, just not by as much. Interestingly, SM Energy and Centennial Resource Development just received price target upgrades from Wells Fargo. That's the type of thing that investors normally applaud with higher prices. But not this time, since energy prices have a much more material impact on the top and bottom lines of exploration and production names than analyst ratings do.
Kosmos Energy was also affected, however this particular driller is focused on the offshore space. Yet it shares some similarities here. Kosmos' market cap is just around $1.2 billion (in line with the two drillers above) and its financial debt-to-EBITDA ratio is an even higher 13.3 times. So it's no shock that investors dimmed on its prospects as oil prices dropped. Put simply, lower prices make it harder for leveraged drillers to turn a profit and mend their balance sheets.
Core Labs got dragged along for the ride, though with a much smaller loss, because energy services names provide their services to drillers. The business tends to be highly cyclical, with demand usually picking up notably only when oil prices are elevated. Today's drop diminished the likelihood of increased demand and investors sold the stock. It's basically par for the course with Core Labs' stock, which has been particularly volatile over the past year or so.
Now what
The energy sector has recovered materially since the worst of 2020. That will make it easier for companies like Centennial, SM Energy, Kosmos Energy, and Core Labs to muddle through to better days. However, it doesn't change the basic way the energy business operates -- oil and natural gas are volatile commodities by nature. And that, in turn, leads to volatility in the shares of drillers and service providers. Most long-term investors looking at the energy patch will probably be better off sticking with more diversified industry giants, like Chevron and Exxon, than delving into smaller and riskier fare.
