What happened
Shares of U.S. energy producer SM Energy (SM +1.05%) rose as much as 14% in early trading on Tuesday. Roughly two hours into trading, the stock was still higher by 12.5%, so the price advance was sticking. And the exploration and production company was hardly alone.
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Also rising notably were Range Resources (RRC +0.36%) and Callon Petroleum (CPE +0.00%) which both hit high-water marks of 12.5%, and Centennial Resource Development (CDEV +1.65%), with a peak gain just shy of 12%. By about 11:30 a.m. EDT today, Centennial's gain had been trimmed to roughly 8%, with Range and Callon both sitting with about 10% advances. All of the excitement here really boils down to the basics: energy prices.
So what
One of the most notable impacts of the economic shutdowns to slow the spread of the coronavirus last year was the reduction in demand for oil and natural gas. That makes sense, given that people were stuck at home and businesses were not operating normally.
But production couldn't be curtailed as quickly as demand fell, resulting in a severe drop in energy prices. It was so bad that key U.S. oil benchmark West Texas Intermediate actually fell below zero for a brief moment. U.S. onshore oil and gas drillers -- like SM Energy, Centennial, Range, and Callon -- were all particularly hard hit financially and by investors dumping out of the sector.
All of the extra energy that was being produced, meanwhile, didn't just push prices lower, it also ended up in storage. To get supply and demand back into better balance, companies and key industry trade group OPEC all pulled in their horns, reducing supply in an attempt to push industry prices higher. However, the overhang of all of the energy stuck in storage has been an ongoing headwind. "Has been" are the key words in the last sentence, because OPEC has now announced that it believes the excess supply is just about worked off.
Meanwhile, the production pullback largely continues. In fact, OPEC now believes that demand will outstrip supply over the second half of the year. So much so, that the group is expected to start slowly bringing production back. Given the price action in the energy sector today, investors appear to believe OPEC can increase its output without causing any material disruptions, as many had worried earlier increases might do. With that backdrop, it's no wonder that oil and gas prices are higher today.
For U.S. drillers, there are multiple benefits from higher prices. For more heavily-leveraged names -- like Callon Petroleum, with a debt-to-equity ratio of 3.8 times -- the solidifying energy market will make it easier to deal with a debt-heavy balance sheet. All drillers, meanwhile, will be able to start looking at slowly increasing their production again, like OPEC. The risk, of course, is that everyone jumps into the drilling pool at once and ruins the fun. But so far, it appears that U.S. onshore drillers are being prudent with their businesses.
SM debt-to-equity-ratio data by YCharts.
That's basically what investors have been demanding, a fact that was true even before the pandemic. So this isn't exactly a newfound conservative stance. Wall Street has clearly told drillers to focus on returning cash to investors and to live within their cash flow means. Notably, Callon, Range, and Centennial were all free-cash-flow positive in the first quarter, with SM Energy expecting to generate free cash flow for the full year. A solid industry outlook from OPEC makes the future for these drillers look even better.
Now what
Oil prices got a nice boost today from news out of OPEC. But there's really more to take away here than just the content of the news, which was definitely positive. Since the coronavirus-led industry downturn, energy prices and energy stocks have been particularly volatile. It doesn't take much to spark a big daily gain or, conversely, a big daily loss. Given that the industry has recovered a lot of lost ground at this point, long-term investors should probably tread carefully here.
Indeed, one day does not make a trend. Most would probably be best served focusing on the energy sector's largest, strongest, and most diversified names. Chevron is probably a good starting point. Only more-intrepid investors who actually like the fact that smaller companies tend to be more leveraged to commodity-price volatility are probably the ones who should be looking at names like Callon, Range, Centennial, and SM Energy.
