Shares of the American energy producer SM Energy (NYSE: SM) rose 14% at the start of Tuesday’s session. About two hours after trading started, the stock was still 12.5% higher, so the price advance held steady. And the exploration and production company was hardly alone.
Also increased significantly Range resources (NYSE: RRC) and Callon Oil (NYSE: CPE) both of which reached high sea levels of 12.5%, and Centennial Resource Development (NASDAQ: CDEV), with a peak gain of just under 12%. By 11:30 a.m. EDT today, Centennial’s gain had been reduced to around 8%, with Range and Callon both sitting around 10% ahead. All the excitement here really comes down to the basics: energy prices.
One of the most notable impacts of economic shutdowns to slow the spread of the coronavirus last year has been reduced demand for oil and natural gas. This makes sense, given that people were stuck in their homes and businesses were not functioning normally.
But production could not be reduced as quickly as demand plummeted, causing energy prices to drop sharply. It was so bad that the US West Texas Intermediate oil benchmark fell below zero for a brief moment. U.S. oil and gas drillers – like SM Energy, Centennial, Range and Callon – have all been particularly hard hit financially and by investors who have pulled out of the industry.
Meanwhile, all the extra energy produced not only pushed prices down, it also ended up in storage. To restore the balance between supply and demand, the companies and the industry’s key trading group, OPEC, have all pulled their horns, cutting supply in an attempt to drive up prices for the industry. ‘industry. However, the overhang of all the energy stuck in storage has been a constant headwind. “Was” are the keywords in the last sentence, as OPEC has now announced that it believes the oversupply is pretty much eliminated.
Meanwhile, much of the decline in production continues. In fact, OPEC now estimates that demand will exceed supply in the second half of the year. So much so that the band should start slowly bringing back production. Given the price action in the energy sector today, investors seem to believe that OPEC can increase production without causing significant disruption, as many feared earlier increases would. Against this background, it is no wonder that oil and gas prices are higher today.
For American drillers, higher prices have multiple advantages. For names with more debt – like Callon Petroleum, with a debt-to-equity ratio of 3.8 times – the solidification of the energy market will make it easier to manage a debt-heavy balance sheet. All drillers, on the other hand, will be able to start looking to slowly increase production again, like OPEC. The risk, of course, is that everyone will jump into the drilling pool at once and ruin the fun. But so far, it appears that US ground drillers are being cautious in their operations.
This is essentially what investors demanded, a fact that was true even before the pandemic. So this is not exactly a new conservative position. Wall Street has clearly told the drillers to focus on returning cash to investors and living within their cash flow. Notably, Callon, Range and Centennial all recorded positive free cash flow in the first quarter, with SM Energy expecting to generate free cash flow for the full year. OPEC’s strong outlook for the industry makes the future for these drillers even better.
Oil prices today benefited from a nice push from OPEC news. But there is really more to remember here than the news content, which was definitely positive. Since the industry downturn induced by the coronaviruses, energy prices and energy stocks have been particularly volatile. It doesn’t take much to trigger a big daily gain or, conversely, a big daily loss. Since the industry has recovered a lot of lost ground at this point, long-term investors should probably be cautious here.
Indeed, a day does not make a trend. Most would likely be best served by focusing on the biggest, strongest, and most diverse names in the energy industry. Chevron is probably a good place to start. Only the more intrepid investors who genuinely appreciate the fact that small businesses tend to be more exploited by commodity price volatility are probably those who should be interested in names like Callon, Range, Centennial and SM Energy.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.