Why Centennial Resource Development, QEP Resources, and SM Energy Fell Sharply on June 15

What happened

Shares of U.S. exploration and production company Centennial Resource Development (CDEV +0.94%) fell as much as 14% in the first 15 minutes of the trading day on June 15. Following along were energy industry peers QEP Resources (QEP +0.00%) and SM Energy (SM +2.68%), down 14% and 12%, respectively, in early trading. Even Denbury Resources (DNR +0.00%) was down 12%, despite the fact that it has a vastly different business model than the other three names here.

So what

The big story is a nearly 5% drop in the price of West Texas Intermediate (WTI) crude, which led investors to dump U.S. drillers. WTI is a key benchmark for U.S. oil drillers. The price decline isn’t a particularly shocking development, since oil is a highly volatile commodity prone to swift price swings. This time around, the fear that COVID-19 is making a resurgence in states that have begun to reopen appears to be the leading cause behind investors’ trepidation. Essentially, if states have to slow down the reopening process, or even backtrack on the progress that has already been made, energy demand will falter. That said, this isn’t a U.S.-centric issue, as China has also been dealing with a resurgence of coronavirus cases. In other words, the world’s top two economies might not be as strong as some investors hope, and that would obviously be bad for energy demand.

Image source: Getty Images.

Unconventional U.S. drillers, like Centennial Resource Development, QEP Resources, and SM Energy, are pretty much at the heart of the storm. The more than decadelong expansion in this industry segment was a key factor that led to a global supply/demand imbalance, which helped push oil prices below zero at one point earlier in the year. As prices cratered, the industry pulled back very hard, even going so far as to shutter operating wells. With oil prices up off those historical lows, however, some companies are starting to reopen closed-in wells. That could end up capping any oil price gains or, if the global economic rebound from COVID-19 is weak, push prices right back down again.

The thing is, it isn’t just unconventional drillers that are getting impacted here. Denbury, which takes older wells and injects carbon dioxide into them to force out oil and extend their useful economic lives, is also taking a hit because of low energy prices. The two extraction methods are very different. The trio above uses fracking, which results in new wells that tend to have high production rates up front and then quick declines. It means that the companies need to keep drilling new wells if they want to maintain production levels. (The fact that many frackers are not drilling new wells is actually a pretty big problem.)

Denbury, on the other hand, is more of a slow and boring option with a relatively modest production decline profile (first quarter 2020 production fell 2% sequentially from the fourth quarter of 2019). It simply doesn’t need to drill, drill, drill – though it can’t exactly stop investing in the future. But when prices are this low, differences like this get lost on investors. And, like its fracking peers above, Denbury has been forced to pull back on its spending, too. The hit probably won’t be as material or show up as quickly, but it does diminish the company’s future prospects.

Now what

Although investors have gone through varying stages of risk-on and risk-off with regard to the energy sector, the unfortunate truth is that a full resolution of the supply/demand imbalance is not in sight yet. There are a lot of moving parts, including COVID-19’s global economic impact, OPEC production cuts, and the reactions of U.S. drillers to oil and natural gas price swings. If you are looking at the energy space, be prepared for volatility to continue for a very long time. If your preference is onshore U.S. drillers, expect that volatility to be pretty extreme at times. This is not an industry that faint-hearted investors should be looking at today.

In fact, if you have been lured here by the fact that energy is so deeply out of favor right now, you’ll probably be better served investing in an integrated energy giant like Chevron, which has a rock-solid balance sheet, a diversified business, and a material position in the onshore U.S. space. At least that way all of your eggs won’t be in one basket.