Shares of Chesapeake Energy (NYSE:CHK) were higher by more than 70% as trading was set to close on Wall Street on June 5. But it wasn’t the only energy stock to see huge gains. Fellow exploration and production company SM Energy (NYSE:SM) was higher by more than 28%, with Centennial Resource Development (NASDAQ:CDEV) up 25%, and Matador Resources (NYSE:MTDR) 22%. Magnolia Oil & Gas (NYSE:MGY) and PDC Energy (NASDAQ:PDCE) lagged behind but still had gains of 15% and 10%, respectively.
Pulling up the rear today was Crescent Point Energy (NYSE:CPG) with a roughly 9% gain, but this stock’s high for the day was a little bit more impressive than that at 13.5%.
Clearly, there was some good news in the oil patch.
Oil and natural gas prices have been at or near historically low levels for a little while now, with the price of oil actually dipping below zero at one point. There were technical reasons for that obviously ridiculous and unsustainably low price, but that couldn’t have happened if the supply/demand dynamics in the sector weren’t so out of balance right now.
To put it simply, exploration and production companies are dealing with an incredibly hostile environment. Across the board, companies are working on cost cutting, reducing capital spending plans, and trying to shore up balance sheets so they can survive this difficult period.
Not every company has been successful in their efforts. Some have already filed for bankruptcy, and others are rumored to be close to the brink. While the hit from low oil and natural gas prices has been felt throughout the energy space, onshore U.S. drillers have really felt the brunt of the downturn. That’s partly because of the decade-long increase in U.S. onshore production that has helped to upend the global balance of power in oil. At first, OPEC tried to offset the increases in U.S. production with oil cuts, but tensions grew around that strategy because U.S. drillers just increased output to pick up any slack that was created. Eventually, OPEC and partner Russia got into a price war that led to more oil flooding into the market. Prices fell dramatically.
Unfortunately, that spat, which has since been resolved (more on this is a second), took place just as COVID-19 was starting to spread around the globe. As countries effectively shut their economies, demand for energy fell sharply. Too much supply and too little demand, as you might expect, resulted in even lower prices. In fact, excess oil started to fill up the easily available storage to the point where tankers were enlisted to act as seaborne storage units — an extremely expensive way to store oil that only gets used when there’s no other choice.
That’s the awful background you need to know before you can understand why Wall Street is so excited today. But, before getting into the details, let’s just say things appear to be getting better. The process has been relatively slow, with generally better news regarding oil in storage (which has mostly been declining) and economic activity restarting, at still reduced levels, around the world. And then there’s today.
The first big story underpinning the June 5 oil rally is that OPEC and Russia have agreed on production cuts. Not exactly news, per se, but it looks like they have actually agreed to push up the date of the next OPEC meeting to finalize a deal to help reduce supply. That meeting is expected to happen this weekend. Oil prices rallied on the news, and exploration and production companies, which have also been cutting back on production, went along for the ride.
The second notable piece of news helping oil prices move higher was U.S. unemployment, which fell from 14.7% in April to 13.3% in May. While that’s still a very high number, it’s heading in the right direction (lower) and is way better than the 20% unemployment rate many on Wall Street had been expecting. It also means the largest economy in the world may recover from the COVID-19 shutdown more quickly than originally expected. That would mean more demand for energy, which would further help to clear out the supply/demand imbalance — another plus for oil prices and the companies that drill for the vital energy source.
In the case of Chesapeake, investors appear to believe that the oil price gains will help it stave off bankruptcy. Others are in the same boat. However, it’s a bit early to make a call like that since oil prices are still at low enough levels that it remains difficult for drillers to turn a profit — especially if they have debt-heavy balance sheets.
Moreover, 13.3% unemployment isn’t a good number, it’s just a less bad number. It’s still reasonable to fear that government efforts to contain the coronavirus will push the United States, and perhaps the world, into a recession, which would be bad for oil demand and oil prices. Meanwhile, OPEC members have a really bad habit of setting production numbers and then promptly ignoring what they had only just recently agreed to. It remains to be seen if the cuts that, with any luck, will be agreed to this weekend will stick.
The point here isn’t to throw cold water on the steaming-hot oil rally today. There are very clear reasons to take a more positive view of the situation these companies face. However, the long-term picture hasn’t changed all that much yet.
Most investors interested in the energy space would probably be better off avoiding E&P names like these and focusing on larger integrated oil majors with strong balance sheets and diversified operations. A company like Chevron, for example, won’t be as exciting to own as Chesapeake Energy, SM Energy, Centennial Resource Development, Matador Resources, or Magnolia Oil & Gas, among others, but that’s likely to be true on the upside and downside alike.
Unless you have a very strong stomach, even the good news today shouldn’t be enough to entice you into these names.