What happened

Shares of small offshore oil driller Kosmos Energy (NYSE: KOS) rose as much as 17% in early trading on Nov. 23. Relatively tiny U.S. onshore exploration and production (E&P) company Callon Petroleum (NYSE: CPE) was up around 18%. Large and heavily indebted energy sector player Occidental Petroleum (NYSE: OXY) reached a peak a little shy of 13%. And energy services company Patterson-UTI Energy (NASDAQ: PTEN) advanced just about 12%. The impetus for all of this was rising oil prices, but the dynamics in the energy sector today aren't really that simple.

So what

Oil and natural gas supply and demand dynamics were slightly out of balance before 2020 began, thanks to a decade-long increase in U.S. energy production. OPEC had been reducing its production to offset the increase, but it wasn't enough to keep prices from remaining relatively weak. And then, in early 2020, the coronavirus pandemic emerged. The economic shutdowns being used to slow its spread have resulted in a massive drop in demand. With supply already a bit high and demand falling off a cliff, oil prices plummeted. At one point in early 2020 key U.S. oil benchmark West Texas Intermediate briefly fell below zero. Although prices have recovered somewhat, that event shows just how deeply out of balance supply and demand are today.

Image source: Getty Images.

However, investors are increasingly thinking that OPEC will continue to curtail its production when its current round of cutbacks rolls off. That will help near-term industry dynamics. Meanwhile, increasingly positive news about a coronavirus vaccine, the most recent of which came from AstraZeneca this morning, suggests that longer-term demand may eventually recover. Not surprisingly, investors took an upbeat view of the future for oil and natural gas and the companies involved in producing them.

While the gains were widespread, the industry is far from homogeneous. For example, $730 million Kosmos is an offshore oil driller but it's pretty small relative to industry giants like $170 billion market cap Chevron that tend to dominate that space. Its small size and material leverage (financial debt-to-equity stood at around six times at the end of the third quarter), however, means that rising energy prices will be very helpful to its business. The company lost $0.09 per share in the third quarter, down from a profit of $0.04 in the same period of 2019. Lower energy prices were a big issue in the year-over-year earnings change.

A similar story unfolds at Callon Petroleum, only it's smaller ($380 million market cap) and even more leveraged (financial debt-to-equity of roughly 16.5 times). And it is entirely focused on the U.S. onshore drilling space, which has been particularly hard hit by the energy market's downturn. Asset impairment charges pushed Callon's third-quarter earnings to a loss of $17.12 a share and it recently completed a debt exchange to help shore up its balance sheet. Sustainably higher oil and gas prices would be very beneficial.

CPE Market Cap data by YCharts

Occidental Petroleum, meanwhile, is working to digest what turned out to be an ill-timed acquisition in late 2019. Unfortunately, the debt-funded purchase of Anadarko Petroleum left Occidental's balance sheet especially unprepared for the hit from COVID-19. It was forced to cut its dividend to a token penny a share in the second quarter, which is a sign of just how bad things are right now. Although it is likely to muddle through, improved energy prices would make mending its finances much, much easier.

Finally, energy services provider Patterson-UTI isn't directly impacted by oil and gas prices, but its customers are. When prices are strong exploration and production companies tend to drill more. When energy prices are weak, like they are today, drillers tend to pull back. For example, at the end of 2019 Patterson-UTI had a fleet of 216 drill rigs, but only 61 of those rigs were working in October. That's just 28% or so of its fleet, a number that has left the energy services company bleeding red ink. If higher oil prices result in increased drilling activity, then Patterson-UTI's future brightens materially.

Now what

As these four examples show, there's a lot under the surface of the energy sector. Yes, all of these names, and many more, rallied today. But the stories behind each company are different and can dramatically change the desirability of the stocks you are looking at. Not to mention that energy prices are notoriously volatile, so today's gains could just as easily turn to losses tomorrow if investors' moods shift. In this deeply out-of-favor sector, most investors would probably be better off sticking to the largest and strongest names, like Chevron, for now.

10 stocks we like better than Occidental Petroleum
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Occidental Petroleum wasn't one of them! That's right -- they think these 10 stocks are even better buys.

See the 10 stocks

*Stock Advisor returns as of November 20, 2020

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.