After a 25% surge in just three days, it would be easy to believe oil prices are on their way to a sustainable recovery. After all, we know $40 a barrel isn’t workable over the medium term. And with U.S. output finally starting to roll over, last week’s reported drop in commercial stockpiles will surely be followed by others.


This is especially seductive reasoning for oil company investors who’ve suffered through a long and costly wait for some good news. On Tuesday, the Energy Select Sector SPDR ETF (NYSE: XLE) closed at its lowest point in nearly four years before rallying 11% over the next three days. That gave it its second winning week in the last 17, a stretch over which the XLE has dropped 21%.

Meanwhile, the SPDR S&P Oil and Gas Exploration and Production ETF (NYSE: XOP), which leans much more on the smaller-cap drillers, is down 33% since April 30 despite its own overdue 13% bounce between Tuesday and Friday.

This is not a signal that the coast is clear but rather a reminder of the big near-term risks that remain for oil and for related equities.

Crude enters the annual autumn demand lull with global inventories still near record highs and with a higher-than-normal proportion of U.S. refining capacity set to be idled for maintenance over the next two months.

As for producers, they will soon face tough decisions on how much to hedge, if at all, as the puts and collars bought in better times roll off, leaving them more exposed to the current low prices.

An intensifying cash crunch could in turn force drillers to tap a backlog of fracked but not completed wells that, in their thousands, currently add up to millions of barrels of readily available supply on top of all the surplus crude in storage.

OPEC members will have similar short-term incentives to increase output at almost any cost to contain deficit spending and reduce the per-barrel cost of overheads like security and social programs.

In an industry temporarily unmoored from long-term fundamentals, the fact that the price of a security has already dropped a lot provides no protection from further losses.

We certainly overstayed our welcome in Hi Crush Partners (NYSE: HCLP), Jones Energy (NYSE: JONE) and Bonanza Creek Energy (NYSE: BCEI) before jettisoning these oil plays on July 8. Yet in less than two months since those names are down 33%, 31% and 54%, respectively. (A fourth recommendation ditched at the same time, Clayton Williams Energy (NYSE: CWEI), has gained 6% since.)

Penn Virginia (NYSE: PVA) is down 80% from the appallingly low price at which we cut it loose on Jan. 31. (All of these numbers through Friday.)

There will unquestionably be excellent trading and investment opportunities out there once the current glut is gone and the narrative shifts yet again. But you won’t have the capital to deploy if you squander it attempting to catch bottoms in equity that could easily end up worthless.

Linn Energy’s (NASDAQ: LINE) bonds now trade at less than 50 cents on the dollar, offering effective yields to maturity above 30%. Which means they should be left to distressed debt specialists. As for the equity, the bond sharps think it’s toast. If you bet against them, you will likely lose.

There’s just no reason to risk capital on such long shots when there are solid, secure yields on offer from shippers of natural gas and refined fuels, and much more upside in the refining and tanker stocks that actually benefit from lower oil prices.

Oil will likely fetch considerably more than it does today in a couple of years. But the current short squeeze might not mark the bottom. Even if it did, the near-term upside for crude looks limited for a variety of fundamental reasons. And that means most producer stocks aren’t worth the risk.