You can't look at the energy sector as one single entity, because the term "energy" covers a lot of ground, from oil drillers to electric utilities. But if you dig in and look at the component parts of the energy sector, you'll find there are investment opportunities for just about any kind of stock investor. Here's a primer so you can better understand what the energy sector is all about, including a short list of some energy sector stocks you might want to look at today.
The energy industry broken down
"Energy" is often used to refer to oil, which has long been one of the most important global energy resources. However, that's not the only energy source in the world and oil isn't the only energy investment you should be looking at. But let's start there and then move on to other ways to play the broad energy sector.
Oil and natural gas drilling (upstream)
Getting oil and natural gas generally requires drilling a hole and pumping the fuels out of the ground. The notable exception here is oil sands, like those found in Canada, which are mined and then processed to separate the oil out from the earth that's been dug up. Oil sands are referred to as upstream in the oil and gas industry.
Energy is a lot bigger than just oil. Image source: Getty Images.
There are many companies that focus just on finding oil and extracting it. And there's a great deal of variety within that space, too, as it includes very small companies willing to take on material risks (often called wildcatters) all the way up to large multinationals like ConocoPhillips that are more conservatively run.
Production, or how much oil and gas a company is pulling out of the ground, is one of the most important factors to examine. Steady or growing production should be the preference in most cases. Production has to be compared with reserves, or how much oil and gas is still in the ground to pull out. A company that doesn't find new oil and gas to replace what it is producing, via exploration and development spending, will be setting itself up for a dismal future.
Also important in all of this is the oil and natural gas price at which a driller can turn a profit. Oil and gas are commodities that go through often volatile ups and downs, causing spikes and dips in the top lines of oil and gas producers. Commodity prices are vital, even though there's little a company can do to control them. It is a problem if a company's production costs are higher than what it can get for the oil it's producing.
For example, when oil prices dipped below $50 a barrel following the oil bear market that started in mid-2014, a lot oil drillers were bleeding red ink. Sometimes called a break-even price, the key is that oil and gas commodity prices are high enough to cover both drilling costs and exploration costs. For companies that pay a dividend, distributions to shareholders should be covered as well.
Pipelines and processing (midstream)
Once oil and natural gas are pulled out of the ground, they have to be moved from the well to where they are used and processed from their raw state (crude oil, for example) into a usable one (gasoline and jet fuel). That is where the midstream sector comes in. This is the initial part of the downstream segment of the oil and gas industry. Companies in this sector are frequently structured as limited partnerships, with long-term, fee-based contracts for use of pipelines and processing facilities used to support distributions to unitholders. An example of a large midstream partnership is industry giant Enterprise Products Partners LP. However, there are plenty of regular corporations that operate in the midstream sector as well, including similarly large Kinder Morgan, Inc.
Some key factors to examine in the midstream sector are a company's size and reach (larger companies can have scale advantages), the percentage of its business that is fee-based (as opposed to revenue tied to volatile commodity prices), and, for those companies that pay dividends, distribution coverage. Since companies here generally grow by expanding their collection of assets, which can include ground-up construction and acquisitions, you'll also want to keep an eye on capital spending plans.
Leverage and share issuances are additional factors to watch, since many midstream companies pass on significant portions of their cash flow to shareholders via distributions and dividends. Unit sales can dilute current unitholders and, if the yield is material at the time of the sale, increase the cost of capital. Debt, meanwhile, can be a useful tool, but it can also increase risk if leverage gets excessive.
Chemicals and refining (downstream)
There's a bit of overlap at this point as we move further downstream. Many midstream companies own pipes and processing facilities, making money for moving oil and natural gas and turning these products into more usable commodities. However, there are some companies, like HollyFrontier Corporation (NYSE: HFC), that focus mainly on the processing side in the downstream space. Key factors to watch here are throughput, or how much oil and gas is being processed, and margins.
Unlike midstream companies that usually charge fees for the use of their assets, often including processing facilities, refiners generally make money on the difference, or spread, between the cost of acquiring and processing oil and natural gas and the market prices of the products created. Specialty chemicals tend to have wider margins than commodity materials like gasoline. The breakdown of the products being made should be something you pay attention to as well, since many refiners produce both commodity and specialty products. That said, prices on both sides of the business can be volatile, leading to big swings in profitability.
In addition, refiners often have relationships with the locations where products are sold, most notably gas stations. These can consist of silent supply agreements, the use of a refiner's name on the gas station, or outright ownership of gas stations.
Integrated energy companies
So we've taken oil and natural gas out of the ground, moved it to processing sites, processed it, and sold it. There are companies focused on each step along the way, but there are also energy companies that do it all under one roof, like integrated energy giant ExxonMobil Corporation. The benefit of the integrated model is scale and diversification. For example, when oil prices are falling, the refining side of the industry will likely be benefiting from low input costs. That helps to even out performance at integrated energy companies.
All of the factors that impact drilling, pipeline, and processing/refining companies will be important to watch at integrated oil companies. That said, you'll want to keep an eye on the actual breakdown within each company here. Some have more exposure to upstream operations and some have more exposure to downstream operations. But make sure to monitor production, reserves, and capital spending plans. Break-even points are also important, though often these giant international companies have enough financial strength to use debt to help them through periods of low oil and natural gas prices.
Interestingly, it is the integrated energy companies where we are starting see to a convergence between the oil and natural gas side of the energy industry and the electric side, another important component of the big picture of energy. For example, France's Total SA recently agreed to buy an electric and natural gas utility as it executes on its goal of diversifying its business beyond oil.
Electricity and natural gas utilities
Oil and natural gas don't cover the full spectrum of energy we use and consume every day by a long shot. They're important, but waking up to hot water, a heated home, and lighting -- not to mention all of the fully powered electronic gadgets we use -- is tied to your local electric utility.
Usually these companies receive a monopoly to produce and deliver electricity in a specific region in exchange for having the rates customers pay approved by regulators. That said, there are also unregulated energy producers, sometimes called independent power producers, that sell electricity to utilities based on supply and demand or under long-term contracts. And there are companies that own only the transmission assets that are used to move electricity around the country (normally for a set fee), without any exposure to utility plants.
There are also utilities that are focused not on electricity, but on the delivery of natural gas. Natural gas utilities work under the same basic model as electric utilities, where a monopoly is granted in exchange for regulation. As with the integrated oil and natural gas companies, however, there are large, diversified utilities that do all of the above, such as Duke Energy, which owns electric utilities, natural gas utilities, and independent power assets (largely renewables).
One key factor to look at for electricity producers is their fuel source. Electricity has historically been generated by burning coal, natural gas, and even oil. These are carbon-based fuels that tend to be relatively dirty (gas is the cleanest of the group). However, electricity also gets generated via nuclear power plants, harnessing the sun's rays (solar), using the wind (wind turbines), and water flowing through rivers (hydroelectric). The last three are an increasingly important component of the power grid as the world seeks to focus on cleaner energy options. You'll want to pay attention to the mix here as production increasingly shifts toward cleaner options. Companies with significant exposure to legacy fuels could find themselves at a disadvantage in the stock market and, perhaps, with their regulators.
That said, regulated utilities have been transitioning to cleaner energy options for many years. The biggest shift lately has been from coal to natural gas, which many consider a transition fuel between today and a point in time when renewable power is a larger contributor to the power grid. This shift keys in on an important aspect of the regulated utility space: Rates generally get approved based on a utility's spending. So building new generating assets and power lines and upgrading existing assets all increase the odds of a utility getting rate hikes approved. In other words, you'll want to pay attention to capital spending plans here. Regulator relationships are also important, with regulator relationships in some regions more constructive than in others.
Execution on big projects is another area on which to focus, since building power plants can cost huge sums and take many years. Problems can be material. For example, SCANA Corporation was recently forced to stop construction on a nuclear power plant in the middle of the project when its contractor went bankrupt. The utility is facing notable regulator and customer backlash, as well as a material financial hit from this decision.
With unregulated power generators, meanwhile, you'll want to pay attention to the way in which they sell power. Long-term contracts will provide the most stability, but operating on the spot electricity market can lead to outsize profits during peak demand times. Unfortunately, electric prices on the spot market have been relatively low for many years, outside of brief peaks, making it harder for these companies to turn a profit. That said, there's a shift taking place here as well, with renewable generation displacing carbon options. Unregulated power generators with material carbon-based production could end up with assets that have little value as customers demand cleaner power options.
Although not necessarily a part of the energy industry, power is where energy increasingly touches mining. Coal and the uranium used in nuclear power plants are pulled from the ground. (Natural gas is, as noted above, drilled for and included in the energy space.) And some of the companies that mine for these materials have increasingly shifted their business models along with their utility customers. For example, the "old" CONSOL Energy started to divest itself of its coal assets (which was the core of the business for over 100 years) as it started to drill for natural gas. It eventually split itself up, with the coal business taking the CONSOL name and the gas business rebranding itself as CNX Resources Corporation (NYSE: CNX).
The point here is that just because a company isn't technically in the energy sector doesn't mean that the energy sector isn't an important area to monitor. As another example, a supply demand imbalance in the uranium market is wreaking havoc on Cameco Corp. (NYSE: CCJ) as low commodity prices make turning a profit increasingly difficult. This is partly being driven by overproduction on the mining side of the business, but also by the demand side from utility customers. Demand for nuclear power fell off after the Fukushima nuclear power plant disaster in Japan even though long-term construction trends in places like China and India suggest it will recover in the future.
If we shift back to oil and natural gas for second, you'll also want to monitor the impact that energy prices have in the drilling services space. Companies like Helmerich & Payne (NYSE: HP) build, lease, and operate drilling rigs. When oil prices fall, demand for this company's products and services tends to fall as well.
In the end, energy is an incredibly broad term for a sector that touches a huge portion of our everyday lives and broad swathes of the business world.
The big energy trends today
That said, you need to keep abreast of the energy industry as it changes over time. Although every industry shifts as time goes on, there is a great deal of change going on right now in the energy space. Here are some of the key issues to monitor.
Moving toward clean energy
At this point, you should be pretty clear on the biggest trend in the energy industry: a shift toward cleaner fuels. For companies engaged in the oil and natural gas sector, this is potentially a very big problem. What they sell is, effectively, being made obsolete. That's a bit of hyperbole, however, because the world is decades away from the day when it no longer needs oil and natural gas. Where the impact has been more meaningful has been in the coal mining industry, as coal-powered generating plants have lost material share of the U.S. power grid. It's likely that coal power will be relatively weak globally, as well, as countries around the world increasingly shift toward cleaner fuel sources.
That said, natural gas has actually seen a net benefit from the shift away from coal even though it is a carbon-based fuel. This is because natural gas burns more cleanly than coal and renewable power options aren't yet sizable enough to offset coal's decline. That has left natural gas to pick up much of coal's share of the power grid during the big-picture transition to renewable power sources. This helps explain why some of the largest integrated energy companies are increasingly focused on natural gas and, specifically, liquefied natural gas (LNG) -- the only way to transport the fuel across oceans or to places that pipelines don't reach.
Electric power generation
The longer-term issue in all of this is the swift growth of renewable power. It's starting from an incredibly small base, so growth won't always be as robust as it is today. But these are still early days in the transition, allowing companies that get in early a huge growth runway. You can invest in this space in a number of different ways, from diversified utilities like NextEra Energy, which gets nearly half of its revenue from renewable power, or with companies like Brookfield Renewable Partners LP (NYSE: BEP) , which is strictly focused on renewable power. Note that Brookfield's core business is well-established hydroelectric power plants, but the partnership's expansion is likely to increasingly be in the solar and wind space.
Conservation and storage
The shift toward renewables is deeper than just a shift away from carbon fuels -- it also touches the consumption side of the equation. For example, the move toward electric automobiles and trucks being pushed by companies like Tesla (NASDAQ: TSLA). Efficiency improvements are also a notable aspect of the change, as evidenced by incandescent light bulbs giving way to more efficient fluorescent bulbs giving way to even more efficient LED bulbs. In fact, one of industrial giant Eaton Corp.'s (NYSE: ETN) primary goals is to help customers make better use of power. And while it doesn't make light bulbs, it now makes heavy use of LED bulbs in its large-scale lighting projects (think lighting sports stadiums), and it recently created a division to serve electric-auto makers.
So as you think about the energy industry, you should be thinking about what happens after the energy is generated. That means consumption, as noted above, but also the fact that oil, natural gas, and gasoline are easy to store. It is much harder to store electricity. Historically this might have been done by pumping water uphill so that gravity could be used to turn an electric turbine at a later time. But today companies like Tesla and global utility AES Corporation (NYSE: AES) are looking to create batteries capable of storing energy at the household and utility levels, respectively.
Rooftop solar power
Another key issue to monitor is the increasingly obvious trend of people producing their own power. That largely means putting solar panels on top of homes. Solar panel manufacturers would seem like a huge beneficiary here, but that hasn't happened. The cost of solar panels has been falling while their efficiency has been increasing amid intense competition and rapid technological advances. This has made it hard for panel makers to achieve lasting profitability.
Solar panel installers have been able to capitalize on these trends, however, since the cost to put solar panels on a roof is declining along with solar panel prices. Every new solar panel installation, meanwhile, potentially means less demand for the local utility. To make matters worse, in some cases, utilities are forced to buy extra power from customers at rates higher than the utility's cost of generation. This is known as distributed generation. Although a relatively small issue on a global scale today, it's something that investors will want to keep an eye on over the long term.
Top energy stocks to consider
Is it worth investing in the energy space? The answer is yes, but you need to carefully consider which stocks are the best fit for your portfolio. The energy industry encompasses a huge collection of companies and just about any investor should be able to find something to their liking in the space.
Some Energy Stocks Worth Researching Today
NextEra Energy (NYSE: NEE)
Utility, renewable power
Duke Energy (NYSE: DUK)
SCANA (NYSE: SCG)
ConocoPhillips (NYSE: COP)
Oil and gas drilling
ExxonMobil (NYSE: XOM)
Integrated oil and gas
Total SA (NYSE: TOT)
Pioneer Natural Resources (NYSE: PXD)
Oil and gas drilling
Enterprise Products Partners (NYSE: EPD)
Kinder Morgan (NYSE: KMI)
Calumet Specialty Products Partners (NASDAQ: CLMT)
Data source: Yahoo Finance. Data as of 8/20/18.
Utilities: For example, NextEra Energy's mix of renewable power and regulated utility operations is expected to support earnings growth of 6% to 8% and dividend growth of 10% or more through 2020. Those returns will be driven by capital spending of as much as $44 billion between 2017 and 2020, a relatively low payout ratio, and modest leverage. With a yield of 2.8%, this is really more of a dividend growth stock than your typical utility.
Giant diversified utility Duke, which is projecting dividend and earnings growth in the mid-single digits, is more of the slow-and-steady income play you'd expect from an established utility. Duke's current yield is a robust 4.8% and it plans to spend around $37 billion on its business between 2018 and 2022 to support its earnings and dividend growth. It's a good fit for more conservative investors.
SCANA, meanwhile, is a special situation stock as it attempts to deal with the fallout from its nuclear power plant decision. In fact, it is a potential acquisition target, adding even more drama to the story. Only aggressive investors should be looking at the stock today.
Oil and gas: The same diversity of investment option lives in the upstream oil and natural gas drilling space. For example, ConocoPhillips has a broad reach, with operations in 17 countries around the world. After splitting off its refining assets (its downstream operations), it's a pure-play driller. Moreover, it has an average cost of supply of less than $35 a barrel. Although the plan right now is for disciplined spending and debt reduction, rising oil prices will likely lead to a rising share price for this driller. Investors will also benefit from the company's goal of returning 30% to 40% of cash flow from operations to shareholders via dividends (the yield is a modest 1.6%) and stock buybacks. If you think oil and natural gas are heading higher, this is a good option to consider.
At the other end of the spectrum would be a company like Exxon. The yield is currently around 4%, with a 30-year-plus history of annual dividend increases behind it. The integrated oil giant has among the least leveraged balance sheets of its peers and a long history of cautious management. Higher oil prices haven't helped the company as much as peers, however, as it has lagged behind in production growth and its returns on capital employed have fallen from industry-leading levels to simply middle of the pack. It's working to address these issues, but in its typically slow and deliberate way. While management works to turn the ship, conservative investors can get a decent yield from a company that errs on the side of safety every chance it gets.
Total, meanwhile, is beginning to push into new spaces as it tries to shift away from its oil and gas history. The recently announced plan to acquire European utility Direct Energie for $1.6 billion materially increases the pace of the transition. Although Total is a big and diversified company taking a largely measured approach in the utility space, that doesn't mean its spending will pan out as expected. I'd rather own a company that's sticking to its core business, like Exxon. But investors with an eye to the future might want to take a look at what it's doing.
And then there's an aggressive driller like Pioneer Natural Resources, which continues to blow past analyst expectations with strong production growth. That said, if oil prices should materially decline, robust production growth won't save the company or its investors from commodity-induced pain. This is an even more aggressive play on oil and gas prices than ConocoPhillips, which would be my preference between the two if I had to pick (but I tend to be pretty conservative).
Midstream/Pipeline: In the midstream and downstream spaces, conservative investors would probably like what they find at Enterprise Products Partners. It is one of the largest and most diversified owners of pipelines and processing facilities in the United States. It has maintained robust distribution coverage of more than 1.2 times for many years, including through the oil downturn. It also has a relatively modest amount of leverage. And while near-term distribution growth is set to slow as it shifts to a self-funding model, that's simply going to make an already conservative partnership even more conservative. Once the transition to self-funding is complete, however, distribution growth at this 5.8% yielding partnership is likely to pick up again.
More aggressive types, meanwhile, might be attracted to Kinder Morgan. It, too, is large and diversified, but it has long taken a more bold approach to growth. For example, its debt-to-EBITDA ratio is roughly 50% higher than Enterprise's. That said, it is projecting robust dividend growth over the next couple of years. This one wouldn't be on my buy list because its aggressive approach led to a dividend cut a few years back, but for risk takers it might be worth a deep dive.
As for special situations, the opportunities are huge in the downstream space. For example, refiner Calumet Specialty Products Partners is working its way back from a dividend suspension as it looks to reduce debt and shift more toward high-margin specialty chemicals. It's still a work in progress, as leverage remains elevated and there's no indication that the partnership will resume distributions in the near term. Essentially, it's a turnaround play -- not my preference, but it may be yours.
So no matter what you're looking for (income, value, growth, or special situations), you can find something that will fit the bill in the energy stock space. Of course, you need to take the big picture of the energy landscape into consideration, but there's something for everyone in this broadly defined industry.
Exchange-traded fund options
Not everyone, however, wants to be a stock picker. That's understandable, and there are options for index-focused investors as well. For example, if you're fond of midstream stocks (perhaps for their relatively high yields), you should look at the Alerian MLP ETF (NYSEMKT: AMLP). This exchange-traded fund (ETF) tracks a large basket of midstream partnerships and offers an impressive 8% yield. If you are looking for safe midstream investments, you'd be better off with Enterprise Products Partners. (I prefer to own individual stocks, myself, so ETFs in general aren't a good fit for me.) But if you want to own a collection of midstream stocks without having to do much work, Alerian MLP ETF is a solid option.
On the upstream side, you could buy SPDR Oil & Gas Exploration & Production ETF (NYSEMKT: XOP). This exchange-traded fund is heavily focused on smaller exploration and production companies, but also includes some integrated giants and some refiners. If oil prices are heading higher, it should benefit. But for more conservative types looking to focus on integrated energy companies like Exxon, iShares Global Energy ETF (NYSEMKT: IXC) would be a better fit. Roughly 50% of its assets are in larger global oil and natural gas stocks.
On the utility side, Vanguard Utilities ETF (NYSEMKT: VPU) provides broad exposure to this piece of the energy sector. With 74 holdings, you will definitely get diversification, but don't expect much excitement. That said, the current yield is around 3%, which is modestly enticing if you are an income investor. Even in the exchange-traded fund space there are a lot of energy sector options to consider.
Time for some deep dives in the energy sector
Energy is both a diverse and changing industry. There's too much going on to say that just one company is the right way to play the space. In fact, there's likely to be something for just about every type of investor if you take the time to dig a little deeper. That said, keep the energy industry's changing dynamics in mind as you do your research. Some companies will be better-positioned over the long term than others.
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