How to Find the Best Energy Stocks

What are energy stocks?

"Energy stocks" is an umbrella term that covers numerous industries involved in the exploration, production, refining, transportation, storage, selling and more as it pertains to oil, natural gas, natural gas liquids, coal, gasoline and other energy commodities and products.

Here's a look at the most common types of businesses you'll find within the energy sector:

Exploration & Production (E&P): You'll often come across this term when dealing with energy stocks that are "streams" – upstream, midstream and downstream. We'll start with upstream, otherwise known as exploration and production. Companies involved with E&P are both exploring for areas where energy commodities (typically oil and natural gas) are found, as well as actually drilling or otherwise extracting those commodities. 

Midstream: "Midstream" is next and this business generally involves transportation and storage of oil, gas and other unfinished energy commodities. The most common industry in the midstream space is pipelines, though midstream covers other sorts of transportation (tank trucks, rail tank cars, tanker ships), as well as infrastructure such as terminals and storage facilities.

Refining: Refining is one of two primary businesses considered "downstream." Refiners take crude oil, natural gas and other energy commodities and make them into finished products — not just first-to-mind energy products like gasoline or heating oils, but even products such as plastics, fertilizers and preservatives.

Marketing/Selling: The other main "downstream" business is marketing and selling, which brings us right back to the pump — as well as other places where these energy products are sold to consumers.

Equipment & Services: Equipment and services companies aren't necessarily considered as part of any stream, but they most often participate in upstream processes. These businesses can do anything, including evaluate formations, test wells, provide drilling technology, consult for midstream businesses, produce and integrate chemical injection pumps, and more.

Integrated: You'll typically hear companies such as blue chip stocks Exxon Mobil (XOM) and Chevron (CVX) referred to as "integrated oil majors." That means they're involved in at least two, if not three, streams. Exxon Mobil, for instance, is involved heavily in exploration and production (upstream), as well as both refining and marketing/selling (downstream).

"Hey! What about green energy stocks?" you ask.

Interestingly, players in solar, wind and other green technologies are typically not categorized within the energy sector. Some firms like First Solar (FSLR) and Canadian Solar (CSIQ) are typically lumped into tech stocks, given that they make solar modules, wafers, cells and other technological products. Others, such as Clearway Energy (CWEN) and Ørsted (DNNGY), are energy generators in the utility sector.

How to find the best energy stocks

Given all of the different flavors you can find in the energy sector, there's no one singular metric that will tell you whether you're getting a great energy stock or not. But in addition to typical factors you look for in a portfolio holding — consistent profitability, a strong balance sheet, growth potential, and/or dividends — here are a few things to consider when exploring the sector: 

The underlying company's relation to commodity prices: As a general rule, energy stocks are similar to gold stocks in that they are extremely sensitive to movements in their underlying commodities. The success of pure-play E&P companies, which sell unrefined commodities, is inextricably tied to oil and gas prices. Same goes with equipment and services companies, especially those tied to E&P — if prices are so low that they make seeking out new sources or producing energy cost-prohibitive, these firms' services become a lot less popular. 

But there are exceptions. Oil refiners, for instance, make money from the spread between the cost of crude and the price that refined products fetch — higher oil prices don't necessarily benefit them and sometimes can even squeeze their profits. Midstream companies aren't as concerned about commodity prices, either — as long as commodities are flowing through their infrastructure, they can do just fine.

Commodity prices/expected price direction: In the event that a stock does have a strong tether to commodity prices, you'll want to keep a close eye on both current and expected prices for oil, gas, etc. Energy prices are impacted by all sorts of forces — economic strength, domestic supply, OPEC (the Organization of the Petroleum Exporting Countries) policy, geopolitics and more. "Oil goes up" is never as straightforward as it seems. 

Is it a master limited partnership? Several companies in the midstream space are structured as master limited partnerships (MLPs). You can learn more about MLPs here, but in short, these entities have a pass-through structure in which income isn't subject to corporate taxation. Instead, it's passed through to limited partners as (typically generous) distributions. For investors who hold MLPs, that means much different tax rules than what applies to their traditional stocks.

Individual stocks vs ETFs. It can be exceedingly difficult for those beginning their investing journeys to determine whether one energy stock is better than another – even some lousy companies can run hot if oil prices rise fast enough. So investors might instead consider owning numerous energy stocks via an exchange-traded fund (ETF). 

You typically have two options here: Broad-based energy ETFs like the Vanguard Energy ETF (VDE) that own energy stocks in numerous industries, or industry-specific energy ETFs like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), Alerian MLP ETF (AMLP) and VanEck Oil Services ETF (OIH).

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