How to Find the Best Energy Stocks

What are energy stocks?

"Energy stocks" is a broad term that includes multiple industries involved in the exploration, production, refining, transportation, storage, distribution and sale of crude oil, natural gas, natural gas liquids, coal, gasoline and other energy commodities and products.

Here are the most common types of businesses you'll find in the energy sector:

Exploration & Production. The energy sector is broadly defined in terms of a stream: You'll often come across terms such as "upstream," "midstream" and "downstream" when you research energy stocks.

Upstream – otherwise known as exploration and production (E&P)  –  is the logical place to begin our discussion.

Companies involved with E&P are both exploring areas where energy commodities might be found as well as actually drilling and extracting those resources once identified. 

Midstream. This business generally involves transportation and storage of crude oil, natural gas and other unfinished energy commodities. The most common industry in the midstream space is pipeline operation.

The midstream includes other transportation modes like tanker trucks, rail tank cars and 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 turn them into finished products.

Refiners make first-to-mind energy products like gasoline and heating oils as well as products such as plastics, fertilizers and preservatives.

Marketing & Selling. The other main "downstream" business is marketing and selling.

That 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 formally considered part of any "stream" but most often participate in E&P processes.

These businesses can do anything: 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 E&P (upstream) as well as both refining and marketing and selling (downstream).

"Hey! What about green energy stocks?" you ask. Well, operators in solar, wind and other green technologies are typically not categorized within the energy sector.

Firms like First Solar (FSLR) and Canadian Solar (CSIQ) are typically considered tech stocks because they make solar modules, wafers, cells and other technological products.

Others, such as Clearway Energy (CWEN) and Ørsted (DNNGY), are considered power generators in the utility sector.

How to find the best energy stocks

There are many types of operating businesses in the energy sector, so it follows that there is no single metric to tell you you're buying a great energy stock. 

Of course you'll want to consider factors you look for in a long-term portfolio holding: consistent profitability, a strong balance sheet, growth potential and shareholder-friendly features such as regular dividends and/or share buybacks.

In addition to these factors, here are a few things to consider when you look for the best energy stocks.

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.

The forecast direction of commodity prices. 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 crude oil and natural gas.

Energy prices are impacted by all sorts of forces, including but not limited to economic growth, domestic supply, policies and practices of the Organization of the Petroleum Exporting Countries (OPEC) and geopolitics.

"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).

Income generated by these pass-through entities is not subject to corporate taxation. Instead, it's passed through to limited partners as (typically generous) distributions.

If you hold MLPs, that means much different tax rules than what applies to your traditional stocks.

Individual stocks vs ETFs. It can be exceedingly difficult for to determine whether one energy stock is better than another. Even lousy companies can run hot if oil prices rise fast enough.

So you 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) hold energy stocks across multiple industries within the sector.

You can also choose industry-specific energy ETFs such as the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), the Alerian MLP ETF (AMLP) and the VanEck Oil Services ETF (OIH).

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