Should You Be Overweight or Underweight Energy Stocks?

For most investors, maintaining a diversified portfolio is a good way to help minimize risk and sleep better at night, while also making sure that they don't miss out on winning sectors.

Diversification can mean many things -- small versus large stocks, value versus growth stocks, and so on -- but most often, it's taken to mean spreading your bets among a variety of industries. Of course, just because you want to have some exposure to a variety of industries doesn't mean that you want to have the same amount of exposure to all industries.

So what of the energy sector? Should we be digging in or pulling back right now? Let's take a look.

Performance
Here's a look at how performance has broken down among the S&P 500 industries:

Sector

Month-to-Date Performance

Quarter-to-Date Performance

Year-to-Date Performance

Consumer Discretionary

(2.4%)

3.5%

13.9%

Industrials

(2.7%)

1.3%

13.9%

Financials

(1.4%)

(0.1%)

10.7%

Consumer Staples

(0.1%)

(1.6%)

3.3%

Energy

(3.1%)

1.2%

1.2%

Information Technology

(2.2%)

(0.5%)

1.2%

Health Care

0%

(3.9%)

(1.1%)

Materials

(4.4%)

(4.0%)

(1.6%)

Utilities

(1.3%)

1.2%

(3.5%)

Telecom Services

(0.7%)

(2.1%)

(7.6%)

S&P 500 Overall

(1.8%)

(0.3%)

4.6%

Source: Standard & Poor's as of May 5.

At the moment, the picture is fairly bleak for the energy industry. The disaster in the Gulf of Mexico has not only hit a number of major energy stocks, but also raised concerns that the spill will lead to tough new restrictions on offshore drilling around the U.S. Meanwhile, the crisis in Europe is putting major pressure on the euro and lending strength to the dollar, which has led to a quick drop in dollar-denominated oil prices.

There's no hiding out in other fuels, either. Since it peaked back in 2008, natural gas has headed straight downhill, and it just can't seem to pull itself back up.

Let's take a closer look
Here's a peek under the hood of some of the major U.S. energy stocks:

Company

Market Cap

Subsector

Trailing Return on Capital

Trailing Price-to-Earnings Multiple

ExxonMobil (NYSE: XOM  )

$311 billion

Integrated oil and gas

16.2%

15.1

Chevron (NYSE: CVX  )

$161 billion

Integrated oil and gas

11.4%

12.3

ConocoPhillips (NYSE: COP  )

$84 billion

Integrated oil and gas

7.2%

14.1

Schlumberger (NYSE: SLB  )

$80 billion

Oil and gas equipment and services

10%

28.9

Occidental Petroleum (NYSE: OXY  )

Integrated oil and gas

Integrated oil and gas

9.8%

24.1

Source: Capital IQ, a Standard & Poor's company.

As far as market cap is concerned, the industry is dominated by major integrated oil and gas players such as Exxon, Chevron, Conoco, and Occidental. These companies obviously aren't all the same. Exxon, for instance, has big eyes for the natural gas market, as evidenced by its proposed deal to acquire XTO Energy. Chevron, meanwhile, has de-emphasized its downstream business; it now has noticeably less exposure to refining than many other oil majors.

But because we're talking about a commodity product, these businesses are very similar at the basic level. For the most part, they all seek to keep up production, cost-effectively find new resources to replace what's they've sold, efficiently run downstream assets, and hope that growing global demand for oil and gas keeps prices at highly profitable levels.

And for the oil majors in the chart above, the results generally speak for themselves. Even though Occidental's operating income fell 60% in 2009 on lower oil prices, that $4.85 billion figure was still nearly 375% above what it reported a decade earlier. A similarly successful ConocoPhillips has maintained an average 13.3% return on capital over the past 10 years.

The big oil companies aren't the only businesses getting rich in the energy industry. Independent energy companies Apache (NYSE: APA  ) and Anadarko Petroleum, for instance, focus primarily on finding and producing oil and gas, and Apache has turned that activity into earnings of nearly $2.2 billion in the past 12 months. Schlumberger gets contracted to help with everything from seismic mapping and well testing to high-tech consulting services. And we can't forget Transocean (NYSE: RIG  ) -- the drilling company involved in the Gulf disaster -- and other drillers, as well as pipeline companies like Enterprise Products Partners and independent refiners like Valero.

Moreover, although coal often stands in the shadow of oil and gas, we can't say we've covered the whole energy space if we forget coal producers like Consol Energy and Alpha Natural Resources.

Putting it all together
To match the S&P 500's weighting in the energy sector, you'd have to have between 10% and 11% of your portfolio in energy stocks. I think that there's good reason to stock up on even more of this sector.

There simply seem to be too many factors tipping in favor of energy -- and particularly oil -- not to be at least a bit overweight. For one, global demand is growing, while good, cheap supply isn't quite as easy to come by. That didn't hold up as justification for 2008's crazy prices, but I see the supply-demand relationship contributing to a longer-term rise in prices. And though the dollar has had a euro-flop tailwind lately, the massive deficits the U.S. is racking up suggest a weaker future for the greenback, which can further support the price of oil.

Meanwhile, many stocks in the sector are trading at very reasonable multiples and, better still, you'll find quite a few with superb long-term track records for paying growing streams of dividends.

But what do you think? Are you bullish or bearish on the energy sector? Scroll down to the comments section and share your thoughts.

You don't need technical analysis to figure out the energy sector. Besides, technical analysis is stupid.

Enterprise Products Partners is a Motley Fool Income Investor pick. The Fool owns shares of XTO Energy. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his Motley Fool CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool’s disclosure policy assures you no Wookiees were harmed in the making of this article.


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