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The Basics of the Energy Sector

Nicole Seghetti
September 20, 2012

Worldwide Invest Better Day 9/25/2012

This month at The Motley Fool we're committing ourselves to getting back to basics, culminating on September 25 with Worldwide Invest Better Day. With this in mind, my Foolish colleagues have armed you with information like our favorite investing books and the worst investment advice we've received. In a previous article, we reviewed stock diversification, a key fundamental of investing. We're looking at stock sectors one by one, focusing today on energy.

Energy sector 101
The sector includes companies that explore, transport, refine, and market oil and gas. With the rise in global geopolitical tensions comes the risk of crude oil supply disruptions. Natural disasters and industry regulations also continually challenge the global supply of, and demand for, crude oil. Consequently, compelling dynamics are under way in the energy sector. Later in this article we'll take a look at some trends that have the potential to notably alter the energy landscape and provide attractive opportunities for investors.

How the sector performs
Energy is considered a cyclical sector, meaning it typically outperforms the market during periods of economic expansion. However, this isn't always the case. During the most recent stock market run-up, from March 2009 to the present, the energy sector returned 106% versus 131% for the S&P 500. In the market decline from October 2007 to March 2009, the sector lost 48%, a time when the S&P 500 lost roughly 55%. However, over long spans of time, energy stocks generally outperform the market. In the past decade, the sector returned nearly 316% versus 110% for the S&P 500.

Energy sector dynamics
Energy companies that explore, transport, and refine oil and natural gas are commonly referred to as upstream, midstream, or downstream depending on where they operate in the process. Huge, integrated oil and gas companies like BP and Chesapeake Energy (NYSE: CHK  ) operate at every stage in the process. Being big has its disadvantages; both companies have seen their share of scrutiny -- BP for its 2010 Gulf oil spill disaster and, more recently, Chesapeake management's questionable leadership.

Exploration or upstream companies include Transocean (NYSE: RIG  ) , which primarily operates offshore drilling services for oil and gas wells across the globe. Along with other companies that operate upstream, this Swiss company is choosing to shed shallow water drilling rigs and make big bets on ultra-deepwater drilling. The most sizable profits -- and biggest potential losses -- occur upstream, so making the right bet can really pay off.

The back end of the process includes downstream companies that specialize in refining, like Valero Energy (NYSE: VLO  ) . Valero avoids the costly and risky exploration piece of the process. By doing so, it reduces its potential for big returns on its investment, but also reduces its risk profile. Valero's current net profit margin is roughly 1%; however, its stock price is up nearly 54% year-to-date.

Advances in drilling techniques like hydraulic fracturing, or "fracking," has led to an increase in supply and lower prices for natural gas. It's also led to an increased need to transport natural gas. Midstream companies that transport oil and natural gas effectively collect a toll on whatever passes through their pipelines. Many midstream companies like Atlas Pipeline Partners (NYSE: APL  ) , with its 9,000 miles of pipeline, are structured as master limited partnerships, or MLPs. MLPs offe