One of the most lucrative areas of the stock market is energy, and the energy sector is primed to power your portfolio in the new year. Oil continues to dominate the energy sector as demand for oil in its crude form keeps rising, topping 100 million barrels per day this year. The commodity remains a crucial fuel for transportation and serves as an important building block for petrochemicals. 

Any investor looking to harness the growth of this sector in their portfolio would do well to learn the ins and outs of the oil market and take a look at some of the most promising oil stocks for 2019, with a focus on those in the U.S., which is now the world's leading oil producer. We'll define how crude oil is produced, sold, and ends up at gas stations around the world, with a price per barrel that always fluctuates. We'll give you the tools to understand what drives the ups and downs of oil prices and which public companies will benefit and suffer when prices at the pump change. Here's how to identify oil companies best positioned for the year ahead, as well as a look at five that stand out as top investments for 2019.

An oil pump with the sun setting in the background.

Image source: Getty Images.

What the oil market did in 2018

On the heels of several challenging years, the oil industry remained cautious as it entered 2018. That's why most oil producers in the U.S. based their budgets on the cash flows they could produce if oil prices were priced around $50 a barrel, which is what they averaged in 2017. That initially proved to be conservative as crude prices in the U.S. soared into the $70s by mid-year, fueled by concerns the Trump administration's decision to reimpose sanctions on Iran would significantly impact supplies.

However, the oil industry's euphoria dissipated toward the end of the year after the Trump administration granted waivers to most of Iran's key buyers, which pushed crude oil below $50 a barrel. This big drop could have a significant impact on financially weaker oil companies in 2019, which is why investors should focus their attention on those that can prosper at lower oil prices. 

What is an oil stock?

Before we drill down into those top stocks for 2019, it's important for investors to understand key aspects of the oil industry. First, an "oil stock" is any publicly traded company that touches a barrel of oil in some form, as well as natural gas, a byproduct of oil production known as associated natural gas. Publicly traded refers to companies that trade on open markets where stocks are bought and sold like the New York Stock Exchange and the Nasdaq. One share, or stock, gives its owner a percentage ownership in the company, which then uses the capital invested to grow its business. 

An oil stock can include the following types of publicly traded companies:

  • Exploration and production companies, which are entities that explore for, drill, and then produce oil and gas. An example of an E&P company is ConocoPhillips, which is the world's largest, based on production. 
  • Oil-field service, equipment, or supply companies provide E&P companies with everything they need to get oil out of the ground. Schlumberger is the world's largest provider of products and services in the industry.
  • Midstream companies that transport, store, and process oil and gas. Enbridge is the largest midstream company in North America, and currently transports 28% of the crude oil consumed in North America each year. 
  • Oil refiners and petrochemical companies that process oil into higher-value products like gasoline and plastics. Phillips 66 is one of the largest independent refining companies in the U.S. as well as a major petrochemical manufacturer. 
  • Integrated oil companies are entities that operate large E&P business and own midstream assets and refineries. ExxonMobil is the largest publicly traded integrated oil companies in the world. 

It's also important to note what's not an oil stock. While many investors use the term oil and energy interchangeably, not all energy stocks are oil stocks. Most public utilities, for example, don't handle any oil or gas. Gas stations, for example, might sell oil-related products, but most would consider them in the retail sector. Finally, some of the biggest oil producers in the world -- such as Saudi Aramco, the national oil company of Saudi Arabia -- aren't publicly traded and therefore don't qualify. 

Investors need to know what role a company plays in the oil industry because that can have a significant impact on its profitability. An oil producer, for example, makes money selling oil. Therefore, it can generate a gusher of profits when the price of a barrel of crude oil, which the industry defines as 55 gallons of unrefined oil, is well above the average cost of production. That cost differs by region as Saudi Arabia currently has the lowest at less than $10 a barrel while in the U.S. it's above $25 a barrel.     

An oil refiner, on the other hand, typically buys oil either from a producer or on the open market, which means it has the potential to make more money when prices fall. That's because they can buy the oil at a cheaper price, which widens their profit margin, or the amount of money they make between the price they buy oil and sell the refined product. Finally, midstream companies tend to generate steady free cash flow -- which is the excess profit after making investments to maintain their assets -- in good times and bad since they often collect predictable fees as oil flows through their pipelines.

One of the draws for oil stocks is that they tend to pay attractive dividends, which are payments, often quarterly, of a portion of a company's profits. Oil stocks tend to offer above-average dividend yields -- which is the percentage of a stock's price a company pays out in dividends -- because oil companies generate lots of cash. Investors can use those lucrative cash payments to supplement their income or reinvest them into the same or other stocks to grow their wealth even more. 

Oil market 2019 outlook

With crude prices quickly coming back down to less than $50 a barrel toward the end of 2018, it muddied the outlook for the year ahead. One of the reasons for the recent collapse in oil was the slowing of demand growth.

The International Energy Agency initially anticipated that oil demand would rise by more than 1.5 million barrels per day (BPD) in 2019. However, it lowered that estimate by 110,000 BPD toward the end of 2018 due to a weakening global economy, dragged down by higher prices earlier in the year and a growing trade war between the U.S. and China after each country imposed tariffs (or fees) on imported goods to protect domestic industries and jobs.

But as growth in the demand for oil cooled down, supplies of oil surged, driven in large part by the U.S., which set an oil production record in 2018 (output averaged roughly 11 million BPD). Production is expected to average 12.1 million BPD by 2019, according to the U.S. Energy Information Agency.

How OPEC impacts oil prices

With oil consumption under pressure due to the trade war and U.S. oil production at record levels, oil supplies could outpace demand in 2019 unless OPEC steps in to support the oil market. OPEC, which stands for Organization of Petroleum Exporting Countries, consists of 14 major oil-producing nations, namely Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, Angola, Equatorial Guinea, and Congo. This group works together as well with some nonmembers to coordinate their policies to try to stabilize the oil market. They typically meet twice a year to set official policy decisions, but will hold emergency meetings if necessary when oil prices fluctuate significantly. If prices are uncomfortably high -- say, trending toward $100 a barrel -- OPEC will agree on a coordinated output increase to ensure that the oil market has enough supply. Conversely, it will reduce production when the price slumps, with its recent actions coming as crude approaches $50 a barrel.  

That decline toward $50 happened in late 2018, which led OPEC and several allies to agree on a coordinated supply reduction in December 2018 of 1.2 million barrels per day starting in January 2019 in an effort to stabilize oil prices.

However, despite that production reduction agreement, oil prices could remain under pressure in 2019 and continue declining because it still might not be enough to get supply and demand back into balance. That's why investors should prepare themselves to hold on to their oil stocks during what's shaking out to be a challenging year ahead. One way to feel good about being patient when the waves hit and you're tempted to sell your oil holdings is by investing in companies that can thrive in a market environment where the price of oil could make wild swings.

A reflection of a row of oil pumps on the water.

Image source: Getty Images.

How to find the best oil stocks 

Not all oil companies have what it takes to prosper in a tough market. Many are still trying to shake off the lingering effects of the deep market downturn that started in late 2014.   

There are particular oil companies that were successful in rebuilding their businesses to be immune to lower oil prices. We want to identify those companies that have shored up their balance sheets for financial flexibility that will allow them to weather the stormy market.

Investors must carefully measure the strength of a company's balance sheet to see whether it's on solid financial footing. The criteria all oil investors must weigh before building a new position in an oil company are as follows:

  • Does it have an investment-grade credit rating? This score gauges whether a company has the money to meet its financial obligations, in case market conditions deteriorate and all its debt came due. 
  • Check its leverage ratio, which is the amount of debt it has compared to its assets or earnings. Key metrics for oil investors are its debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio and net debt-to-capital ratio. If a company has exposure to oil prices -- i.e., it either produces or consumes crude oil -- it should have a debt-to-EBITDA ratio below 2.0 times and a net debt-to-capital ratio of less than 30% if it has exposure to commodity prices. In the meantime, if a company generates more predictable fee-based cash flow -- i.e., most midstream companies -- those metrics can be as high as five times and 50%, respectively. Many oil companies will publish their current leverage metrics in an investor presentation on their website. 
  • Finally, investors should look at liquidity, which is money that a company can quickly access to meet its financial needs such as cash on its balance sheet. Ideally, an oil producer should have enough cash on its balance sheet to fund its capital plans for several months. Investors can figure this out by dividing a company's announced capital budget by its cash on hand. 

An oil stock that is sufficiently insulated against a big drop in oil prices boasts a strong credit rating, low leverage ratio, and lots of liquidity. These kinds of companies will be good investments, even when oil prices are scraping the bottom of the barrel. 

Oil companies have also bolstered their ability to profit, despite a challenging oil price environment, by enhancing their sustainability in operations.

For an oil producer, sustainability improvements mean a reduced cost structure that allows it to operate on the cash flows produced at lower oil prices. A good target for oil producers is if they can finance their dividend (if they pay one) and the investments needed to drill enough wells to maintain their current production level on the cash flows they can produce if oil is around $40 a barrel, which is the low oil price target level of most of the world's largest oil companies. An oil company that can finance its dividend and capital expense budget on the cash flows produced at $40 oil have what's known as a low breakeven level since it balances cash inflows with outflows at a low oil price.  

Investors should be able to easily spot companies with low breakeven levels since they tend to highlight this fact in their latest investor presentation, which is available on the investor relations section of their website.

Sustainability for midstream companies means they can fund their dividend (almost all midstream companies pay one) and at least half of their planned capital expenses with internally generated cash flow.

Finally, investors should also look for oil stocks that can grow even if market conditions deteriorate, like oil producers that can expand production at a meaningful rate when oil is priced at $50. Worth considering are midstream companies that have several expansion projects underway.

The top oil stocks to buy for 2019

Using those factors as a guide, five oil stocks stand out as those that could outperform their peers in the next year, especially if market conditions remain challenging.

Oil Stock Dividend Yield Type of Oil Stock

Anadarko Petroleum (NYSE:APC)

2.4%

Oil producer

Enbridge (NYSE:ENB)

6.1%

Oil pipeline company

Occidental Petroleum (NYSE:OXY)

4.3%

Oil producer

Phillips 66 (NYSE:PSX)

3.4%

Oil refiner and pipeline company

Plains All American Pipeline (NYSE:PAA)

5.5%

Oil pipeline company

Data source: Google Finance. Dividend yield as of Nov. 22, 2018.

Here's a closer look at why each of these companies looks like a top oil stock to buy in 2019. 

Anadarko Petroleum: Thriving at $50

Anadarko Petroleum unveiled its 2019 strategy at the end of the year, which revealed plans to invest $4.3 billion to $4.7 billion on capital projects in the coming year, slightly below the $4.5 billion to $4.8 billion spent the previous year. The company will be able to finance this investment with the cash flows produced from $50 oil. The company also anticipates that this spending range will enable it to grow its U.S. oil production by about 10% compared to 2018's level, meaningful growth for a company with a more than $20 billion market cap. In other words, it checks the box for thriving at $50 oil.

Also, Anadarko fulfills the necessary balance sheet criteria. It has a strong, investment grade-rated balance sheet and improved its financial profile by paying off $1.5 billion in debt over the past year. It expects to repay another $500 million in debt in 2019 as well, funded with cash on its balance sheet, which tallied nearly $4 billion after selling its midstream business to Western Gas Partners.

In addition to shoring up its balance sheet, Anadarko Petroleum expects to return more cash to shareholders in 2019 in the form of dividends. The company boosted its dividend by another 20% toward the end of 2018, which brought its year-to-date increase up to a jaw-dropping 500%. The company then added another $1 billion to its share repurchase authorization, giving it $1.5 billion remaining on its $5 billion program that had seen the oil giant retire 10% of its outstanding shares over the past year. Share repurchases are another way oil companies can return cash to shareholders outside of their dividend. They help reduce the number of shares outstanding, which makes the remaining ones more valuable since the company will divide its profits against fewer shares. 

With a business that can thrive on $50 oil and ample liquidity to further improve its balance sheet while also returning a healthy dose of cash to shareholders, Anadarko Petroleum stands out as a shining star in the sector. Its strategy has put it on track to expand production per debt-adjusted share by 15% in the coming year. That's a faster pace than the company expects to grow production overall because it takes into account the decline in outstanding shares and its debt level. That could potentially give it the fuel to deliver peer-leading total returns in 2019, making it an excellent oil stock for growth-focused investors. 

Enbridge: Ready to rise 

Canadian oil pipeline giant Enbridge spent much of 2018 repositioning its business for what lies ahead, selling off noncore assets to bolster its balance sheet. As a result, the company pushed its debt-to-EBITDA ratio to 4.7 times toward the end of the year, which was below its target to get this ratio below 5.0 times. 

While the company was paring its portfolio, it was also investing heavily in other areas. Overall, the company expected to complete construction on 7 billion Canadian dollars ($5.3 billion) in new assets during 2018. Those expansions put the company on track to deliver a bigger-than-expected increase in cash flow during 2018 and set it up for continued growth in 2019.

With several more expansion projects in the pipeline, and the funding secured to build those assets, Enbridge expects to grow its cash flow per share by at least a 10% annual rate through 2020. That positions the company to also increase its dividend at a similar double-digit pace over that time frame, meaning investors can expect healthy annual dividend increases. 

By agreeing to acquire all of its publicly traded affiliates, Enbridge also simplified its corporate structure during 2018. It used those entities in the past as vehicles to raise money from investors. However, it needed to change course to sidestep a regulatory issue that impacted the cash flows of some of those affiliates as well as to retain more cash flow from operations going forward to help finance expansion projects.

Enbridge's 2018 efforts positioned it for exceptional returns in 2019. The company has simplified its business model, reduced debt, and expanded its asset base. Its cash flow and dividend should grow quickly in the coming year. Those factors not only make it an ideal stock for income seekers, who would be happy with its healthy dividend, but also for value investors who are looking for a good business in the long run, as shares are dirt cheap after a 2018 retreat in stock price.

Occidental Petroleum: Reset to run as low as $40

Houston-based Occidental Petroleum completed a multiyear transformation in 2018 by finishing its low oil price breakeven plan during the second quarter. As a result, the company can produce enough cash flow at $40 oil to pay its lucrative dividend while fully funding the new wells required to maintain current production. Meanwhile, it can generate enough money at $50 a barrel to grow its production by 5% to 8% per year, so Occidental is well prepared for whatever happens to oil prices in the next year.

Occidental Petroleum has been led by Vicki Hollub, the first woman CEO of a major American oil company, since 2016 and has a strong, cash-rich balance sheet. Thanks to higher oil prices and the $2.6 billion sale of its midstream assets in the Permian Basin, an oil-rich and fast-growing region in Western Texas.

Occidental Petroleum hauled in $5 billion in cash above its 2018 plan. The company plowed $1.1 billion of that money back into drilling more wells, which will provide a production boost in 2019. Meanwhile, it allocated $2 billion to repurchase stock by the end of 2019. Finally, it will use the rest of that money to enhance its financial flexibility, with the company reporting $3 billion in cash on its balance sheet at the end of 2018's third quarter. That money not only provides it with a cushion to weather oil price volatility but a war chest to go shopping if the right opportunity arises.

The moves Occidental made during 2018 set it up for success in the coming year. Through a combination of achieving its low oil price breakeven plan and pumping more cash into its drilling program, the company is on pace to grow its production by more than 10% over the next year. Occidental is on target to return more than $5 billion in cash to shareholders through its steadily increasing dividend and stock buyback program in 2019. That combination of growth and cash returns has the potential to generate solid gains for investors in the coming year if oil prices stagnate and outsized profit potential if crude rebounds, making it an excellent oil stock for both growth and income investors.

An oil rig in the middle of an ocean with the sun setting behind it.

Image source: Getty Images.

Phillips 66: Feeding on lower oil prices

Refining and logistics giant Phillips 66 directly benefits from lower oil prices since it consumes oil. That's why it has spent the past several years investing in projects at its refineries to process higher volumes of oil produced in North America because that oil sells for a much lower price than oil produced in other parts of the world.

In addition, the company and its master limited partnershipPhillips 66 Partners -- which is a separate company that operates many of Phillips 66's midstream assets -- have invested heavily in building new oil pipelines as well as other oil-related infrastructure over the past few years to improve the flow of oil to the company's refineries as well as to the Gulf Coast, where it can exit via export terminals to global markets. For example, Phillips 66 and some other partners built the Bakken pipeline system, which is moving crude oil from North Dakota to Phillips 66's refinery in Illinois as well as those along the Gulf Coast. Phillips 66 Partners is working with other midstream companies to build a much-needed oil pipeline from the Permian Basin to the Gulf Coast refining and export market. Finally, Phillips 66 and Phillips 66 Partners are working to develop and expand several other oil pipelines that will not only improve the flow of crude oil to its refineries but enable the company to cash in on moving more domestically produced crude.

With a refining business that thrives on lower oil prices and a fast-growing midstream business that generates stable cash flow in good times and bad, Phillips 66 can prosper if oil market conditions remain weak in 2019. The company has a strong investment-grade balance sheet backed by a debt-to-capital ratio of less than 25% and nearly $1 billion in cash, which further enhances its prospects. The refining and midstream giant should have no problem continuing to grow its dividend while also reducing its outstanding share count though additional stock repurchases in 2019, which would increase its earnings on a per-share basis, making the remaining ones more valuable. Phillips 66's dividend and ability to make money on lower oil prices make it an ideal oil stock to own during a turbulent market.

Plains All American Pipeline: Turning the corner

Plains All American Pipeline has spent recent years repositioning its business to better weather the challenges of the oil market. One way the company has done that is to shore up its balance sheet by reducing its dividend and selling noncore assets. These efforts have the pipeline company in the position to achieve its targeted balance sheet metrics -- including a debt-to-EBITDA ratio of less than 4.0 times -- in early 2019.

The Houston-based pipeline company has also been investing to expand in the Permian Basin. It finished one new long-haul oil pipeline expansion in the Permian toward the end of 2018 and expects to finish an even larger pipeline expansion in 2019. These projects and others position Plains to grow earnings by more than 10% in the coming year. The company expects to continue making progress with additional expansion projects in 2019, including an oil pipeline joint venture with ExxonMobil, which could enable Plains to maintain a strong growth rate in the coming years.

With Plains All American expecting to reach its balance sheet target in early 2019, the company will be in the position to start increasing its dividend distribution to investors once again, which it reduced in 2016 to retain more cash to finance expansion projects and improve its balance sheet. Given the growth coming down the pipeline, which the company can fund with excess cash flow and its stronger balance sheet, Plains could potentially expand its payout at a double-digit rate over the next several years, making it an excellent option for income investors.

Should you invest in an oil ETF?

While these five oil stocks look like ideal options for 2019, some investors might prefer to take a more broad-based approach to the sector. One way to do that is by investing in exchange-traded funds, which are publicly traded funds that own several stocks. Because ETFs own many stocks, it reduces an investor's risk of picking the wrong stock in a particular sector like oil. Investors who want less risk in their portfolio, especially those who are less than five years away from retirement, might want to opt for an ETF. Two options worth considering are the Vanguard Energy ETF and the Alerian Energy Infrastructure ETF

The Vanguard Energy ETF is a fund that held more than 140 energy stocks as of the end of 2018. Among its 10 largest holdings were integrated oil giant ExxonMobil, E&P behemoth ConocoPhillips, oil-field services kingpin Schlumberger, and refining and midstream company Phillips 66. It therefore offers investors broad exposure to the entire oil sector. 

The Alerian Energy Infrastructure ETF, on the other hand, focuses mainly on the lower-risk midstream segment. The fund held more than 40 companies, including Enbridge, Plains All American Pipeline, and Phillips 66 Partners. Because of its focus on high-yielding midstream companies, this ETF offers an attractive dividend that yielded more than 5.5% in late December. 

2019's top oil stocks share one thing in common

All five of these oil companies boast strengthening balance sheets, businesses able to thrive at lower oil prices, and visible growth prospects in 2019.

Each one can handle whatever happens in the oil market in the coming year. That puts them in the position to potentially outperform rivals if 2019 turns out to be a tough year, with ample upside if crude prices rebound. That ability to prosper no matter what happens in the oil market makes them the top oil stocks for the coming year.

Matthew DiLallo owns shares of ConocoPhillips, Enbridge, and Phillips 66. The Motley Fool recommends Enbridge. The Motley Fool has a disclosure policy.