As recent owners of oil stocks know, investing in the energy sector can be risky. Profitability is tied to the commodity price, and it takes a large amount of capital to continue to generate cash flow. If a company's debt level is too high when the commodity price drops, it can be in a precarious position, and the stock price will reflect that. 

An investor can hedge that risk by diversifying in the sector to include refiners, midstream companies, and renewable energy producers, among others.

Another way for an investor to gain the benefits of oil when it is thriving (while still limiting the risk) is to invest in steel stocks. The steel industry supplies the pipe that transports oil and natural gas, as well as material for other equipment needed to drill and pump wells. And if the price of oil plummets, steelmakers can pivot their mills to produce other products where demand is higher.

Like oil, though, the steel business is capital intensive and tied to commodity pricing, so investors should look to the most-efficient and best-run producers, like Nucor (NYSE:NUE) and Steel Dynamics (NASDAQ:STLD), to have the best chance of success. 

Nucor's Gallatin, KY mill from the outside with Nucor sign and American flag

Image source: Nucor.

Diversity of customers

Nucor is North America's largest steel company, with interests in the entire supply chain from raw materials used in steelmaking through downstream operations that supply steel building products. Steel Dynamics, which was started by former Nucor employees, also has operations throughout the supply chain. 

Nucor said that it supplied 11% of its steel and steel products directly to the energy sector in 2019, and another 11% went to machinery and industrial equipment that can also be used by oil companies. Steel Dynamics had slightly less exposure, with 7% going directly to energy companies. Both steel producers, however, have capacity to increase sales to the oil sector if it enters a boom cycle.

Growth plans

While oil companies of all sizes have announced they are cutting back on capital spending in the current volatile environment, Nucor has a history of investing through down cycles to emerge stronger when business peaks. Both Nucor and Steel Dynamics currently have major investment projects underway. 

Steel Dynamics shipped a record 10.8 million tons in 2019, and its new flat-rolled sheet mill under construction in Texas will increase its overall steelmaking capacity by 25%. The project is an investment of almost $2 billion and is expected to start production in mid-2021. Nucor also has several large investments at various stages of development. These combine for an estimated $3.5 billion investment, including almost half of that for a greenfield state-of-the-art plate mill in Kentucky.

Return of capital

In addition to investing for the future, these two U.S. steel leaders are cognizant of shareholder returns. In a cyclical industry, it's important for investors to know there will be consistent returns as the stock price ebbs and flows. Nucor has increased its base dividend for 47 straight years, and has stated it plans to continue that record with a goal of returning 40% of earnings to shareholders. 

Both pay a dividend without hurting the balance sheet. This contrasts with domestic competitor United States Steel (NYSE:X), which has cut its dividend to a penny, and is struggling to manage its debt during the current economic slowdown. 

NUE Dividend Chart

NUE Dividend data by YCharts.

So while investors may look at the recent volatility in oil stocks as an opportunity to buy, it may be worth thinking about investing that money in the steel sector for the cyclical portion of a portfolio. Quality steel companies like Nucor and Steel Dynamics continue to invest in their businesses, and would also benefit from a thriving oil sector. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.