Investing in Energy Stocks

The energy sector produces and supplies fuels and electricity for the global economy. It includes companies involved in the following activities:

• The upstream exploration and production of oil, natural gas, and related liquids (such as natural gas liquids, or NGLs).
• The midstream transportation, processing, and storage of natural gas and liquids.
• The downstream refining, marketing, and distribution of petroleum products.
• The mining and processing of coal, uranium, and bitumen (oil sands) used to generate electricity or make liquid fuels.
• The generation of electricity (produced by fossil fuels and cleaner sources like renewable energy) and the distribution of power and natural gas by utilities.

This broad industry is crucial to providing the economy with the energy it needs. It's also an important one for investors to understand.

Energy sector stocks to buy

Hundreds of public companies focus on the production and distribution of energy. However, a few leaders stand out, not only for their size but also for the strength of their financial profiles. Here are three of the top ones to consider:

Source: Companies' websites

ConocoPhillips

ConocoPhillips (NYSE:COP) is a diversified oil and gas producer geographically (it has operations around the world) and by extraction method. The company operates deepwater wells, oil sands production complexes, liquified natural gas (LNG) production and export facilities, and conventional and unconventional (i.e., shale) oil and gas wells. The company also enjoys low-cost operations, with an average cost of supply of less than $30 a barrel following its acquisition of fellow oil and gas producer Concho Resources in 2020.

ConocoPhillips complements its low cost of supply with a strong balance sheet. It has an investment-grade bond rating backed by a low leverage ratio and lots of cash. That provides it with plenty of cushion to weather periods of low oil and gas prices, which there were plenty of in 2020. While COVID-19 forced ConocoPhillips to alter its game plan, the oil giant will survive this downturn and come out the other side even stronger thanks to its merger with Concho Resources.

NextEra Energy

NextEra Energy (NYSE:NEE) is one of the country's largest electric utility companies. It's also the global leader in producing power from the wind and sun through its energy resources segment, which sells clean energy to other utilities and end users around the country. Both businesses generate relatively stable cash flow backed by regulated rates and fixed-price contracts on the power NextEra produces and distributes to customers. This business model has proven its resiliency during the COVID-19 pandemic, as NextEra hasn’t suffered much thanks to steady electricity demand and rates.

The company also boasts one of the best balance sheets in the electric utility sector, including one of the highest credit ratings in its peer group. It also has a conservative dividend payout ratio for a utility, which adds to its strong financial profile.

TC Energy

One of the largest natural gas pipeline operators in North America, TC Energy (NYSE:TRP) has pipes in the U.S., Mexico, and its home country of Canada. The company also owns a premier liquids pipeline system, including its status as one of Canada's leading oil exporters and largest power producers.

Those energy infrastructure assets generate relatively stable cash flows, backed primarily by fee-based contracts and regulated rates. This low-risk business model has proven to be highly durable during COVID-19, as TC Energy continued to generate steady cash flows. Meanwhile, the company pays out a conservative amount of its annual earnings via its dividend and has one of the top credit ratings in the pipeline sector. Those factors provide it with the financial flexibility to continue expanding its pipeline network while also making TC Energy one of the lower-risk companies in the energy sector.

How to invest in the energy sector

The energy sector is a challenging one for investors, especially oil and gas companies. Energy prices can change in a heartbeat, which can have a massive impact on the sector as well as the global economy. That became abundantly clear at the start of the COVID-19 pandemic. The outbreak shut down large portions of the global economy, like air travel and commuting to work, which torpedoed oil demand and pricing. This downturn weighed heavily on oil company stock prices, with some ending up worthless; several companies filed for bankruptcy.

Because of the impact commodity price volatility can have on the energy sector, investors need to understand how to invest in energy stocks. That includes keeping downside risk in mind by not allocating too much of their portfolio to one energy stock or the industry as a whole. Further, they should focus on companies unlikely to go out of business if industry conditions deteriorate significantly.

Factors that increase an energy company's durability include:

• Low production costs, or stable revenue with minimal exposure to fluctuations in volumes or pricing (i.e., supported by regulated rates or long-term fixed-fee contracts).
• A strong balance sheet, including a high investment-grade credit rating, lots of liquidity (cash on hand and borrowing capacity), and minimal near-term debt maturities.
• A conservative dividend payout ratio compared to its sub-sector peers.
• Manageable capital spending programs financed primarily with post-dividend free cash flow and prudent use of debt.

Energy companies with these characteristics will be in a better position to withstand the inevitable downturns. That means not only that they'll still be around when conditions improve, but also that they have more flexibility than their weaker peers to capture opportunities that can create value for their investors.

Energy stocks are important but risky

The energy sector is vital to the global economy because it provides the fuel and power needed to drive trade and travel. However, when the economy slows, as it has during the COVID-19 pandemic, it can have a major impact on energy demand and prices, which weighs on stock prices. Conversely, when it hits the accelerator, which should happen in 2021 as vaccines roll out to stop the pandemic, demand soars and usually takes prices up with it.

Because of that, investors should focus on the stocks of companies that can easily survive a downturn, since that also puts them in the best position to thrive when market conditions improve. Further, they should also consider focusing more attention on cleaner energy companies, like renewables and natural gas, especially during the Biden administration, given his pledge to put the country on a path toward an emissions-free future.