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Investing in Energy Stocks

Updated: May 26, 2021, 5:05 p.m.

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

  • Renewable Energy Stocks: Renewable energy companies produce electricity using renewable resources such as solar, wind, hydroelectric, and geothermal.
  • Solar Energy Stocks: A subgroup of renewable energy, solar companies primarily focus on manufacturing solar panels and components or generating electricity from the sun.
  • Oil Stocks: Oil companies focus on exploring for, producing, transporting, or refining crude oil.
  • Natural Gas Stocks: Natural gas companies concentrate on exploring for, producing, transporting, or exporting natural gas.
  • Liquefied Natural Gas Stocks: A subgroup of the natural gas industry, liquified natural gas (LNG) companies develop and operate facilities to liquefy natural gas for export.
  • Electric Utility Stocks: Electric utility companies generate and distribute electricity to customers.

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 because they’re larger in size and have strong financial profiles. Here are three of the top ones to consider:

Company Ticker What it does
ConocoPhillips NYSE:COP Globally diversified oil and gas producer
NextEra Energy NYSE:NEE Leading utility and renewable energy producer
TC Energy NYSE:TRP Leading pipeline operator and electricity producer

Source: Companies' websites

ConocoPhillips

ConocoPhillips (NYSE:COP) is a diversified oil and gas producer. It has operations around the world and uses several methods to produce energy. The company operates deepwater wells, oil sands production complexes, LNG production and export facilities, and conventional (e.g., vertical drilling) and unconventional (e.g., horizontal drilling into shale formations using hydraulic fracturing) oil and gas wells.

The company also enjoys low-cost operations. It has 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.

COVID-19 forced ConocoPhillips to alter its game plan in 2020 as oil prices plunged. However, the oil giant survived this downturn and came 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 government-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. NextEra hasn’t suffered at all, thanks to steady electricity demand and rates.

The company also boasts one of the best balance sheets in the electric utility sector and also has one of the highest credit ratings in its peer group. The energy-producing company has a conservative dividend payout ratio for a utility, which adds to its strong financial profile. Those factors enable NextEra to pay a stable and growing dividend, making it an excellent renewable energy dividend stock.

TC Energy

One of the largest natural gas pipeline operators in North America, TC Energy (NYSE:TRP) has pipelines in the U.S., Mexico, and its home country of Canada. In addition, the company owns a premier liquids pipeline system, giving it status as one of Canada's leading oil exporters. It’s also one of the country’s 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. It also has one of the top credit ratings in the pipeline sector. Those factors give it 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 on 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 such as 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 after 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 a 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 significantly deteriorate.

Factors that increase an energy company's durability include:

  • Low production costs or stable revenue with minimal exposure to fluctuations in volumes or pricing (e.g., 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 subsector 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 inevitable economic downturns. That means they'll still be around when conditions improve. Furthermore, they'll 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 did during the COVID-19 pandemic, it can have a major impact on energy demand and prices. That can put significant weight on energy stock prices. Conversely, when the economy hits the accelerator, which started happening in 2021 as more vaccines rolled out to limit 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. That will also put them in the best position to thrive when market conditions improve. In addition, they should consider focusing more attention on cleaner energy companies using renewable sources. That’s especially important during the Biden administration, given its pledge to put the country on a path toward an emissions-free future.

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