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The Energy Investing Sector: Opportunities and Challenges

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The energy market has been changing rapidly and will continue to do so for some time. While renewables only have a minuscule piece of that market so far, and coal is slowing down, oil and gas are enjoying the “energy renaissance.” 

After two fairly moribund decades, about 2010 the oil patch blossomed anew with the advent of hydraulic fracturing, or fracking. “Unconventional drilling has changed the landscape for energy investing,” says John Dowd, portfolio manager of Fidelity’s Select Energy, Select Natural Resources and Advisor Energy Fund.

Fracking rigs drill vertically and often then horizontally into deeply buried, massive shale formations to extract veins of oil and gas. Sand, chemicals and tons of water are pumped into the shale to fracture the stone and force fuels to the surface. While shale oil is not new, the technology and equipment to harvest it efficiently was only recently developed. 

As a result, the U.S. has now surpassed Saudi Arabia as the world’s largest producer of oil and gas–keeping prices of both reasonable, according to the Institute for Energy Research. Reliance on foreign oil has dropped as oil production has grown dramatically. Over 13,000 rigs, up from 700 since 2010, now dot the four big shale basins in Texas, North Dakota and Pennsylvania.

But this explosive growth has created environmental headwinds that have bedeviled the industry’s image and could slow its growth. For instance, according to Reuters, on Tuesday the state of Pennsylvania “sought a record $4.5 million penalty from EQT Corp., a natural gas producer, for damage caused by the release of fracking fluids from a gas drilling site in the Marcellus region.” If too many incidents of environmental damage occur, industry profits, along with investor enthusiam, could shrink.

For now, though, this energy renaissance is helping to drive the U.S. economic recovery and creating new investment opportunities.

Energy has been a profitable long-term investment. But in the past few months, oil prices, normally about $100 a barrel, retrenched to $90, driving down stock prices of many oil companies. While the price could go lower before it comes up, this could be a good time to buy, says Edward Youngberg, a senior energy analyst for Edward Jones. “Generally I think it’s a good opportunity now that there’s a pullback, and everything is 20% off.”  

Three Kinds of Firms

There are basically three kinds of oil and gas companies: exploration and production (E&P) companies, which locate and extract deposits; infrastructure companies, which transport and store oil and gas; and service companies, which build equipment, map geological formations and generally assist E&P companies.       

E&P companies are risky because they track oil prices. Many of them are also weighted down with huge capital investments in shale basin properties, advanced technology to find and place rigs efficiently and new, more automated high-tech rigs (some of which can “walk” from one site to another).

To shop among them for investment purposes, analysts agree that investors and their advisors should look for low costs, full balance sheets and great management. You want companies “whose costs are lowest and have a good reservoir and good technology,” says Dowd. “Companies that own property with untapped supplies that bought an oil field 10 to 15 years ago would be very profitable.”

He thinks EOG Resources, Anadarko, and Noble Energy should be able to deliver superior growth. 

Youngberg also likes Marathon and Devon because they’re good companies that are undervalued. You would own the bigger integrated companies, the “super majors,” like ExxonMobil, Chevron and ConocoPhilips for the dividend, he says, because they are too big to grow much, However, many oil giants are divesting overseas and offshore operations to focus on U.S. shale.

For example, ConocoPhillips, which pays a 4% dividend, broke down into an E&P company and Phillips66, which deals in pipelines and chemicals. 

Analysts also recommend service companies, such as Sclumberger and Haliburton. Youngberg adds National Oilwell and Novarko, a “one-stop shop for oil field equipment.”      

MLPs, Pipelines and Coal

A more stable play is investing in pipelines via Master Limited Partnerships (MLPs), which pay out most of their revenues and receive favorable tax treatment. E&P companies pay pipelines to transport their goods. The pipelines sit back and collect the toll, says Tyler Kokon, portfolio manager for North American Shale Energy Hedge Fund. “And pipelines are 50% less correlated to E&Ps and service companies.”

Because there is huge pentup demand for pipelines, “it’s a good story that isn’t going to go away any time soon,” says Kokon. He likes KinderMorgan and Enbridge. But he warns that MLP yields will drop if interest rates rise. 

There is already a glut of natural gas and a seemingly infinite supply going forward, but the current low prices for natural gas could rise with cold weather and when companies build export terminals, says Kokon. In addition, manufacturing companies coming back to the U.S. in part for cheap energy will likely use cleaner-burning natural gas. 

Coal is the loser in all this, says Mike LaRusso, managing director and group head of CIT Corp. Finance, Energy. “Coal-fired power plants are being retired because they’re old and inefficient” and it’s very expensive for such companies to meet EPA regulations. Coal is the most polluting of fossil fuels, and it has to compete with cheap, cleaner natural gas. However, coal-fired plants that have been or will be retrofitted still supply some 30% of US energy, and demand remains strong from some emerging markets for coal. 

Generally speaking, the energy sector is riding a tailwind that should grow in strength. There are some headwinds, however. It will be years before infrastructure catches up with supply to transport fuels at home and abroad. Another snag is lifting the ban on exporting crude oil—a hangover from the 1970s oil crisis. Finally, climate change and environmentalists could pose problems.

If and when these hurdles are cleared, though, investors who are already in the market stand to make even greater returns. 

While Youngberg says you can easily put together a diversified portfolio of six energy stocks, investors can get more diversification without the headaches with a mutual fund. Among the top energy funds, according to Zacks, are Rydex Series Trust Energy Services, ING Natural Resources, Franklin Natural Resources and Vanguard Energy. Clients who are concerned about greenhouse gases may prefer Guinness Atkinson Alternative Energy, one of many alternative energy choices.

In ETFs, Zacks’ top three picks are Powershares S&P Small Cap Energy, DJ US Oil Equipment Services and S&P Oil & Gas Exploration and Production.

– Check out: How Far Will the Shale Boom Go? on ThinkAdvisor