The energy industry is an important part of the global economy. In fact, the energy sector and global economy are so closely intertwined that some economists use the values of crude oil and natural gas as a gauge of global economic health.
However, the energy sector is changing quickly. Once dominated by traditional oil and gas companies, clean energy alternatives like solar, wind, and fuel cell technologies are throwing a wrench in the traditional energy sector of the past.
The emergence of the clean energy subsector and transition into the subsector by some of the world’s most dominant energy players are creating compelling investment opportunities that have the potential to yield well above average gains in the long run. So, it’s not surprising that so many investors are interested in getting involved in energy.
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What Are Energy Stocks?
Energy stocks represent companies within the energy sector. The sector consists of traditional energy companies like oil and gas companies, power plants, utility companies, and clean energy companies that produce solar, wind, and other forms of energy from renewable natural resources.
In more recent years, we’ve seen a bit of a change in the sector as clean energy companies have joined the fray. These include solar energy companies, fuel-cell energy companies, and other businesses focused on the technology used to generate clean energy from natural resources, the development of clean energy farms like solar and wind farms, and the storage and delivery of clean power.
Essentially, if the stock represents a company whose core product or service is based on fuel or electricity, the company is considered to be an energy company.
Energy Stock Pros and Cons
In any corner of the stock market, there will always be benefits and risks associated with making an investment. The energy sector is no exception.
Energy Stock Pros
With some energy stocks such as Exxon Mobil, Chevron, and Kinder Morgan seeing tremendous increases in valuations over the years, it’s clear that there are plenty of benefits to making the right moves in the energy sector. Some of the most important positives include:
- Energy Is a Necessity. The energy sector isn’t going anywhere. In developed nations, there will always be a need to fuel vehicles, light buildings, and keep stored foods cold. As such, there is basically zero chance that the products developed by energy companies will fall out of favor with consumers. This offers a unique peace of mind for investors.
- It’s Relatively Easy to Assess Swings in Value. The energy sector as a whole is centered around crude oil. Therefore, when oil prices are on the rise, energy stocks will climb as well, and vice versa. Because energy — whether produced by crude oil or natural resources — is a commodity, it is driven by supply and demand. So, keeping an eye on factors like geopolitical conditions, winter weather, and moves made by the world’s largest oil and gas companies will give you a good idea of where most stocks in the energy sector will head.
- Smart Investments Will Lead To Big Gains. The energy sector has seen several stocks make incredible runs over the years. As such, making the right long-term investments can lead to tremendous returns. Moreover, large, established energy companies tend to offer impressive dividend yields. This is especially the case with stocks in the utilities and energy infrastructure subsector of the energy space. However, the energy sector also sees quite a bit of volatility. So, taking the time to learn what causes swings in the sector can lead to short-term trades that yield fantastic gains. As a result, the energy sector is a great place to find opportunities, both for the buy-and-hold investor and the short-term trader.
Energy Stock Cons
Although there are plenty of positives to consider when investing in energy stocks, there is no such thing as a zero-risk investment. Ultimately, there are a few negatives that you should consider before diving into the energy sector with your hard-earned money.
- High Volatility Increases Risk. Volatility is a measure of how quickly stock values move up and down. Stocks in highly volatile sectors can have wide swings in value from day to day, while stocks with low volatility will see slow and steady growth or declines. Due to the highly volatile nature of energy stocks, extreme losses can happen quickly, whereas with lower volatility stocks in other sectors it’s often possible to get out of an investment before the losses become too much to handle. If you would like to invest in the energy sector but want to shield yourself from volatility, you will find more stable opportunities with utility and energy infrastructure companies than with traditional oil and gas or clean energy companies.
- Energy Stocks Are at the Mercy of the Economy and Supply Chain. At the moment, energy stocks are struggling. Increasing case counts in the COVID-19 pandemic are leading to demand concerns. At the same time, there’s a massive surplus supply of crude oil and natural gas. Between these two factors, the price of oil is struggling to come off its lows, and there’s no indication that this will happen any time soon. Since January of 2020, Exxon Mobil has lost more than half of its value, with a similar story being seen among many of the traditional oil and gas companies in the space. The energy sector won’t be down forever, and when it comes back, today’s valuations may look like a huge discount. Nonetheless, when a recovery may happen is unknown, and further economic and supply struggles could lead to further declines across the energy sector.
- Traditional Energy Stocks Could Become Stocks of Diminishing Returns. Traditionally, energy stocks have done well over time, but these companies may be in some real trouble over the next decade if they don’t evolve to produce the clean energy the world is looking for. As the environmental dangers of high-emission energy sources become more clear, there’s a push around the world to do away with oil-based energy and move toward clean, renewable energy sources. While this will bode well for those companies in the clean energy corner of the sector, it may become a painful change for the traditional oil and gas companies of the energy sector, adding to the risk associated with investing in these traditional options.
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How Much Should You Invest in Energy Stocks?
No single investment, sector, or investment vehicle is a sure enough bet to represent 100% of most investor portfolios. A diversified portfolio is key to the average investor’s success in the stock market.
If you don’t diversify, your portfolio will be at the mercy of the energy sector overall. Should consumer demand for gasoline, natural gas, oil, or even renewable energy solutions falter — or if various factors combine to create an abundance of supply — you stand a chance of experiencing losses in your energy holdings. However, with a properly diversified portfolio, gains in other areas of the stock market will lighten the blow if any one sector, stock, or investment vehicle takes on water.
So, how do you decide how much of your portfolio should be invested in energy stocks?
Note: Energy Stocks Are Not a Substitute for Bonds
Most investing professionals agree that a properly diversified portfolio includes bonds. Although bonds generally don’t lead to gains as large as what you expect with stocks, they’re a more stable investing option, generally outperforming inflation while protecting your portfolio from extreme volatility and losses.
Before deciding how much of your portfolio should be allocated to stocks in any specific sector, it’s important to allocate some of your investing dollars to bonds. A common way to decide how much is to use your age. If you’re 35 years old, 35% of your investing dollars should be allocated to bonds, with 65% allocated to stocks. As you age, a larger percentage of your portfolio will be allocated to bonds, securing more stable investment income as you reach your golden years.
The generous dividend yields offered by many energy stocks can make them tempting as an income play, but their volatility makes them ill-suited to replace bonds as the source of the stable income you want in retirement.
Consider Economic Conditions
Energy is an important commodity, and there will always be demand for it. However, during poor economic conditions, energy demand falls, leading to lower costs due to the basic principles of supply and demand.
When economic conditions are poor, consumers focus more on saving, leading to a willingness to deal with home temperatures a little higher in the summer and colder in the winter. During these times, reduced shopping habits mean less demand for fuel for personal vehicles and shipping companies alike. As a result, energy demand falters, leading to declines in oil prices.
When energy prices fall, consumers enjoy lower prices at the pump, but energy companies and their investors receive less revenue for the crude oil, natural gas, gasoline, and electricity they provide.
So, when economic conditions are poor, reduce your exposure to energy stocks. Conversely, when economic conditions are positive, increasing exposure to the energy sector may be a fruitful endeavor as demand and energy prices rise.
Follow Supply Closely
Although renewable energy solutions are throwing a wrench in the plans of many traditional energy companies, crude oil still rules the energy industry. When oil prices fall, traditional energy stocks feel the pain first. This downward action among the big players of the industry can lead to an industry-wide selloff, affecting clean energy companies as well.
One of the most important factors that plays a role in the determination of the price of oil is supply. When supplies decline and demand rises, oil prices increase as consumers must compete for the limited energy available. On the other hand, when supplies are high and demand is low, the price of oil falls as consumers have easy access to all the oil and energy products they want.
Following the ebbs and flows of the crude-oil supply will give you a good idea of where energy stocks as a whole will head in the future. If oil supplies are up, it’s time to decrease your exposure to the energy sector because prices are likely to fall. If oil supplies are down, an increase of exposure may be in order to take advantage of the likely resulting climb in energy prices.
Follow the Professionals
If you’re a beginner to the stock market and aren’t sure where to start with regard to your energy sector allocation, it’s a good idea to look to the pros for ideas.
The greats of the investing world like Warren Buffett and George Soros don’t hide what they’re investing in. You can find Warren Buffett’s Berkshire Hathaway holdings by sector at gurufocus. The site also outlines the holdings of George Soros and several other uber-successful stock market gurus.
Following along the allocation lines of the investors that have proven to be the best in the world is just about always a good idea. However, keep in mind that blindly following anyone is never good. Even the gurus get it wrong sometimes, so do your own research or speak to a professional investment advisor before making any investment decisions.
Choosing Energy Stocks Wisely
Although there’s no sector that guarantees risk-free investing, the energy sector is riddled with high-risk stocks, making deciding which stocks to invest in a bit more difficult.
General Rule for Newcomers
If you’re new to investing, or even an intermediate investor new to the energy sector, it’s wise to only invest in names you know. Chevron, ExxonMobil, Shell, and other popular gas stations are publicly traded.
Household names in any sector tend to make the most stable investments. So, if you’re looking to get involved in energy-related investments, start with company names you recognize as you learn more about the unique nature of these types of stocks.
It’s also a good idea to consider energy-focused exchange-traded funds (ETFs). These ETFs are composed of energy stocks chosen strategically by professionals, taking the guesswork out of investing for newcomers. You can find ETFs geared specifically to crude oil, renewable energy sources, or a mix of the two. As a result, when investing in energy ETFs, you have the ability to decide which area of the energy sector you’d like exposure to.
Key Factors to Look for in Lesser-Known Energy Stocks
Once you’ve had success investing in some of the well-known names in the energy sector, you may decide to venture out into lesser-known opportunities looking for larger gains. Of course, doing so will come with an added level of risk, but the allure of big potential gains can be hard to resist. If you’re going to make investments in lesser-known energy companies, these tips will help:
- Only Invest in Companies That Are Actually Producing a Product. There are so many energy penny stocks on the stock market that represent small companies with nothing more than a land lease. These companies boast big plans to tap into crude oil reserves below the earth that haven’t been proven, raising millions from investors to do so. Oftentimes, the plans fail before drilling begins, and even if drilling begins, there’s no guarantee that the amount of crude oil that can be extracted from the reserve will be anywhere near expectations. These are highly speculative plays that could lead to tremendous losses.
- Dig Into Financial Data. Even if a company is producing crude oil, technology to tap into renewable energy sources, or some other energy product, they may not be producing enough to stay afloat. Dig into the past four financial reports released by the company, looking specifically for net cash from operations and total cash and cash equivalents. Growth in these key areas are a strong indication that the company is doing well financially. Due to the high volatility associated with the energy industry, it is imperative that any company you invest in has a strong balance sheet.
- Make Sure the Company Is Profitable. Profitability isn’t easy to come by in the energy sector, and many young energy companies will never reach it. So, while you dig into the balance sheet, look for net earnings to ensure that the company is profitable or near profitability.
- Involvement in Clean Energy. Crude oil isn’t going anywhere any time soon. However, as the renewable energy movement continues to gain steam, the likely result is that demand for crude oil will fall over the long term, leading to lower energy prices. Savvy energy companies, including all the largest companies in the space, are venturing into the renewable energy subsector. Those that do not adjust their business model are failing to hedge their bets in the face of a renewable energy revolution, which could lead to long-term losses.
As the energy sector continues to evolve, and savvy investors place educated bets on the right energy companies, more and more millionaires will be made. However, it’s important to keep in mind that not all energy stocks are created equal, and if you’re just entering the stock market or beginning to get your feet wet in the energy sector, it’s wise to tread lightly.
When making an investment in an energy stock, pay close attention to the company’s balance sheet, production, profitability, free cash flow, and business model. Moreover, a keen eye for trends in the sector as a whole as well as the broader economy will assist in making educated investment decisions.
Do you invest in the energy sector? What is your favorite energy stock?