Solar bulls are on a tear, given oil's remorseless march towards $150, along with global efforts to cut carbon dioxide emissions and reliance on oil.

But the solar bulls could get burned if they're not smart about the sector. Many of these companies are swamped in red ink, with their stocks trading at stratospheric multiples, making them highly speculative and volatile. That's why the number of shares sold short in the 20 top solar companies has risen 12-fold, to 96.4 mn, from a year ago, says John Tabacco, chief executive of Locatestock.com.

The solar sector lives and breathes on whether or not governments around the world, notably the biggest players Germany, the US and Japan, will preserve tax credits that keep the industry afloat.

At the same time, government subsidies are drawing a flood of new players, hurting existing ones. That means investors must focus on solar companies that have better operating cash flow than others. Keep an eye on cash from operations in particular to see how healthy these companies are.

Solar has a lot of upside, don't get me wrong. For instance, its backers point out that solar energy is not as hampered as the nuclear industry with regards to waste disposal. Big companies with rich balance sheets such as Google (Goog), Chevron (CVX) and Wal-Mart (WMT) are plowing money into solar, with some aiming to produce their own electricity through solar power.

JPMorgan Chase (JPM) and Wells Fargo (WFC) invested last year in the biggest solar plant built in decades.

Watch too global companies long active in the solar space. They include Kyocera (KYO), BP (BP), Boeing's Spectrolab (BA), and Applied Materials (AMAT), which produces thin-film solar module fabrication lines other companies purchase to make solar modules in their own plants. 

"Costs for the [solar] technology will fall below coal as soon as 2020, the U.S. government estimates," says Bloomberg.

China is big on solar too. For instance, Rizhao, a coastal city of nearly 3 mn people, is one of a number of cities there that have heavily invested in solar electricity.

The solar industry has grown at a 47% average annual rate in the past six years, with about $30 billion in sales in 2007, according to Photon International. Though solar power accounts for only 0.06% of world electricity generation, Photon thinks the sector has room to grow at double-digit rates for years to come. Sales from solar panels (known in the industry as photovoltaic) will triple to $71 bn by 2012 as a shortfall in silicon has caused prices to rise and margins to drop.

But silicon supply pressures and threats of cutbacks in government subsidies to the sector could whipsaw the stocks.

Germany, which has the biggest market for solar energy at about 55% of world demand (Japan is next at about 20%, the US is at 5%) now plans to cut back its subsidies to the sector by 7% next year, though it still has generous subsidies whereby solar energy can be sold to its grid for as much as 20 years at a fixed price that's more than the standard price for electricity.

The US Congress has threatened to cut its subsidies, which have at times been perilously hanging by a thread.

The House Ways and Means committee voted to approve a six-year extension of the solar energy tax credit--but it is paying for it and other measures by ending the ability of hedge fund managers to defer US taxation from offshore earnings. Not a solid pipeline of support here.

Though the solar industry is still small versus the electricity sector, which relies on coal or gas to power its plants and utilities, its prognosis looks good with analysts saying solar costs will come down dramatically in coming years as technology improves. Solar electricity still accounts for less than one-thousandth of global energy consumption, largely because of costs. 

Despite government subsidies, retail prices for solar power still are on average twice those for electricity from standard utilities. Solar systems sell electricity at about 30 cents per kilowatt hour, versus retail prices for electricity around the world of 15 cents to 18 cents.

A growing number of corporate executives think this price gap is fast closing. They include Jeffrey Immelt, chief executive of General Electric (GE). GE has bought two small US solar concerns in recent years. "I am convinced that in the next five years, the solar industry has the ability to take out half its [manufacturing] costs," he has said.

Here's what to watch out for.

JA Solar Holdings (JASO) just came out with solid earnings. LDK Solar (LDK), Canadian Solar (CSIQ), and Yingli Green Energy Holding (YGE) are all on the radar screen.

JA Solar Holdings' (JASO) first-quarter net income almost tripled amid increased demand for solar products and a strong boost in income from operations. The Chinese manufacturer of high-performance solar cells posted net income of $22 mn, or 14 cents a share; a year earlier, income was $8.63 mn, or 7 cents a share. Revenue surged to $160 mn from $47.8 mn. JA Solar is Chinese and it is thought of by many as one of the cheapest cost producers with solid pipeline of silicon supplies.

Another hot solar stock is Trina Solar (TSL), which recently re-affirmed 2008 revenue guidance to between $770 mn and $808 mn, and operating margin guidance at 15% to 17%.  

But JA Solar and other solar stocks fell recently when analysts said solar cell makers with heavy exposure to soaring silicon prices could be at risk.

Calyon Securities analyst George Kotzias said in a client note that so-called thin-film technology stands to gain on silicon because thin-film technology is less expensive than silicon. Thin-film had a 12% market share in 2007, which could grow to about 20% in 2008, he said.

That means you should watch out for companies that make solar cells with silicon such as SunPower Corp., JA Solar Holdings (JASO), LDK Solar (LDK), Trina Solar (TSL), Canadian Solar (CSIQ) and Yingli Green Energy Holding (YGE).

On April 1, LDK Solar, a China-based supplier of the silicon wafers, cut its profit outlook. LDK, which makes multicrystalline photovoltaic wafers, is vulnerable to polysilicon pricing-silicon shortages have led to price spikes--as well as increasing competition in the wafer segment on gross margin. LDK Solar is a middleman, it buys its pure silicon in China at low prices and kneads it into wafers that are sold around the globe. 

Another company to watch, especially if it ever has an initial public offering, is Hemlock Semiconductor, a US company owned by Dow Corning, which is the world's biggest producer of silicon for solar cells. All the silicon Hemlock produces until 2012 is already sold out, with production due to quadruple over the next five years.

Silicon costs comprise at least a third of the total manufactured cost of a typical solar module. Currently there are only seven big makers of silicon needed for solar cells, which ought to show you how technological complex the processes are when it comes to refining the material. (Silicon used for solar cells has to be 99.9999% pure.)

Besides Hemlock, other silicon makers include Tokuyama Mitsubishi Materials and Sumitomo Metal of Japan, as well as Wacker of Germany and US-based MEMC Electronic Materials (WFR).

But new players are entering the field, as many as 50 in just over a year, driven by a shortage of silicon that has pushed up prices for the material in the past five years.

Among the new entrants is Asia Silicon, a China-based company that has raised more than $150 mn from investors to build a silicon plant in northern China, which says it can sell silicon for just $40 per kilogram in just seven years time, versus the going price of about $70 now. 

LDK and other silicon wafer suppliers may soon be threatened by a new technology which may replace silicon. Talk is of solar materials that can be "painted" on to surfaces in so-called "thin-film" applications.

Nanosolar, a US private company backed by $150m from investors, is leading the way here. FirstSolar (FSLR), a US company that sells thin-film cells made with cadmium telluride, has seen its market capitalize soar ten times from its initial public offering last year, now at $20 bn.

Despite all that, as companies and countries around the world move toward solar, costs may drop as supply chains proliferate. And solar could hit grid parity with standard electricity by around 2012 as the industry works to cut costs and prices conventional forms of electricity are expected to rise.

And watch what happens to the solar industry if governments around the world either enact or raise carbon taxes on oil and gas to combat climate change. That will make fossil fuels, and in turn electricity, look even more prohibitively expensive than they do now, and can only make solar look that much more attractive.