How to Invest in Energy

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The energy industry is breathtakingly large. To try putting its size into perspective, consider that last year oil companies around the world produced 96 million barrels of crude per day, which at $50 a barrel implies a more than $1.7 trillion market. That's more than the entire metals and mining market combined and makes the $170 billion gold market look like pocket change. And that doesn't include natural gas, coal, electricity, and everything else that falls into the energy basket.

Because of its massive size, the energy sector offers a bounty of investment options, including oil and gas companies, utilities, coal miners, and renewable-power producers. However, to simplify things, we're going to focus our attention on the three primary segments of the enormous oil and gas industry: upstream, midstream, and downstream. That should give investors a flavor of how they'd best benefit from investing in the energy sector.

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Upstream: It's all about risk and reward

One of the draws of investing in energy is that these stocks can power an investor's portfolio when oil and gas prices are on the rise, since that plays a prominent role in improving producer profitability. But commodity price volatility works both ways, and in recent years, lower oil prices have weighed heavily on the profitability and stock prices of producers. Investors therefore need to be mindful of their ability to tolerate the ebb and flow of energy prices before investing in a producer.

However, for those who have their heart set on investing in an oil and gas stock, there are three primary ways to accomplish that aim. One is to invest in an exploration and production (E&P) company, which are those that explore for and produce oil and gas. These stocks range in risk profile from a lower-risk E&P giant such as ConocoPhillips, which boasts a top-tier balance sheet and diversified portfolio, to a riskier fast-growing single-basin-driller such as Sanchez Energy. Overall, E&P companies offer investors the most upside to rising oil and gas prices, but that potential reward comes with greater risk. For example, the 33% plunge in oil over the past three years caused Sanchez Energy's stock to crater nearly 80% while ConocoPhillips' is down "only" 27%.

Another option for investors is an integrated oil company, which are those that operate E&P assets as well as in the midstream and/or downstream segments. Big oil behemoths ExxonMobil and Chevron fit this category, since each operates a diversified portfolio of oil and gas assets, as well as oil refineries and chemical complexes. Those downstream assets typically benefit from lower energy prices, thereby providing a natural hedge that helps protect cash flow. These companies thus tend to offer less upside but often pay lucrative dividends, with Exxon and Chevron both currently yielding more than 3.6%.

A third option to consider is investing in an exchange-traded fund (ETF) focused on energy stocks. The Vanguard Energy ETF (NYSEMKT: VDE), for example, owns a balance of integrated oil and gas stocks and E&Ps, as well as equipment and service providers, refining and marketing companies, and storage and transportation operators. That makes it a one-stop shop for adding some energy to your portfolio.

Midstream: The tollbooth of the energy superhighway

The biggest downside of investing in the upstream segment is commodity price volatility. Investors who want to minimize that impact could consider the midstream segment, since most of these companies typically transport, process, and store energy for a fee, which limits their direct exposure to commodity prices.

For example, Enterprise Products Partners (NYSE: EPD) is a master limited partnership (MLP) that operates a variety of transportation and storage assets across the U.S., with fees from those assets currently supporting 92% of its earnings. Meanwhile, Canadian energy infrastructure giant Enbridge (NYSE: ENB) gets 96% of its profits from fee-based and regulated assets. The stable income from those fees enables both companies to pay generous dividends to investors, with Enbridge and Enterprise currently yielding 4.5% and 6.5%, respectively. Furthermore, both expect to increase their payouts at a healthy rate over the next few years, regardless of what happens with oil and gas prices, because both have several fee-based projects under construction.

Not all midstream companies are as strong as these two, which is why investors might want to consider investing in an ETF instead of trying to find a winner. The Alerian Energy Infrastructure ETF (NYSEMKT: ENFR) is one option that offers exposure to the entire midstream sector, while still yielding an enticing 4.8%.

Downstream: Turning oil and gas into something more valuable

Downstream companies complete the energy market cycle. They take the oil and gas produced upstream and transported via midstream assets and turn it into higher-valued products. Refining companies such as Phillips 66, for example, transform crude oil into gasoline, diesel, and jet fuel, getting paid a market-based margin in the process. Meanwhile, chemical manufacturers, such as the CPChem joint venture between Phillips 66 and Chevron, transform oil and natural gas into the basic building blocks for plastics.

One of the benefits of investing in downstream companies is that these entities typically earn more money when oil and gas prices fall, since it reduces their costs. Investors therefore might want to consider pairing a downstream company with an E&P or invest in the iShares U.S. Oil and Gas E&P ETF (NYSEMKT: IEO), which holds both refiners and oil stocks.

How to invest in energy the easy way

There is an abundance of ways to invest in energy. That's why investors need to know their risk tolerance and investing thesis before they start buying. For example, those seeking income should focus on the midstream segment, while those who are bullish on oil, and willing to take on more risk, should consider E&P stocks.

The easiest way to invest in energy is to buy an ETF with broad exposure to the sector. One of the top options is the Vanguard Energy ETF, because it holds 134 energy stocks across the upstream, midstream, and downstream segments and charges 93% lower management fees than funds with similar holdings. While that doesn't guarantee a gusher of a return, investors stand to lose less money when energy markets turn south with ample upside when prices catch fire.

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Matthew DiLallo owns shares of ConocoPhillips, Enterprise Products Partners, and Phillips 66. The Motley Fool owns shares of and recommends Enbridge. The Motley Fool recommends Chevron and Enterprise Products Partners. The Motley Fool has a disclosure policy.