Energy Sector

Classification

It’s important for investors to have a general knowledge of the classification in the energy sector as it helps them to make informed decisions that are in line with their investment goals. For example, an investor might want to invest in refineries but not exploration & production. These classifications accompany stocks and ETFs and help investors to make targeted decisions.

GICS classification is used in this article. There are two more classifications: MorningStar and ICB (Industry Classification Benchmark).
(side note: GICS or Global Industry Classification Standard is developed by MSCI and S&P Dow Jones and includes 11 Sectors, 24 Industry Groups, 69 Industries, and 158 Sub-Industries.)
The description of each industry and segment is also provided for further clarification.

Energy sector is categorized into the following industries:

As shown above, there are two major industries under Energy Sector: 1) Energy Equipment & Services and 2) Oil, Gas & Consumable Fuels

1) Energy Equipment & Services

1-A. Oil and Gas Drilling
- Drilling contractors or owners of drilling rigs that contract their services for drilling wells.
1-B. Oil & Gas Equipment & Services
- Manufacturers of equipment, including drilling rigs and equipment, and providers of supplies and services to companies involved in the
  drilling, evaluation and completion of oil and gas wells.

2) Oil, Gas & Consumable Fuels

2-A. Integrated Oil & Gas
- Integrated oil companies engaged in the exploration and production of oil and gas, as well as at least one other significant activity in
  either refining, marketing and transportation, or chemicals.
2-B. Oil & Gas Exploration & Production
- Companies engaged in the exploration and production of oil and gas not classified elsewhere.
2-C. Oil & Gas refining & Marketing
- Companies engaged in the refining and marketing of oil, gas and/or refined products not classified in the Integrated Oil & Gas or
  Independent Power Producers & Energy Traders sub-industries.
2-D. Oil & Gas Storage & Transportation
- Companies engaged in the storage and/or transportation of oil, gas and/or refined products. Includes diversified midstream natural gas
  companies facing competitive markets, oil and refined product pipelines, coal slurry pipelines and oil & gas shipping companies.
2-E. Coal & Consumable Fuels
- Companies primarily involved in the production and mining of coal, related products and other consumable fuels related to the
  generation of energy. Excludes companies primarily producing gases classified in the Industrial Gases sub-industry.

Other terminology

Upstream, Midstream, Downstream

Upstream company is involved in the exploration and production of oil and gas. Such companies conduct research to find oil reserves followed by extracting the findings out of the ground. (See 2-B under the classification above, which describes Upstream operations). These companies usually do not own the drilling equipment and hire other companies (see 1-A and 1-B) to do the drilling work for them.
Upstream companies are valued by their estimated reserves.
Investment in Upstream or ‘Exploration & Production’ companies can be volatile since the nature of the operations of these companies is risky. That is, great uncertainty in 1) finding the reserves, 2) volatile oil and gas prices, 3) geopolitical issues and 4) environmental concerns.

Midstream company is involved in the transportation of oil and gas products. Good examples are pipelines and oil ships. See 2-D in GICS classification above.
Midstream operations are more stable but require heavy capital and dealing with high regulation. As an example of a controversial project, The Keystone XL pipeline which was intended to bring Canadian oil to US refineries was shut down by the Obama administration, reinstated by Trump, and shut down again by the Biden administration.

Downstream companies are refineries. See 2-C in GICS classification above.

Why investing in the energy sector?

Energy is essential to all of our daily activities. So it’s not surprising that energy consumption has a positive correlation with economic activities. As more energy is demanded, and assuming that supply remains constant, the price of energy will rise (the rule of supply and demand). This is why when we hear in the news that the economic activities of a major economy is about to cool down, it is usually followed by a drop in oil prices. We can measure the global economic activities by the global GDP growth.
In general, the economic activities of the nations is expected to expand (in the short-term, it might contract, but the general trend is growth). This will result in more demand for energy.

On the supply side, the countries that export oil have created a cartel named OPEC in order to control the supply side. OPEC’s intention is to create price and supply stability. So even if the price of oil drops to a low level, OPEC will not take a disruptive action.

Given the scale of the operation (as it’s affecting the global economy) there will always be a mismatch between supply and demand. It’s not easy to ramp up production to match the economic activities, which can only be known in the hindsight. This mismatch will result in fluctuations in oil and gas prices, which in turn, will result in price fluctuations of the energy companies. An investor who identified the mismatches ahead of time (before everyone else has identified it) can benefit from buying or selling the energy sector and make a profit.

Another reason for investing in the energy sector is the decade-long underinvestment in this sector. The move toward green energy requires a lot of energy, and ironically from fossil fuels. In addition, large economies such as US are investing heavily in infrastructure, which combined with the recent deglobalization movement, requires energy to build the infrastructure needed.

Natural gas has received specific attention recently because many experts believe the transition from coal to green energy cannot be done overnight and requires an intermediary and less harmful fossil fuel such as natural gas. In addition, the infrastructure that is built for natural gas can be repurposed in the future and used for other green sources of energy.

Geopolitical tensions, which are on the rise, are another reason for expected higher energy prices through the following mechanism: 1) most of the energy-producing countries are located in regions that are unstable and acts of vandalism, terrorism, or sabbotage can disrupt the normal flow; and 2) sanctions against certain countries can result in their producing capacity to become unusable.

Finally, we’re faced with severe weather conditions that is destroying cities and their infrastructure. To combat the issues resulting from severe weather conditions, additional fossil fuel is needed. In addition, extreme weather conditions can disrupt both production, refinery, and transportation of energy

Below is the price chart of crude oil and natural gas.

How to invest in energy?

1. Buy ETFs that track the price of oil and gas

In US markets: USO (United States Oil Fund LP), UCO (ProShares Ultra Bloomberg Crude Oil), SCO (ProShares UltraShort Bloomberg Crude Oil), DBO (Investco DB Oil Fund), USL (United States 12 month Oil Fund LP), OIL (iPath Pure Beta Crude Oil ETN).
In Canadian markets: HXE, ZEO, HUC, HOG, HXF, HUN

Note that each of the ETFs has its unique specifications and expense ratio. You can find more about the ETF by search in google for their fact sheet.

Below is an example of USO. On the fact sheet, it states which type of oil it’s following and it also shows which contracts it is holding. Basically, a big portion of the underlying assets are forward contracts. A forward contract is the a binding contract that the two parties agree to buy and sell at a certain price. As the spot price changes, the value of the contract increases or decreases. For example, if you have a forward contract to buy 10 barrels of oil at $10, and then the oil price increases to $12, then your contract is worth more because you can buy the 10 barrels at $10 then sell them immediately at $12.

2. Buy individual oil and gas company stocks

If you have insight into a specific company or you believe that the company has a unique operations or markets that advantages them over other companies, you can buy the shares of that company directly.

Companies operating in the US:

DVN (Devon Energy Corporation) {good choice investing in natural gas]
COP (ConocoPhillips) [good choice for investing in natural gas ]
PXD (Pioneer Natural Resources Company)
OXY (Occidental Petroleum Corporation) [side note: Warren Buffet bought shares of this company]
MRO (Marathon Oil Corporation)
CVX (Chevron Corporation)
XOM (Exxon Mobil Corporation)

3. Buy ETFs that hold a basket of shares

If you’re not sure which company is better or you are generally optimistic about the prospect of oil and gas but do not want to tie your capital to one company, then buying ETF is a good choice for you. Below are a list of large ETFs.

Broach Energy
- FXN (First Trust Energy AlphaDEX Fund)
- ICLN (iShares Global Clean Energy ETF)
- QCLN (First Trust NASDAQ Clean Edge Green Energy Index Fund)
- PBW (Invesco WilderHill Clean Energy ETF)
Oil & Gas Exploration & Production
- XLE (Energy Select Sector SPDR Fund)
- VDE (Vanguard Energy ETF)
- XOP (SPDR S&P Oil & Gas Exploration & Production ETF)
- IYE (iShares U.S. Energy ETF)
- IXC (iShares Global Energy ETF)
- NRGU (MicroSectors U.S. Big Oil Index 3X Leveraged ETN)
- FENY (Fidelity MSCI Energy Index ETF)
Oil Equipment & Services
- OIH (VanEck Oil Services ETF)

Final Word:

As with any other investment, make sure that the attributes of the energy sector are in line with your investment goals. (See our post on Investment Policy Statement.)
Paying dividends and a modest reinvestment of the free cash flow is one of the features of this sector. So, if you’re a high-income investor and prefer no cash payout now, then this might not be the right investment for you. On the other hand, if you’re counting on the dividend payout, then you should explore this sector more.