"You have to be selective with energy," adds Raymond James & Associates analyst Stacey Hudson. While the alternative energy industry tends to benefit from higher oil prices as they render alternative energy fuels more economical, the correlated companies carry a lot of execution risk. "Many of these companies are still in the process of scaling up their technology and working towards commercialization," Hudson cautions.
In oil, the least volatile stocks are the large, integrated companies, which both produce oil and have refining businesses. "In general, the integrateds are going to be the safest," says Weiss. "They have a more diversified revenue stream, so even if prices fall, they're still going to profitable." Typically, these oil majors derive a much bigger portion of their earnings from upstream, or exploration and production operations, than downstream, or refining and product marketing operations.
That said, the problem with the integrated companies is they're less able to take advantage of higher oil prices than oil services companies, such as the drilling contractors and pressure-pumping outfits. "With an integrated oil company, [it] doesn't control the price of oil. It is whatever the market says it will be," says Weiss.
When oil prices rise, the refining side of the integrated companies can be a bit of a drag due to higher feed stock costs. And even though the integrated companies have the incentive to ramp up their production and exploration operations as oil prices rise, doing so also means taking on higher services costs. "You can't just say, oil prices are higher. I'm going to produce more oil. It doesn't quite work that way," Weiss points out.
Services companies, on the other hand, are less diversified and therefore riskier than integrated oil companies. However, they also have a greater ability to benefit from higher oil prices. "Increased demand leads to greater pricing because there's only so much service to go around," says Weiss. "The law of supply and demand basically says that as oil prices rise, generally services companies generate better profits." Services companies, who don't own any oil, are better able to control their revenue stream and pricing in times of higher oil prices, says Weiss. Their customers range from the major, integrated oil companies to national oil companies.
That said, safe investments in services companies are possible, says Weiss. With its 5% dividend yield at current prices,
(RIG - Get Report)
, the world's largest offshore contract drilling company is one of them. "I just upgraded [the stock to buy]. Based on the strength of the company's balance sheet and cash flow, that dividend seems safe to me. Even if I'm wrong [about] when the stock will appreciate, you'll get paid to wait with the dividends."
Read on for more leaders in the energy sector ...