The energy sector offers a number of investment options.

Investing in the energy sector can be complex, since the industry spans from companies that drill for oil to renewable businesses, which focus on wind and solar power generation. The evaluation of energy companies is broad, too. For instance, the exploration and production of crude oil companies include those in the upstream, downstream and midstream sectors. Utilities and renewable companies derive their profit margins and free cash flow in different ways. Here are seven things to know about investing in the energy industry whether it's for stocks or energy-focused funds.

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Oil prices

The price of crude oil is the "uber variable upon which all other energy activity depends," says Ethan Bellamy, a managing director who covers energy stocks at Baird, a Milwaukee-based investment bank. Oil is the most important global commodity because it fuels "global trade and most global transportation," he says. A dip in prices for an extended period can affect the company's cash flow and earnings per share. "Right now we're in the Goldilocks zone. Oil is not too expensive to destroy demand and not too cheap to destroy drilling activity," he says. "Investors should always guard against oil price volatility. Oil has long, medium and short cycles and the largest producers are in a cartel that is slowly slipping from power as U.S. production grows."

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The energy sector offers a number of investment options.

Investing in the energy sector can be complex, since the industry spans from companies that drill for oil to renewable businesses, which focus on wind and solar power generation. The evaluation of energy companies is broad, too. For instance, the exploration and production of crude oil companies include those in the upstream, downstream and midstream sectors. Utilities and renewable companies derive their profit margins and free cash flow in different ways. Here are seven things to know about investing in the energy industry whether it's for stocks or energy-focused funds.

Oil prices

The price of crude oil is the "uber variable upon which all other energy activity depends," says Ethan Bellamy, a managing director who covers energy stocks at Baird, a Milwaukee-based investment bank. Oil is the most important global commodity because it fuels "global trade and most global transportation," he says. A dip in prices for an extended period can affect the company's cash flow and earnings per share. "Right now we're in the Goldilocks zone. Oil is not too expensive to destroy demand and not too cheap to destroy drilling activity," he says. "Investors should always guard against oil price volatility. Oil has long, medium and short cycles and the largest producers are in a cartel that is slowly slipping from power as U.S. production grows."

Blue-chip oil companies

Blue-chip stalwarts like Exxon Mobil Corp. (ticker: XOM) and Chevron Corp. (CVX) tend to produce high returns over longer periods with less volatility. Adding large-cap energy stocks along with independent oil and gas companies can increase returns, says Bernard Weinstein, an associate director of the Maguire Energy Institute at Southern Methodist University. "Fossil fuels will continue to command the lion's share of energy production for the next 20 to 30 years," he says. While blue-chip stalwarts may feel safe to investors, relying too heavily on one investment adds risk, says Mike Loewengart, chief investment officer at E-Trade Financial. "Crude oil's major price swings play a large part in dictating the direction of these stocks," he adds.

Energy exchange-traded funds

Energy-focused ETFs have less risk than adding single stocks to a portfolio. One less volatile fund is the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). "This is more of an equal-weighted index and focuses more (on) U.S. companies but does not distinguish quality," says Rob Thummel, a portfolio manager at Tortoise Capital. "Not all oil and gas producers are the same." The Energy Select Sector SPDR ETF (XLE) has the largest assets under management, with an expense ratio of 0.13% but only 30 holdings. Exxon and Chevron comprise more than 41% of XLE, increasing international exposure to oil and gas production, he says. XLE provides limited exposure to energy infrastructure and refining sectors.

Midstream sector

The midstream sector transports oil by pipeline, rail or trucks and investing factors include geology, cash flow visibility and regulatory environment, Bellamy says. Since the 2014 oil downturn, the driving factors are leverage and free cash flow. "Investors want sustainable business models that don't borrow too much and don't outspend cash flow," he says. "The energy sector has a bad reputation for plowing money into the ground that doesn't reap returns." The best blue-chip midstream company is ONEOK (OKE), but it trades at a premium valuation, he says. Energy infrastructure stocks like Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP) and The Williams Companies (WMB) offer dividend yields of 5% to 6.5%.

Net exporters

Production growth from the shale revolution thrust the U.S. into becoming a net exporter of energy by 2020, Thummel says. Shale has unlocked a significant source of supply that has helped to keep commodity prices low. Independents such as Pioneer Natural Resources (PXD), Concho Resources (CXO) and Diamondback Energy (FANG) amassed large land positions of shale acreage with decades worth of drilling opportunities and were the early adopters of shale technology, he says. Nearly 300,000 miles of pipelines are planned or under construction, an indicator that some midstream companies are attractive investments, Weinstein says.

Renewable industry

Renewable energy for electric power generation will continue to grow as a share of America's energy mix, Weinstein says. The state and federal tax credits that have spurred wind and solar projects over the past decade may be "repealed or reduced over the next year or two, making these investments less attractive," he says. Renewables and natural gas are clean, abundant and cheap for the next generation of energy, Thummel says. Finding a pure-play, publicly traded renewables company that isn't extremely volatile is difficult. "The only one that is working is NextEra Energy Partners (NEP) and buys wind and solar projects from its parent NextEra Energy," Thummel says. NEP's current yield is around 4%.

Utilities

The stable business models of power and water utilities result in the majority of companies paying a dividend. Utility valuations look rich relative to historical averages, Thummel says. "Our favorite utility is NextEra Energy, which has become the world's largest producer of wind and solar energy and is the predominant supplier of electricity to the state of Florida," he says. Investors should consider adding water utilities to their portfolios. "The American Water Works Association estimates $1 trillion is necessary to maintain and expand service demands over the next 25 years," Thummel says. "This allows water utilities like Aqua America (WTR) to pay a dividend around 2%, yet deliver above average dividend growth."

Learn these aspects about energy companies before investing.

Oil prices.Blue-chip oil companies.Energy exchange-traded funds.Midstream sector.Net exporters.Renewable industry.Utilities.1 of 10

Ellen Chang, Contributor

Ellen Chang has been a contributing investing and financial writer for U.S. News & World ...  Read more

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