With the world awash in cheap oil, analysts do not see an immediate rebound and expect more punishing times ahead. Therefore, one needs to have an appetite for risk in order to invest in the energy sector today. But for savvy investors, there are opportunities to earn big returns.

Downstream: Never Been So Good

Investors need not fear energy stocks, as there are still a handful of them that are showing strength during this shaky period. In particular, with oil prices cooling off, U.S. downstream (refining and marketing) stocks have been notching up healthy gains and earnings beats.

The business of the downstream players is negatively correlated with crude prices. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, lower the oil price, higher will be their profits.

To add to this, robust demand for gasoline (the most widely used petroleum product) has lifted crack spreads and is set to provide further upside to the companies’ bottom line.

Finally, in order to take advantage of the strong gasoline demand and higher margins, the companies are operating their units at record high capacity, sometimes at more than 100%. Therefore, the future looks bright indeed, regardless of Tesoro Corp. (TSO- Analyst Report), Valero Energy Corp. (VLO - Analyst Report), HollyFrontier Corp. (HFC - Snapshot Report) and Alon USA Energy Inc.’s (ALJ -Snapshot Report) share price hovering near their 52-week highs.

Hold Integrated Majors Despite the Bloodbath

In this current turbulent market environment, we advocate the relatively low-risk energy conglomerate business structures of the large-cap integrated companies, with their fortress-like balance sheets, ample free cash flows even in a low oil price environment and steady dividends.

Thanks to their integrated structures, companies like Exxon Mobil Corp. (XOM -Analyst Report), Chevron Corp. (CVX - Analyst Report), Royal Dutch Shell plc (RDS.A -Analyst Report) are able to withstand plunging oil prices better than the rest and protect their top and bottom lines to a certain extent on downstream strength. With the refining unit of these conglomerates being buyers of crude -- whose price is in a freefall -- their profitability improves due to a fall in the input cost.

The companies’ financial flexibility and strong balance sheet provide them with a larger war chest to draw upon in this highly-uncertain period for the economy. Most of them remain in excellent financial health, with ample cash on hand and investment-grade credit ratings with a manageable debt-to-capitalization ratio. On top of this, managements have established quite a track record of conservative capital management and cash returns to shareholders. They also pay a safe dividend, yielding attractive returns.
 

While most of them are near 52-week lows after coming out with dismal second quarter results, holding on to them can still prove to be an astute move.

Time to Buy MLPs

A safer way of playing the sector would be to utilize Master Limited Partnerships (MLPs), which offer considerable returns at significantly lower risk.

Most MLPs are involved in processing and transportation of energy commodities such as natural gas, crude oil and refined products, under long-term contracts. As such they have relatively consistent and predictable cash flows unlike the E&P companies, whose profits are highly correlated with commodity prices.

Given the current weaknesses in petroleum stocks, MLPs are probably the best method of investing in the sector. They also offer liquidity and tax benefits which add to their appeal. This is why these stocks would make good additions to your portfolio.

We suggest Spectra Energy Partners L.P. (SEP - Snapshot Report), TC PipeLines L.P. (TCP - Analyst Report) and Valero Energy Partners L.P. (VLP - Snapshot Report).