Thus far, 2014 has marked a return to the top for the energy sector. As Bloomberg notes, $5 billion has flowed into the energy sector via exchange traded funds (ETFs) this year, which is an astounding 17 times more than in the final quarter of 2013. So far this year the energy sector has taken 63 percent of all the money flowing into sector ETFs, and the Standard & Poor’s Energy Index has been setting record highs.

A rising tide may lift all boats, but our objective – which we achieved in 2013 and so far in 2014 in The Energy Strategist portfolios — is to outperform the sector indexes whether the tide is rising or falling.

Energy is such a diverse sector that there are always opportunities regardless of the broader sector performance. Thus, I don’t attempt to time the sector, but seek instead to find the best opportunities within.

Over the course of the past year, more and more energy companies began to look undervalued, so I am not surprised at this influx of new money into the sector. But it will be more challenging to find good picks in the months ahead as this money rotation into the sector should fully value many of our favorite companies.  

It may seem a bit ironic, but on the day that the National Climate Assessment report was released, the Standard & Poor’s Energy Index reached a new record high. This index of 44 companies includes major energy names like ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), ConocoPhillips (NYSE: COP), Halliburton (NYSE: HAL), Kinder Morgan (NYSE: KMI), Peabody (NYSE: BTU) and Valero (NYSE: VLO). All of the companies in the index produce or enable the production of fossil fuels, which end up as carbon dioxide in the atmosphere.

Why the disconnect between urgent calls to take action on climate, and all the money pouring into fossil fuel companies? It’s because demand for energy continues to grow, but the money hasn’t flowed evenly. Per the aforementioned Bloomberg article:

“Natural gas companies also will be the first beneficiaries of President Barack Obama’s climate policy, which has consistently discouraged the use of coal without requiring renewables to be used as a substitute, said Stephen Smith, executive director of the Southern Alliance for Clean Energy in Knoxville, Tennessee.”  

Regular readers know that I have been beating the natural gas drum for more than a year now. One of the factors behind my bullishness is that natural gas is a much cleaner fuel than coal, and regulations are going to increasingly tighten the noose around the latter. According to the US Environmental Protection Agency, the average air emissions from natural gas-fired power are half as much carbon dioxide, less than a third as much nitrogen oxides, and one percent as much sulfur oxides as the emissions from a equivalent amount of coal-fired generation. So trading coal for natural gas looks like a very attractive option for slashing our carbon emissions.

In a future where the world treats climate change as a crisis and acts — as the National Climate Assessment urges — the options are fairly limited because the world will continue to demand energy. Coal is by far the biggest threat. A 2012 paper by Neil C. Swart and Andrew J. Weaver that was published in Nature Climate Change showed that a whopping 80 percent of the potential climate warming is tied to the potential use of coal. Thus, lower emission replacements for coal are imperative.

The options are fairly few. While renewables like wind and solar will continue to grow exponentially, they are growing from a tiny base and still provide a small fraction of the overall power supply. Further, baseload power is needed due to the intermittency of wind and solar and the inadequacy of current  energy storage options. That leaves nuclear power and natural gas as the two scalable, baseload power options for displacing coal. Each has its critics on environmental grounds, but unfortunately we don’t have a totally consequence-free, massively scalable alternative. Natural gas has gained ground from coal, and is expected by the US Energy Information Administration to continue to do so.

Utilities in the US have begun to switch to natural gas (although there was some backsliding last year as natural gas prices rose), and this is a major factor behind falling carbon emissions in the US. Carbon dioxide emissions fell by 217 million metric tons (MMT) in 2012 to lead all countries. Over the past five years carbon dioxide emissions in the US have fallen by 738 MMT, a decline of 11 percent from 2007 levels, once again placing the US in the global lead.

One caveat is that certainly these declines are coming from a very high starting point. But we have been headed in the right direction, and should continue to build on these recent successes. And we will try to continue to invest accordingly.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Core Drilled After Warning

Reservoir analysis specialist Core Laboratories (NYSE: CLB) has been one of the energy sector’s superstars, a high-margin, high-growth leader in its niche that has consistently returned mountains of free cash flow to shareholders.

But no run lasts forever, which is why a month ago, after a return of 137 percent for our Growth Portfolio since late 2010, we downgraded Core to a Hold, warning that “it will be hard pressed to justify a valuation now grown to 26 times EV/EBITDA” and that “Patient investors should find better entry points down the road.”

We’re a lot further along that road now after Monday’s profit warning by the company, but not yet near the point at which Core would be an attractive destination for new money. The company announced that second-quarter and full-year sales and profits would fall short of guidance issued just three weeks earlier as a result of the dropoff in its core analysis business in leading North American shale basins such as Marcellus, Bakken and the Eagle Ford, among others.

With many of the leading operators in these plays shifting to intensive exploitation after delineating and de-risking their acreage, Core is not counting on the this trend to reverse any time soon, placing its hopes instead on newer unconventional reservoirs as well as growing exploration activity in the Gulf of Mexico.

In the meantime, Core has trimmed its second-quarter revenue forecast by 5 percent and the low end of its earning-per-share guidance by 11 percent, with smaller nicks to the annual targets and no abandonment as yet of its goal of raising its operating profit margin from 31 to 33 percent for the year.

The share price slumped 12 percent on the news, and is now down 25 percent from the record high hit less than three weeks ago. For a company still valued at more than 20 times trailing EBITDA, slowing growth is a big downside risk, and management’s inability to spot the trend before offering annual guidance last month doesn’t exactly breed confidence.

Still, those 30-percent-plus margins speak to the company’s technical excellence, and the punishment the stock has absorbed since the warning may yet prove excessive if some growth drivers management is counting on come through in the second half of the year. CLB remains a Hold.

— Igor Greenwald