How does the energy sector compare in terms of value right now?

Our models indicate that energy is tied with telecommunications, offering about $1.20 in value for every $1 invested. That’s also ahead of the broader market. So we’d say energy is extremely value-rich now and has a strong probability of leading the market in the future.

Within energy, however, you really have to be selective. For example, there’s not much value left in the integrated oil-and-gas companies, where we estimate investors are getting $1 back for each $1 invested, and the same is true for coal and consumable fuels.

Contrast this with refining and marketing companies: We think they offer roughly $1.36 of value for every $1 invested. So refining/marketing has been one of our largest overweight positions, at about 26 percent of assets vs. just over 7 percent for our benchmark.

Where do you see energy demand going over the next 12 months?

Oil prices haven’t really gone anywhere this year and are actually down slightly. This might well be the case for all of 2013.

But let’s take a look at the “crack spread,” the difference between crude oil and wholesale gasoline prices. This is basically the profit margin on refining operations.

So far in 2013, the crack spread is up about 38 percent. It’s no surprise that the stocks of refining/marketing companies are also up 32 percent year to date. However, we’re still seeing $1.36 in value for every dollar invested in the refining sector, so we think this theme will continue to play out, since it isn’t anywhere near its value ceiling yet.

Why is the crack spread so important?

Consider that the five-year average for the crack spread is close to $13 per barrel. Right now, the spread is about three times higher than that, at $31 per barrel and rising. What’s more, it has been above the five-year average for quite a while. And analyst estimates have been rapidly increasing over the last 18 months, trying to keep pace. Previous spikes in the crack spread in 2004 and 2007 were high but not persistent. So historically, there’s nothing that compares to the current higher-than-usual profitability in refining and marketing.

That’s one of the reasons ConocoPhillips (NYSE: COP) spun off its refining and marketing segment as Phillips 66 (NYSE: PSX), and why Marathon Petroleum Corp (NYSE: MPC) is trying to take advantage of the unique profitability that currently exists in this space.

Why are refining prices continuing to rise even as the price of oil drifts?

Refineries have been trying to increase their productivity, so there’s been a lot of scheduled maintenance and that has reduced capacity. Also, consumers are in pretty good financial shape. So the pricing power of refiners/marketers is good, and consumption is still high despite the fluctuations in oil prices. A big unknown is how the new refining capacity coming online is going to affect forward earnings.

Natural gas prices have been extremely depressed due to overproduction the past few years. Is there any upside there?

Not really. A key factor is technology, which people don’t tend to associate with the energy sector. But technology has been very effectively applied to resource extraction and has increased the supply of natural gas, depressing prices and pretty much destroying the coal industry in the process.

Extraction efficiencies through fracking and horizontal drilling, as opposed to traditional vertical drilling, have had a major impact on supply. They have pushed up the proven reserves of both oil and natural gas, since more of both can now be extracted.

What do you consider the high points in energy technology?

Ten years ago, you poked a hole in the ground and what seeped into the well from the walls was pumped out. Now you can drill two holes, a half-mile apart, and then drill horizontally to connect the two, increasing the flow rate tremendously. Then you pump in the fracking material, which creates cracks in the well bore, to increase the flow rate further. This really is the story behind falling natural gas prices.

Where do exploration and production companies stand given current energy prices?

Earnings estimates for oil and gas producers were cut last year, causing a sharp drop in stock prices around mid-2012. But prices have since stabilized.

There is some value in exploration and production; you get about $1.19 in value for every dollar invested. But the integrated companies don’t get any advantage from a rising crack spread since they own everything in the production process, from extraction to delivery. That’s why some of them have split off their refining and marketing businesses.

Our exposure to the drilling industry is mostly through offshore operators. They are still attractive, but they’re starting to get a little expensive as their earnings outlooks improve. Things really have stabilized and forward earnings are even starting to get lowered again, looking out to 2014.

Which energy subsectors would you avoid now?

Coal and consumable fuels should definitely be avoided, despite the recent selloff. The growth outlook and actual earnings just don’t offer any value right now, even though they are starting to improve a bit.

Drilling isn’t as attractive as it used to be, nor are the integrated energy companies, which is kind of interesting since they have first-line exposure to the price of oil.

The second tier is the oil equipment- and-services companies, which are one step removed from the price of oil. As long as there’s demand for drilling, it doesn’t matter what the price of oil is for them. So equipment and services looks attractive, offering about $1.38 in value for every dollar invested.

Storage and transportation offers just $1.19 in value for every dollar invested, so we’re neutral there. The names in this space don’t look particularly attractive, but they’re certainly not overpriced as of yet, so I’d consider them a solid hold.

To recap, the best opportunities are in refining and marketing, followed by equipment and services. Coal, consumable fuels and the integrated oils should be avoided.

Which companies are most attractive to you right now?

In refining and marketing, we like Valero Energy Corp (NYSE: VLO). It currently offers about $1.30 in value for every $1 invested, despite the recent run-up in price.

The company’s long-term growth outlook has improved substantially, as its profit margins keep rising. Over the course of 2012, analysts increased Valero’s 12-month forward earnings outlook by 127 percent, estimating that it could earn about $2.50 per share. By the end of last year, analysts were saying that 2014 earnings would be closer to $5.70 per share.

If you take a look at Valero’s stock price, it was up only about 27 percent by the end of 2012, so earnings revisions were significantly outpacing the price movement. The stock price has since started to catch up, as the market is beginning to realize there’s true value there. But we think there’s still plenty of upside left, since investors are just starting to shake loose from their macroeconomic worries.

The inverse happened last year with coal, where the stocks don’t yet fully reflect the downside, despite falling 26 percent last year. There’s very little value there, and the market hasn’t punished coal stocks enough. A new coal-burning power plant hasn’t been opened in the US over the past five years. Part of that is obviously due to the fact that natural gas is so much cheaper now than coal, but there are also regulatory and environmental hurdles that make coal extremely unattractive.

Oceaneering International (NYSE: OII), an offshore equipment and services company, is also very attractive. According to our models, it offers about $1.40 in value for every $1 invested. This is a very high-quality company in terms of the strength of its balance sheet and earnings.