How to Profit When Oil Prices Slide

Oil prices continue to slide. On the first day of October West Texas Intermediate (WTI) dipped below $90 per barrel for the first time since spring 2013. Brent also declined, dropping below $93 per barrel, its lowest level in more than two years.

The sudden decline in oil prices, owing to a combination of greater supplies from U.S. shale, weak global demand, and a strengthening U.S. dollar, caught many by surprise. Investors have grown accustomed to the commodity boom, which saw rising prices for raw materials across the board over the last decade. Oil prices seemed to be on a relentless climb upwards, stopped only by the 2008 financial crisis. After recovering in 2009, they resumed their upward trajectory.

While the underlying supply and demand picture for oil still points to rising prices in the coming years, for now investors should keep in mind that the commodity boom may be coming to an end. Saudi Arabia cut its selling price for crude oil on October 1, an indication that it may be willing to live with lower oil prices for a while rather than pursue an aggressive cut back strategy to prop up prices.

All of this is to suggest that oil markets could remain soft for an extended period of time. How, then, to profit in the energy sector with a growing surplus of oil?

Refining

First, take a look at the refining sector. Refiners operate in a notoriously low-margin environment, but U.S. refiners have benefited from the surge in oil production over the last few years. With oil as an input, rather than a product it sells, refining companies benefit from lower oil prices.

Take Valero Energy (NYSE: VLO), the world's largest independent refiner with a market capitalization of over $24 billion. The company operates 15 refineries with a combined refining capacity of 2.9 million barrels per day. Many of its refineries are located on the Gulf Coast, well positioned to take advantage of the staggering growth in production coming from the Eagle Ford and Permian.

Its stock price has more than doubled since the beginning of 2012. Despite that performance, it is down since the beginning of this year, providing investors with an entry point. It is generating a lot of cash and has good prospects for growth. Given its relatively low price to earnings ratio of 8.19, which is low compared to its peers, the stock appears to be undervalued.

One of Valero's competitors is Tesoro Corporation (NYSE: TSO). Tesoro also benefits from lower input costs for its refined products. It too has posted remarkable success over the past few years - its stock price has nearly tripled since the beginning of 2012. With six refineries operating mostly in the western half of the United States, Tesoro has a combined throughput of about 850,000 barrels per day. With a market cap of just $7.85 billion, Tesoro is just one-third of the size of Valero.

As it is largely based in the west, Tesoro stands to benefit from crude coming from the Bakken in North Dakota. That is because of its Mandan refinery - the only operational refinery in North Dakota. Tesoro is also increasingly sourcing its oil from the booming production in Colorado.

One of the largest trends benefitting refining stocks right now is the spread between WTI and Brent crude. The price differential is largely due to a lack of infrastructure as well as the ban on crude exports from the United States. As a result much of the oil produced in the U.S. trades cheaper than its international counterpart. This has been an enormous boon to the refining sector, which can take cheap crude, refine it into gasoline, jet fuel, and other petroleum products, and then export them overseas for a premium.

It is important to note that the fate of the crude oil export ban will go a long way to determining the Brent/WTI spread. Proponents of ditching the ban have gained momentum in 2014, but political gridlock will likely ensure the ban persists for a while longer.

The price spread continues, but it is narrowing. Investors should keep an eye on this as it is one of the largest determinants of how refining stocks will perform. The more the two benchmarks converge, the worse it will be for U.S. refiners. For now, there is still a bit of room for these companies to make some good money.

Dividend Stocks

While the refining sector offers investors a route to portfolio growth during an oil price downturn, another option is to play it safe with high-dividend stocks. That way, even if share prices disappoint, dividends can still provide a good overall return.

For example, there is Kinder Morgan (NYSE: KMI), which owns 80,000 miles of oil and gas pipelines. Kinder Morgan has stuck by a very generous dividend, paying $1.72 per share for a 4.70% yield. It recently completed the purchase of its two related companies, Kinder Morgan Energy Partners (NYSE: KMP) and El Paso Pipeline Partners (NYSE: EPB), and dismantled the Master Limited Partnership model. This, the company says, will allow for faster growth. The company is now the third largest oil and gas company in the United States, just behind ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX).

Kinder Morgan also offers energy investors a potentially safer bet than upstream exploration and production companies. Its extensive pipeline network acts as a massive toll road - it charges for transportation services. This is a big advantage relative to other energy stocks because Kinder Morgan is not vulnerable to price swings for oil and gas, a particularly attractive feature in today's price environment.

Similarly, Enbridge (NYSE: ENB) offers investors another dividend stock. Just like Kinder Morgan, Enbridge is owns and operates a massive oil and gas pipeline network - in this case, the longest pipeline network in the world. Enbridge maintains a $1.40 per share dividend, or a 2.52% yield and has posted 19 consecutive years of increasing its dividend. Viewed another way, the company has achieved an impressive 13.66% dividend growth rate on a five-year average basis. Its stock has been on a steady march upwards since 2010, only recently pairing back gains. This offers investors a great opportunity to get in while they still can.

The only downside for Enbridge is that it has large bets on cross border pipeline flows between the U.S. and Canada. And like Keystone XL, its pipeline assets have become politicized. The company said on September 30 that it believes its plans to double the capacity of its Alberta Clipper pipeline to 800,000 barrels per day would be delayed by a year. The pipeline runs from Alberta to Wisconsin.

Finally, there is Chevron (NYSE: CVX). The oil major has a $4.28 per share dividend for a yield of 3.30%. Chevron saw its stock nearly double from a low point of near $70 per share in 2010 to around $135 per share this past summer. However, more recently its stock has taken a hit as global oil prices have retreated. Its share price has dipped by more than 13% since July.

Unlike the stocks mentioned above, Chevron would be more of a pure bet on oil prices, and its stock could still see its price slide further if oil prices continue to decline. But for investors who believe that oil prices are nearing a bottom, they should take a look at Chevron. It would offer investors both the safety of strong quarterly dividends combined with a strong upside opportunity given the potential for a return to higher oil prices.

And there is the rub. Oil prices are notoriously unpredictable, so it is important for investors who normally look at oil and gas exploration companies to broaden their scope to include companies that are either insulated from price swings, or that are positioned to benefit on the dip.