As Energy Stocks Lead Market, What Are the Best Plays?

Tracing the market's pattern this year has been easy: Just follow the energy stocks, which helped stocks surge earlier in the year but have been rally killers in the second quarter.

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The pattern is expected to continue through the summer, with most pros expecting choppy trading that will give way to a late-year rally, fulfilling the lofty expectations of solid gains for 2011.

That trend was clear this week, when energy led a strong stocks rally Tuesday then was among the weaker performers in Wednesday's slide.

"It certainly has been a pretty volatile year for energy—the past few years have been pretty volatile for energy," says Brad Sorensen, director of market and sector research at Charles Schwab in San Francisco. "This year has been characterized by a couple of natural disasters unfortunately and the flare-ups in the Middle East and Northern Africa. That has really impacted the market."

Energy was humming along earlier in the year, posting a 15 percent gain from the first trading session until the market peaked on May 2.

But it had been a bumpy ride getting even there. A surge in oil prices, which is good for energy stocks as long as the gain is gradual and consumers can afford it, proved a difficult hurdle.

Soaring prices at the pump, though, began to take a toll as oil underwent what economists call "demand destruction," in which consumers rebel against high prices and change their driving habits. Oil prices have tailed off since early May, and so have energy stocks.

As such, energy has been the worst performer of the ten S&P 500 sectors, registering a 9 percent drop in the second quarter.

"Once we saw demand destruction, we downgraded" oil stocks, Sorensen said.

But he believes that the longer-term picture, once energy stabilizes, is solid for the sector.

"Over the next two, three years we think energy is still a pretty good place to be," Sorensen says. "Emerging markets are still going to continue to demand more. There's plenty of oil out there to get, but it's not coming cheaply."

Sorensen says drillers may outperform their peers in the sector, but he thinks in general energy will glide higher so long as the broader market regains its footing.

Investors have a variety of industries from which to choose when selecting energy plays.

For instance, Petroleum Development Corp. recently received an upgrade from Canaccord Genuity, which cited the firm's "production performance, additional Marcellus (shale) results and and potential improvement in Niobrara wells (that) should drive the stock higher."

And energy stocks, of course, are not all about oil.

Investors have been looking for plays in other areas such as natural gas and solar, though alternative energy for now is widely considered a tougher partof the space to call because of heavy supplies.

"We remain cautious on solar," Credit Suisse analysts Satya Kumar and Brandon Heieken said in a note to clients that examined the state of solar stocks amid what they call an "overabundance of polysilicon" used to make solar panels.

"This overhang of excess poly will continue to pressure poly prices, and until poly prices bottom, panel prices will have a downward bias," they wrote.

Still, the Credit Suisse analysts believe JinkoSolar Holding is one of the better plays in the group. The Chinese-based company manufactures and sells solar panels and will benefit from the lower cost, the analysts said in upgrading Jinko, which has seen its stock tumble over the past month but is still outperforming its peers.

Conversely, Canaccord cut its full-year price target for First Solar from $115 to $100 on the notion that the Tempe, Ariz.-based company would face tough challenges from its Chinese competitors.

Natural gas also has drawn considerable investor attention, in light of the T. Boone Pickens campaign to switch the nation's truck fleet fuel away from diesel, as well as a slew of new exploration projects in Pennsylvania and elsewhere.

UBS told clients it is "cautious" on the outlook for gas, reasoning that the powerful surge in prices—up about 20 percent from its March lows despite a recent downturn—"has run its course (with) prices to fall into the summer."

The firm is directing its clients towards oil-weighted exploration and production (E&P) companies and away from E&Ps in the natural gas space.

Its top picks are Anadarko Petroleum , Noble Energy , Occidental Petroleum and Apache .

Some strategists, though, believe that the entire sector is likely to track the gyrations of stocks and energy prices.

"They'll follow the broader market. If we get a bounce energy will do quite well," says Michael Church, president of Addison Capital in Yardley, Pa. "With crude hovering around $100 a lot of these stocks are pretty cheap."

The answer to direction, then, could come later in the summer if the market is able to shake off the various shocks it has receivedover the past two months.

"For the entire market there's a rebound in store, so that in general should boost energy stocks at some point," says Oscar Carboni, chief commodities analyst at Omni Trading. "I would be buyer of dips, especially coming out of the summer."