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Managing Risk With Energy Investing

I'm just putting out some notes on how I approach investing in energy, and building a portfolio.

Energy, as a rule, can be very volatile - it can literally make you or break you - risk management is needed.

This applies whether you have a $3,000 or $100,000 portfolio.

a) Diversification and Risk Management

I allocate 1/3 to cash, 1/3 to a super-major, and the remainder to small-caps.

Cash = funds in a money market or US Treasuries; this is your anchor, which puts drag on the whole thing, and protects you when oil and gas are in downtrends.

It also supplies some "dry powder" for purchases if/when the situation warrants.

These funds should be available to you and liquid on demand, not tied up in CDs, etc.

b) Try to build around a super-major or two.

- which particular super-major is debatable and really a personal preference, for example XOM, OXY, CVX, etc are all reasonably safe plays; the idea here is to generate some income via dividends, with capital gains a secondary consideration; safety also comes into play when your wild-catters are going south.

c) Small-caps - these are the Laredo Petroleums, Bill Barrett Corps and Sanchez Energies of the world.

Here is the part of your portfolio that is positioned for growth and capital gains.

This area requires due diligence and research on your part.

-read the Annual Reports

-pay attention to corporate data - the Income Statement, Current Assets & Liabilities, Long-Term Debt, etc.

-look for trends in that data; annually and quarterly

Most of us are not CPAs; however, with a little practice, knowing what to look for, it becomes easier over time.

Don't trust or distrust management too much - verify what they are saying.

Take a look at who owns the stock - at the very top of the list you will see huge investment groups (Vanguard, etc) and hedge funds. As you go thru that list you will find things like Teacher's and Public Employee State Retirement Funds. A good reference is nasdaq for this type of information. I like to see who is invested in the shares I am considering, i.e. there is comfort in having good company.

Don't just buy 10,000 shares of a $3 or $4 energy stock because "things look good" or "intriguing" or someone sent you a colorful 6-page brochure - do your own due diligence in black and white. It's boring that way, but when money is on the line, its better to be bored and knowledgeable than broke and entertained.

Scale into your positions - if the stock is down 25% on the year and it looks like a "buy" to you - take a 1/4 or 1/3 position. You can add the remaining shares later once the stock sets a trend (up or down) or at least stabilizes. Do not buy a falling knife (obvious).

Don't try to predict trends or call bottoms - no one knows the price of oil or gas tomorrow, in two weeks, or in two years.

Alternatively, you can just buy an ETF and let them sweat the portfolio management.

Be safe.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long OXY, CRZO, and QEP.