What is Australia’s best performing stock market sector over the last two years? Some investors will plump for Healthcare. Others may choose the Materials sector. Telstra shareholders can attest it is not Telecoms, although the relatively tiny IT sector did well. However the best performing sector from May 2016 until the present is Energy.

This surprises many local investors. The higher volatility of energy shares means they are often shunned. High volatility can rattle investor nerves. Yet it’s a given that higher risk investments offer potentially higher rewards, and the table above illustrates the case for the Energy sector over the last two years.

Admittedly it was difficult to buy energy stocks in May 2016. From mid-2014 West Texas crude oil tumbled from above US $100 a barrel to a low point in February 2016 below $30. It recovered to touch $50, but in May the oil price was sliding again amid predictions of new lows. As the table shows, investors with the steel to buy in at that stage have gained 67.7% in capital returns, as well as the odd dividend.

Investors who missed these market leading returns may not be too late. There is a clear upward trend on longer term charts – both for energy prices and energy share prices.

The volatility of the sector presents challenges. The right entry level makes it much easier to ride out the wilder swings in share prices. Just like other sectors Energy shares can hit sudden slides, either due to broader market weakness or sector specific factors. Less commonly the sector can also “melt up”. The sudden outbreak of hostilities in oil producing regions, a hurricane, or other natural disasters, can put a rocket under oil prices.

The energy sector makes up about 6% of the value of the Australia 200 index. Investors with less than 6% of their total share portfolio in oil, gas and coal stocks are underweight. If investors are comfortable with a gradually improving global industrial outlook and are devoid or underweight the energy sector a strategic approach is available.

Naturally, buying dips is one approach. However investors concerned about a lack of energy exposure may wish to put their foot on some holdings now. Buying between 10% and 30% of the desired amount of energy shares could help guard against a further surge in prices. Lowering this risk may make it easier for investors to then wait for a downward swing in oil prices before adding to holdings.

The “right” share within the sector is a matter for individuals. Some may prefer the higher leverage to the oil price in stocks like Beach Energy or Santos, although with Santos now the subject of a binding takeover bid that investment option may disappear. Others may seek an aggressive coal exposure through a stock like Whitehaven, or a more balanced coal exposure in Soul Pattinson.

In my view the better long term exposure is to the gas producers with world class assets. In a carbon dioxide constrained world gas offers a lower emission option that is still economically viable and of sufficient size to meet the globe’s energy needs. That’s why both Woodside Petroleum and Oil Search are on my list of long term holdings.

Both companies have demonstrated solid construction and operating capability, with long term growth prospects. Woodside in particular demonstrates a higher level of investment process discipline. Exploring and producing oil, gas and coal is a risky business, often involving billions of dollars. In my opinion this is the reason to focus on the highest quality stocks in the energy sector.