3-point checklist for investing in oil stocks

The price of oil has risen by 16% to almost $57 since the end of November, thanks to a rare deal between OPEC countries and non-OPEC producers to cut oil production. This includes the world's biggest oil producers, Russia and Saudi Arabia.

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They'll be hoping that this rare show of cooperation will be enough to cause oil storage levels to fall, providing support for a higher oil price. Opinions vary on how likely the countries involved are to stick to their agreed production cuts, but I think it's fair to say the market is likely to move towards a more balanced supply-demand position in 2017.

If you've been steering clear of oil stocks during the downturn, then now could be a good time to take a fresh look. However, many oil stocks have delivered big gains already in 2016. In my view, careful selection will be required to profit from the next round of gains.

I've put together a three-point checklist designed to help identify stocks that could deliver further gains, without excessive risk.

1. Debt

A number of companies have been forced into costly refinancing deals over the last couple of years. The biggest losers in these cases have been shareholders, who've faced significant dilution.

It's tempting to think that this is no longer a risk, but I disagree. Heavily-indebted companies may continue to face problems. The example that most concerns me today is Premier Oil, which had net debt of $2.8bn at the end of October. The company has been in talks with its lenders for a number of months. Premier says a deal is close, but the number of lenders involved has made it complex to negotiate.

I'm confident that a refinancing deal will be agreed, but I believe that debt repayments will leave very little spare cash for growth, or shareholder returns.

2. Production versus exploration

As the mining sector has started to recover over the last year, we've seen companies rewarded for focusing on cost-cutting and production. Most companies have made heavy cuts to planned spending on new projects and exploration.

I believe we'll see similar patterns in the oil sector. The market will reward companies that are able to generate strong profit growth, backed by genuine free cash flow.

At this point in the cycle, I think it makes sense to focus on companies with rising production, low operating costs and limited spending commitments. In my view, such companies should be lower risk investments and offer more reliable returns.

One possible example is Ithaca Energy. This North Sea firm has already reduced net debt from nearly $800m to $590m, and should have significant new production coming on-stream over the next year.

3. Dividends

Many medium-sized oil and gas firms have cut or suspended their dividends over the last couple of years. The FTSE Oil & Gas sector only contains a handful of companies that are expected to return cash to shareholders this year.

I suspect that companies of all sizes that can generate free cash flow and increase shareholder returns will be sought after by investors. Among the companies that already pay dividends, I think that SOCO International and Royal Dutch Shell could be good options.

Which stocks will be the biggest winners?

Many analysts believe that reductions in exploration spending today could cause supply shortages in a few years' time.

If they're right, then investing in companies with high-quality exploration portfolios could yield big profits in the future. If you're interested in using oil and gas stocks to target a £1m pound portfolio, I strongly recommend 10 Steps To Making A Million In The Market.

This FREE, no-obligation report contains details of a simple 10-step process that could help improve your future returns. To download your copy today, click here now.

Roland Head owns shares of Royal Dutch Shell. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.