Building on its second annual gain in a row, oil prices witnessed a solid start to the New Year. While, the first week of 2018 saw U.S. oil benchmark rally 1.7%, expectation of another massive draw catapulted the commodity to a new three-year high yesterday. To be precise, the front month West Texas Intermediate (WTI) crude futures climbed 2% (or $1.23) to end at $62.96 per barrel Tuesday – the highest settlement since December 2014.

Reasons for Oil’s Surge

Sharp Inventory Drawdowns: Investors have pinned hopes of recovery over the recent U.S. Energy Department’s inventory releases that show multiple weeks of strong inventory draws in the domestic crude stockpiles – pointing to a slowdown in shale output. The nation’s oil stockpiles have shrunk in 31 of the last 39 weeks and are down almost 109 million barrels since April.

Production Cut Deal Extension: One of the significant reasons why the U.S. oil benchmark soared nearly 17% last quarter revolved around expectations that OPEC and other major producers will agree to expand their output-cut deal beyond March. True to predictions, the coalition prolonged the current dynamic for another nine months to the end of 2018. The agreement, now renewed twice, keeps 1.8 million barrels a day (or 2% of global supply) off the market in an attempt to clear a supply glut.

Drop in OPEC Output: Meanwhile, the producer group pumped 32.5 million barrels daily in November, about 133,500 barrels a day less than their October output and the lowest level since May. The group’s success in capping production has shrunk the huge global stockpiles of oil and supported prices.

Decline in Rig Count: Data showing the number of U.S. oil rigs going down over the past few weeks also helped cement oil’s gains. An early indicator of future crude volumes, rigs engaged in oil exploration and production in the U.S. totaled 742 for the week ending Jan 5 – down by seven from November and importantly, a sign of brake in shale oil production.

Geopolitical Concerns: Political turmoil in Iran, which has raised the specter of output disruption in OPEC’s third-biggest producer, was also a price driver.

Analysts Warn of Overheated Market

Despite the recent uptick in prices, some analysts, however, believe thee sustainability of these gains is highly uncertain.

Rising U.S. Shale Output: Arguably, the biggest headwind is the steady climb in U.S. shale production. Last month it rose to 9.8 million barrels per day, the most since the EIA started maintaining weekly data in 1983. The breakthrough development in global oil markets over the last few years, the relentless increase in North American shale output has repeatedly undermined efforts by OPEC and other major producers’ to ‘rebalance’ the market and prop up prices.

Already at a financial equilibrium, the shale firms are starting to ramp up activity. Throughout the downturn, producers worked tirelessly to cut costs down to a bare minimum and look for innovative ways to churn out more oil from rock. And they managed to do just that by improving drilling techniques. With these efforts, many upstream companies have repositioned themselves to adapt to the new ‘low oil’ reality and even thrive at those prices. In fact, shale output from the United States is expected to surge to a record 10 million barrels per day sometime this month, just behind top producers Russia and Saudi Arabia.

Poor Refining Margins in Asia: Another concern is the recent fall in Asian refining margins. Overall spreads have also been dragged lower amid abundant fuel supply and surging oil prices. The business of the downstream players is negatively correlated with crude prices. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, higher the oil price, lower will be their profits.

This decline in profitability might lead to depressed near-term demand from Asian refiners and weigh on crude prices.

What Does the Future hold?

The uncertainty of oil prices means that the future direction of the commodity’s movement is anybody’s guess. While we cheer strong inventory draws in the U.S., there are still a host of bearish factors that might induce oil’s fall into the mid-$40s and spell doom for investors.

On the contrary though, the commodity’s push ahead towards $65, predictably, has had a positive effect on stocks in the sector. In particular, savvy investors might view the price bump as the impetus the stocks need after freefalling for three years. Undoubtedly, still a long way to go, but improving crude prices may have already primed certain oil producers and linked entities for upward momentum.

Play it Smart

But it’s important to keep in mind that even in these tumultuous times, there are some stocks that stands out.

Amid the uncertainty, it is necessary that investors adopt a cautious approach. It is prudent to opt for large cap stocks. These have a market capitalization of over $10 billion, and also have further room for upside. These companies enjoy leading market positions, have a global footprint, strong cash positions and are large enough to stay strong even in the face of unfavorable events.

To guide investors to the right picks, we highlight 5 stocks that carry a Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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Finally, the chosen ones have VGM Score less than or equal to B. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three scores. Such a score allows you to eliminate the negative aspects of stocks and select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM score.

Our research shows that stocks with a VGM Score of A or B when combined with a Zacks Rank #1 or #2 offer the best upside potential.

Our Choices

First on our list is Royal Dutch Shell RDS.A. Headquartered in the Netherlands, Shell is one of the largest integrated energy companies engaged in production, refining, distribution and marketing of oil and natural gas. This Zacks Rank #1 stock, with a market cap of $267.6 billion, sports a VGM Score of A.

Chevron Corporation CVX, another #1 Ranked stock, is our next pick. One of the largest publicly traded oil and gas companies in the world, based on proved reserves, San Ramon, CA-based Chevron has a VGM Score of B and a current market cap of $227 billion.

Then we have Statoil ASA STO, again a #1 Ranked stock. It is a major international integrated energy company with operations in all major hydrocarbon-producing regions of the world and an upstream focus on the Norwegian Continental Shelf. Stavanger, Norway-based Statoil – with a market cap of $66.3 billion –– has a VGM Score of A.

Our fourth choice is Rome, Italy-based Eni SpA E – a company engaged in oil and gas, electricity generation, petrochemicals, oilfield services and engineering industries. With a current market cap of roughly $59.7 billion, this #2 Ranked stock flaunts a VGM Score of A.

Finally, there is Petrobras PBR. Headquartered in Rio de Janeiro, Petrobras is the largest integrated energy firm in Brazil and one of the largest in Latin America. This Zacks Rank #2 stock, with a market cap of $61.8 billion, sports a VGM Score of A.

Bottom Line

While there are ample reasons to be cautious, there is still enough room to make money in energy stocks, if one focuses on the right companies. In particular, large cap stocks with a favorable Zacks Rank prove to be attractive options for investment.

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