Last year was another abysmal one for oil stocks. The average oil producer in the SPDR S&P Oil & Gas Exploration & Production ETF plunged 38%. Meanwhile, the oil ETF is down more than 55% over the last three years. While lower oil prices are partially to blame -- West Texas Intermediate, the main U.S. oil price benchmark, has lost about a third of its value during that timeframe -- oil producers have burned through billions of dollars in capital by drilling wells to grow production at all costs.

However, 2021 has started much better for the oil patch. WTI has rallied more than 10%, rising above $50 a barrel for the first time since last February. That's pushed the SPDR oil ETF up more than 20% already this year. That rally might be just the beginning, given how crucial $50 crude is to some oil producers.

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The case for getting bullish on oil stocks

Most oil producers spent the past year focused on reducing costs to survive at lower oil prices. One of the tools many have used is increasing their scale through mergers. Oil giant Chevron (NYSE:CVX) kicked off the current M&A wave by acquiring Noble Energy last year for $13 billion. The main driver of the deal is the expectation that the combined company can capture $300 million of annual cost savings. Many peers followed that blueprint by acquiring a rival to drive down costs. Devon Energy (NYSE:DVN) recently closed its merger of equals with WPX Energy in a deal that will increase its annual cost savings from $300 million to $575 million by the end of this year. Meanwhile, ConocoPhillips (NYSE:COP) is on track to close its acquisition of Concho Resources (NYSE:CXO) this year, which should enable it to capture $500 million of annual cost and capital savings by 2022. 

As a result of these deals, oil producers were on track to generate more cash in 2021 at lower oil prices than they would have last year. Because of that, they can produce an even bigger gusher now that crude oil is in the $50s. For example, ConocoPhillips estimated that by combining with Concho Resources, it could generate between $7.5 billion and $7.8 billion of operating cash flow at $40 oil, which is enough cash to fund the capital to maintain its current production rate and its dividend with room to spare. Meanwhile, at $50 oil, the combined company could produce an additional $3 billion in cash this year. Devon Energy only needs oil to average $33 a barrel to fund its dividend and production maintenance program. Because of that, it's on track to produce more than $500 million of free cash flow at $40 crude oil and upwards of $1.5 billion if oil stays around $50 a barrel this year.

Usually, oil producers would immediately reinvest their incremental cash flows at higher oil prices to ramp up their drilling programs and boost production. However, after getting burned by that approach in the past, most producers are planning to hold their output flat this year even if oil prices continue rallying. If they do, they'll generate massive gushers of excess cash that they can use to repay debt and return money to shareholders. Devon has already pledged to pay special dividends of up to 50% of its excess cash this year, while ConocoPhillips will likely continue buying back its stock.

The bear case for oil stocks

While the oil market is improving, it's still in rough shape. There's a delicate balance between supply and demand. While consumption is on track to improve this year, the pandemic could continue to affect how fast it rebounds. If vaccines roll out quickly, people will be able to return to their offices and travel much more this year, which will drive demand for gasoline and jet fuel. However, if the rollout stalls due to production issues or tepid demand, oil consumption might not meet expectations, causing a dip in crude oil prices.

Meanwhile, supplies are on track to rise this year as OPEC and many of its partners restart some of their idled output. If they ramp up too quickly, or if U.S. producers start getting greedy, it could put pressure on oil prices, even though Saudi Arabia is doing everything in its power to hold back global supply.

If oil prices were to lose their grip on $50 a barrel, it would likely cause oil stocks to give back much of their early gains. Meanwhile, a slide back down to around $40 a barrel would put significant pressure on financially weaker oil producers, which could cause another bankruptcy wave to wash across the sector.

Cautious optimism

If oil prices keep climbing, oil stocks could do very well this year. That's especially true of those that have taken steps to reduce their costs as they're on track to produce a gusher of free cash flow this year if oil stays in the $50s. Given their pledge to keep production flat, many will return this windfall to shareholders via stock buybacks and special dividends, which could send their stock prices much higher.

However, downside risks remain, which is why investors need to stay cautious by focusing on producers that can thrive even if oil prices cool off.