‘Near term economic risks, but long term positive’: Goldman Sachs suggests 2 energy stocks to buy

Goldman Sachs analyst Neil Mehta, in a recent note, takes a deeper look at energy companies and sees that the falling consumer and investor sentiment, paired with economic growth concerns around the world, has enhanced the near-term risk factors. At the same time, Mehta believes that the longer-term view for energy stocks is positive.

“We maintain a long-term constructive/bullish posture given strong cash flow, discounted valuation, the growing strategic value of US gas/oil, and improving returns on and of capital. We believe the key focus this quarter will be on (1) production execution; (2) ability to manage costs despite higher inflation; (3) capital returns outlook; and (4) managing commodity risks through hedging,” Mehta opined.

Against this backdrop, it’s no wonder that Mehta sees current conditions offering an opportunity to buy into energy stocks for the long haul. The analyst is especially bullish on two names, and he’s not alone. According to TipRanks platform, both tickers carry a Strong Buy consensus rating from the analyst community. Let’s take a closer look.

Ovintiv (OVV)

First up, Ovintiv, is a hydrocarbon exploration and production firm operating in the Unita basin of Utah, the Bakken fields of North Dakota, and Permian basin of Texas. The company also has energy claims in Oklahoma’s Anadarko region, and in the Montney formation in the Canadian Rockies. Ovintiv boats a market cap near $13 billion, and its stock has outperformed the broader markets so far this year; where the S&P is down 13%, OVV shares are up 53%.

This strong performance has been driven by production. Ovintiv has been extracting some 500,000 barrels of equivalent per day. In the first quarter, this production generated a non-GAAP cash flow of $1.04 billion, of which some $592 million was listed as free cash flow (FCF). That last is important to investors, as it supports the company’s dividend payout. Ovintiv’s last dividend payment came to 25 cents per common share, and yielded 2.1%. Ovintiv plans to double its cash return to shareholders.

To fund the planned doubling, the company will be selling off parts of its Unita and Bakken assets for total proceeds of $250 million, and will use the windfall to move its planned cash return increase up to October 1 of this year. At that time, the company will start returning 50% of free cash flow to investors. In Q3, most of that return is expected to be in the form of share buybacks.

In his comments on OVV, Mehta takes note of the capital returns, and goes on to say, “We now see a 1-yr forward capital returns yield of ~15%. We believe the company’s improving balance sheet, differentiated return of capital to shareholders and largely de-risked production/capex guidance following 1Q earnings revisions offer potential for shares to re-rate higher.”

For investors, the analyst sees several points of interest, and sets them out clearly: “(1) updates to near and long-term net debt targets; (2) FCF generation and the company’s ability to sustain its capital returns framework; (3) ability to meet its production guidance due to higher Canadian royalty payments; and (4) future hedging strategy as the balance sheet improves.”

In Mehta’s view, all this adds up to a Buy rating, and a price target of $63, which implies a one-year upside of 23%. (To watch Mehta’s track record, click here)

Sometimes, a company’s advantages are so clear that Wall Street can’t help but agree – and that’s the case here. Of 11 recent analyst reviews, all are to Buy, making the Strong Buy consensus rating unanimous. Shares in OVV are trading for $51.09 and the $68.55 average price target indicates potential for 34% appreciation in the coming year. (See Ovintiv stock forecast on TipRanks)

Diamondback Energy (FANG)

For the second stock on Goldman Sachs’ list, we’ll look at Diamondback Energy, a peer of Ovintiv with ~$22 billion market cap and extensive activities in the Texas Permian basin. Diamondback generated 375,000 barrels of oil equivalent per day last year, and in the first quarter of this year that number rose to 381,400 barrels.

Diamondback has seen its earnings increase steadily since early 2020, and has posted six consecutive quarters of EPS gains. In 1Q22, the most recent reported, the company reported $5.20 in diluted EPS, based on an adjusted net income of $929 million and up 126% from the year-ago quarter. Total revenues for the quarter came to $2.4 billion, a year-over-year gain of 103%.

The strong revenue and earnings gains were complemented by a free cash flow of $974 million, almost triple the 1Q21 value. Diamondback returned 57% of that FCF to investors during the quarter, a total of $555 million, through a combination of dividends and share buybacks. The company’s current dividend payment includes a common share base payment of 70 cents and a variable payment of $2.35; the base alone gives a yield of 2.3%, with the variable dividend added in, that yield reaches 4.3%.

Going forward, Diamondback announced on June 21 that it will increase the base dividend to 75 cents, and that the company policy will be to increase the capital return commitment from 50% to 75% of the free cash flow. These changes will take effect in Q3 of this year.

For analyst Mehta, these cash return changes are the first of several important points investors should consider when looking at FANG. Listing those points, Mehta writes, “The focus on the quarter for investors will likely revolve around (1) the future outlook/form of capital returns after increasing its commitment to returning at least 75% of FCF to shareholders vs. 50% previously; (2) ability to offset cost inflation pressures and meet production objectives during the quarter; and (3) M&A outlook following its bolt-on transaction in the Delaware Basin and after announcing plans to acquire the remaining interest in RTLR.”

Everything that FANG has going for it prompted Mehta to rate the stock a Buy. His $160 price target implies 25% upside from current levels. (To watch Mehta’s track record, click here)

Turning to the rest of the street, almost all of the analysts agree with Mehta. 16 Buys and 1 Hold signify a Strong Buy consensus rating. The shares are trading for $128.02 and their $180.18 average price target implies a 12-month gain of ~41% for the stock. (See FANG stock forecast on TipRanks)

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Disclaimer: The opinions expressed in this article are solely those of the featured analysts. The content is intended to be used for informational purposes only. It is very important to do your own analysis before making any investment.