Oil companies have a poor track record as dividend stocks. The shareholder payout is usually the first thing to go when crude oil prices take a tumble, which has happened frequently in recent years. Now most income investors have sworn off the sector because it's become an unreliable source of cash flow.

However, one oil stock is seeking to change the narrative around the sector by adjusting how it pays dividends. Instead of focusing on delivering a high base payout -- which runs to risk of a reduction at the next oil price crash -- Pioneer Natural Resources (PXD) plans to add a variable dividend based on oil prices. This strategy could serve as a new model in the sector by rewarding income investors during periods of higher oil prices, without completely abandoning them during more turbulent market conditions.

A roll of $100 bills next to a sign reading dividends.

Image source: Getty Images.

Drilling down into Pioneer's dividend plan

Pioneer Natural Resources has put a much higher priority on returning cash to shareholders in recent years. After paying a tiny semiannual dividend for years, Pioneer started pumping up its payout in 2018, increasing it several times and switching to a quarterly payment schedule. It went from paying a paltry $0.04 per share every six months to dishing out $0.55 per share every quarter this year. It also supplemented that fast-rising base dividend with share repurchases when it had some spare cash. 

Pioneer still plans to pay that base dividend, which it intends to keep growing, albeit at a much slower pace. However, it's also exploring the adoption of a variable dividend framework. It's still working on the mechanics, but the initial thoughts are to pay a variable dividend starting in 2022 (likely quarterly) based on its free cash flow in 2021 after paying that year's base dividend. It estimates it could pay one as long as the global oil price benchmark (Brent) is at $45 a barrel or above next year (Brent was recently right around that level). 

The company believes that its variable dividend could be substantial in future years. CEO Scott Sheffield stated on the second-quarter conference call that "I would anticipate the variable dividend significantly exceed the payout of the base dividend over time." That's because the company doesn't plan on ramping up its drilling activities during periods of higher oil prices. Instead, it would return that free cash to investors via the variable dividend.

The start of a new trend

Pioneer Natural Resources isn't the only oil producer exploring a variable dividend concept, as several discussed the idea when they reported their second-quarter results over the past month. For example, Devon Energy (DVN -1.95%) said that it would pay its investors a special cash dividend of $0.26 per share after closing an upcoming asset sale. That payment is in addition to its regular quarterly dividend of $0.11 per share. Devon also hinted at the possibility of paying additional special dividends in the future.

Meanwhile, ConocoPhillips (COP -1.84%) said that it's looking at a range of options to return additional cash to shareholders in the future above its current base dividend. CEO Ryan Lance stated on the second-quarter conference call that: "As we think about price recovery and incremental cash flows coming, we are thinking about what is the optimum or the best way to return money back to the shareholder. And obviously, share buyback is one of those options that we're looking at as well as some sort of variable dividend type of structure." 

Concho Resources (CXO) is also open to paying a variable dividend in addition to its base payout. CEO Tim Leach stated on the second-quarter call that "I think we'd be well positioned to do something like that (pay a variable dividend)." 

One of the driving factors behind the recent interest in variable dividends is that the sector has a terrible track record with share repurchases, which is another way it has tried to return cash to investors in the past. Most oil companies only have enough free cash to buy back shares when oil prices -- and their stock values -- are high. Their recent repurchases have consequently destroyed value rather than creating it, since their stock prices all tumbled during this year's oil price crash. On the other hand, paying a variable dividend would provide all investors with a tangible return when oil prices are higher, which is why the industry thinks that option could make a lot more sense.

An interesting trend to watch

The oil industry has struggled with capital allocation over the years. The sector poured too much money into drilling new wells, paying high base dividends, and repurchasing shares, which backfired when prices collapsed. That's causing a growing number of companies to consider a more creative approach by using variable dividends as the main outlet for excess free cash during periods of higher prices. Pioneer seems to be leading this charge, making it a company to watch in the coming years as its approach could be a trend-setter in the sector.