Diamondback Energy (FANG -0.21%) has delivered impressive dividend growth since initiating a payout in 2018. Given the surge in oil prices this year, the oil company recently took its dividend to another level by adding a variable payment to return more of its cash flow to shareholders. Its combined dividend for the first quarter implies a yield of 9.7% on its recent stock price. If oil prices remain elevated, Diamondback Energy could continue to pay out a gusher of dividends.

Oil fueled cash flows

Diamondback Energy is cashing in on this year's surge in crude prices. The oil company generated $1.4 billion in cash flow during the first quarter, more than enough to cover the $444 million it invested in drilling and completing new oil wells. That enabled the company to produce $974 million of free cash flow during the first quarter, up 26% from the fourth quarter. 

A person measuring a yield sign.

Image source: Getty Images.

That gave it the money to pay out a massive amount in dividends. Diamondback Energy boosted its base quarterly dividend payment by 17% to $0.70 per share ($2.80 per share annualized). That pushed its dividend yield up to 2.2%, well ahead of the S&P 500's 1.5% yield. The company has increased its regular dividend by 75% over the past year while growing it at an industry-leading 11% compound annual rate since initiating it in 2018. 

In addition to that base payment, Diamondback Energy declared its first variable dividend. It's paying out an incremental $2.45 per share, bringing its total dividend outlay for the quarter to $3.05 per share. That implies a 9.7% annualized dividend yield at the recent stock price.

Overall, Diamondback Energy returned more than half its free cash flow to shareholders in the quarter. It paid $548 million in dividends and repurchased $7 million of repurchases.

More fuel to grow the dividend

Diamondback Energy remains committed to returning at least half its free cash flow to shareholders each quarter. Even though oil prices have surged, the company doesn't plan to increase its capital spending. CEO Travis Stice stated in the earnings release: "While we believe that efficiently growing our production base is achievable over the long-term, we do not feel that today is the appropriate time to begin spending dollars that would not equate to additional barrels until multiple quarters from today given the uncertainty and volatility currently in the market." That's due in part to continued labor and material shortages. Stice noted that "increasing activity today would result in capital efficiency degradation and would not meaningfully contribute to the global supply and demand imbalance in the oil market today."

The company's near-term focus therefore remains on operating well to keep its costs down. That will enable it to cash in on the current market environment. This outlook suggests the company could continue paying out a significant amount of cash in dividends, given its target of returning at least half its free cash flow to shareholders.  

The company has made a noticeable shift in how it returns cash to shareholders over the past quarter. It had used share repurchases as its primary method of achieving its 50% target. For example, it spent $409 million in the fourth quarter to repurchase more than 3.8 million shares (2.1% of its shares outstanding) at an average cost of $105.96 per share. However, with its stock price surging along with crude prices this year, Diamondback Energy only spent $6.7 million to repurchase 57,3000 shares at an average price of $117.34 per share in the first quarter. With the stock currently in the $130s, Diamondback Energy will likely save much of the remaining capacity on its $2 billion share repurchase authorization for a more opportunistic time.   

Instead, the company appears poised to return its growing windfall to shareholders through variable dividends. While future payments will fluctuate with cash flow and repurchases, they could be even higher than the first quarter payment if cash flow keeps growing and it doesn't make any repurchases.

The start of what could be a gusher of dividends in 2022

Diamondback Energy has been a dividend growth machine over the past few years. However, it's taking its payout to the next level by layering in a variable payment. Given where oil and its stock price are these days, future variable dividends could be significant. That makes Diamondback Energy a compelling option for investors seeking income with upside potential.