Last year, oil companies paid a gusher of dividends. Many oil producers set new capital allocation frameworks to return the majority of their free cash flow to investors. Most opted to accomplish this goal by paying variable dividends.

This year, some of those oil companies are shifting their capital return strategy away from paying outsized dividends toward repurchasing shares. Driving this pivot is the belief that their stocks are incredible bargains. Here's a look at two oil stocks buying back their shares hand over fist this year.

Taking advantage of its flexibility

Diamondback Energy (FANG 0.17%) established a new capital return target last year. It aims to return 75% of its quarterly free cash flow to investors, up from 50%. The base return is a fixed quarterly dividend. Diamondback had the flexibility to pay variable dividends and repurchase shares to achieve its 75% target.

While Diamondback Energy utilized both options last year, it paid significant dividends:

A chart showing Diamondback Energy's dividend payments in 2022.

Data source: Diamondback Energy. Chart by the author. 

This year, share repurchases have become a priority. In a letter to shareholders, CEO Travis Stice noted that Diamondback generated $646 million of free cash flow in the first quarter. Given its 75% payout policy, it will return $485 million to shareholders. He noted that the company paid its base dividend of $0.80 per share ($147 million total). It used most of the rest of its free cash flow ($332 million) to repurchase shares. That left only $6 million for the variable dividend, which tacked on $0.03 per share to its quarterly payout.

Stice wrote: "The first quarter is exactly the reason we elected to implement a return of capital program with flexibility to allocate capital between share repurchases and a variable dividend. During the banking crisis and Silicon Valley Bank collapse, we took advantage of volatility and repurchased a significant amount of stock." Diamondback spent more on share repurchases in the first quarter ($332 million) than in the entire first half of 2022 ($309 million).

A big driver of the repurchases is the company's bottom-of-the-barrel valuation. At $70 oil (slightly below the recent price), Diamondback could produce nearly $15 of free cash flow per share this year. With its stock price recently around $130 a share, it trades at an 11.5% free cash flow yield. That's a more than 50% discount to the broader market indexes. The S&P 500 trade at about a 5% free cash flow yield, while the Nasdaq 100 is even more expensive at a 4% free cash flow yield.

Shifting priorities

Coterra Energy (CTRA -0.28%) has committed to returning 50%+ of its quarterly free cash flows to investors. Initially, it did that through its base plus variable dividend framework. In addition, the company had planned to use share repurchase as a supplemental way of returning cash to investors. 

However, buybacks have become a priority this year. CEO Thomas Jorden stated in the company's first-quarter earnings report that it planned to return $420 million of its free cash flow to shareholders in the quarter, which works out to 76% of the total. That return included its recently increased base dividend ($0.20 per share and $152 million overall) and $268 million of share repurchases. Jorden commented," We reiterate our commitment to return 50%+ of free cash flow to shareholders, with an emphasis on the base dividend and buybacks, in the near-term." 

A big driver is its cheap valuation. Coterra expects to produce over $6 billion in free cash flow in the 2023 to 2025 timeframe based on recent oil and gas prices. That gives it a free cash flow yield of around 10% based on its current $19 billion market cap.

Dirt-cheap oil stocks

Diamondback Energy and Coterra Energy are returning the majority of their free cash flow to shareholders. While they opted to accomplish that goal mainly through dividends last year, they're shifting to repurchasing shares this year. They believe their stocks trade at such bargain prices right now that buybacks are a better use of shareholder capital. That makes them intriguing options for value-seeking investors.