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For some companies, the dividend is the first expense they cut when times get tough. However, others prioritize the dividend payment, aiming to preserve the shareholder payout at all costs.

Diamondback Energy (NASDAQ: FANG) is in that latter group. The oil company believes it owes it to investors to pay a sustainable base dividend. Because of that, they should be able to count on receiving payments, even if tough times return to the oil patch.

Indebted to its investors

Diamondback Energy has done a superb job paying dividends since it initiated the payment in 2018. The oil company has grown its base dividend payment at a 10% average quarterly compound annual rate since its first one. That’s the fastest growth rate in the oil patch.

It recently boosted its quarterly payment by 5% to $0.84 per share ($3.36 annualized). That gives it a 2.2% dividend yield at its recent stock price, a bit higher than the S&P 500‘s average (1.6%).

The company doesn’t take dividend payments lightly. Chief Executive Officer Travis Stice wrote about how the company sees its base dividend in his second-quarter letter to investors. Stice commented:

Our Board continues to believe the primary method to return capital to stockholders needs to be through our base dividend, one that is sustainable and well-protected through the cycles inherent in a cyclical industry. The Board considers the base dividend to be a “debt” owed to our stockholders, and stress-tests that debt to ensure it is protected down to $40 per barrel oil prices.

Diamondback Energy’s most recent stress test gave it the confidence to increase its dividend by another 5%. Its lower actual debt burden, falling share count, and reduced reinvestment rate to support its operations fueled its ability to continue growing the dividend.

Taking steps to enhance its ability to meet its shareholder obligation

The oil company sees its base dividend as a fixed cost, on par with interest expenses paid to bondholders. Because of that, it focuses on doing what’s necessary to protect that payment.

A big part of its strategy is using oil hedging contracts to protect its downside. The company’s current hedges have locked in a $55 per-barrel oil-price floor. That gives it a big cushion should oil prices unexpectedly crash. Meanwhile, its hedging strategy still provides Diamondback with ample upside to higher oil prices.

Another aspect of Diamondback’s strategy to protect its dividend is ensuring it has a fortress-like balance sheet. The company has been steadily paying off debt. Its total debt has fallen from over $7 billion at the end of the first quarter to $6.7 billion at the end of the second quarter.

Debt should continue declining because the company expects to sell $1.1 billion of non-core assets to further strengthen its already rock-solid balance sheet. Debt reduction reduces interest expenses to bondholders, freeing up that cash for other uses.

Diamondback also uses some of its excess free cash to opportunistically repurchase shares. The company has repurchased nearly 5.4 million shares this year, more than the shares issued to close its acquisition of Lario in January. Meanwhile, it has spent $2.2 billion to buy back 18.2 million shares since initiating the program in 2021.

Those repurchases have helped offset the dilution from issuing shares to make acquisitions, keeping its outstanding shares from growing too fast. These repurchases will enhance its ability to pay dividends because it will make payments over fewer shares.

A bankable dividend from the oil patch

The oil industry has a rather spotty track record of paying dividends. Diamondback Energy aims to change that by placing an extremely high priority on the dividend. That drives its strategy of ensuring it can protect the payment at much lower oil prices.

These factors make Diamondback Energy a great option for investors seeking a very sustainable payout from the oil patch.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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