While interest rates are on the rise, yield-seekers still don't have many appealing options they can use to collect a steady income stream. The best CD rates in late 2018 were around 2.5% for a one-year term, while the 10-year Treasury was slightly more than 3%. With those low rates, income-seekers need to take on more risk for the reward of a higher yield.

Most stocks also don't hold much appeal, since the average yield of those in the S&P 500 is just 1.7%. However, high-yield dividend stocks do exist, as long as you know where to look. One sector known for paying rather generous dividends is the oil patch.

Money bursts out of a barrel as a businessman next to it strikes a celebratory pose.

Image source: Getty Images.

What is a dividend?

A dividend is a distribution of a portion of a company's earnings to holders of its stock. Similar to rates on bonds and CDs, a stock's dividend yield is the annual cash return an investor can expect to be paid on that investment. It fluctuates based on a stock's price, since companies pay out dividends on a per-share basis. So when a stock rises, its yield falls, and vice versa.

This payout often makes up a significant portion of a stock's total return: On average, dividends contribute to 27% of the total annual return for stocks in the S&P 500, according to a study by Guinness Atkinson Funds. That's why it's a good idea to focus your attention on stocks that pay dividends, especially those that can increase the dividend on an annual basis -- dividend growth stocks tend to outperform their stingier peers.

Why oil stocks pay high yields

When it comes to dividend yields, oil stocks tend to be above average. Aside from the fact that oil companies generate a gusher of cash flow during good times, another reason the sector offers such high yields is that oil stocks are riskier due to their exposure to oil prices, which caused several oil producers to reduce or eliminate their payouts when prices plunged a few years ago. That higher yield helps compensate investors for taking on the additional risk that comes with oil-price volatility -- so you can score a big-time yield from the sector's top dividend-paying stocks.

Many stocks in the energy sector pay higher-than-average yields; the highest often come from companies operating in the so-called midstream, which transports, processes, and stores oil and gas. However, if we narrow our focus to just the companies that produce oil, the list shrinks a bit, though you can still score some pretty attractive yields from oil-focused stocks:

Oil Dividend Stock

Ticker Symbol

Dividend Yield

BP

(NYSE:BP)

6%

Royal Dutch Shell

(NYSE:RDS-A) (NYSE:RDS-B)

6%

Eni

(NYSE:E)

5.4%

Total

(NYSE:TOT)

5.2%

Occidental Petroleum

(NYSE:OXY)

4.2%

ExxonMobil

(NYSE:XOM)

4.1%

Chevron

(NYSE:CVX)

3.8%

Equinor ASA

(NYSE:EQNR)

3.7%

Canadian Natural Resources

(NYSE:CNQ)

3.6%

Suncor Energy

(NYSE:SU)

3.3%

Dividend yield as of Nov. 11, 2018.

Drilling down into the world's highest-yielding oil-fueled dividend stocks

Another reason this list of oil producers pays so well is that investors are still a bit skittish on the sector, given what has happened in recent years. After enjoying a long run where oil was in the triple digits, crude prices started tumbling in 2014, as demand weakened but production continued growing. That cut deeply into the cash flow oil companies produced by selling oil. As cash flow fell, so did their ability to fund new wells, meet their other financial obligations such as debt payments, and pay dividends. This financial strain wreaked havoc on the sector, burning investors in the process: Hundreds of smaller oil companies went bankrupt, while many larger ones slashed costs, including their dividends.

It took the oil industry several years to fix those issues. A combination of improving demand and falling supplies -- due in part to an agreement by several oil-producing nations, including members of OPEC, to reduce their production -- enabled the industry to finally start recovering in 2017. While oil prices aren't back to their peak, they have improved dramatically from their bottom; thanks to the industry's cost-cutting initiatives during the downturn, they're now high enough that oil companies can generate a gusher of cash flow to fund new capital projects, buy back their stock, and pay higher dividends.

While oil-company earnings and dividends are on the rise, their stock prices haven't recovered quite as fast. That's one reason dividend yields in the sector remain high, making it a good place for income-seekers to explore. Here's a closer look at a few of the standout dividend payers on that top-10 list.

BP: The highest-yielding dividend stock in oil

As one of the top-yielding oil stocks, BP catches the eye of most income seekers. One of the main reasons that the company offers such a high yield is that it pays out a large portion of its cash flow to fund its dividend. In 2017, the oil giant generated $24.1 billion in cash from operating activities and paid out nearly $6.3 billion in dividends, or slightly more than a quarter of its cash flow. That still left the company with plenty of excess cash to reinvest in its business; it spent $16.5 billion in capital to maintain and grow its production, leaving it some excess to start repurchasing shares. With oil prices improving further in 2018, BP has generated even more cash flow in support of its dividend and capital program, enabling the oil giant to raise its payout by 2.5% for 2018, its first increase since 2014.

The second reason BP has the highest yield is that investors aren't willing to pay as much for its stock as they are for shares of some of its peers. In part, that's because the company still suffers lingering effects from the Deepwater Horizon oil spill in the Gulf of Mexico. The company is still paying for that disaster and will continue to do so for a few more years, though it has built up a huge war chest to fund those payments. That issue, when combined with the lingering effects of the oil-market downturn, is why BP's stock is down about 20% over the past decade, which has pushed its dividend yield higher.

However, the concerns weighing on BP's stock are fading, which is why investors can now focus on the vastly improving sustainably of the company's massive dividend. Through the first half of 2018, the company generated $12.4 billion in cash, which was enough to cover capital spending and its dividend payout with $1.6 billion left over. Meanwhile, the company's growth projects position it to generate $14 billion to $15 million in annual free cash flow by 2021, which is enough money to cover its 2018 dividend by more than twofold. Furthermore, the company has a strong balance sheet, with its leverage ratio ending the second quarter of 2018 at 28%, which is within its 20% to 30% target range. These factors suggest that BP should have plenty of fuel to continue growing its high-yielding dividend over the next several years.

An oil pump is silhouetted against a background of stacks of $100 bills.

Image source: Getty Images.

Royal Dutch Shell: A high-yield oil stock

Royal Dutch Shell also clocks in with one of the highest-yielding dividends in the oil patch, right up there with BP. The company resisted the urge to cut its payout during the downturn even though the massive $70 billion acquisition of BG Group in 2015 weighed heavily on its stock, which is still down more than 20% from its high. Instead, the company sold a boatload of assets, and it offered investors the option to get paid in shares instead of cash, to bridge the gap between cash flow and outflows for dividends and capital expenses over the last few years. In the fourth quarter of 2017, for example, the oil giant shelled out $3.9 billion in dividends to investors, including $1.6 billion paid in stock.

Those moves bought the company time to get its balance sheet back on solid ground, which Shell accomplished after it was able to sell $30 billion in assets once it bought BG Group, giving it the funds to pay down $13 billion in debt. That allowed the company to cancel a program that allowed investors to receive their dividends in stock as opposed to cash. Meanwhile, cash flow has improved alongside oil prices. Through the first half of 2018, Shell generated $18.2 billion in cash, while paying $8.2 billion in dividends and funding $10 billion in capital expenses.

Shell expects to start generating a growing stream of excess cash flow above its dividend and capital investment program as its expansion projects drive earnings higher, which is the company's priority versus purely pursuing production growth. That strategy puts the company on pace to generate $25 billion to $30 billion in free cash flow through 2020, which led it to authorize a $25 billion share buyback program through that same time frame. While Shell is earmarking a large portion of its excess cash to buy back stock, the company could still allocate some to increasing its dividend, something it hasn't done since 2013. However, even if it chooses not to increase the dividend, it's now on solid ground, making Shell a great stock for yield-seekers to consider buying for the long haul.

ExxonMobil: The Aristocrat of oil dividend stocks

ExxonMobil might not have the highest-yielding dividend in the oil patch, but it does boast the longest growth streak at 35 years. It's just one of two Dividend Aristocrats (companies in the S&P 500 that have increased their dividends in each of the last 25 years) in the sector -- along with Chevron. That shows just how much oil-price volatility can impact dividends, and is a testament to Exxon's ability to navigate through the oil market's ups and downs.

One reason Exxon has been able to continue paying a growing dividend is that the company generates lots of cash. In 2017, the oil giant hauled in $30.1 billion in cash flow from operations, while paying $13 billion in dividends; that left it with a significant amount of cash to reinvest in its business. While Exxon ended up spending $18.9 billion, it bridged the gap by selling some noncore assets and tapping its top-notch balance sheet. ExxonMobil boasts the highest credit rating in the oil industry -- and one of the highest in the world -- which is a sign that rating agencies believe the company can pay its bills even during the deepest economic downturn.

With oil prices on the upswing, Exxon expects to plow an increasing amount of money into growing its oil and gas production. In 2018, the oil giant unveiled an ambitious plan to expand, with expectations to increase its capital spending level to $24 billion in 2018, then to $28 billion in 2019, and spend an average of $30 billion per year from 2023 through 2025. These investments should enable Exxon to double its earnings and cash flow by 2025, assuming 2017's oil-price level. That growing income stream should give Exxon the fuel it needs to keep its incredible dividend growth streak alive.

Occidental Petroleum: An under-the-radar dividend growth stock

Investors tend to overlook Occidental Petroleum since it doesn't have the name recognition of BP, Shell, and Exxon. However, the oil company has treated income investors well over the years. In July of 2018, the company announced its 16th consecutive annual dividend increase. The company has increased its payout a jaw-dropping 500% over that time frame, which is one reason the yield is as high as it is today.

Occidental Petroleum can easily afford its current dividend level, since it recently achieved its breakeven plan. It can generate enough cash flow with oil at $40 per barrel to fund its dividend, as well as the capital to finance the new wells necessary to sustain its current production rate.

Occidental Petroleum's goal, however, isn't just to maintain the status quo. Instead, it aims to grow production at 5% to 8% annually, financing that with the cash flow generated by $50-per-barrel oil. That growing production stream positions the company to continue increasing its dividend.

Meanwhile, with oil prices well above that level in 2018, Occidental Petroleum now has the resources to boost its capital spending level so it can accelerate its growth rate. That should provide the company with even more cash flow, which would push its dividend payout ratio down further, making its high yield much safer.

Canadian Natural Resources and Suncor Energy: Often-missed Canadian dividend growth stocks

As with Occidental Petroleum, income investors often overlook Canada's two largest energy companies because they don't have the name recognition of their more globally focused peers. This duo, however, is worth a closer look because they've been excellent dividend growth stocks over the years.

Canadian Natural Resources is Canada's largest producer of natural gas and heavy oil. It has also been a great income stock since the company first started paying a dividend in 2001. Not only has it increased its payout on an annualized basis throughout its history, but even more impressively, the company has grown its dividend at a 22% compound annual growth rate (CAGR) since 2009.

More dividend growth appears to be in the cards at Canadian Natural Resources. Thanks to higher oil prices and the expansion projects the company has under way, its free cash flow is on pace to surge in the coming years. With the company's balance sheet on solid ground, it will likely send the bulk of that money back to shareholders through share repurchases and a higher dividend.

Suncor Energy is almost a carbon copy of Canadian Natural Resources. The leading producer from Canada's oil sands has increased its dividend for the last 16 years, with it expanding the payout at a 20% CAGR since 2012. Meanwhile, the company can support its current dividend as well as the capital to sustain its production rate as long as oil is above $45 per barrel.

Suncor Energy also has ample fuel to continue growing its dividend in the future. The company recently completed two major expansion projects as well as a large acquisition, which should fuel a 10% CAGR in production per share through the end of 2019. Meanwhile, a combination of cost reductions and other initiatives should fuel an additional 5% CAGR in cash flow from 2020 through 2023. With few expansion projects in the pipeline and a top-notch balance sheet, Suncor should generate a growing stream of free cash flow in the coming years that it will likely use to continue buying back stock and increasing its dividend.

A man holds a small plastic oil barrel labeled "Caution" in one hand, and a sheaf of $100 bills in the other hand.

Image source: Getty Images.

Oil stock dividends: A word of caution

Investors searching for yield in the oil patch need to be mindful of risk. More often than not, a higher yield carries higher risk, since it can mean that an oil company is paying out a large portion of its cash flow to support the payout. If oil prices plunge, cash flow will follow, which means the dividend could be next in line for a fall.

The best way to prevent a scenario like that is to make sure an oil company can support its dividend and an adequate reinvestment level at lower oil prices. Ideal targets are companies with a cash flow breakeven level of less than $50 per barrel. In addition, pay close attention to the company's balance sheet and see if it has a low leverage ratio -- ideally less than two times earnings -- and a strong investment-grade credit rating; those factors would give it more flexibility to maintain its dividend during the industry's next downturn.

Oil stocks can be great options for dividend investors

The oil industry can be both a blessing and a curse to dividend investors. During rough patches such as those in recent years, it can be a challenging place for income-seekers, since weaker companies need to reduce or eliminate their dividends to make it through a downturn.

However, the strongest ones were able to get through the industry's last downturn with their dividends intact, which is why they offer such high yields today. Meanwhile, with oil prices on the upswing, those payouts are likely going to be heading higher in the coming years. That's why yield-focused investors may want to consider adding an oil stock to their portfolios: The reward can be well worth the risk.

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.