Investors are paying increasing attention to energy companies as oil prices recover from the lows seen in 2014. Shareholders also have rising expectations that dividend payments could increase as cash flow recovers at these companies. For example, ConocoPhillips (COP) increased its annual dividend payment in the first quarter of 2017 by 6% after slashing it by more than 66% in 2016 under pressure from low oil prices and high operating costs. But despite the improving macro picture for oil producers, investors might find better dividends rates for their money in other sectors, such as electric utilities.

The Best Dividend Yields Are Not In Oil

Examining a list of companies in the S&P 500 energy and utilities sub-sectors with the highest dividends relative to their share price, a concept known as dividend yield, shows the top three are utility companies rather than oil and gas companies. FirstEnergy Corp (FE), Entergy Corp (ETR) and Southern Co (SO) have current dividend yields of 4.82%, 4.79% and 4.51%, respectively. This is higher than the three largest U.S. oil companies ExxonMobil Corp (XOM), Chevron Corp (CVX) and ConocoPhillips, which have current dividend yields of 3.64%, 3.82% and 2.14%, respectively. (For more see: Big Oil Faces Uphill Battle in 2017.)

How to Decide Where Best to Invest

Beyond just looking at the dividend yield, investors need to consider other factors such as dividend stability and dividend growth. This can be done by examining a combination of the company’s payment track record relative to financial performance. Using this information, investors are better able to judge what potential future dividend payments could be generated.

Going back to our top three dividend yielding stocks in the S&P 500, both Entergy and Southern have sustained steadily rising dividends over the past six years. Entergy now pays an annual dividend of $3.48/share and has increased it twice since 2011. Southern pays $2.24/share and has increased its pay-out five times since 2011, most recently in the second quarter of 2016. FirstEnergy, unfortunately, cut its annual dividend by 34.5% to $1.44/share from $2.20/share in 2014 as the company’s financial performance deteriorated, but it has had a stable dividend since then.

Companies Need Cash to Pay Dividends

Beyond looking at a company’s payment history, investors should consider examining a few simple fundamental financial metrics in order to judge a company’s ability to sustain its dividend payment. Most important of these is free cash flow (FCF), or a measure of the cash a company is able to generate after spending the money required to run or expand its business. Companies with healthy free cash flow are able to sustain dividends without borrowing or increasing debt.

Going back to our top three S&P 500 energy and utility dividend payers, we see a mixed picture in terms of self-sustained cash generation. As you can see in the table below, FirstEnergy had the largest dip in its free cash flow out of the last six years in 2014, the same year it cut its dividend.

Source: Morningstar

The tables below suggest Southern Co is also seeing a worrying trend, with negative free cash flow of $3.7 billion as of the third quarter of 2016. The company has made up for this shortfall by increasing borrowing, up an eye watering $17.6 billion in 2016, which investors anticipate will partly be used to maintain or even increase the annual dividend​. This trend will need to reverse soon or else dividend payments could come under pressure.

Source: Morningstar

ETF Investments Are Best for Retail Investors

Companies don’t always maintain dividends. For investors to mitigate this risk, it is best to have a diversified portfolio of high dividend paying stocks. Professional investors suggest holding a portfolio of no less than 30 stocks to eliminate what is known as unsystematic risk, or the risk investors face that can’t be eliminated by investing in more and more stocks. Maintaining such a portfolio of individual stocks can be costly to an individual investor, so smaller players may want to consider the Utilities Select Sector SPDR ETF (XLU), which has a current dividend yield of 3.37%. By comparison, holding an equally weighted portfolio of the 30 stocks in the S&P 500 energy and utility sub-sectors would give a dividend yield of 3.822%. This yield is not much more than the ETF, and possibly even less after costs.

Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for Investopedia. The observations he makes are his own and are not intended as investment advice. Gary does not own any of the stocks or ETFs mentioned in this article.

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