- Oil companies have historically underperformed, with reinvestment often eroding shareholder value rather than enhancing it.
- Unlike other industries, oil companies’ reinvested earnings have frequently decreased shareholder value, making a case for focusing on dividends rather than relentless expansion.
- Given weak demand and ample supply, further oil production may only lower prices, questioning the wisdom of recent acquisitions and aggressive drilling strategies.
No this is not about politics.
A while ago, we argued that, facing weak demand and no shortage of supply, oil companies should not put their resources into producing more oil. The industry has an abominably bad record of investing in a way that does not benefit its owners, so why not just give the money back to them in the form of dividends instead of throwing it into holes in the ground? We didn’t get a lot of fan letters for that piece. Plus, right after we aired our opinion, both ExxonMobil and Chevron made huge acquisitions of oil and gas properties. The heavyweights have spoken. What do these guys know?
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A few days ago, Donald Trump made a campaign appearance in Pennsylvania and enunciated his energy policy as frack, frack, frack, drill, baby drill, or words to that effect. We understand the attraction of that policy to people who make their living drilling for oil and gas. But a Trump administration will have difficulty making people drive more, or convincing Brazil and Guyana not to dump more oil into the market (they want their share) or convincing our Saudi friends to step back, considering that their oil sales are falling below what they need to finance their development projects. Putting more oil and gas on the market will just depress prices, we would guess.
But that is the background. Our argument is that over more than a decade oil companies have consistently invested in a manner that does not earn the cost of capital and the market has noticed. It works this way: An oil company invests $100 in a well whose risk characteristics demand a 10% return. The well earns only 8%. The market, which requires a 10% return, decides the well is worth only $80. Now think of an oil company as one big oil well. A company raises $100 to put into the ground. Investors want to earn 10% ($10) but soon realize that the company will earn only $8 (8%), so they drop the price they pay for the company to $80 in order to earn that 10% return.)