Thursday, February 09, 2006

Allocating the Profit Pool

The Financial Times reported that BP expects to return up to $65 billion to shareholders over the next five years via dividends and share repurchases, if oil prices remain close to current levels. The same article suggested that the aggregate figure for Exxon, BP, Shell, Chevron and Total could reach $250 billion, based on estimates by UBS. This presumably represents a similar allocation of profits to 2005, when these companies collectively sent shareholders roughly 1.5 times as much money as they plowed back into the business. Politicians will draw their own inferences from these decisions, particularly given the magnitude of alternative energy programs these sums could fund. Nor do I believe the story here is as simple as a shortage of good opportunities for reinvestment. The response of the stock market plays a role, too.

While some company oil stocks did well over the last 12 months, with Exxon and BP outperforming the S&P 500 by about 4%--though Chevron has recently fallen back to even vs. a year ago--this is hardly the stock price performance you'd expect from companies generating the earnings and cash that these are, with no end in sight. Moreover, the valuations of these stocks clearly don't reflect today's oil prices continuing out into the future, even though that's just what the futures market shows. It's hard to account for this inconsistency, although futures prices are not a particularly good forecast of future prices. (Perhaps the best analogy is to quantum physics, with the futures contract behaving like a collapsed Schrödinger wave function.)

Back in the real world, you have a system of executive pay that has been carefully aligned by successive generations of compensation consultants to track the performance of each company's stock. Holders of large numbers of options, in particular, need to see steady appreciation in stock values, to cash in on their contingent pay. Now, if the market doesn't trust its own best estimate of the future price of the primary driver of cash flows for these firms, might it see a commitment by management to return large amounts of future cash to shareholders as less uncertain than risky oil prices, and could that give stock values the nudge that oil markets haven't?

I'm not suggesting that this fully explains the way oil companies are spending their profits. For the last two years I've been writing about the factors that make it hard for the Supermajors to replace reserves and production, including access to resources, materiality of opportunities, and queuing of technical capabilities. These all still loom large. But I certainly wouldn't discount the importance of smart people trying to succeed by the rules that have been set up for them. If we want them to do something different, such as investing in large-scale alternative energy, then we need to change the metrics for which we reward them, rather than browbeating and berating them.

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