30-09-05 During past periods of high oil prices, oil companies have tended to spend billions diversifying -- and burnt their fingers.
This hard lesson has led oil companies to prefer share buybacks during the current bout of high oil prices, but now new questions are being asked about whether this is a mistake too.

During the World Petroleum Congress it too has become clearer that the current high oil prices have more to do with the lack of refining capacity and other infrastructural issues, rather than a lack of oil reserves. The point was driven home graphically by Saudi Arabia’s Oil Minister Ali Naimi, who told the conference that in response to calls for increased supply in the wake of the high prices and US hurricanes, spare barrels were made available. But, he said, there were no takers.
Existing oil reserves are more than enough to meet rising future demand, but without new refineries prices will remain high and markets volatile, he says.

With comments like this from the world’s leadingproducer, it now appears that the huge amounts of money oil companies have been spending on share buybacks would have been better spent on developing infrastructure and building refineries.
The issue was tangentially referred to during a session on natural gas by George Verberg, the president of the International Gas Union. He told the congress that when the issue of share buybacks was first raised he thought the amount spent by oil companies on this form of financial engineering amounted to “peanuts” in relation to the size of the industry as a whole. But, intrigued, he asked his staff to investigate the issue. The results were staggering. The top five oil companies alone had in the recent past, spent more than $ 70bn on share buybacks.

It is easy to see why the companies have adopted this course.
First, they are rolling in money. Oil major ExxonMobil ended last year with net income of $ 25,3 bn on sales of $ 291,2 bn. Its cash pile has continued to grow at a massive rate, and its earnings for thelatest quarter alone were just under $ 8 bn, bringing its total cash amassed to $ 18,5 bn. Since then, the oil price and the company’s earnings have risen yet higher.
Second, share buybacks are attractive to existing shareholders and tend to improve comparable performance in terms of many of the ratios typically used to compare performance, for example, earnings a share.

During past periods of high oil prices and surplus cash, oil companies have branched out into related industries -- and some totally unrelated. During the 1970s, Mobil bought retailing company Montgomery Ward; Atlantic Richfield bought Anaconda, a metal and mining company; Shell bought a mass of coal companies around the world; and Exxon bought a majority stake in Vydec, a company specialising in office automation.
According to a McKinsey study, the oil industry in the 1970s was a good example of an industry utilising its capital badly. The huge price umbrella provided by the Organisation of Petroleum Exporting Countries (OPEC) allowed oil companies to operate with relatively high margins.

“Nevertheless, for almost three decades the spread between return on invested capital and cost of capital for the industry as a whole was negative,” authors Richard Dobbs and Werner Rehm wrote in the study.
“In most cases, buybacks create value because they help improve tax efficiency and prevent managers from investing in the wrong assets.”

But it now seems as if the industry ought to have been investing in itself. Verberg says that had the $ 70 bn given back to shareholders have been used to generate capacity, and assuming companies retained debt of 25 %-75 % of equity, then a total of 4,7-mm bpd would be available now.
This compares with the current production of OPEC of about 33-mm bpd, which will have made a significant difference to the current undersupply. Verberg questions, however, whether the refinery and infrastructure projects were available for investment, echoing other delegates who have emphasised difficulties in finding viable projects because of recent increases in costs of building infrastructure.

It is apparent from a variety of speakers at the conference that, like the mining industry, the coordinated and expanded global economic upturn has put strain on all aspects of the production supply chain.
The result is that shareholders can probably look forward to more cash windfalls in the form of share buybacks until viable projects present themselves.