I read with interest yesterday ConocoPhillips’ announcement that they will increase their share buyback program to around $15 billion through 2008. It was originally expected that their share buyback would be around $4 billion in 2007. The new number represents nearly a 100% increase in their original buyback plan. The announcement sent their shares soaring by 3.5% on the day. Conoco’s announcement did not surprise me (there has been little in this market that has surprised me of late). Rather, it’s made me wonder what we can infer from the fact that Conoco decided to buy back more shares.

A firm has several options with its free cash flow. It can reinvest the money back in the business or give it back to its rightful owners (the shareholders) in the form of dividends (and/or ostensibly, share buybacks).

Oil companies have a substantial amount of free cash flow right now.
After all, oil is hovering around $70 per barrel. How can you not make
money in this environment? What then can we infer from Conoco’s
increase in its share buyback program with its increased cash? There are several possible inferences:

1. Management does not think that there are any more profitable opportunities to invest in in its current business.

2. Management is acting in its own short-term interests instead of the long-term interests  of the firm and its shareholders.

I find the first explanation not very convincing. I am left then to conclude that, unfortunately, explanation #2 makes more sense.

Why do I not believe that reason #1 holds water? Well, just as recently as February, Conoco announced that it would be reducing its capital expenditure by 25% from 2006 to 2007. You mean to tell me that with oil prices near an all time high, there is no more value-increasing investment in exploration, new refining capacity, or the expansion desulfurization and/or cat cracking capabilities? If we believe the recent OECD report, we are near peak oil and we are likely to face an oil shortage within the next five years – leading to further increases in oil prices. This is not to say that oil will run dry anytime soon. Rather, it seems that there are a confluence of events leading to a general upward trend in prices. First, demand is growing briskly in emerging markets like China and India. Emerging markets will represent 46% of worldwide demand within five years (versus 42% currently). Second, demand growth projections for the next five years were revised upwards (from 2% to 2.2%) in developed countries. Finally, although there will be an ample supply of dirtier crude oil for some time after peak oil and the opportunity to convert coal to fuel and/or oil sands to fuel, these processes are currently expensive and would likewise result higher oil prices. For this reason, there seems to be ample opportunity for investment in this market.

I am therefore left to conclude that there is a bit of an incentive problem at work here. When firms buy back their shares, the effect is immediate. There is an automatic bump in share price. Therefore, the shares and options that managers hold instantly increase in value. By contrast, when management announces a large capital investment, its outcomes are less certain to market participants, and the immediate effect on share price isn’t always realized, …even though we expect managers to make such investments when projects are NPV positive. Moreover, as I described in a previous post, market participants are not very good at valuing the long-term
consequences (with more than a 5 years horizon) of current managerial decisions.

There is one other potential explanation that I neglected to mention in the list above. Some  macro economists have recently pointed out that share buybacks have reached an all-time high in 2006 and 2007 as a result of general market pessimism. That is, with remarkable earnings over the past several years, managers are becoming nervous that their earnings will not be able to keep pace, especially as the business cycle turns and the economy stumbles. As a result, companies buy back their shares to increase there earnings-per-share growth. With fewer shares outstanding, EPS looks more impressive even though total earnings have not changed. It’s essentially an illusion meant to buffer the company’s stock price when managers expect tough going in difficult markets. I’m not a macro guy, but some of this could be at work as well. However, I’d like to believe that investors are smarter than that. But even if you buy into that rationale, on closer inspection, it’s not too far removed from reason #2.

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