Oil Companies Deploy Capital Allocation

 | Jul 29, 2013 | 1:00 PM EDT  | Comments
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Stock quotes in this article:

xom

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bp

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cvx

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rds.a

This is a big week for oil, or more specifically for big oil. By the end of this week Exxon Mobil (XOM), BP (BP), Chevron (CVX), and Royal Dutch Shell (RDS-A) will have reported earnings. The market will then have a good picture of the state of the oil industry today after these Big Four provide results and issue outlooks. 

But an interesting thing is happening to oil stocks, namely the equities of the major producers. A barrel of oil today is at $107, a price where the majors can certainly make plenty of money. But five years ago this week -- as the markets were about to implode -- a barrel of oil hit $147. Since the price of oil weighs heavily on the profitability, and therefore the share price, of oil companies, one would rationally expect that owning oil stocks has been dreadful the past five years. 

According to the Wall Street Journal, the four oil majors collectively earned $28 billion in profits last quarter. That was $10 billion less, however, than the collective number five years ago. Indeed, the 40% drop in the price of oil over those five years was a factor.

Just as important was the capital allocation decisions that occurred. Big Oil reduced investment in exploration and some have even gotten smaller by selling off assets. The Journal further notes that the Big Four are collectively producing 300,000 fewer barrels per day than they were five years ago. 

Yet during those five years, the oil majors continued to allocate capital toward share buybacks and dividend payments. In the past four years, Exxon's annual dividend payout has increased from $1.66 a share to $2.18 a share. Shares outstanding have declined from 4.8 billion to 4.6 billion. Shares are up around 30% over that time even though the price of oil has steadily dropped.

Chevron has increased its dividend payout from $2.66 a share to $3.51 a share in four years. Shares outstanding have dropped slightly from 2 billion to 1.96 billion. Shares are up over 80%. 

This experience with the oil companies should crystallize to investors one important thing: the undeniable value of capital allocation in the overall performance of a company. Take two companies with identical operating activities but different capital allocation strategies, and the best shareholder returns will come from the company that does a better job deploying its capital.

For most companies not called Berkshire Hathaway, the best course of actions is to buy back your own stock and return cash to shareholders. 

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