Big Oil's big 'problem'

US giants Conoco and Exxon have more money these days than they know what to do with, so they're handing it out to shareholders. What they aren't doing with it is much that will reduce the oil crunch.

By Michael Brush
While many Americans struggle to fill their gas tanks, big U.S. oil companies are making so much money that they literally don't know what to do with it.

Instead of reinvesting more of their newfound wealth to increase supplies or develop emerging technologies that might one day reduce energy costs, they are giving much of the loot to shareholders already enjoying outsized gains.

In a capital-intensive business, giving cash back to shareholders is often the equivalent of throwing in the towel. It's saying "we can't do anything with this money to improve our business."

And it certainly doesn't address the oil crunch that consumers pay for every day at the pump.

Is that what oil giants pay executives exorbitant salaries to do? Especially in a sector where better long-term vision and reserve development 10 years ago might have helped avoid the current mess?

I don't think so. But that's what's happening.

Big money is worried, too
This isn't just an issue for disgruntled consumers. Analysts debated the issue with ConocoPhillips (COP, news, msgs) execs on its last conference call.

The company made $11.9 billion in net income last year, and it will do even better this year. It plans to give it all back to shareholders, paying more than $3 billion in dividends and spending $10 billion to buy back shares. (Buybacks reduce the number of shares on the market, usually increasing the share price.)

That's a lot of cash, enough to take 9 cents off the price of every one of the 141 billion gallons of gasoline consumed in the United States in a year.

Michael LaMotte of JPMorgan Chase (JPM, news, msgs) questioned why ConocoPhillips wasn't devoting more than $15 billion to its capital budget. After all, ConocoPhillips production volumes declined in the last quarter, even without counting production lost when it got booted out of Venezuela.

Citing the juicy returns that energy companies get from finding and producing oil with crude prices are so high, LaMotte expressed exasperation. "I mean, clearly excess cash goes to buyback, but if I look at returns of a buyback program versus (capital spending), what's the thought process there?" he asked.

Conoco chief James Mulva, who places a big emphasis on cutting costs as a way to raise his company's stock, brushed off the protest. "We like the discipline of the share repurchase," he said. "If we find that we have more cash flow, it's not really going to be going toward capital spending."

Exxon's billions
For example, take a look at ExxonMobil (XOM, news, msgs), the biggest publicly traded U.S. oil company. It generated $40.6 billion in net income last year and $36.6 billion in free cash flow. What did it do with those riches?

It gave $38.4 billion back to shareholders -- $7.4 billion in dividend payments and $31 billion through share buybacks.

Let's put that $38.4 billion in perspective. Assume the average household spent $2,200 on gasoline last year, up 10% from the $2,000 the Bureau of Labor Statistics (BLS) says they spent in 2005, the latest numbers available.

This means the windfall profits that ExxonMobil gave back to shareholders last year were enough to buy all the households in both California and Pennsylvania gasoline for the entire year.

It was enough to give everyone a 27 cents-a-gallon discount on gas nationwide for the whole year.

Despite ExxonMobil's generosity with shareholders, it's made so much money recently that it still had $31.4 billion in cash, net of debt, at the end of the first quarter of 2008. This year, ExxonMobil plans to give $24 billion back to shareholders in the form of buybacks and more than $8 billion in dividends.

This despite the fact that, as my colleague Jim Jubak reported recently, Exxon's production is falling.

What about the future?
Certainly, there's nothing wrong with rewarding shareholders; that's what capitalism is all about. But we should all get a little uneasy when we consider what big U.S. oil companies are not doing with the current windfall.

They're not spending proportionately more wealth to develop new reserves. At a time when energy experts say gas prices are soaring in part because of a dearth of development over the past decade, this seems shortsighted and irresponsible. But that's what's happening.

Thanks to rising energy prices, ExxonMobil's free cash flow jumped 135% to $36.6 billion last year, from $15.6 billion in 2003. The company has hiked dividends 8.3% a year, annualized, over the past five years, according to Morningstar. The amount of money spent on share buybacks increased 427% to $31 billion last year, compared to 2003. But capital spending only went up 20% in the same time frame, to $15.4 billion.

ConocoPhillips' free cash flow increased 300% to $12.7 billion in 2007, compared to 2003. Over the past five years, it increased dividends by 17.3% a year, annualized. It bought back no stock in 2003 and 2004. But stock buybacks advanced to $7 billion last year and will increase again to $10 billion this year. In contrast, capital spending increased only 90% in the same time frame to $11.8 billion.

While ExxonMobil and ConocoPhillips reinvest just 29% and 48% of their cash from operations into their capital budgets, foreign energy giants with prodigious cash flow like Royal Dutch Shell (RDS.A, news, msgs) and Total (TOT) are doing more to assure sufficient energy supplies down the road. They reinvest 71% and 63% of operating cash flow into capital spending.

Talk back: How high will gas prices go this summer?

They're not spending substantially more on green, sustainable and renewable energy alternatives. While BP (BP, news, msgs) may overplay its green image, as I wrote recently, at least it is spending a decent amount on alternative energy development. Comparable spending at ExxonMobil and ConocoPhillips remains pathetically low, maintains industry critic Antonia Juhasz, a fellow at Oil Change International and author of "The Tyranny of Oil: The World's Most Powerful Industry, and What We Must Do to Stop It," due out in September.

BP spent $688 million, or 4.5% of its capital budget, on renewable energy in 2006 (including a few other activities lumped in to this budget line.) ExxonMobil spent nothing that year, says Juhasz. ConocoPhillips spent only 0.5% of its capital budget, or $80 million, on "emerging businesses," which includes alternative energy along with many other projects, says Juhasz.

Where the money also goes
Along with dividends and buybacks, energy companies are spending big chunks of their windfall on executive salaries and lobbying.

ConocoPhillips' Mulva earned $50.5 million last year, the bulk of which was performance-related. The top seven execs at ExxonMobil got $93.7 million last year including $16.7 million for chief Rex Tillerson.

ExxonMobil spent more than $15.5 million on federal lobbying in 2006, says Juhasz, and ConocoPhillips spent $4 million last year -- no doubt a reason the two companies enjoyed the billions of dollars in federal tax subsidies the energy industry gets each year.

ExxonMobil and ConocoPhillips both declined to respond for this article.

In fairness to them, however, I'd point out that critics are off base when they say these companies are "gouging" consumers, now that crude prices are high. Their refining arms are in fact being hurt because the costs of buying raw materials -- crude oil -- are rising faster than prices at the pump. But of course, these giants are still better off when oil is at $125 a barrel. Higher profits from oil production more than offset compressed margins on the refining side.

Talk back: Have you been hit with 'sticker shock' at the gas pump?

As for underinvestment, the American Petroleum Institute (API) says the U.S. oil industry did its part back when oil was cheap and profits were lean. The industry invested more than $1.25 trillion in long-term energy initiatives between 1992 and 2006, compared to net income of $900 billion during the same time, says API.

And ExxonMobil and ConocoPhillips are bringing new supply on line. ExxonMobil has 12 new energy production projects coming in 2008.

One problem is that so much of the world's rich oil reserves are in the hands of national oil companies, says Tom Nelson, a London-based energy sector analyst with Guiness Atkinson Global Energy Fund (GAGEX). Another is that much of known U.S. reserve is off limits for environmental reasons, says Charles Drevna, president of the National Petrochemical and Refiners Association. "Where do you want ExxonMobil or ConocoPhillips to put that money?" he asks.

This argument does hold some water. After all, Royal Dutch Shell and Total can put money in areas of the world that the U.S. government keeps off limits for U.S. companies -- like Iran, Syria, Sudan and Cuba.

But when you see what a smaller, enterprising company like Contango Oil & Gas (MCF, news, msgs) is up to, it's hard to buy in completely. Since I first met Contango chief Kenneth Peak in 2005, he has uncovered enough energy finds in the Gulf of Mexico to add over $1 billion in market capitalization to his company. And he's not done. He plans to spin off much of his proved reserve base and keep looking.

That billion dollars in market cap, by itself, might not make a huge difference at a giant like ExxonMobil. But as a return on one of dozens of comparable-sized projects, it would have value.

And Chevron (CVX, news, msgs), the other U.S. oil giant, doesn't seem to have problems finding potential projects. Like the European energy giants, it's spending close to 60% of its cash flow on developing new reserves, says J. Robinson West, chairman of PFC Energy, an energy sector consultant.

That's not a bad strategy, given the recent huge unexpected Tupi oil field discovery off the coast of Brazil and the rapid expansion of Canadian oil-sand projects. It's just one that the other U.S. oil giants don't seem to be following -- at least as closely as they should.

Shareholders at Exxon and Conoco no doubt like the cash back now, but they may wind up paying in the end if they hold on long enough.

And in the meantime, they're oil consumers like the rest of us. We'll be paying more at the gas pump -- now, and in the future.

At the time of publication, Michael Brush did not own or control shares of any of the stocks mentioned in this column.

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