Cash is gushing into international oil companies after the recent jump in the price of oil and gas. According to our estimates, the five largest corporations generated more than $120 billion in cash flow before capital expenditure in 2005—equivalent to about twice their capital expenditure over each of the past few years and more than one and a half times the annual cash flow recorded during the industry's last boom, from 1979 to 1981.¹ Suppliers are also benefiting: oil field service companies are expected to report increases of more than 50 percent in full-year 2005 profits over the figures for 2004.

What should companies do with the extra cash? Although executives might be expected to relish such a problem, the decisions they make will have ramifications far beyond the oil industry. On the one hand, companies face pressure to invest more in exploration, production, and refining (where margins have also risen): consumers and governments are angry about high prices, the industry's large profits, and the channeling of those profits into share buybacks and dividends rather than into investments that might bring down prices. On the other hand, with the industry outperforming the S&P 500 by almost 30 percent since 2003, the capital markets seem to be rewarding companies for the share buybacks and dividends—amounting in total to almost $120 billion—that have been announced during this period.²

The conundrum is this: has the industry entered an era of permanently higher oil and gas prices and refining margins or is it merely experiencing another market bubble? If executives believe the former hypothesis, they will focus their companies' excess cash on long-term investments, though at the risk of precipitating the kind of price collapse that would destroy the value of those investments. If they believe the latter, they will return the cash to shareholders and risk missing opportunities to create value over the long term if prices remain high.

We believe that such crucial decisions would be better informed if the industry were to reflect upon its history—in particular, its inability to return its cost of capital over four decades of boom and bust. Coupled with an understanding of the economics of new capacity and of alternative fuel technologies, the evidence suggests that dangers await companies that place too large a bet on a fundamental structural change by investing in projects that will be profitable only if the market has indeed altered for good. They would do better to exercise discipline over capital spending and to invest in opportunities to build sources of competitive advantage that they can sustain regardless of whether prices shift structurally or revert to levels closer to the long-term averages.

A familiar road

The history of the oil industry is long on boom-and-bust cycles in crude prices and refining margins and short on examples of capital discipline. In the 25 years to 1998, the industry's total return to shareholders (TRS) was below that of the S&P 500 (Exhibit 1) because the industry failed to return its cost of capital over the cycle. During booms, oil companies would behave as if the world had changed permanently, investing in projects that could make a profit only if prices stayed high.³ The exceptions were the larger, globally integrated companies, such as BP, ExxonMobil, and Royal Dutch/Shell, which delivered TRS in line with the overall market. These companies did show capital discipline: they made strategic investments in assets and technologies, including very large oil fields and deep-water drilling, that demanded specialist capabilities and large amounts of capital, as well as investments in refining portfolios that use better technologies and are located in economically attractive places. In this way, they generated returns roughly in line with the cost of capital over the cycle.

Since 1998, the industry has enjoyed its longest boom in 40 years and consistently earned returns above its cost of capital (Exhibit 2). Recently, prices have been pushed ever upward thanks to unexpected increases in demand from the United States and China, as well as a tightening of supplies caused by delays in upstream projects, the war in Iraq, and last autumn's hurricanes in the Gulf of Mexico. Margins on refining have also risen. These external factors, combined with a fall in real interest rates,⁴ have enhanced the value of oil companies (Exhibit 3). Since 1998, the industry's TRS has been 13 percent, compared with less than 1 percent for the S&P 500.

Here we go again?

The executives who must decide which direction the industry will take see conflicting signals. Initially, the case for the idea that a structural change has occurred seems strong: most large oil fields are maturing, a significant proportion of the reserves is located in politically unstable or unsafe areas, and the need for secure oil supplies is greater than ever—in developed and developing economies alike. Indeed, it is demand, rather than constraints on supply by OPEC,⁵ that differentiates the recent spike in oil prices from earlier increases. In refining, the chronic overcapacity of the 1980s and 1990s has also disappeared.

At the same time, though, the messages from financial markets are decidedly mixed. The forward curve⁶ of prices suggests a structural shift: crude futures contracts appear to have abandoned the $20–to–$25 range of the past decade and are forecasting prices as high as $60 a barrel until 2010. To justify the stock price of oil and gas companies, you would have to believe that oil prices will be something closer to $30 to $40 a barrel. Moreover, predictions vary wildly from one analyst to another, with long-run price forecasts for crude oil ranging from as little as $30 to more than $90 a barrel—and even a few extreme forecasts of more than $200.

Executives must also factor in the macroeconomic conditions, such as global GDP growth, that influence margins. Traditionally, economic growth slows as oil prices rise, although high prices might have less effect now than they had in the past, given the combination of low worldwide interest rates⁷ and what by historical standards is a lower than usual global dependency on crude oil. Even so, the developing world's demand for oil is vulnerable to a setback in China's fragile banking system, for example, or to a monsoon in India.

More difficult still is the task of forecasting the behavior of other executives, national oil companies, and new industry participants and investors, such as private equity firms. Their actions—particularly in relation to capital investment and the development of alternative fuels and fuel efficiency—could swiftly change the industry's outlook.

The old enemy

With so much cash available, companies may be sorely tempted to loosen their capital discipline. Many opportunities to invest in refining and upstream assets are highly attractive at current prices and margins. Moreover, companies that in recent years have invested in projects requiring prices and margins to remain high have reaped rewards, at least so far. And evidence suggests that the level of investment is rising rapidly: capital expenditure by integrated players and by the exploration and production business has nearly doubled since 1999 (Exhibit 4).

There are three main reasons for the increase in capital expenditure. One is inflation—the result of higher prices for commodities such as steel and of shortages in essential inputs such as engineering resources and drilling equipment. Another is incremental investments (which can have quick paybacks) in existing fields and refineries. But the third is strategic bets on high long-term oil prices and refining margins. In some cases, such bets are being placed because industry players have difficulty finding investment opportunities that are attractive at lower prices and because of pressure to replace reserves.⁸ In hindsight, it will be thought that these investments either reflected deep insights into a structural shift in the oil industry or represented further examples of its lack of capital discipline.

The risk is that lax discipline in pursuing investments could severely erode margins. McKinsey analysis suggests that if all private-sector and national oil companies increased their capital spending from the current level of about 75 percent of cash flow to 90 percent (in line with the industry average over the past decade), by 2010 worldwide production and refining capacity would rise by 10 to 15 percent of the current level, in addition to the growth that is already expected. Depending on how much demand grows, a significant amount of this capacity could be unused, leading to the familiar bust.

A further threat to oil and gas prices comes from the rise of alternative fuels and substitute technologies. The longer crude prices and refining margins remain high, the greater the incentive for outsiders to invest in renewable generation, in nonfossil fuels such as biodiesel, and in hybrid-car technology—and the more price-competitive these technologies become as a result of scale effects. Governments can also tilt the field toward new technologies by providing incentives for reducing carbon dioxide emissions.

Clearly, the industry faces more uncertainty than it has at any time in the past decade. This uncertainty—and the accompanying volatility—will probably continue for some time. Given these conditions, there are three possible outcomes. In the first, capital discipline could slip in the core business while investment in alternative technologies increased. The result would be excess capacity and below-cost-of-capital returns across the value chain. In the second scenario, the downturn might be limited to refining and service areas such as shipping, since it is easier to add capacity there than in exploration and production. Such an outcome might lead to a softer landing of adequate returns on capital in exploration and production, where overinvestment is less likely because exploration opportunities are limited and often found in restricted geographies, such as Iraq. In this scenario, exploration and production investments might also benefit from OPEC's support of oil prices. The longer prices remain high, however, the greater the opportunity for overinvestment—and the worse the first two scenarios become. In the third scenario, the whole industry could enjoy a soft landing if executives were to use discipline in placing their bets and if investment in alternative fuels were limited.

What will set the winners apart?

Faced with such uncertainty, how might executives plot their strategies? First, they need to move the focus of their discussions with boards and investors beyond volume-based metrics such as market share and reserves replaced. A preoccupation with these measures increases the likelihood of an indiscriminate capital expenditure to meet a target. Instead, the emphasis should be on the conditions needed for new reserves to create value. Next, since the industry's immediate outlook is sound, the logical move would be to pursue investment opportunities that benefit from high current and likely near-term margins but do not depend on permanent structural price shifts.

In an uncertain climate, executives should also keep the following principles in mind:

• Think for the long term. In current conditions, oil companies should be able to build positions that are competitive under most market conditions. They can invest, for example, in new technologies and capabilities, in new territories (as ExxonMobil has done in Qatar and Schlumberger in Russia), and in the booming markets of China and India. To give themselves options down the road, they should also invest enough in less common types of oil, such as heavy crude and tar sands, and in alternatives to oil and gas, such as wind power, solar power, and biofuels.⁹ These options, which could be attractive if costs came down significantly or higher prices and margins were sustained, must be balanced against their longer-term strategic positioning.
• Sell high. With so much money available, now is a good time to dispose of disadvantaged assets at attractive prices to buyers who might also be better placed to exploit them. Sellers can then redeploy their human and financial capital to other investments.
• Focus M&A. Companies should avoid deals whose value relies on the sustainability of high margins. Mergers of equals, asset swaps, and the purchase of capabilities are all relatively independent of future market prices. In addition, if companies understand the margin assumptions embedded in their own share price, they can selectively use their shares for acquisitions when prices are in line with these assumptions. Companies might be able to pay high prices by using the futures market, hedging near-term production to justify the acquisitions, and then keeping the assets as a long-term play. They might also undertake strategic acquisitions, including assets or capabilities to support future business building, to enter new geographies, or to acquire expertise in alternative fuels.
• Maintain capital discipline. Rather than spend excess cash on projects that require high prices and margins, executives should use them to increase dividends or buy back shares—even if this approach affects the company's ability to replenish reserves or to bolster market share—and resist pressure from governments and consumers to invest more. When deciding between share buybacks and increased or special dividends, executives must take into account the valuation of their companies instead of considering only the boost in earnings per share. They should also develop a deep understanding of the way cash flows evolve over the economic cycle, so that they have the flexibility to seize opportunities both when cash is plentiful and when it is not (see "Making capital structure support strategy," coming in early February).

During all oil price booms, it becomes possible to imagine that the industry's economics have changed forever. But history shows that the point when industry observers start to say that things are really different this time around usually marks the top of the cycle. By then, the seeds of the crash to come have germinated. In the current boom, companies at all stages of the value chain need to maintain investment discipline. Executives should use excess cash to build sources of competitive advantage while shifting the focus to measures of true value creation. They will then be equipped to generate value in a highly uncertain environment and to break the pattern of the past 40 years.