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Profitable Investments or Dissipated Cash?: Evidence on the Investment-Cash Flow Relationship From Oil and Gas Lease Bidding

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  • Marianne Bertrand
  • Sendhil Mullainathan

Abstract

Both agency- and non-agency-based interpretations have been proposed to explain the strong positive empirical relationship between corporate cash flow and corporate investment. In this paper, we attempt to distinguish between these different interpretations using project-level data in the oil and gas industry. The specific projects we consider are mineral exploration leases on tracts of land. The standard positive relationship between investment and cash flow holds for these projects, in that we find that positive shocks to residual cash flow (netting out firm and time effects) are associated with higher spending on these projects. Interestingly, the increased investment comes from an increase in the price paid per tract with little to no change in the total number of tracts or total acreage of land bought. The positive association between price and cash flow holds even after controlling for a set of tract and firm characteristics that might be ex-ante related to expected return on a given tract. This data is most useful, however, because we can directly observe the eventual productivity of the projects undertaken. We find that the variation in bid price induced by higher cash flow is, if anything, negatively related to tract productivity. More importantly, the overall number of productive tracts does not increase with the cash flow in the year these tracts were bought. In other words, while higher cash flow is associated with higher spending on these projects, higher cash flow does not lead to higher revenues from these projects. Combining this finding with the lack of a quantity response, we conclude that our results are best described by an agency model where managers use cash flow to simplify their job (or live a “quiet life”) rather than “empire-build. ”

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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 2063.

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Date of creation: 2005
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Handle: RePEc:fth:harver:2063

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  1. Ulrike Malmendier & Geoffrey Tate, 2005. "CEO Overconfidence and Corporate Investment," Journal of Finance, American Finance Association, vol. 60(6), pages 2661-2700, December.
  2. Cabalero, R.J., 1997. "Aggregaete Investment," Working papers 97-20, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. J B Heaton, 2002. "Managerial Optimism and Corporate Finance," Financial Management, Financial Management Association, vol. 31(2), Summer.
  4. Kaplan, Steven N & Zingales, Luigi, 1997. "Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints," The Quarterly Journal of Economics, MIT Press, vol. 112(1), pages 169-215, February.
  5. Marianne Bertrand & Sendhil Mullainathan, 2003. "Enjoying the Quiet Life? Corporate Governance and Managerial Preferences," Journal of Political Economy, University of Chicago Press, vol. 111(5), pages 1043-1075, October.
  6. Daniel Kahneman & Dan Lovallo, 1993. "Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking," Management Science, INFORMS, vol. 39(1), pages 17-31, January.
  7. Timothy Erickson & Toni M. Whited, 2000. "Measurement Error and the Relationship between Investment and q," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 1027-1057, October.
  8. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  9. Aydogan Alti, 2003. "How Sensitive Is Investment to Cash Flow When Financing Is Frictionless?," Journal of Finance, American Finance Association, vol. 58(2), pages 707-722, 04.
  10. Kenneth Hendricks & Joris Pinkse & Robert H. Porter, 2001. "Empirical Implications of Equilibrium Bidding in First-Price, Symmetric, Common Value Auctions," NBER Working Papers 8294, National Bureau of Economic Research, Inc.
  11. Lamont, Owen, 1997. " Cash Flow and Investment: Evidence from Internal Capital Markets," Journal of Finance, American Finance Association, vol. 52(1), pages 83-109, March.
  12. Steven M. Fazzari & R. Glenn Hubbard & BRUCE C. PETERSEN, 1988. "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 141-206.
  13. Hendricks, Kenneth & Porter, Robert H, 1996. "The Timing and Incidence of Exploratory Drilling on Offshore Wildcat Tracts," American Economic Review, American Economic Association, vol. 86(3), pages 388-407, June.
  14. Marianne Bertrand & Esther Duflo & Sendhil Mullainathan, 2004. "How Much Should We Trust Differences-in-Differences Estimates?," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 249-275, February.
  15. Hyun-Han Shin & René M. Stulz, 1998. "Are Internal Capital Markets Efficient?," The Quarterly Journal of Economics, MIT Press, vol. 113(2), pages 531-552, May.
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Cited by:
  1. Osmundsen, Petter & Mohn, Klaus & Misund, Bard & Asche, Frank, 2007. "Is oil supply choked by financial market pressures?," Energy Policy, Elsevier, vol. 35(1), pages 467-474, January.
  2. Beshears, John, 2013. "The performance of corporate alliances: Evidence from oil and gas drilling in the Gulf of Mexico," Journal of Financial Economics, Elsevier, vol. 110(2), pages 324-346.
  3. Nuno Torres & Óscar Afonso & Isabel Soares, 2010. "The connection between oil and economic growth revisited," FEP Working Papers 377, Universidade do Porto, Faculdade de Economia do Porto.

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