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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

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Abstract

The strong positive relationship between corporate cash flow and investment has been interpreted through the lens of both agency- and non-agency-based models. In this paper, we distinguish between these two interpretations using project-level data in the oil and gas industry. The specific projects we consider are auctioned-off leases that give mineral exploration rights to tracts of federal land. We find the standard positive relationship between investment and cash flow in this data, in that positive shocks to residual cash flow (netting out firm and time effects) are associated with higher spending on these leases. 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 each of these projects. We find that the increase in price induced by higher cash flow is associated with lower average productivity. In fact, the total number of productive tracts does not increase with cash flow. 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11126.

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Date of creation: Feb 2005
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Handle: RePEc:nbr:nberwo:11126

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G3 - Financial Economics - - Corporate Finance and Governance

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  1. 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. [Downloadable!] (restricted)
  2. 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. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
  4. Caballero, Ricardo J., 1999. "Aggregate investment," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 12, pages 813-862 Elsevier. [Downloadable!] (restricted)
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  5. 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. [Downloadable!] (restricted)
  6. 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. [Downloadable!] (restricted)
  7. Steven Fazzari & R. Glenn Hubbard & Bruce C. Petersen, 1988. "Financing Constraints and Corporate Investment," NBER Working Papers 2387, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Marianne Bertrand & Esther Duflo & Sendhil Mullainathan, 2002. "How Much Should We Trust Differences-in-Differences Estimates?," NBER Working Papers 8841, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. 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.
  10. Kenneth Hendricks & Joris Pinkse & Robert H. Porter, 2003. "Empirical Implications of Equilibrium Bidding in First--Price, Symmetric, Common Value Auctions," Review of Economic Studies, Blackwell Publishing, vol. 70(1), pages 115-145, January.
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  11. 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. [Downloadable!] (restricted)
  12. 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. [Downloadable!] (restricted)
  13. J B Heaton, 2002. "Managerial Optimism and Corporate Finance," Financial Management, Financial Management Association, vol. 31(2), Summer.
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