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

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. ”