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Cash Flow and Outcomes

How the Availability of Cash Impacts the Likelihood of Investing Wisely

Research by Marianne Bertrand

As a firm's cash flow increases, it is expected that its investment in potential revenue-generating opportunities will also increase. However, recent research examining the auctions of oil and gas leases shows that greater cash flow does not lead to investment in a greater number of tracts, a larger amount of acreage, or more productive, revenue-generating tracts. Instead, greater cash flow leads to paying more for leases that are not more productive.

A number of investment studies have demonstrated that cash flow is an effective way to predict investment. There are three primary interpretations of this relationship. The first states that a surge in company cash flow is a good indicator of an increased availability of valuable investment projects.

The second interpretation argues that companies already know about potential investment opportunities, but are prevented from investing because of limited access to external sources of financing. As cash flow improves, companies are able to partake of attractive opportunities that would be otherwise unavailable.

The third, known as the "free cash flow theory," asserts that managers do not behave in a manner consistent with profit maximization, as the first two interpretations suggest. Managers instead use increased cash flow to pursue objectives that have little to do with increasing profits and a great deal to do with making the managers' lives better (such as increasing the size of their company), or easier.

In the study "Cash Flow and Investment Project Outcomes: Evidence from Bidding on Oil and Gas Leases," University of Chicago Graduate School of Business professor Marianne Bertrand and Sendhil Mullainathan of Massachusetts Institute of Technology gauge the accuracy of these interpretations. They use data from federal auctions of mineral rights to offshore tracts to create a more vivid picture of the link between investment and cash flow.

Their results appear to confirm a version of the "free cash flow theory" interpretation.

"Some have argued that managers may have a preference for building empires, and therefore if I give a manager more cash, he will try to expand the company," says Bertrand. "Our findings contradict this view. When there is more cash, managers do end up spending more, but they are not bidding on more tracts. They are bidding more per tract on tracts that seem to be of approximately the same value."

Bidding for a Bonanza

For the past 50 years, firms have bid on leases that provide mineral exploration rights to federal land tracts in Alaska and off the coasts of the Gulf of Mexico and the Pacific Ocean. The leases, typically five years in length, are auctioned by the U.S. Department of the Interior.

A company with a winning bid is permitted to explore a tract, drill holes, and test for the presence of gas, oil, and other minerals. If no mineral reserves are found during the lease period, ownership of the tract reverts to the federal government. However, if minerals are found, the lease is automatically renewed for as long as minerals are produced. In essence, exploration leases provide monopoly rights to extraction.

To study the relationship between cash flow and investment, Bertrand and Mullainathan focused on leases for tracts in the Gulf of Mexico. The authors used Minerals Management Service (MMS) data, which provides bidding information, tract characteristics, contract characteristics, and whether leases were productive by the time the exploration period ended. The authors then merged this information with balance sheet data from COMPUSTAT for publicly-held companies bidding on tracts. They combined the two data sources and tracked approximately 120 companies from 1963 to 1999.

Because they focused on a specific industry and investment type, Bertrand and Mullainathan first had to answer two fundamental questions. First, did companies in this industry, like those elsewhere, display a strong correlation between cash flow and balance sheet capital expenditures? Second, did overall capital expenditures by firms correlate with the amounts bid and expended on oil and gas leases? In each case, they found the answer was yes.

The authors then investigated the relationship between cash flow and total lease expenditures within the mineral exploration field. They found that an increase in cash flow also boosted the total amount bid and spent on tracts.

Exploring a Quantity Effect

If the "empire building" interpretations were correct, it would be reasonable to expect that as cash flow increased, so too would the number of leases or the total number of acres on which companies would bid. However, Bertrand and Mullainathan found no relationship between cash flow and either quantitative measure.

"There is no quantity effect," Bertrand says. "Greater cash flow doesn't necessarily mean companies are investing in more projects or in more acreage. Companies are just spending more per project."

The finding that the average price per lease or per acre increased with cash flow left the authors with two possible interpretations. One is that firms experiencing increases in cash flow might be opting to bid on less risky leases that boasted a higher probability of eventually yielding a profit. Such leases would thus merit higher bids. The second possible interpretation is that rich firms may simply be wasting cash by paying too much for leases of equal quality.

To determine which interpretation was most plausible, Bertrand and Mullainathan analyzed how various characteristics of tracts impacted the price of bids. Recognizing that larger tracts tend to be less productive, they examined lease acreage and its impact on bid prices. Similarly, they studied the depth of the tracts, because deeper tracts have historically proven harder to exploit. The authors also looked at the productivity of previously auctioned tracts in the same geographic area, and its effect on the price of bids.

As predicted, larger tracts were found to sell at lower prices, and lower bids were recorded for deeper tracts.

Bids were higher for tracts in the same geographic areas as other tracts that were productive. However, controlling for those characteristics had little impact on the connection between greater cash flow and higher bid prices.

Another characteristic, "next highest bid," was even more revealing. The authors tracked winning and second-highest bids and found that when cash flow increased, companies not only bid more for leases, they also bid more after Bertrand and Mullainathan accounted for the next highest bid.

The authors also examined the proximity of tracts to areas already explored by the firm, which might lower exploration and extraction costs. Such proximity could lead firms to justify higher bid prices. But the authors found that increased cash flows did not result in firms being more likely to bid on tracts located in areas where they had a greater presence.

Bertrand and Mullainathan conclude that the relationship between cash flow and bid prices is not affected by tract characteristics. Instead, the link between greater cash flow and greater bid price appears robust after accounting for these observable tract characteristics.

Access to Private Information

Was it possible that firms with higher cash flow were privy to private data about tract quality, and therefore bid more based on this information?

To test this alternative explanation, the authors examined whether the cash flows of firms at the time of auction could predict the eventual productivity of tracts on which those firms bid. When cash flow-driven increases in bid price per acre were compared with tract productivity, no correlation was found.

If any pattern emerged, it was that a small increase in bid price per acre due to a surge in cash flow was associated with a tract eventually proving slightly less, not more, productive.

"The beauty of the data is that we could actually observe individual investment projects," says Bertrand. "Furthermore, we could observe some measure of return on the projects; basically whether or not the companies found any oil or gas. Looking at the outcome of the projects should theoretically give us a sense of whether private information can explain the positive relationship between cash flow and bid price. We find that this is
not the case."

Just as productivity of tracts did not increase with cash flow-driven increases in bid price, neither did revenues.

"We do not find a connection between revenue and cash flow," says Bertrand. "When companies have greater cash flow, they spend more on these investment projects, but when they have this additional cash flow, it does not lead to these projects generating more revenue."

A final question was whether cash-rich firms took bigger risks, bidding on tracts that might be less likely to yield oil or gas, but would provide greater amounts of oil or gas when minerals were found. Here again, bid price was not a predictor of greater output. Higher bids fueled by cash flows did not result in the acquisition of tracts producing greater amounts of minerals conditional on being productive. The clear message: Bidders are not able to accurately predict the amount of resources in the ground.

Bertrand and Mullainathan suggest that future research might look at how the separate divisions of companies make their bidding decisions based on the cash flow available to them. Researchers may also want to examine other industries for the same tendencies evident in oil and gas exploration.


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Marianne Bertrand is professor of economics and Neubauer Family Faculty Fellow at the University of Chicago Graduate School of Business.

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