Independents Rely Heavily on External Funds

Although they are more debt-dependent than the majors, the independents have been conscientious about reducing their dependence on debt. A highly leveraged firm (a firm with more debt than its peers) usually finds itself with higher fixed charges in the form of interest payments relative to discretionary outlays such as dividend payments. Faced with a crisis such as the oil price collapse, it would be less likely that a highly leveraged firm would be able to cover its interest payments with its operating cash flow, and may default on debt. The prospect of default and bankruptcy can be assumed to have a negative effect on investors, and the hope of reassuring investors may have motivated the independent oil producers to reduce debt. Since 1986, the surviving independents have allocated about 44 percent per year of their cash for debt reduction, while the majors have allocated about 27 percent of funds to reduce debt (Table 4) (in PDF format). This allocation of funds has resulted in a dramatic decrease in the ratio of debt to equity for the surviving independents from over 150 percent to just under 110 percent in 1993 (Figure 12). This is in contrast to the large industrial companies (as represented by the Standard and Poor's (S&P) 400 group of industrial firms), who have increased debt relative to equity markedly since the 1980's.

In addition to reduction of debt, the independents devoted the bulk of their cash to reinvestment in their own operations, about 52 percent of cash outlays from 1991 through 1993 (Table 4). The increases in debt reduction and reinvestment came at the expense of stockholder payout. Cash dividends paid to stockholders fell from 6 percent of cash outlays in 1986 through 1990 to only 4 percent of cash outlays in 1991 through 1993.

Profitability

Expected profitability is an important determinant of investors' perceptions of a company. Past profitability is usually regarded as a useful indicator of future profitability, and can be a guide to comparing companies' financial performance. An often-used measure of company profitability is net income as a percent of stockholders' equity, referred to as return on equity. The major oil companies typically engage in oil and gas production ("upstream" operations) and in refining and marketing ("downstream" operations). Poor profitability in the majors' upstream operations in low-oil-price years can sometimes be offset by better performance in downstream operations. Lacking this integration, the independents were devastated by the oil price collapse, earning a negative rate of return on investment for the years immediately following the price collapse (Figure 13).

The independents that survived the oil price collapse managed to improve profitability through the remainder of the 1980's (Figure 13). One indicator of investors' evaluation of this improved performance is the ratio of market value of the companies' shares to book value of the companies' net assets (i.e., stockholders' equity). A company's current share price reflects investors' expectations of profitability at the time the shares are purchased; book value reflects the future expected profitability of productive assets at the time the assets were purchased. The steadily increasing ratio of market value to book value for the independents reflected investor expectations of continued improvement in profitability (Figure 14). However, investors are more optimistic about the future of companies outside of oil and gas production, as evidenced by the much greater growth in the ratio of market value to book value for the S&P 400 group during the 1990's (Figure 14).

Although profitability has improved since the 1980's, return on equity for the independents has been persistently lower than return on equity for the majors and for the S&P 400 group of companies since 1986 (Figure 13). Coupled with their relatively high rate of reinvestment of funds and low payout to shareholders, this could indicate that the independents tend to overinvest in their own operations, allocating operating cash flow to relatively low-return projects, at least as measured by accounting rates of return.

Investor Risk and the Cost of Capital

A closer analysis of another measure of investor perception of risk helps explain the apparent anomaly of the low interest rates paid by the independents. An investor can reduce the risk of loss within a portfolio of assets by purchasing a variety of stocks. As long as the returns from the stocks are not perfectly correlated with one another, adding even a relatively risky stock may reduce portfolio risk. The risk of owning the stock of an independent oil company can thus be reduced by diversification, and only the undiversifiable, or systematic, risk is relevant to the investor.

An often used measure of a company's systematic risk is "beta," which is the regression coefficient of stock value of a company with the value of the market. A stock with a beta value of one moves exactly with the market. If the market goes up 1 percent, the stock will go up 1 percent. A stock with a beta of less than 1 is less volatile than the market. If the value of the overall market decreases by 1 percent, the value of a stock with a beta of 0.8 will decrease by 0.8 percent. Thus, a stock with a beta of less than one is regarded as a valuable defense against a declining market (see endnote 28). Even highly volatile stocks may have low betas, as long as they do not tend to move with the overall market.

The beta values for the independents tend to be less than one, and following the oil price collapse, are usually less than the betas for the majors until 1992.

This finding indicates that investors have been able to diversify away a substantial portion of the risk of investing in these companies. The independents' unexpectedly low interest rates reflect relatively low systematic risk.

Whether interest rates reflect systematic or unsystematic risk, the oil price crash appeared to increase the capital markets' risk premium for investment in both the majors and the independents. The average interest rate for the independents was 30 percent higher than the Moody's Aaa rate on low risk corporate bonds in 1986, and the majors' overall interest rate was noticeably higher as well (see endnote 29). Since then, the gap between the rates has steadily narrowed, indicating a lessening of the risk premia demanded by investors of the majors and the independents.

Because the predominant source of external funds for the independents is long-term debt (and because, for any firm, the alternative to investing in one's own operations is simply to invest in other stocks and bonds), the rate of interest is a good reflection of the independents' cost of capital. The reductions in debt and improvement in profitability accordingly reduced their cost of capital, and the rates of interest paid by both the majors and the independents have approached the yield on low risk (rated "Aaa" by Moody's Investor Service) corporate bonds (Figure 15).