Richard J. Gonzalez

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: Regularization of Business Investment
Volume Author/Editor: Universities-National Bureau
Volume Publisher: UMI
Volume ISBN: 0-87014-195-3
Volume URL: http://www.nber.org/books/univ54-1
Publication Date: 1954
Chapter Title: Regularizing Petroleum Investment
Chapter Author: Richard J. Gonzalez
Chapter URL: http://www.nber.org/chapters/c3024
Chapter pages in book: (p. 137 - 146)REGULARIZING PETROLEUM INVESTMENT
RICHARD J. GONZALEZ
HUMBLE OIL AND BEFINING COMPANY
possibilities of achieving greater stability in capital expendi-
tures depend upon the nature of the industry, the circumstances
encountered during the business cycle, and the financial situation.
Among the characteristics of the petroleum industry that affect the
stability of its capital expenditures, the following appear to be
particularly important: a strong growth trend; the large number of
wells, service stations, and similar facilities involved; the competi-
tive development resulting from the discovery of a large new field;
and the great reliance on funds generated within the business in the
financing of new investments.
The demand for petroleum products in the United States has
increased at an average rate of 5 per cent annually over several
decades. Only in five years since 1920 has there been a decrease in
domestic demand for petroleum, and in only one year was the
decrease greater than 3 per cent. The prospect of increasing demand
should be a favorable factor in planning investments with some
degree of regularity.
The capital expenditures of the industry are made up of some
large, and many relatively small, investments. Major refinery units,
tankers, and large pipelines involve large sums and are built irregu-
larly. Regular annual investments include those for many service
stations, over 40,000 wells, and many small gathering lines and
similar facilities that involve from $25,000 up to $100,000 as a rule,
although some of these facilities occasionally cost much more than
$100,000. The opportunity for regularization of investment is better
in this situation, therefore, than for industries with few capital
projects.
The competitive development following the discovery of large
new oil fields may work against efforts to increase stability in drill-
ing expenditures. The search for oil may be carried on regularly
but the discovery of the very large fields is erratic. Once a great
field is found, the pace of drilling is usually set by the character of
lease ownership, regardless of the business cycle. From the stand-
point of regularization of investment, however, it is interesting to
note that major discoveries may have a favorable influence on
drilling during a decline inbusinessactivity. For example, the huge
137V
PETROLEUM INVESTMENT
East Texas field was found in 1930 and the largest field of recent
years (Scurry County) was developed rapidly in 1949.
Earnings retained in the business and funds recovered from
previous expenditures by depreciation and similar charges are mainly
relied upon in the financing of new investments in the petroleum
industry. It is exceptional among the large oil companies for the
amount of outside funds secured (through new equity financing or
borrowing) to amount to as much as 25 per cent of the capital
expenditures over a five-year period. Even during the postwar years
of heavy capital expenditures, 1946-1950, twenty principal oil com-
panies raised from outside sources an amount equal to only 15 per
cent of their capital expenditures. Consequently, fluctuations in
earnings will tend to affect new investment correspondingly unless
working capital is used as a cushion or outside funds are used when
earnings decline, which means increasing dependence on external
funds.
Regularization of capital expenditures in any industry depends
upon ability and willingness to finance investment in surplus capac-
ity during a depression, and upon having sufficient capacity in a
boom to be able to postpone major expansion. During the depression
of the thirties the petroleum industry did expand productive capac-
ity far beyond immediate needs, to the great benefit of the nation
later, in World War II. If additional capacity is needed during the
top phase of the cycle to take care of immediate requirements, as
was the case for the petroleum industry in 1948, large capital
expenditures must be made regardless of the apparent desirability
of waiting for a more favorable time in the business cycle. In such
a case, customer relations may be a more important consideration
than economic stability.
The preceding preliminary general observations provide a back-
ground for consideration of the record of capital expenditures in the
petroleum industry during recent cycles. For the periods of 1936-
1940 and 1946-1950, statistics on capital expenditures for thirty
principal oil companies are available in the studies by Joseph E.
Pogue and Frederick Coqueron, of the Chase National Bank. For
the cycle of 1928-1932, however, only meager statistics on individual
companies and on the expenditures for drilling are available.
Boom and Depression, 1928-1932
Although demand did not decrease more than 12 per cent between
1929 and 1932, there was a much larger decrease in operations
138PETROLEUM INVESTMENT
because of the usual tendency to add to inventories in a boom and
to reduce them in a depression. The average price per barrel of
crude oil decreased from $1.27 in 1929 to $0.65 in 1931. The com-
bined drop of volume and price resulted in a decrease of nearly
60 per cent in the value of crude oil production. A corresponding
decrease occurred in expenditures for drilling and in the number of
well completions, as shown by the following tabulation:
TABLE 1
PETROLEUM INDUSTRY OPERATIONS
Domestic
demand
(1)
Domestic
oil Net
production exports
(2) (3)
Refinery
(4)
Value of
production
(millions)
(5)
Number
of wells
completed
(6)
Expendi-
tures for
drillinga
(millions)
(7) (millions of barrels)
1928 861 947 63 913 $1,055 22,331
1929 940 1,063 54 988 1,280. 26,356 $302
1930 926 953 51 927 1,070 21,240 260
1931 903 897 38 895 551 12,432 145
1932 835 822 29 820 680 15,021 186
a Includescost of drilling dry holes.
Sources: Cols. 1-5 from Bureau of Mines Annual Summaries; coi. 6 from Oil
and Gas Journal; col. 7 from Department of Commerce.
The decrease in capital expenditures for refining, transportation,
and marketing during the Great Depression was apparently even
more severe than in those for production, judging from the experi-
ence of a few large companies for which data are available on
capital expenditures by departments for the years 1928-1932. Drill-
ing in East Texas forced some expenditures by the companies own-
ing leases there, but for other operations new investments by these
companies virtually came to a halt. Two large integrated com-
panies reported a decline in total capital expenditures between
1929 and 1932 of nearly 70 per cent, while the decline in their new
investments in production was much smaller.
Recovery and Recession, 1936-1940
The recovery in business following 1932 included substantial expan-
sion in petroleum operations. By 1937 new records surpassing those
of 1929 had been achieved in domestic crude oil production and
refining. As is usual in a boom, supply began to outrun demand by
1937. Consequently, the recession of 1938 was felt immediately in
139PETROLEUM INVESTMENT
the petroleum industry and extended into 1939 and 1940. It was not
until 1940 that crude oil production exceeded the records of 1937.
TABLE2
U.S. PETROLEUMINDUSTRYDATA
1936-1940
Domestic
demand
Domestic oilNet
production exports
Refinery
runs Number
of wells
completed
Expenditures
for drilling
(millions) (millions of barrels)
1936 1,093 1,145 75 1,069 25,888 $297
1937 1,170 1,331 116 1,183 32,560 413
1988 1,137 1,267 139 1,165 27,149 368
1989 1,231 1,319 130 1,238 26,839 366
1940 1,327 1,412 47 1,294 30,040 401
In 1937 there was an increase for the industry of 16 per cent in
crude oil production and 26 per cent in well completions. The
decrease in 1938 was about 5 per cent in production and about 15
per cent in drilling. Refinery runs increased rapidly in the years
1985-1937 and showed only a slight decrease in 1938 before attaining
new record levels in 1939-1940. To meet demands, it was necessary
to expand facilities substantially in 1937. Capital expenditures for
this purpose by thirty oil companies consequently increased that
year and remained relatively stable through 1940. Capital expendi-
tures for marketing and transportation also showed only
fluctuations in this period.
TABLE 3
DATA FOR THIRTY OILCOMPANIES
1936-1940
.
Netcrude oilRefinery
production runs
Net
income
Capital expenditures
Production RefiningOther Total
(millions of barrels) (millions)
1936 512.4 894.1 $412 $370.8 $59.6$146.8$576.7
1937 590.6 963.2 573 462.5 96.0 183.5 742.0
1938 544.2 926.0 300 855.7 88.8 127.8 571.8
1989 567.9 977.5 321 319.7 98.6 159.0 577.3
1940 620.0 1,028.5 377 331.2 97.5 172.9 601.6
Total capital expenditures by thirty oil companies moved in phase
with income but with a smaller fluctuation. From 1936 to 1937
140PETROLEUM INVESTMENT
there was an increase of 28.7 per cent in capital expenditures corn.
pared with 39.1 per cent in net income. The declines between 1987
and 1938 were 22.9 per cent and 47.6 per cent, respectively, for
these two items.
Postwar Experience, 1946-1950
The war created a great increase in demand for petroleum products,
but the shortage of steel drastically limited construction of new
facilities to keep pace with demand. The petroleum industry was
able to fuel a major war without requiring large amounts of steel
because of the reserve productive capacity developed during the
thirties under a system of state conservation regulations, including
regulation of production in accordance with market demand in
order to prevent waste.
Demands for petroleum quickly increased to new record levels in
the postwar period despite the decline in military consumption.
Relative to coal and commodity prices generally, prices of petroleum
products remained so attractive that domestic oil consumption in-
creased nearly 18 per cent between 1946 and 1948. Without an
adequate breathing spell in which to rebuild reserve capacity, the
petroleum industry had to undertake a tremendous program of capi-
tal expenditures. Capacity finally began to outrun demand in the
latter part of 1948, and there was some decrease in operations in
1949, but drilling remained high and operations again increased
sharply in 1950.
TABLE 4
U.S. PETROLEUM INDusTRY DATA
1946-1950
Domestic
demand
Domestic oilNet
production exports
Refinery
runsNumber
of wells
completed
Expenditures
for drilling
(millions)
.
(millions of barrels)
1946 1,793 1,852 15 1,730 29,228 $ 650
1947 1,990 1,990 5 1,852 33,098 773
1948 2,114 2,167 —53 2,031 39,778 1,049
1949 2,118 1,999 —116 1,944 39,038 1,064
1950 2,372 2,154 —198 2,095 43,279 1,279
It may be noted that in 1951 petroleum industry operations will
again set new records in practically every phase of operations.
Expenditures for drilling as estimated by the Department of Corn-
141PETROLEUM INVESTMENT
merce (which are understated in recent years because well costs
have not been adjusted fully for the effect of deeper drilling) will
increase for the ninth consecutive year. Capital expenditures by
thirty oil companies will also show an increase in 1951, although
they declined substantially in 1949 and 1950.
TABLE 5
DATA FOB THIRTY OIL COMPANIES
1946-1950
Net crude oilRefinery
production runs
Net
income
Capital expenditures
Production RefiningOtherTotal
(millions of barrels) (millions) .
1946
1947
1948
1949
1950
923.8 1,413.6
992.1 1,519.9
1,113.7 1,716.5
947.9 1,668.1
1,016.2 1,804.2
$ 762
1,219
1,929
1,407
1,739
$674.3$189.4
879.0 849.5
1,260.9 513.5
1,128.6 888.5
1,064.5 248.6
$824.6
508.6
541.6
456.1
853.4
$1,188.8
1,737.1
2,316.0
1,973.2
1,666.5
Expenditures for refining and other facilities(transportation,
marketing, and miscellaneous) this time proved more erratic than
those for production. Peak expenditures, excluding production in
1948, were about one-fourth more than the year before or after, and
more than twice as high as expenditures in 1946. This fluctuation
reflects the difference in the nature of investments in refining and
transportation as against production. Capital expenditures in pro-
duction are primarily for the drilling of thousands of wells, but in
refining and transportation they are for relatively few extremely
expensive units. New distillation and cracking equipment in refining
and new pipelines in transportation frequently involve investments
in excess of $15 million for a single unit and its related facilities.
Several years may be required from the initial planning of a unit to
its final completion. As usual in building new facilities, it is wise to
make the expansion large enough to minimize the cost per unit of
capacity. Once such an expansion has been made, several years may
elapse before further expenditures of similar size are required.
Consequently, investments in refining and transportation are in-
herently erratic and apparently tend to be initiated in the rising
phase of the cycle, rather than in a recession or trough when capac-
ity is more than adequate to meet demands.
142T
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lPETROLEUM INVESTMENT
Differences among Companies
Analysis of the capital expenditures of different companies shows
significant variations in the stability of capital expenditures, which
may reflect either the effect of divergent experience with respect to
discovery of new fields, or cOnscious efforts on the part of manage-
ment to follow a long-term program regardless of temporary fluctua-
tions in business and income. The diversity in pattern is indicated
by the experience for 1947-1950 of the companies with the most
stable, and those with the most erratic, capital expenditures of the
thirty oil companies included in the annual financial analyses of the
Chase National Bank.
The thirty oil companies as a group experienced a range in capital
expenditures from —13.3 to +20.4 per cent from the average for
1947-1950. This compares with a range of —3.1 to +7.2 per cent for
the five companies with the most stable capital expenditures and
—27.4 to +26.7 per cent for the five companies with the least stable
capital expenditures. The differences in stability of new investments
were not related to the relative stability of earnings since the five
companies with the least stable capital expenditures experienced less
fluctuation in earnings than did the five companies with more stable
capital investments. The fluctuation in expenditures and earnings
for the three groups is summarized in the following tabulation:
TABLE 7
MAXIMUMDEVIATIONS FROM 1947-1950CAPITALEXPENDITURES AND E1uu.aNcs
(per cent)
FIVE COMPANIES WITH FIVE COMPANIES WITH
SMALLEST FLUCTUATION INGREATEST FLUCTUATION IN
THIRTY COMPANIES CAPITAL EXPENDITURES CAPITAL EXPENDITURES
Capital Capital Capital
expenditures Net incomeexpenditures Net incomeexpenditures Net income
—13.3 —22.5 —8.1 —18.4 —27.4 —18.5
+20.4 +22.6 +7.2 +31.4 +26.7 +19.7
Comprehensive analysis of capital expenditures by individual
companies, which cannot be made from published financial statistics,
would be required to determine whether the more stable invest-
ments in 1947-1950 by some companies were the result of chance or
of conscious policy directed at regularizing capital expenditures.
144PETROLEUM INVESTMENT
Conclusion
Several factors modify the application in petroleum operations of
an investment policy designed to effect stable or countercyclical
expenditures. Investments in production are largely governed by
the discovery of important new fields and the competitive pressures
of their development by different operators. Investments in refining
and transportation frequently involve very large facilities and ex-
penditures, which make it difficult to prevent wide fluctuations.
Capital expenditures in the petroleum industry have shown
fluctuations that follow the usual pattern of the business cycle. Even
the relatively mild recession of 1949 brought about a substantial
decrease in capital expenditures for refining and transportation,
although drilling expenditures were carried on without interruption.
Whi]e some companies may make progress toward a program of
stable expenditures, particularly in drilling and production, circum-
stances inherent in the operations will probably lead most com-
panies to follow the usual pattern of fluctuation in investments.
145

Regularization of Business Investment

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