It is difficult to imagine a less controversial corporate goal than shareholder wealth creation. Nearly all public companies pay at least lip service to the notion, yet it also remains a somewhat nebulous concept. Any discussion of wealth creation should begin with a definition. First, shareholders reasonably expect the return of their original capital invested. Second, they expect a proper return on it as well. For the purpose of this article, we will use an annualized required rate of return on equity of 11% (representing a long-term mean of equity returns) for companies in the oil industry. Shareholders may also receive a stream of dividends during the period. As these dividends may or may not have been reinvested in the particular company, we simply assumed that whatever dividends were paid out were reinvested somewhere to yield 11% annually until the end of the decade. Well, given this definition, how have leading companies in the oil industry actually done during the past decade? The tables accompanying this article examine what $1 invested in a company's common stock at year-end 1989 was actually worth at year-end 1999 (just before commodity prices moved up strongly) and at year-end 2000. Given that the required rate of return is 11% for the period, each dollar invested should have been worth $2.84 by year-end 1999 and $3.15 in 2000. In calculating what a dollar invested in 1990 is worth at the end of the decade, companies are given credit for dividends paid and for share repurchases. The amounts above $2.84 or $3.15 represent wealth creation1. It is important to note that growth in total market value, while clearly important, is only part of the wealth creation picture. Exxon was a top performer, not only during the 1990s but during the prior decade as well. Yet, Shell managed to increase its market value to more than Exxon's by 1997 (i.e. before the acquisition of Mobil). Nevertheless, Exxon created more wealth for its shareholders. How was this possible? In addition to paying out a respectable dividend, Exxon returned large amounts of cash to its shareholders in the form of share repurchases2. By 1997, Exxon had repurchased a third of the shares it had outstanding in 1981. Exxon maintained exemplary capital spending discipline throughout the period. Any time senior managers felt the company could not generate adequate returns on its cash, this cash was returned to shareholders, who were then able to reinvest elsewhere. How did they do? Four of the supermajors have done quite well during the past decade. By year-end 1999, shareholders of Exxon Mobil (simply Exxon before 1998), Shell, BP and Chevron enjoyed higher-than-expected returns. Smaller integrated oil companies performed relatively poorly. Several other underperforming integrated oil companies disappeared entirely during the '90s through merger. Refining The independent refining sector was not successful. Of the six independents, only Tosco managed to create wealth. A dollar invested in Tosco in 1990 grew to be worth $4.08 in 1999 and $5.06 in 2000, both well in excess of the $2.84 and $3.15 benchmarks. Tosco, however, pursued a buy-rather-than-build growth strategy. Tosco's strategy did not add capacity to the industry, and its shareholders benefited at the expense of major oil companies who sold assets on the cheap. There is much evidence indicating majors were eager to sell refining assets to boost their accounting based return-on-capital-employed (ROCE) calculations, a badly misused metric unconnected to shareholder wealth creation3. Service companies The "Big Three" service companies were also disappointing. None were in positive wealth creation territory by year-end 1999, before rising commodity prices boosted drilling activity. Schlumberger just managed to exceed investor expectations by year-end 2000, but Halliburton and Baker Hughes performed poorly. Independents A few of the top 15 independent E&P companies did quite well, but most did not. By year-end 1999, only Barrett Resources and Newfield Exploration had delivered more than investors had reasonably expected in 1990. The sharp increase in commodity prices that began in early 2000 boosted several independents over the wealth creation threshold by year-end 2000. These were Anadarko Petroleum, Apache Corp., Devon Energy, EOG Resources, Vintage Petroleum and, just barely, Pogo Producing. That only a minority of firms managed to exceed expectations during the decade indicates how challenging the industry is. Furthermore, we admit there is a very significant survivor's bias to our table. Many of the poorest performing E&P companies disappeared through acquisition during the 1990s. Implications What conclusions should managers draw from all this? Is being big, or getting big, the key to financial success? Generally, large majors did much better than small ones, and also better than both independent E&P companies and refiners. Some of the most conspicuously successful (Exxon, BP, Anadarko, Apache) made large acquisitions. It is important to ask what economic benefits accrue to shareholders as a result of mergers. After all, in most industries during the last two decades, the shareholders of acquiring companies tended to do poorly. Benefits tended to flow to the shareholders of the firms being acquired. In the oil industry during the 1990s however, the stock market often greeted merger news by rewarding both sets of shareholders immediately. Examples include BP's acquisition of Amoco, Exxon's of Mobil, Anadarko's of UPR and Apache's of the Canadian assets of Fletcher Challenge Energy. What are the advantages of size in the oil industry? Strategists offer explanations involving terms such as scale, scope and synergy. Often, it is argued that a larger company is able to pursue international opportunities requiring large capital investment but where competition among oil companies is less fierce. While we are in no position to deny the existence of such benefits, we cannot find any data that point in that direction. What we have found is that companies with overlapping operations can merge and eliminate redundant overhead. The shareholder wealth created in successful mergers has corresponded to the present value of expected benefits from overhead elimination. For example, shareholders of Exxon and Mobil enjoyed an increase in wealth of $14.8 billion through the week following their merger announcement in late 1999. This figure represents an increase in the market value of both companies. No new capital had been spent to create these benefits. In a joint announcement on November 27, 1999, Exxon chief executive officer Lee Raymond and Mobil CEO Lucio Noto declared, "The merging of these two companies will deliver significant near-term pretax synergies of about $2.8 billion...We expect to benefit from a reduction of costs in the short-term...." What would these savings have been worth to shareholders? If we assume the new company's marginal effective tax rate is 25%, the $2.8 billion in pretax savings came to $2.1 billion in net operating profit after tax. Discounted at 11% in perpetuity, this would have had a present value of $19.1 billion. If, as most observers seemed to expect, it would take two years to get these benefits, the present value would have been $15.5 billion, just a bit more than the shareholder wealth created upon the merger news. In other words, the stock market immediately priced 95% of the benefits expected into the shares in the week following the merger announcement. We have found similar patterns in other mergers. In the case of BP's acquisition of Amoco, the stock market's reaction exceeded 100% of the present value of cost savings. No doubt, BP's John Browne has an admirable record of underpromising and overdelivering. Can the industry simply merge its way to financial success? Well, no. Benefits accrue to companies with significantly overlapping operations. Eliminating redundant overhead is a finite source of wealth creation. Much of the low-hanging fruit in this respect has been picked. BP's experience during the last two years seems to bear this out. It produced tremendous gains for shareholders from 1992-99 that were directly related to huge overhead cost reductions in the original BP and also those achieved (or expected) from the acquisitions of Amoco, Arco and Burmah Castrol. Despite a booming commodity market in 2000 and 2001, BP has not continued to provide the same benefits for shareholders. The shareholder wealth performance of other supermajors has also met with a plateau recently. Even some of the most respected independent E&P companies have found diminishing shareholder returns from acquisitions. Devon Energy managed to increase the wealth of its shareholders and those of Northstar when they acquired that company in June of 1998. Acquiring PennzEnergy 11 months later also rewarded both sets of shareholders though the benefits were proportionately higher for PennzEnergy shareholders. When Devon acquired Santa Fe Snyder in 2000, the transaction created wealth for society-the combined market value of the two entities was greater after the merger announcement than before. Nevertheless, virtually all the benefits flowed to the shareholders of Santa Fe Snyder. It was simply a wash for Devon shareholders. There were examples of wealth destruction resulting from mergers during the last decade as well. UPR erased a huge amount of shareholder wealth as a result of its acquisition of Norcen in 1998. More recently, mergers have produced market reactions that were, initially at least, unfavorable. Phillips Petroleum surprised financial markets by announcing a plan to acquire Tosco. Tosco's market value increased by $1 billion but Phillips' market value dropped by $1 billion. Valero Energy's share price also suffered upon the announcement of Ultramar Diamond Shamrock's acquisition plan. The shares of Phillips and Valero recovered in the weeks and months after the news but it is hard to be sure whether this reflects the stock market's reassessment of the economics of the mergers, or whether these companies benefited from trends affecting the entire refining industry. Two oil companies may have "won by losing" during 2001. Amerada Hess demonstrated great self-control in refusing to increase its bid for Lasmo when Eni topped Hess' initial offer. Shell made a hostile bid of $55 per share for Barrett Resources, which had been trading at $45, and increased the bid to $60, but Barrett's board still rejected the offer. When The Williams Cos. bid more than $73 per share, Shell retired from the competition. The winning bid added $200 million to the wealth of Barrett shareholders, but William's market value declined $1.5 billion upon the announcement. Why do some companies approach wealth creation limits through growth? Overhead costs cannot be spread infinitely over operations. Additionally, managerial challenges are often greater in large organizations, focus becomes increasingly difficult, and core competencies may dissipate. Very often, the special competencies that give firms competitive advantages are applicable only to particular regions or projects involving particular technologies. Once the opportunities for exploiting such opportunities are exhausted, growth through acquisition may actually lead to diseconomies of scale. The use of equity in transactions may also encourage managers to make acquisitions that do not create wealth. Because accounting does not charge for the use of equity, earnings-oriented managers may believe that equity-funded acquisitions are "cheap." If, as was the case with several large mergers in the '90s, acquiring firms are able to employ the "pooling" rather than "purchase" accounting method then earnings would appear to be even better, though the choice of accounting methods has no effect upon future cash flows. Certainly, size has something to do with success but it's more accurate to characterize size as something that accrues to good management rather than a driver of wealth creation itself. Companies that consistently find and exploit positive net-present-value projects can fund expansion even by issuing equity and still watch their share prices rise. Well-managed companies also tend to be able to acquire less well-managed firms at less than net asset value. Much wealth can be created through modest-size firms that stick to core competencies. Organic growth can be very successful and the rewards of mergers tend to fall disproportionately to shareholders of the company being acquired. After all, our performance list is topped by Barrett which was itself taken over in 2001. John McCormack is a senior vice president and Mitchell Moss is a financial analyst with consulting firm Stern Stewart & Co. in New York. 1 It is important to note that this definition differs very significantly from supposedly similar "shareholder value" concepts. For example, many managers believe they are "growing value" if their firm increases its market value over time. A firm reinvesting its cash flows in projects generating 3-4% annually will "grow value" in this sense but it will certainly not be creating wealth. Shareholders could have done better had they invested elsewhere for a similar risk. Similarly, the commonly used accounting metric, return on capital employed, abbreviated as ROCE (AKA RONA, ROACE etc.) fails to provide much useful information. Neither the numerator nor the denominator reflects economic reality. The numerator, "R", is usually just accounting earnings with the after-tax cost of interest thrown back in. Accounting ignores capital appreciation (e.g. in the form of increased hydrocarbon reserve values) even though it is of essential importance to investors. The denominator also fails to reflect economic reality. Shareholders are looking for a proper return on the market value of their investment. Unfortunately, the "capital employed" figure is not the same thing as market value and, especially in the upstream, represents only a residue of what firms have actually invested. Moreover, this "CE" cannot incorporate the time value of investor's capital. 2 See article by Smith/Fan/McCormack in June 2001 Oil and Gas Investor for a discussion of why share repurchases are also a far better way of returning cash to shareholders than dividends. 3 Refining assets often sold for less than book. Selling them reduced the denominator in the ROCE calculation. As the "R" in upstream operations has been higher than in the downstream for almost all companies, the resulting ROCE always increased. This provides no direct benefits to shareholders, however. The stock market, unlike accountants, recognized all along that refining assets were worth less than book. 4 See McCormack and Vytheeswaran in the April, 1999 Oil and Gas Investor for more on the operation of an EVA system.