sufficient to overcome the potentially high-cost technological challenges of exploring and producing in a very rugged offshore environment. As a share of worldwide FRS company E&D expenditures, the growth areas of U.S. onshore, Canada, and Europe rose from less than half in 1974 to nearly two-thirds in 1978.

In late 1978, the ruling regime in Iran was overthrown, and, within a year, Iran and Iraq were at war. Reduced oil production and rapid accumulation of petroleum inventories put severe pressures on oil prices. Between late 1978 and early 1981, world oil prices rose on the order of $25 a barrel. From 1978 to 1981, the FRS companies' cash flow almost doubled and their worldwide spending for exploration and development more than doubled, totaling $45.4 billion in 1981. All regions except the Middle East registered sizable increases. The surge in onshore expenditures was led by increased drilling activity, with a tripling in the FRS companies' onshore drilling expenditures and a 52-percent increase in their onshore well completions. Offshore, their increased spending was mainly for unproved acreage, expenditures that increased almost 400 percent, reflecting both the increased offerings of Federal OCS acreage and the higher bid prices induced by sharply higher oil prices.

Abroad, two-thirds of the increase in E&D expenditures was traceable to increased drilling. Regions registering the steepest growth in drilling were the Other Eastern Hemisphere (well completions up 39 percent between 1978 and 1981) and the Other Western Hemisphere (up 172 percent). Increased expenditures for Africa largely reflected exploratory efforts. Europe registered the largest absolute increase in expenditures, the bulk of which was for developmental efforts in order to bring production from North Sea fields on line. Development of North Sea production capability was reflected in the number of oil producers as well as the level of production: in 1974, FRS companies produced a total of 76 thousand barrels per day (mbd) of oil in Europe, with only four companies reporting more than 1 mbd of production; in 1981, 14 FRS companies reported European production in excess of 1 mbd, totalling 759 mbd.

Comparison of FRS company E&D expenditures for Canada in 1978 with 1981 expenditures indicates little growth. However, this comparison masks some important developments. Canada continued to be a target of FRS companies' investment through 1980. In 1980, the FRS companies' E&D expenditures for Canada, at $3.1 billion, were about double the 1978 level. Canadian energy policy changed dramatically with the passage of the National Energy Policy of 1981 (NEP).151 The NEP directly encouraged greater Canadian ownership of energy resources in Canada through a system of subsidies and taxes. One of the effects of NEP was discouragement of energy investment in Canada by non-Canadian companies. The FRS companies cut back their Canadian E&D spending by 40 percent to $1.8 billion in 1981. Apart from the effects of intragroup mergers of FRS companies, Canadian E&D expenditures remained below $2 billion until 1988, when Canadian oil and gas development again became an attractive target, in part because the most onerous provisions of the NEP were moderated.15

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Over the 1974-1981 period, the FRS companies' downstream capital expenditures increased from a worldwide total of $5.6 billion to $9.5 billion (Table 26). Domestic refining operations accounted for the major share of this increase, which occurred between 1978 and 1981, and continued into 1982 when the FRS companies' capital expenditures for U.S. refineries reached $4.8 billion (excluding the effects of intra-FRS mergers153). This upswing in spending was largely directed toward upgrading of refineries to produce unleaded gasoline requiring high-octane blending components and to utilize heavier, more sulfurous crude oil inputs. The FRS companies began to reduce their simple distillation capacity in 1981 in response to reduced demand for petroleum products and to an overall excess of refining capacity. Abroad, the FRS companies reduced their crude distillation capacity by 1.3 million barrels per day between 1974 and 1981 and continued this retrenchment into the mid-1980's. Nevertheless, their capital expenditures for foreign refining and marketing operations generally rose over the period, reaching a peak of $2.4 billion in 1981, indicating that retained facilities were objects of upgrading.

154

Transport operations were occasional investment targets in the 1974-1981 period (Table 26). The heightened level of capital expenditures for liquids pipelines in 19751977 was largely due to the building of the Trans Alaskan Pipeline System from the Alaskan North Slope to the port of Valdez, a $9.2-billion project. International marine operations (mainly oil tankers) were the primary target of the FRS companies' foreign downstream investments in 1974 and 1975. Capital expenditures for tankers exceeded $1 billion in 1974 and 1975. This emphasis on tankers was part of the surge in tanker capacity accompanying the growth in world oil trade. However, as petroleum demand fell in the context of the 1979-1981 oil price escalation and thereafter, international movements of oil, particularly from the Persian Gulf, were reduced, resulting in excess world tanker capacity. Capital expenditures for tankers dropped steeply and were less than $100 million annually during most of the 1980's.

The distribution of the FRS companies' productive assets across lines of activity shifted substantially as a result of their investment behavior. In their core area of petroleum (including natural gas production), the emphasis moved from downstream to upstream. The share of total net PP&E allocated to oil and gas production increased from 39 percent in 1974 to 50 percent in 1981, with most of the gain in U.S. operations, while the downstream share declined from 42 percent to 26 percent (Table 31). Diversified nonenergy businesses (apart from railroads) were 7 percent of the FRS companies' net asset base in 1981, more than double the 1974 share, reflecting the use of diversification as a channel for investment and growth. Chemical manufacture and energy production outside petroleum also registered higher shares of the FRS companies' productive assets.

When oil prices peaked in 1981, the FRS companies were much more oriented to oil and gas production and more diversified beyond petroleum than they were in 1974 at the onset of the crude oil price escalations.

Consolidation and Restructuring

Crude oil prices peaked in early 1981. Although the price of oil in fact began to decline later in 1981, many oil market participants and observers at that time regarded this downward movement as transitory and expected oil prices to resume an upward course. However, a number of fundamental developments that

154 New York Times (June 2, 1977), p. D1.

Fundamental changes in capital markets, which were to have profound effects on the FRS companies' deployment of assets, were also occurring. Unlike the 1970's and earlier post-World War II decades, shareholders were demanding greater cash payouts by corporations in the form of dividends and common stock repurchases and were placing less importance on reinvestment of cash flows. Probably the main development that drove shareholders to agitate for greater cash payout was the sharp upswing in real rates. of return generally available to investors. For example, Figure 19 shows a surrogate for the real rate of return-the average yield on corporate bonds rated AAA by Moody's Investors Services minus the annual percent change in the Gross Domestic Product (GDP) implicit price deflator. By this measure, the real rate of return on low-risk corporate debt rose steeply, from about 1 percent in the late 1970's to over 8 percent by the mid-1980's. Accordingly, investors increasingly preferred receiving the cash generated by corporate operations directly, unless the corporation through its reinvestment program could convincingly match the step-ups in market returns. Also, the deterrence to dividend payout posed by the U.S. tax laws was moderated. In part, substantial changes in tax laws in the early 1980's, particularly lower marginal tax rates, reduced the taxation of dividends. Greater prominence of institutional investors and foreign investors, both of whom were little affected by U.S. tax laws and their enforcement, tended to increase the overall preference for dividends and other corporate cash payouts.

With a greater preference for direct disbursement of corporate cash flows and heightened standards of profit performance on the part of investors, many of the major energy companies became objects of shareholder discontent. Investors had a number of reasons to be dissatisfied. First, oil prices began to decline in 1981. The prospect of a long-term decline in oil prices, which had been in the realm of the unthinkable for many investors only months before, dampened the expected profit outlook for companies heavily involved in oil and gas production. Corporate involvement in downstream petroleum offered little solace to investors, since refinery capacity was in great excess and abandonment of service stations appeared to be a daily occurrence.

Second, the FRS companies' investments outside their core petroleum and chemical businesses yielded disappointing results. The profitability of these ventures tended to be not only low compared with their core

this ratio is, since investors will bid up the price of the corporation's shares. Conversely, downward revisions. in the profit outlook for a company tend to produce a decline in the market-to-book ratio. In 1980 and 1981, the market-to-book ratio was close in value for the FRS companies and other large industrial companies (as represented by the S&P 400, excluding the FRS companies) (Figure 20). However, as investors ratcheted down their oil price expectations beginning in late 1981, market values of most of the FRS companies plummeted below book values, and by 1983 the market-tobook ratio for the FRS companies was only about half the value of the S&P group.

Deteriorating stock prices led to shareholder dissatisfaction, and shareholder dissatisfaction led to a climate favorable to takeover proposals by corporate raiders. In principle, with the market value of common shares below the net realizable value of corporate assets, a corporate raider could gain ownership through stock purchases and resell the assets for a profit. The credibility of corporate raiders and their takeover threats was strengthened by investor acceptance of lowgrade bonds, generally termed junk bonds. Also, falling market values provided those major oil companies that had relatively high costs of finding reserves with the

Figure 20. Ratio of Market Value to Book Value, 1980-1993

opportunity of adding oil and gas reserves at a favorable cost.156

During the 1981-1984 period, six FRS companies succumbed to takeovers, in transactions totaling $47.0 billion in value (Table 32). Four of these takeovers were by FRS companies (Chevron's acquisition of Gulf Oil, Mobil - Superior Oil, Occidental Petroleum - Cities Service, and Texaco - Getty Oil) and the other two takeovers brought DuPont (through their acquisition of Conoco) and USX, formerly U.S. Steel, (through their acquisition of Marathon Oil) into the ranks of major energy companies. 157 Also, attempted takeovers of Phillips Petroleum and Unocal in 1985 were thwarted mainly through massive disbursements of cash to shareholders.

The challenge for the FRS companies was to develop strategies that would increase shareholder value and overall corporate profitability in the context of shareholder discontent and investor demands for greater payouts. The challenge was made more difficult by a declining rate of return in oil and gas production, their most profitable line of activity through the first half of the 1980's (Figure 21). The response of the FRS companies largely involved restructuring and redirection of investment strategies.

Figure 21. Rates of Return by Line of Business for FRS Companies, 1977-1993