The Allocation of Free Cash Flow: Evidence from the Persian Gulf Crisis

The short-lived oil price shock at the beginning of the Persian Gulf Crisis created a natural experiment. Oil producers were left with an unexpected, one-time cash flow shock and unchanged investment opportunities. We examine how they spent this free cash flow. Most firms followed an expansionary path, but there is considerable variation in how the cash flow was allocated. Both costly external financing theories and agency conflict theories have power in explaining this variation and neither dominates the other. Managerial ownership is negatively related to allocations to expansionary activities. Firms identified as financially constrained prior to the shock used the cash to reduce debt, bolster their cash reserves and expand the firm. We conclude that both agency conflict and financing theories are necessary to explain how firms allocated this cash flow. * We thank Neil Fargher, Randy Heron, Tim Kruse, Erik Lie, Wayne Mikkleson, and participants at a University of Oregon Research Roundup for their comments and Todd Perry and Craig Rennie for research assistance.