CEO Pay Is the Last Temptation of Shale
(Bloomberg Opinion) -- I can’t say I agree with Continental Resources Inc.’s philosophy on executive pay, but the way it’s couched in the proxy statement has an appealing candor:
We maintain and incorporate flexibility into our compensation programs and in the assessment process, which we believe is particularly important in a changing commodity price environment. As such, we do not apply rigid formulas in determining the amount and mix of compensation elements.
Honestly, who could argue against a bit of “flexibility” or in favor of “rigid formulas”? As it happens, it’s the very people oil and gas producers such as Continental need to win back.
There’s a lot riding on this E&P earnings season, which kicks off next week. The rally in oil since last November has been restorative but also raises the question of whether new-found discipline on spending will dissipate.
As if on cue, this week’s sudden plunge in oil prices offered a reminder of how fickle the hydrocarbon gods can be. While the oil-futures strip dropped by 10%, it remained a healthy $64 a barrel. The sector’s cash-flow multiple, though, fell back to the dark days of late 2020.
Trust is fragile, and until generalist investors are comfortable the sector has changed for real, rallies will be hard to sustain. The surest sign isn’t what management says on earnings calls but what gets built into the incentives driving their decisions. Executive compensation, in other words.
There has been a noticeable shift in what gets rewarded in the past couple of years. Yet the latest survey from Kimmeridge Energy Management Co. LLC, an activist fund, finds much room for improvement.
The good news is that growing production, the obsession that busted the shale business model, has been demoted as a performance metric for c-suite pay. Cash flow and returns, meanwhile, are now more prominent — and, incidentally, align better with those environmental goals that have also become commonplace.
And yet it just feels weird that in 2020, the median executive at firms surveyed by Kimmeridge was paid 95% of their target bonus. That’s less than the 100%+ routinely paid in yesteryear. Still, a 5% ding in a soul-crushing year — median return: negative 36% — seems a tad light.
One counterargument rests on force majeure: Why punish an oil CEO for a pandemic? Sound as that is, it would resonate a bit more if the logic applied in the other direction, too. There is ample evidence of a long-standing heads-I-win-tails-you-lose asymmetry at work in this industry. The rewards of an oil-price rally are reaped in higher compensation, but the losses of a crash are often blamed on outside forces and, therefore, largely factored out.
In Kimmeridge’s sample, many bonuses were paid out at around 90% of target despite stocks being down anywhere from a fifth to two-thirds. Separately, analysts at Evercore ISI, which has been producing a comprehensive annual survey of the industry’s pay practices for years, point out the companies they track paid bonuses at 130-150% of target in 2018 and 2019, a period of largely supportive commodity prices yet mostly mediocre return on capital.
Last year, when things were truly dismal, the average payout for E&P companies surveyed by Evercore was still 87% of target, in line with where they clustered in Kimmeridge’s sample. Which just goes to show that, while in most crises all correlations go to one, when it comes to oil-boss bonuses, correlations go to zero.
The most egregious examples of this asymmetry concerned companies effectively lowering the bar for bonuses in 2020. APA Corp., for example, shifted weightings for the second half of 2020 as Covid-19 upended the oil market. Such flexibility — to borrow a phrase — seems justified amid turmoil. But it feels weird that it somehow resulted in paying out bonuses at 137% of target in a year when APA’s total return was negative 44%, underperforming an already-underperforming sector — again. And even if mid-year switch-ups are unusual, E&P companies can shift weightings and metrics from year to year in ways that keep bonuses safe.
Coming back to Continental’s mantra, you could almost argue it’s preferable to just say up front that these payouts are all essentially discretionary. The elaborate tables of percentages, performance goals and “rigid formulas” gracing E&P proxy filings too often result in the same outcome anyway. Yet as long as the energy sector remains mired at less than 3% of the market — it just fell back below real estate again — fixing this misalignment is a priority.
Otherwise, E&P stocks will continue to face their own pernicious asymmetry: cautious rallies when oil’s well and outright abandonment when it is not.
APA's total return in 2020 was -43.7% compared with -35.3% for the S&P 1500 Composite Oil & Gas E&P index. For 2017-20, APA returned -63.8% versus -45.0%. For 2014-2019, -54.1% versus 32.4%. For 2009-2019, -71.0% versus -18.7%. Source: Bloomberg.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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