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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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Are Oil & Gas Executives Paid Based On Luck?

Are oil and gas executives paid based on luck?

That’s the premise of a new paper from the Energy Institute at Haas, which looks at the link between executive pay and oil prices. Building on a 2001 paper that found a tight link between oil prices and executive compensation, the recently published paper from Lucas W. Davis and Catherine Hausman finds that the trend has only become more pronounced in the intervening years.

Typically, corporate executives are rewarded for the strong performance of their companies. This “pay-for-performance” model incentivizes CEOs to maximize company value. But in the oil and gas industry, much of a company’s value is determined by the price of oil, which is entirely outside of management’s control.

In addition, while there is other literature out there on the possible links between luck and executive pay, the energy industry offers a very interesting example because luck can be parsed out in a clearer way. Unlike other industries, where companies produce some widget, and the performance of the company could be determined by any number of factors, the oil industry is different. “[T]he fortunes of energy companies are highly dependent on a single, highly-salient, well-understood, widely-available, plausibly exogenous factor – the price of oil,” the authors point out. As such, “luck,” and its connection to executive compensation, is easier to test.

The global price of oil, to a large degree, dictates the profitability of an oil company from year to year. In that context, the CEO of an oil company is rewarded for luckily finding himself (yes, it always seems to be a man) at the helm of the ship during an upcycle, for instance.

The Energy Institute analyzed executive compensation from 80 major oil and gas E&Ps between 1992 and 2016, and found that a 10 percent increase in oil prices has translated into a 2 percent increase in executive compensation. Related: Don’t Expect A Price Shock In Natural Gas

In fact, the “pay-for-luck” phenomenon is even more pronounced than in the past. Total executive compensation has nearly doubled since 2001, the Energy Institute paper finds, and there is still a high correlation with oil prices, “indicating that executives continue to be rewarded for luck despite the increased availability of more sophisticated compensation mechanisms.”

Moreover, executive compensation has become more dependent on a firm’s share price because the oil industry has increasingly relied on stock options to compensate executives. And, of course, the share price is heavily determined by the price of oil, so CEOs enjoy a windfall when prices spike, even if they haven’t done anything specifically to deserve it.

But it isn’t just the share price. “Pay-for-luck” is consistent across different components of compensation, not just stocks and options, but also bonuses and long-term cash incentives. The authors argue that this is important, since it suggests that executive compensation is not merely driven by a mechanical relationship between compensation and the company’s share price. There is something deeper going on.

The “pay-for-luck” approach to rewarding executives is “asymmetric” – oil and gas executives are paid even more when oil prices rise, but are not docked as much as one might think when oil prices fall. “These patterns are more consistent with rent extraction by executives than with maximizing shareholder value,” the authors argue.

This “rent extraction” idea suggests that executives at oil and gas companies “have co-opted the pay-setting process, and are increasing compensation as much as possible, for example during periods of oil price increases and in poorly-governed firms,” the authors conclude. Related: A Bearish September For Oil

“This is a market where firm value hinges to a large degree on observable luck, so the fact that we observe little filtering of luck from executive pay is particularly striking,” the authors conclude.

It’s odd that, for instance, executive compensation is not based more on a company’s relative performance to its peers, which could somewhat diminish the direct link between pay and the vagaries of the oil market. If oil prices crashed but Company A did much better than Company B, perhaps Company A had better leadership. In essence, paying for relative performance would control for the oil price to some degree, linking compensation more to the performance that the executive does have control over.

But that’s not what we see in many cases, the authors argue. Luck still dominates executive pay.

By Nick Cunningham of Oilprice.com

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