The oil and gas industry is particularly sensitive to macroeconomic events, which can create volatility and affect company incentives and strategies as they seek to mitigate risks and capitalize on short-term opportunities. The industry’s cyclical nature and its sensitivity to volatile commodity prices necessitates a proactive approach to potential disruptions. This involves relying on established strategies, or a playbook, to effectively manage uncertainties.
Accordingly, incentive decisions traditionally have focused on how proficiently management navigates challenging environments and adapts to ensuing changes. Having the compensation committee evaluate management's competency in risk mitigation and adaptation is crucial for sustaining strong business performance and appropriately assessing the impact on incentives.
The fundamental issue affecting the industry
When oil prices increase, exploration and production companies are incentivized to maximize production and capitalize on high prices. When prices are high, annual incentives might focus on maximizing output, whereas during low prices, the focus might shift to cost-cutting and operational efficiency.
Increasing production will result in increased investments in exploration and production activities, including the revival of previously unviable projects. However, this typically leads to substantial cost increases as companies across the sector compete for services capacity (e.g., extra drill rigs, constrained pipelines, storage capacity). Companies will redirect capital toward short-term gains, focusing on increasing output rather than long-term sustainability.
This pattern traditionally has resulted in a cycle of boom and bust, where overinvestment during periods of high prices leads to overcapacity and subsequent cost reductions during times of low prices. While increasing production is important, maintaining a healthy balance sheet is crucial versus prioritizing production at all costs — which can lead to over-leveraging, cash flow issues and potential insolvency. However, in the post-COVID period, we have observed greater restraint, suggesting a reluctance to significantly increase investment due to political and global risks.
Impact on executive incentive plans
The oil and gas sector is highly exposed to fluctuations in commodity prices, as their revenue depends on oil and gas prices. In annual incentive plans, we generally observe a balanced scorecard approach with most of the metrics centered on operational measures.
Exploration and production companies perform price sensitivity analyses and use hedging strategies to establish more realistic goals capable of withstanding market volatility. If the forecasted commodity prices deviate significantly during the year, the effects generally influence the following year's goals rather than modifying annual incentives in-flight.
However, extraordinary events, like geopolitical crises or drastic regulatory changes, might lead to adjustments even within the current cycle. For long-term incentives, many exploration and production companies employ relative and absolute total shareholder return (rTSR/aTSR) as metrics with a TSR pay cap or matrix.
“Extraordinary events, like geopolitical crises or drastic regulatory changes, might lead to adjustments in executive incentives even within the current cycle. "
Shareholder-return measures are not typically adjusted in-cycle because they are directly linked to shareholder value and serve as indicators of the market's perception of management's effectiveness in responding to external conditions compared to similarly exposed companies. However, long-term incentives based on internal performance measures like free cash flow (FCF) or return measures might be adjusted in response to extraordinary events to ensure fairness and motivation for executives.
Key success factors
It is important that exploration and production companies assess compensation program changes with a focus on long-term objectives rather than reacting hastily to fluctuating markets. The industry typically has developed plans and scenarios that account for a wide range of economic possibilities, building resilience in the face of market volatility.
Thus, altering in-flight incentives usually necessitates meeting a high threshold regarding the magnitude of the external situation and its impact. When evaluating the design of annual and long-term incentive plans, it is crucial to ensure that potential payouts are aligned with performance attributable to executives, rather than simply reflecting changing market conditions. The following are key factors when evaluating incentive plans.
Alignment with performance
Incentive plans often are designed to align the interests of company executives with shareholder interests, typically tying compensation to performance metrics like stock price, cash flow or production targets. Market fluctuations in commodity prices can affect these metrics, thus influencing the payouts from these incentive plans. Align payouts with measurable operational and financial performance in the control of management.
Impact of volatility
Evaluate how variations in commodity prices influence outstanding annual incentives and outstanding performance awards. Implement necessary adjustments to incentive plans to account for this volatility by assessing the company’s ability to manage risks and maintain operational efficiency during price fluctuations.
Recalibration of budgets and goals
Modify financial projections in incentive plans to address a broader or wider range of potential outcomes and commodity price scenarios when defining threshold, target and maximum levels of performance. The situation requires strategic foresight to ensure that incentives are structured properly to promote the right behaviors and ensure they remain achievable and relevant.
Use of discretion
Boards should contemplate the use of discretion when determining the final payout, especially negative discretion, to better align payouts with performance results.
Flexibility and resilience
Develop compensation strategies that are adaptable and resilient amid market changes, ensuring lasting effectiveness and alignment with business strategies.
Overall, while some companies might benefit from short-term price increases in the global market, the long-term impacts of conflicts generally pose significant challenges, leading to increased costs and operational difficulties. Most oil and gas companies are accustomed to tolerating a certain degree of volatility, especially if it is anticipated to be short-term, and they often adopt a wait-and-see approach in these situations.
However, in exceptional circumstances or when faced with prolonged volatility, companies may find it necessary to adjust ongoing incentives or exercise strategic discretion. This ensures that they can adapt to the new operating environment and align with revised business goals and objectives.
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