We have previously covered how realisable executive remuneration using unhurdled share options is often a matter of luck, and how CEOs in US oil companies (where share option grants are prevalent) have been found to be paid for luck that comes from oil price movements (see HERE) .
In a recent paper by Professors Lucas W. Davis and Catherine Hausman executive remuneration at US oil and gas companies has once again been found to be closely tied to the price of oil, with shareholders essentially paying for luck rather than for performance. Even if executives need to exert more effort when oil prices are high due to higher production and investment activity, the authors included controls for capital and labour but still observed a statistically significant impact of oil prices on remuneration.
Unsurprisingly, crude oil prices are important for oil and gas firms – the authors show that a 10 percent rise in oil prices increases the market value of 80 US oil and gas production companies by 9.9 percent, i.e. almost a 1-for-1 relationship.
Interestingly, the new paper found that the most sensitive components of remuneration were short-term and long-term incentives, implying that pay-for-luck cannot be explained only by the use of shares and options (the authors looked at the grant-date fair value of awarded shares and options, rather than the realised value of vested equity). When oil prices move the market value by 10 percent, short-term incentives increase by 5.9 percent and long-term incentives by 5.6 percent – a substantial correlation to the price of oil.
How can incentive pay be allowed to be so dependent on a factor outside of executives’ control? After all, boards should be able to filter out the effects of oil price movements on these components of executive remuneration.
The authors note that common metrics for short-term incentives in the US oil and gas industry are based on production targets and value of reserves, both of which are positively correlated with oil prices. For long-term incentives, a common metric is total shareholder return (TSR) – which is also positively correlated with oil prices. Even if companies use a mix of absolute and relative TSR, the result suggests that the relative comparison fails to filter out luck driven by oil prices. Oil and gas companies are no exception to the potential issues with relative TSR which we have covered in previous newsletters (see HERE and HERE) and which directors need to be aware of.
If not explained by companies simply failing to filter out oil price volatility from executive remuneration, how can pay-for-luck persist in the oil and gas industry? The authors offer an alternative explanation based on “rent-extraction”, i.e. that executives are able to influence the remuneration setting process in their favour. To test for this, the authors separated the number of insiders (e.g. close relatives of employees) versus independents on the board of directors. Alarmingly, they found that pay-for-luck was highest at companies with insiders on the board and lowest at the companies with independents on the board, suggesting that when companies are less well-governed it can be easier for executives to push through remuneration packages which tend to award luck rather than performance.
See the paper HERE© Guerdon Associates 2021 Back to all articles