Driving Capital Efficiency within the E&P Industry

Executive Incentives Evolve to Reflect Shareholder Expectations

The exploration and production (E&P) industry is in the midst of a sea-change in investor expectations. Investors have indicated that they are no longer supportive of unprofitable growth, rather they are shifting their focus to financial/investor returns and disciplined capital allocation. Companies should assess whether their executive incentive plans are evolving to support changes in business strategy and investor expectations.

Expectations for Financial and Shareholder Returns is Reaching Critical Mass

Stock prices within the energy industry have not fully recovered from the dramatic drop in oil prices in late 2014.  In light of lower stock prices and the historical boom or bust nature of the industry, many investors have been urging management teams of E&P companies to focus their efforts on capital efficiency and returns. According to a recent Wall Street Journal article, “Twelve major shareholders in U.S. shale-oil-and-gas producers met this September in a Midtown Manhattan high-rise with a view of Times Square to discuss a common goal, getting those frackers to make money for a change.”^[i] To motivate this change, investors have been calling on companies to change the focus of their incentive plans from rewarding for growth (e.g., production and reserves) to rewarding for financial returns.

One of the more vocal investors calling for change has been SailingStone Capital. In an August 2017 letter it stated:

"Despite the overwhelming evidence that shows that there is no relationship between long-term shareholder returns and absolute production growth, most companies in the sector continue to use production growth as one of the primary metrics when evaluating management performance. Production is an outcome of the capital allocation process, not something that should ever be targeted."

Responding to Investor Feedback

In addition to the open letters and news articles outlining shareholder expectations, E&P companies have engaged in one-on-one discussions with their largest shareholders to better understand their expectations and goals. The feedback from these discussions has been nearly universal – investors are looking for incentive plans that reflect a business strategy optimizing returns to shareholders and focusing on capital efficiency. 

Use of Capital Efficiency and Return Measures within the E&P Industry

FW Cook reviewed 2017 proxy statements of 56 US companies in the E&P industry and found approximately 20% of companies use a capital efficiency or return measure in their incentive plans. Specifically, we examined the annual and long-term incentive plan designs to determine whether capital efficiency or return measures were used and how the measures were structured.  In our analysis, we defined capital efficiency as any metric that tied growth or profitability to some form of capital deployment.  

Examples of capital efficiency and return measures being used within incentive plans are:

• Drilling rate of return
• Return on capital employed (ROCE)
• Return on invested capital (ROIC)
• Cash return on capital employed (CROCE)
• Ratio of CapEx to after-tax cash flow

Although the use of capital efficiency and return measures are not currently as prevalent as operational or financial measures within incentive plans, we expect the use of efficiency and return goals to increase significantly in the upcoming years (many E&P companies will likely disclose changes to their incentive plans in 2018 in response to shareholder feedback).   

Considerations in Implementing Capital Efficiency and Return Measures

Most E&P companies build their annual operating plans on capital budgets and rates of return assumptions. However, most E&P companies have not historically included return-based measures in their incentive plans. When implementing a capital efficiency or return measure, it is important to consider the following:

• Alignment with company strategy
• Line of sight to participants
• Calculating the performance measure
• Adjustment items
• Performance timeline

Alignment with company strategy

The selected capital efficiency metric should support the company’s business strategy.  While investors appear to be consistent in their message around returns, not every company has the same strategy for delivering returns.  In addition, every company is in a different position with respect to the asset base upon which it built its strategy. For these reasons, one size does not fit all when it comes to incentive design. Further, the metrics used in the incentive plans should be consistent with and support the message being communicated to investors on a regular basis. 

Line of sight to participants

Performance plans should incorporate goals that provide line-of-sight to participants (i.e., metrics that participants feel they can influence). Typically, the closer the goal is to total returns (e.g., ROCE, ROIC), the lower the line of sight.  For this reason, many companies are considering whether one incentive plan is appropriate for all participants, or if multiple incentive plan designs can provide better line-of-sight based on level within the organization.

Historically, E&P companies have favored one incentive plan for all participants in the company to drive a singular performance message throughout the organization. Hence, these programs have included a significant focus on operational measures such as: production volumes, reserve additions, cost metrics (operating, G&A, LOE), etc. However, investors have little or no visibility to incentive arrangements further down the organization. They are clearly most interested in how the senior executives are rewarded. For this reason, we believe there will be pressure on companies to design incentive plans tailored to the various levels in the organization. These plans may have different metrics but they should all complement the key metrics found in the executive incentive plans. In other words, the executive incentive plans could be focused on returns while the incentive plans for lower levels in the organization could be focused on the components of returns for which they have better line of sight (e.g., production, cost metrics).

One hybrid approach is to implement a performance measure that has high line of sight value for participants (such as reserves or production) while incorporating a focus on the company’s capital structure (e.g., reserve growth and production growth per debt-adjusted share). This allows for consistent messaging throughout the organization around targets such as production while holding executives responsible for decisions related to capital structure.

Calculating the performance measure

Return and capital efficiency metrics, like most metrics, can be measured in various ways:

• Absolute compared to plan/budget,
• Absolute compared to an enduring standard,
• Relative compared to peers or an index, or
• Relative compared to year over year change.  

Each approach has pros and cons. The use of an absolute measure could result in volatile payouts as long-term goals are difficult to set in a commodity price-driven industry.  If using an absolute return measure, it is important to consider how investors will view the disclosed goal versus the company’s cost of capital. In addition, it is important to consider the year-over-year impact of commodity price volatility when setting the performance goals. For example, investors and proxy advisory firms often expect companies to set goals at increasingly higher levels.  This can create challenges in communications to investors and participants.  

If measuring performance relative to peers, companies need to evaluate how they will calculate performance and determine the companies against which they will compare performance. For the calculation method, companies consider using change in performance to normalize for the impact of prior investment decisions. For example, companies could focus on the relative change / improvement in ROCE rather than absolute ROCE. This keeps the plan motivational while focusing executives on the ultimate end goal – financial and shareholder returns.

For the performance group, consider using a more narrowly defined group that focuses on companies with similar assets or acreage in the same basins to recognize the different return profiles of the various assets / basins. This peer group may differ from a company’s compensation peer group.

Adjustment items

Companies should consider which adjustments, if any, are appropriate when determining the performance outcome. Return on capital measures often involve adjusting for extraordinary outcomes, as well as the timing of certain investment decisions.  Such adjustments may make sense for maintaining the motivational value of the program, however, those adjustments could complicate shareholder disclosure.  Care should be taken to maintain the credibility of the program with investors.  In addition, the SEC requires U.S. filers to describe such adjustments and reconcile the numbers to GAAP accounting standards.  If measuring performance on a relative basis, companies should consider if they have enough information to apply adjustments equally to both the company and its peers.

Performance timeline

One of the most difficult aspects of implementing a return-based performance metric in incentive plans is setting a performance period that allows for a meaningful assessment of performance. This is true because most return-based metrics reward for long-term performance over multi-year periods. In today’s market, the most common approach is to use an annual measurement period for the bonus and a three-year measurement period for long-term incentive plans.

Before implementing a capital efficiency or financial return metric, companies should evaluate the potential impact of the performance timeline. For example, can the company meaningfully move absolute return metrics in one year? If not, the company could consider using it as a long-term performance metric rather than an annual performance metric.

Another consideration when choosing the performance timeline is how the performance period aligns with the company’s investment cycle. This includes evaluating whether the company’s assets are short-cycle or long-cycle investments, balance sheet constraints, and place in the business cycle (e.g., early-stage growth company or later-stage mature company).

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^[i] Olson, Bradley and Cook, Lynn. “Wall Street’s Fracking Frenzy Runs Dry as Profits Fail to Materialize.” The Wall Street Journal Online 6 Dec. 2017.

Matt Lum
Principal

Matt Lum works with clients across a wide array of industries and within various stages of the business cycle. He has experience in aligning companies’ incentive plans with their long-term strategy, advising on total compensation structures, and comparing pay and performance. 

Austin Lee
Principal

Austin Lee is a consultant in the Houston office. He works with clients on a variety of projects which include conducting market analysis on executive pay levels, designing performance based annual and long-term incentive programs, and evaluating the relationship between executive pay and company performance.

Steven L. Cross
Managing Director & Head of Houston Office

For over 25 years, Steve has served as the outside advisor to the board of directors and executive management in the design and ongoing administration of executive compensation programs.  He has extensive experience in the energy industry providing consulting services to a broad range of oil and gas clients including domestic, international, and national oil companies.