Are Energy Executives Rewarded for Luck?

• Author: Davis, Lucas W.
• Position: Report

1. INTRODUCTION

   From January 2014 to January 2016, oil prices fell from nearly $100 per barrel to just over $30 per barrel. In those same two years, the CEOs of 30 large U.S. oil and gas exploration companies lost an average of over half a million dollars each in annual compensation. Perhaps in no other industry are the fortunes of so many executives so dependent on a single global commodity price.

   In this paper, we analyze executive compensation data from 78 U. S. oil and gas companies over a 24-year period. We document a strong correlation between crude oil prices, company value, and executive compensation. In our preferred instrumental variables specification, a 10% increase in company value driven by oil prices leads to a 2% increase in executive compensation.

   We then perform a series of additional analyses to better understand the mechanisms. First, we show that this oil price effect is robust to including time-varying controls for capital expenditures and labor. Second, we show that the oil price effect holds for both CEOs and non-CEOs. Third, we show that the oil price effect is widespread across the different individual components of executive compensation, including not only total compensation, but also bonuses and long-term cash incentives. Fourth, we show that the oil price effect is smaller at better-governed companies. Results are similar with two measures of firm governance, both related to the presence of more insiders on the board. Finally, we show that the oil price effect is asymmetric, with executive compensation increasing more with rising oil prices than it decreases with falling oil prices.

   We then discuss potential interpretations, drawing from the existing literature on executive compensation. Much of the broader literature on executive compensation is aimed at reconciling the "rent extraction" and "shareholder value" views. (1) Under the rent extraction view, executives have co-opted the pay-setting process, and are increasing compensation as much as possible. In contrast, under the shareholder value model, pay is set within a competitive executive market, structured in such a way that executives are properly incentivized to exert effort on behalf of the firm.

   An influential analysis by Bertrand and Mullainathan (2001) (hereafter B&M) interprets regression results similar to ours as evidence of rent extraction. B&M test whether CEOs are rewarded for shocks to firm performance beyond their control. Their paper uses several different measures of such shocks, but some of the most compelling evidence comes from a case study of the oil industry. They find that CEO compensation responds just as much to changes driven by oil prices as it does to generic changes in company value, an effect which they term "pay-for-luck." As first pointed out by Holmstrom (1979), companies that are maximizing shareholder value should "filter out" oil prices and other forms of observable luck. Executives are risk averse, so the optimal pay-for-performance contract focuses purely on factors under control of the executive. To include luck only makes the contract riskier without providing better incentives. Indeed, it is difficult to reconcile this oil price effect with the predictions of this standard simple contracting model.

   Still, there are ways to reconcile the oil price effect with shareholder value maximization. For example, under a simple model of profit maximization, firms buy more inputs when output prices go up. One could imagine that when oil prices are high, additional executive effort is needed, and so compensation rises to induce that effort. This could explain our main oil price effect, but would not in its simplest form explain our additional results relating to governance and asymmetry. As in much of the rest of the literature, we are unable to sharply distinguish shareholder value and rent extraction interpretations. (2) Part of the challenge, as explained by Murphy (2013), is that these two views are not mutually exclusive, with both forces impacting compensation to varying degrees across firms and over time.

   In addition to providing an advantageous case study, the U.S. energy industry is of significant intrinsic interest. The United States is the world's largest producer of oil and natural gas. The annual value of U.S. oil and natural gas production exceeds $200 billion, and the firms in our sample had a total market value of almost half a trillion dollars in 2016. Reflecting the size of this industry, the dollar value at stake in executive pay is substantial: total compensation of all oil and gas executives in the latter part of our sample is almost $ 1 billion per year. That said, using oil price variation means that we must identify our main effects of interest using a single national time series.

   The paper proceeds as follows. Section 2 provides background on the related literature and on the oil and gas industry. Section 3 describes our data. Sections 4 and 5 present empirical results. Section 6 discusses the results in the context of the existing competing theories about executive compensation, and Section 7 concludes.

2. BACKGROUND

   2.1 Related Literature

   There is an immense existing literature on executive compensation. However, other than B&M, we are not aware of any other study focused on the effect of oil prices on executive compensation. While there is a substantial literature since B&M on the question of whether executives are "paid-for-luck," these studies have instead focused on relative performance, i.e., how an executive's own company's performance compares to that of other companies in the same industry, and how this "relative performance" affects the executive's compensation. In these studies, "luck" is measured using within-industry average performance. Just as a contract could filter out the effect of oil prices, so could a contract filter out within-industry average performance. Filtering out the exogenous industry-wide ebbs and flows decreases the variance of compensation, without reducing incentives for executives to take actions to benefit the firm.

   The literature testing for relative performance evaluation has found mixed evidence (Antle and Smith, 1986; Aggarwal and Samwick, 1999b; Gibbons and Murphy, 1990; Garen, 1994; Garvey and Milbourn, 2003). Typically these studies take the form of testing whether executive compensation is tied to absolute firm performance, which depends in part on industry-wide lucky breaks, or is tied to relative firm performance, which filters out observable industry-wide shocks. However, conclusions in that literature depend in large part on how the researcher defines the peer group, and for some peer comparison groups there is evidence of relative performance evaluation (Gong et al., 2011; Lewellen, 2015). (3)

   A significant advantage of using relative performance is that this measure is available for all industries, facilitating larger-scale analyses and cross-industry comparisons. Oil prices have certain advantages too, however. Oil prices are both exogenous and highly volatile, driven by worldwide shocks. (4) In contrast, with relative performance studies there is ambiguity about how the "peer group" is defined, which introduces measurement error and potential endogeneity, since compensation boards have some flexibility in these choices. Moreover, in industries that are not perfectly competitive, executives may be able to directly influence competitor market value (Aggarwal and Samwick, 1999a).

   One of our additional analyses is motivated by several studies in the relative performance literature that test for asymmetry. Garvey and Milbourn (2006) document that executives are rewarded more for good luck than they are punished for bad, which the authors argue is consistent with rent extraction. This argument is bolstered by their finding that both "pay-for-luck" and the asymmetry are stronger at firms with worse governance. (5) In contrast, Bizjak et al. (2008) argue that asymmetry in "pay-for-luck" could be the result of compensation boards using benchmarking to set wages at market reservation levels, motivated by their finding that the asymmetry appears for firms paying their CEOs below the peer group median. They also argue more generally that other observed empirical facts are consistent with executive compensation being set in a competitive environment rather than as a result of rent-seeking. Campbell and Thompson (2015) also argue that retention concerns are better able to explain asymmetric "pay-for-luck" than are explanations relating to rent extraction. Finally, Bell and Van Reenen (2016) examine both asymmetry and the impacts of firm governance, finding evidence of "pay-for-luck" in UK firms.

   Another paper in the relative performance evaluation literature is Cremers and Grinstein (2014). They ask whether retention concerns can explain observed "pay-for-luck," arguing that compensation practices depend on whether the pool of executives comes from within the industry or from outside industries. They write that, "in an industry with many outsider CEOs and where the overall supply of CEOs will be relatively inelastic, boards may be forced to raise their CEOs' compensation if there is a positive industry-wide shock.... However, in industries with few outsider CEOs, such a competitive labor market argument would be less compelling because CEOs and top executives are beholden to the firm" (p. 947). Interestingly, Cremers and Grinstein (2014) find that the oil and gas industry is one of the sectors with few outside hires. According to their logic, observed "pay-for-luck" in a sector like oil and gas would be difficult to explain by retention concerns in a competitive labor market. We view our paper as complementary to this existing literature on asymmetry and retention concerns, in an industry context in which luck is particularly important and easy to measure.

   2.2 U.S. Oil and Gas Sector

   Our results provide a window into...