Preparing pay plans for what's next: in a 'lower for longer' price environment, such as in the energy industry's upstream sector, boards face key issues.

Author:Charlebois, Stephen
Position:COMPENSATION MATTERS
 
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The oil environment over the past 18 months has raised a stiff challenge to energy-company compensation committees. In 2015, typical industry pay plans that were neatly crafted to reward executives for increased production and exploration paid off when executives delivered on their promises. But the payoff was often misaligned with share price performance, which fell dramatically across the industry.

This situation raises the question as to how compensation committees should respond when commodity-price-driven bottom-line performance doesn't deliver to investors in the same degree as it does to executives.

In the Short-Term ... With the future of oil prices still unknown and potential that the market reverses course, resist drastic changes to incentive plan design. Instead, look to adjust weightings in the annual incentive plan to match the company's current strategy. For example, if the company is limiting new exploration and focusing on maximizing current opportunities, lower the weighting on reserve additions and encourage more efficient capital spending. If commodity prices stay low, you may also want to add goals tied to debt reduction, such as debt-to-capital ratio or interest expense per barrel.

At the same time, be wary of focusing on efficiency metrics, like the cost of reserve additions per barrel. Moving the strategic focus of the company towards lean production and cost-effective reserve additions is an appropriate response in a low price environment, but efficiency metrics are subject to awkward distortions when measured on a one-year basis. Measuring reserve additions against capital spent in a given year ignores the issue that reserves are often a result of several years of capital investment--reserves added this year are likely the result of capital invested in prior years.

We don't recommend removing efficiency metrics from the annual plan, of course. But rewards in the annual plan will pay out more fairly if you balance operational metrics, like capital spending, with shareholder-centric metrics, like return on capital employed. You can also monitor efficiency metrics outside the pay plan over several years and use the findings to inform the committee's year-end decisions.

In the Long-Term ... Fine-tuning of this kind, and the downward discretion as used by a large number of committees in 2015, may not be enough to adequately align pay with longer-term operating and share price performance.

In a "lower for longer" price...

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