Recently, the BOE Report published an article that flagged a considerable problem for some sections of the oil patch – a misalignment of incentives that rewards the wrong behavior. In this instance, the problem is oil production growth, which is sometimes being rewarded at the exact time it should be discouraged. In an era of low or falling commodity prices, there should be an extreme emphasis on the health of the company rather than accelerating a problem, but sadly that’s not much on display. Some companies are growing themselves right into the graveyard.
The habit is part of the culture. The growth-at-all-costs mentality is a very difficult demon to exorcise from modern public company CEO’s. Analysts rate and rank stocks based on such yardsticks, and are relentless. To contemplate something other than a growth strategy is nearly impossible, like trying to avoid seagulls with a fish tied to your back. You don’t have to take my word for it; here’s a quote from a first quarter 2016 Pioneer Resources conference call: “We had a first-quarter adjusted loss of $104 million or $0.64 per diluted share. What’s more important is that the company hit record production again first quarter of 2016, 222,000 barrels of oil equivalent per day, 55% oil.” Yes, that’s more important than that niggling little quarterly loss of $100 million…I guess when your peer group is losing billions that looks pretty good.
Does it matter? It’s hard to say, because most people regard the stock market as a crapshoot anyway, and these actions simply reinforce that belief. But shouldn’t it be possible to aim a bit higher? Shouldn’t the underlying requirement of a management team be, first, don’t kill the damn company?
Here’s an example of attempted murder. There is no better place to illustrate than with Chesapeake Energy Ltd., a legend in the energy business, Chesapeake was started from scratch in 1989 and grew production to nearly 700,000 barrels per day equivalent (gas and oil) by 2015. It was a remarkable run, up until the 2014 price crash. Of course the price crash caused the destruction of a lot of companies, but not all. Some companies succumbed to the disease, while other (rare) entities showed restraint.
Chesapeake was designed for growth. Take a look at this recent snippet from Chesapeake Energy’s most recent compensation disclosure document on EDGAR. Keep in mind that Chesapeake is now on death’s doorstep, one foot ahead of the creditors, with a $10 billion debt load and plenty of fancy footwork required to keep ahead of the rubble falling on their heads.
You don’t need to make sense of all the factors; in fact you’re not supposed to be able to. Murkiness makes fewer headlines. What’s worth noting is two key data points: first, that production growth is initially weighted 20 percent in bonus calculations, meaning it’s weighted significantly, and secondly that in the final tally (of the 138% bonus allocation) production growth accounts for 40 of the 138 percent.
One might overlook this if it was an aberration or a new development, but the warning signs at Chesapeake are nothing new. The company announced a $6 billion write-down of assets – in 2009. The write-down was at least in part a result of shutting in relatively new production that was uneconomic at the then-current prices, which were actually pretty good compared to today.
Midstates Petroleum is another poster child. Midstates went public in 2012, raising nearly $500 million and increasing production to over 30,000 b/d by 2015. In late 2015 the company boasted about driving down drilling costs and maintaining production growth, and executive compensation was 30 percent weighted to production growth. That statistic is unfortunately a year old because they didn’t file a current one; they were preoccupied in early 2016 with filing for bankruptcy. It’s shares fell from more than $70 apiece in late 2014 to zero, leaving creditors with $2 billion in debt to fight over.
When looking at compensation schemes, conspicuous by its absence is any penalty for bringing an organization to the brink of extinction. In other words, no matter what state the beast is in, executives sometimes make more money by increasing production rather than doing anything else. They are incentivized to, with no penalty if they ride the horse to death (they might be out of work, but generally with a nice severance package). In an environment like we’ve seen recently, companies should be 100 percent in survival mode, not preoccupied with growth. Even if they had the opportunity to grow production, is it a smart thing to do, blowing out reserves at the lowest prices in 15 years?
Someone somewhere will surely point out that there are other factors and reasons for keeping production up, some of them true. The point is that executives are incentivized to do one thing, even at the detriment of the organization, and often times these misguided incentives got them in this problem in the first place.