Recently, BOE Report contributor Terry Etam wrote an insightful article discussing the role financial incentives have in the outcomes of energy companies. As part of his article, he responded to a Bloomberg article sourcing a Moody’s study on executive pay structure among the fifteen biggest North American oil companies. The researchers stressed that executive bonuses heavily influence executive strategy, and that they are being incentivized to increase production to increase revenues. While in an economic vacuum this may make sense, since the only way for a competitive firm to increase revenue is to increase the quantity sold or price received per unit, certain economic realities bar the conclusion that increasing revenues will increase return on investment. In the study, Moody’s found that firms were over-weighting bonuses hinging upon production. But the real kicker was their finding that doing so ultimately saw an increase to the firm’s risk in becoming insolvent.
This point was reverberated in a Wall Street Journal article discussing the the same study. The Journal reported that his ‘grow at all cost’ strategy is performs weaker than other strategies to protect overall creditworthiness, and thus the health of the company. Examples in Terry’s article all too succinctly capture the decline and demise of several American firms adopting this strategy.
As American creditors continue to adapt to prolonged low crude oil prices, what about the Canadian creditors financing Canada’s upstream oil and gas development? Can it be said that Canadian oil and gas creditors are set to experience what their American counterparts have, or are there differences? Moody’s ascertains that a 40% proportion of bonuses tied to production targets is extreme, and even at 30% corporations have floundered. Canadian firms will be assessed against these with numbers derived from the most recent proxy circulars filed on Sedar. Generally speaking, the top eight Canadian oil companies by market cap can be divided into two categories, companies with a high proportion of compensation dedicated to short-term incentives and those with the lowest.
Of those eight, the companies with the highest proportion of executive compensation tied to short-term incentive plans, or cash bonuses, are Suncor and Repsol (Talisman), both at roughly 16%. Cenovus and Encana, each have a 15% weighting. Given these firms weigh short-term compensation the highest, they will be most sensitive to production incentives within their bonus plans. At Suncor around 12% of the bonus structure is directly tied to meeting and exceeding production targets, though a clause states that a minimum cost reduction on production must be met to be eligible for bonuses. Repsol (using the 2014 Talisman proxy) pools production targets and cost reduction together, which account for ~33% of their bonus structure – assuming an equal weighting – one could estimate ~14% is directly tied to production targets. Cenovus also combines cost savings and production together in its operational performance metric. At ~38% one could assume around a ~19% allocation to production activities. Encana’s bonus structure allows executives to capture about a 25% increase in their annual compensation by exceeding production targets. However, bonuses are tempered based on job responsibility, Doug Suttles, Encana’s CEO stands to make ~30% of his bonus from production, while executives further down the corporate ladder ~15% from production.
The oil companies with the lowest proportion of executive compensation tied to short-term incentive plans are Crescent Point at ~11%, Imperial at ~5% and Husky at ~0%. Since their bonus structure accounts for less of their total compensation, these companies can be expected to be less sensitive to production targets. Crescent Point’s bonus plan in fact omits production targets. Imperial Oil’s bonus structure is subjective and highly varied. Decisions are made based on the discretion of their executive resources committee. Production is not a direct key metric among their list of performance measures. Husky abandoned bonuses in 2015 due to the prolonged depression of oil prices.
The argument that short-term incentives dictate the strategy implored by executives is intuitive. The cases reported on by Terry Etam strengthen this notion. Given Moody’s and Etam’s qualifications of what proportion of executive pay given to production is extreme, significant and detrimental, it appears Canadian oil companies, at least at the top of the pyramid, are not significantly engaged in the ‘growth at all costs’ strategy floundering American firms. It would seem Canadian creditors focusing on blue-chip oil and gas companies are not exposed to the risks imposed by high production bonus weights.