Avoiding Feast or Famine: Designing Incentive Plans in Oil & Gas

Jake: In this season of Pearl Meyer Unscripted, we're looking at executive compensation through an industry lens. Our cohosts, Mark Rosen and Aalap Shah, are joined by several colleagues who specialize in different industries, including technology, healthcare, oil and gas, and more, to examine the aspects of compensation design that are unique to each.

We continue our oil and gas discussions with a closer look at incentive design in a sector defined by cyclicality, commodity price volatility, and shifting investor expectations.

Mark and Aalap are joined by managing director Wes Hart from Pearl Meyer's Houston office. Wes advises boards and management teams across the oil and gas industry and other cyclical sectors on executive and director compensation, incentive plan design, peer group development, pay-for-performance alignment, governance matters, and compensation issues arising from mergers, acquisitions, and bankruptcies.

Together, they discuss how compensation committees can avoid feast or famine outcomes, set credible goals in an unpredictable price environment, balance formulaic metrics with judgment, and design short and long-term incentive programs that remain disciplined while allowing for the flexibility this industry often requires. Let's listen in.

Mark: Hey Wes, great to have you on the podcast. We're really excited to have this conversation today.

Wes: Hey Mark, it's a pleasure to be here.

Aalap: Yeah, Wes, great to have you.

Mark: So, let's kick this off. Wes, you work in the oil and gas industry, and we've seen a lot of volatility in prices. The first thing we want to talk about is how do you deal, especially in short term plans, the cash plans, with that cyclicality, with that volatility of pricing. Can you talk to us a little bit about that?

Wes: Yeah, that's a great question. And before we even go there, the main thing we're trying to do is avoid feast and famine outcomes. So some payouts or zero payouts that happen if we don't do anything, if we don't make any adjustments at all, we end up with feast and famine. So technically we're trying to avoid some of those things or mitigate those things.

One of the things we can do is set each year's financial targets based on what's expected that year. So, we don't have a long history and look back across time and see if we're tracking forward. We really set this year's targets based on price activity expectations, what we think is going to happen. And yeah, we can get some flak from advisory services sometimes when we're not setting targets that are always growing, but we know we want to set things based on the realities that we find.

Aalap: And Wes, let's dive into that criticism a little bit? How do you think about that criticism and how to combat that? How do you ensure to shareholders that you are still having the appropriate degree of stretch in your incentive programs, even if it's not showing that incrementally the goals are growing each year?

Wes: Yeah, there's really two sides to that. I mean, I'll start with the outward facing side, which is we do a really good job in the filings, the CD&As, of explaining to the shareholders that we are setting aggressive targets. But the truth of the matter is in the back of the house, we really are setting aggressive targets. So, we take great pains to set targets based on expectations, but there's no sandbagging, no softballs here. So, table stakes is hitting expectations within what we can do within the price environment we find ourselves. So, we go to great lengths to set aggressive goals and then we go to great lengths to explain those to shareholders in the filings.

Mark: That sounds great, but you know, we have a price expectation of seventy-five bucks a barrel and the average is a hundred bucks a barrel for the year. It doesn't matter what expectations you set; you're going to max out.

Wes: Yeah, but you'll max out on the piece that's tied to those things. And that's a change we've seen over the last five, six years is the movement to a basket of metrics. So, we've got price control metrics, we've got safety metrics, we've got cash flow metrics, and maybe we have production or activity metrics.

The production or price-based piece of it may only be twenty percent of the bonus plan. So, the other eighty percent is based on safety, environmental things, no environmental harms, no severe incidents, things like that. 

Aalap: Let’s talk about that a little bit. What you're saying is that basically by having a basket of metrics, you're spreading the risk, which sounds to be a really good idea. But are all those metrics equal in the sense that all of them generate like a two hundred percent payout if they're achieved above target?

Wes: Yes, they do. And in most cases, they're independent of each other. So, as you know, Aalap, it's hard to hit maximum on five independent metrics. You've got to really do something special. It's like hitting three home runs in a row. It’s not, we hit one thing and we max out the whole bonus, that isn't happening anymore. It’s very specific about different things we're trying to do as a firm and as, you know, things ebb and flow, some companies have added other things to their portfolio, things they're trying to do, and they add metrics for those things. And so, there's a different track over there, a different way of hitting maximum.

Mark: Do you see individual modifiers or individual performance layered in?

Wes: At the executive level, you see that sometimes and sometimes you don't. It’s more of a fifty-fifty proposition, I think it's important though. Building on individual performance and going a little bit broader than that, the idea of discretion has a really solid place in the oil and gas industry. We don't always know what can or will happen before the year started. It's important to keep a place for discretion, whether it's individual or overall, and some companies have actually gone so far as to make half of the bonus plan discretionary in some cases, where they've captured the other half may be very financial driven, but they want to maintain a piece of that that's got the ability to flex with what really happened that year.

Mark: When you use the term discretion, what do you mean? We don't know what's going to happen, so we're just going to wait until the end and see? ‘Cause that doesn't usually work very well.

Wes: No, it's more qualitative, a basket of qualitative unnamed goals, I'll call it, where we achieved these five, six, seven things, we achieved them all quite well, our stock price is beating our peers, so we know we had a good year. We couldn't count which things we were going to count ahead of time, but we know ex post facto, we had a really good year, both relative and absolute, across these other things that we were trying to do.

Aalap: So talk about how you would explain that in the disclosures. One aspect of using these qualitative metrics is that you have, again using the term basket, you have a basket of metrics that you decide early on in the year and you can say, look programmatically, this is what we apply discretion on. We're going to assess how we get to the end of the year against those. And that could be some guardrails around discretion. But if there aren't any guardrails around discretion, how would you go about explaining that?

Wes: Sure. I think the most typical case is not that fifty percent discretion case that this was kind of an outlier. The more typical case is somewhere between 10 and 20% of the bonus program is qualitative and very loosely defined as successful things we did during the year. So, because it's only 10-20% of the bonus plan, it's not going to have a huge impact on the actual outcome, but it is going to be able to capture things we didn't know were going to happen before the year started that we succeeded on. So, I think the key is keeping that piece of it probably within its lane, frankly, not outside of its lane.

Aalap: So not to put words in your mouth, but what you're saying is that the true guardrail is the weighting you give to this and make sure that the emphasis continues to be on the financial and the operational metrics of the organization. Is that right?

Wes: That's the most robust guardrail. I mean, I think the other guardrail is, you want to have a list of goals for the year that you're tracking and some of those may fall away because we decided not to do that. It’s important to, ahead of time, have a laundry list of goals you're trying to achieve that are qualitative. But as long as it's in its lane and as long as you track the things that ended up being important. You don't always know what's going to be the most important thing for the year, depending on what's happening. Whether you're either in a new basin or have another program starting out.

Mark: Yeah, I like to use the term judgment because that's ultimately why the committee is there, to exercise their judgment and to create a framework of what good looks like, recognizing that we've got several strategic objectives that have to be accomplished during the year. We don't know which one we're going to make the most progress on because it's often dependent on external circumstances, including pricing. And by laying out what good looks like, we're able to have a framework in which to exercise that judgment. And I like to use that term rather than discretion because while it is discretionary, I think that the term judgment resonates better with investors.

Aalap: Yeah. Tomato-tomato, but I take your point, Mark. But Mark, if you don't have anything else on the annual incentive program, I'd really love to understand from Wes’ perspective how this cyclicality impacts long-term incentives. Because as we know, a good portion, and if not the majority portion of compensation, is in the long term. Wes?

Wes: Sure, before we dive too deeply into that, I'll say one thing that sort of applies to both kinds of short-term and long-term metric. The idea of having wider fairways in a cyclical industry. So, both for the long-term plan and for the short-term plan, it's important to have a fairway from threshold to maximum that captures the likely outcomes and possible things that are going to happen and I think that's a wider fairway in some cases in a cyclical industry than it would be in other industries.

But jumping further into the LTI, I think the key fact on the long-term incentive side of things is, it's nearly impossible and almost not worth doing trying to set a three-year financial target—you don't know what the oil price is going to be in six weeks. So, it's not even a useful exercise setting a three-year EBIDTA target. I mean people try, but it just it's not worth doing.

So, what does that leave us with? It leaves us with relative metrics, in many cases relative TSR, and it leaves us with, if we're going to use a financial metric, having some kind of commodity price collar or matrix that if the price shifts far from what we thought it was going to be, we somehow account for that, either down or up.

Aalap: When you consider how to deal with this particular issue, relative metrics is a potential path. How do you think about relative metrics in relation to absolute metrics in the long-term incentive plan?

Wes: Sure. I think when we can't know what's going to happen in the future oil prices, activity levels commodity cycles, you know, geopolitical things that go different directions than what we're expecting to have happen. The typical of relative metric, frankly, is relative TSR. And I think the key there is coming up with a good peer group that works for us, that captures the right level of risk adjusted potential TSR for the group of companies we're going to compare against. And then if we beat those companies, we do well in the incentive plan, if we don't, we don't.

The absolute metrics really the preferred absolute metric is going to be stock price as well in many cases because that's how the shareholders get to the promised land, frankly. So, we've seen companies going back to thinking about, well, absolute stock price, what do we do with that? We can add that as a collar or a modifier on the relative TSR plan. We can increase the weighting in time-based equity in some cases and have longer vesting on those cycles to capture the longer-term absolute stock price growth. And in rare cases you can see companies even considering stock options, but that's not typically the most common choice. In terms of absolute financial metrics, because we can't really project those things, I don't see them being used much in the oil and gas space.

Mark: Wes, one of the trends we've seen over the last few years is the desire of investors to see greater efficiency and return of capital. So, it's pushed companies towards return metrics, sometimes relative to the peers, but often just absolute. What are you seeing there and how do you deal with that in that cyclical or commodity price environment?

Wes: In terms of return metrics, if you can come up with or achieve a peer group of like companies with similar asset bases, similar business cycles, I think a relative return metric can work in those cases. You know, lacking a peer group that works that way we can go with a matrix based on the commodity price and have a return metric where the return expected changes based on the oil price over the three-year cycle.

So, depending on at the end of the three-year cycle, you look back, what was the oil price and pick that row of the matrix to be your return threshold target maximum. And I think that can work well if you're very thoughtful in the design of that program. It's complicated, but it works well when it works.

Aalap: Yeah, I really like that. I think this is one of the areas we're always trying to simplify incentive programs, but having a little bit more of a complex solution probably gets you to a better answer.

Wes: And what would I recommend in cases like that? I think if we go back six or eight years, people tried to hide their black box and hide those matrices, and this is too much information to give away. I think we've decided, well no, it's really not. We put those matrices in the CD&A. So, you can see what were we fighting against? What was the full list of things that could have happened at different prices and we can see where we came out. So, there's nothing hidden now after the fact. So, after the grant has matured over the three-year cycle, we're fine to now show the investor this is what we were up against and this is how we did. I think that's important to build credibility, frankly.

Aalap: Wes, it sounds like there's a theme around just having a bit more flexibility when you're looking at planned designs and incentive metrics year to year. But what about executives and business units outside the traditional oil and gas ecosystem?

Wes: Sure, Aalap. The areas outside of the traditional oil gas have definitely been the growth engine for some companies. As we’ve seen less growth in the oil and gas, traditional space, we're seeing a lot of growth in energy, AI, data centers, power generation, various flexible things like that. And when we have business units, that's all they're doing in that business unit, we tend to see the executives paid seventy to a hundred percent based on how their product line is doing. It's important to tie them to the product line because that is your growth engine. You want to make sure they're getting rewarded and encouraged to operate within that sphere.

Aalap: Definitely something to discuss. I think there is some interesting complexity that's coming into the sector as companies continue to consolidate as well as diversify in terms of the different business units.

Wes: Yeah, I think, last takeaway I'll give you is, I think the, you know, what Mark said earlier about judgment, I think a flexible and disciplined program is the key to and those are kind of in opposition to each other, there's a tension there. Flexibility and discipline and the key is using judgment around those things to get programs and outcomes that are fair.

Aalap: Wes, this has been great. Really appreciate you sharing some wisdom with us.

Mark: Yeah, thanks a lot, Wes.

Wes: Yeah guys, thanks for having me, and I'm happy to come back. It's very fascinating for all of us.

Jake: Thanks again to Wes for guiding us through incentive design considerations in a sector defined by cyclicality and commodity price volatility. We'll be closing out our oil and gas series in our next episode. Wes and Malcolm will return to the pod, and Mark, an oil and gas expert himself, will join them to field questions from Aalap and discuss and debate how to incentivize different parts of the business when performance is uneven.

Until then, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thanks as always for listening, and we'll meet you back here next week.