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Investors Seek to Alter Compensation Plan for Shale Drillers

Zacks

Activist investors are calling for a paradigm shift in compensation methods to leaders in the energy sector. The current model awards shale drillers as per growth in production. This has increased production vastly and hence CEOs' pay has also been excessive.

However, the boost in production didn’t help in improving financials. Therefore, investors didn’t gain anything. This fired up investors to demand a change in the pattern of compensating executives. Investors want CEO pays to be linked to returns.

Previous Methods V/S New Practice of Compensation

Per the earlier norm, the executives received large compensation when they made large investments in new wells. This sparked a new age of shale gas that made the United States a global energy powerhouse and encouraged higher oil and gas drilling. In fact, the current crude output in the country amounts to a robust 9.6 million barrels a day — the highest since July 2015.

Per this practice, the 10 biggest U.S. shale producers paid their chief executives $2.2 billion over the past decade despite shareholder returns of 1.7%. These companies include Apache Corp APA and Devon Energy Corp DVN. Both these companies hold a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

On the other hand, the integrated companies like ExxonMobil Corporation XOM and others paid their executives cumulatively a total of $600 million during the same period and achieved a stronger 3.5% return.

The performance of the broader oil industry can also be gauged by the returns it has delivered in comparison to the S&P 500 index. The industry’s performance did not reach any closer to the index’s return of 7.4% in the last 10 years. The difference became more prominent this year, with shares of shale producers down over 20% and the index gained about 14%.

Companies like Cabot Oil & Gas Corp COG and EOG Resources EOG are an exception. These companies have more investor-friendly policies. Even executive compensation is calculated in a manner keeping in mind long-term benefits. Shares for executives are to be vested after three years rather than immediately. These companies also benefited due to their practices as their shares have outperformed peers. Since 2012, EOG Resources’ share price increased 96%.

Gradually, other companies have started or are planning to follow suit. One such company having transformed its practice is Range Resources plc RRC. The company decided to switch policies after its shares dropped about 70% since 2012, per Reuters analysis.

This comparison of prices between companies following different policies is evidence enough to establish the rationality of the more relevant strategy.

On the other hand, companies not agreeing to follow suit are facing the heat. EQT Corp EQT is one such company, which is being asked to explain the logic behind the payment of $130 million to its executive. In September, the company has agreed to eliminate that bonus and focus on efficiency and cost, not production.

Even as investors get more aware, they are allocating their money to companies that compensate leaders for returns.

Change is Not Easy

Despite low returns, the companies will continue to increase production as they would need cash flow to pay debt and other expenses. Executives will continue with their old habits till they are paid per the production increase. Shale executives receive higher pay. For example, Noble Energy Inc’s (NBL) executive was paid $10.1 million in 2016, up 40% from 2015. SandRidge Energy Inc CEO was also awarded $18.8 million in the year the company exited bankruptcy protection.

Winners & Losers

If the change is implicated, it would put an end to spending on new wells, disturbing a shale boom that has placed U.S. motorists and consumers advantageously. However, it will benefit the Organization of the Petroleum Exporting Countries, Russia and other producers who are aggressively trying to control global crude surplus. Flourishing U.S. shale production has mainly upset OPEC output cuts expected at lifting prices. Consecutively, low oil prices have damaged shareholder returns.

Conclusion

If more companies changed policies, production will decline,leading to increase in shareholder returns. These will have widespread impacts on the shale sector as well as international oil markets.

If there is a change in the payment structure, shareholders will benefit from higher cash flows and less funds would be directed to drilling. The surplus funds would be distributed in the form of dividends rather than financing new shale wells. This is likely to result in higher share prices and better return on capital. But that would also mean more reserved oil production.

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