CALIFORNIA: Following a long slump, crude prices have rebounded to about US$70 per barrel. That may make 2018 the most profitable year for oil and gas companies in at least four years.
Will oil and gas executives reap big rewards as well?
WHAT DO EXECUTIVES DO EXACTLY?
Before getting to the evidence, it is worth considering what executives do in general, and how they get compensated.
Chief executive officers, chief financial officers and other C-level executives make important strategic decisions. If they act wisely, their companies are more likely to succeed and earn bigger profits.
Oil and gas executives, for example, make critical decisions about where, when and how much to invest.
In many industries, the decisions executives make can also impact the prices their companies can charge.
For example, Apple’s ability to charge US$1,000 for an iPhone X reflects in part the skills of CEO Tim Cook and other Apple executives at developing a desirable product and marketing it. But in a global commodity market like oil, executives have zero control over price.
No matter how talented CEOs are, or how hard they work, they can’t single-handedly make oil prices rise.
In economic parlance, hiring an executive is a principal-agent problem. The board of directors, the principal, hires an executive, the agent, to act on its behalf. The principal wants the agent to work hard and to make good decisions, but it is hard to measure this effort.
Instead, executive compensation typically includes incentives like bonuses, stock options and other forms of pay, designed to align the interests of the executive with the interests of the company.
The Nobel Prize-winning economist Bengt Holmstrom pointed out, however, that it makes no sense for executive compensation to depend on what other scholars have since called “observable luck.”
Tying compensation to luck just makes compensation more volatile, which in turn makes both companies and executives worse off. Holmstrom and others have found it easy to remove luck from compensation by, for example, basing compensation on a company’s performance relative to its competitors.
REWARDED FOR BEING IN INDUSTRY AT THE RIGHT TIME
Oil prices are the classic example of observable luck. We looked, in particular, at US oil and gas production companies, because these are the ones most impacted by oil prices.
We excluded companies engaged partially or exclusively in oil refining – including Valero Energy, Chevron and Exxon Mobil, because the impact of oil prices is less clear and direct on that line of business.
We found that a 10 per cent rise in oil prices increases the market value of these oil and gas production companies by 9.9 per cent – almost a 1-for-1 relationship. Perhaps in no other industry are so many companies’ fortunes driven by a single global price.
More surprising, however, we determined that executive compensation follows a similar pattern. In particular, a 10 per cent rise in oil prices increases executive compensation by 2 per cent.
That is, we find strong evidence of a “pay-for-luck” dynamic, with large rewards to executives who happen to be in the industry at the right time.
We found this pay-for-luck pattern to be widespread across the different individual components of compensation for the top five executives at oil and gas companies. This includes not only stocks and options, but also bonuses and long-term cash incentives.
This pattern is asymmetrical.
Executive compensation rises more with increasing oil prices than it falls with decreasing oil prices. This is consistent with anecdotal evidence that the criteria used for executive compensation changes over time. And that they are more quantitative during “boom” times and more qualitative during “bust” times.
In other words, US oil and gas executives reap big rewards, when prices go up and they aren’t punished that much when prices fall.
WHY IS THIS HAPPENING?
Everyone in the industry understands that oil prices are highly variable and completely out of the control of individual executives. So why do executives earn more when oil prices go up?
The most likely explanation is that these CEOs and other top executives have co-opted the pay-setting process. Economists call this “rent extraction.”
That is, at least to some degree, executives are exercising influence over the board of directors – extracting compensation packages that exceed what would be expected in a competitive labour market.
And the compensation of all oil and gas executives in our sample, all told, totals almost US$1 billion per year, making the money at stake substantial.
With median pay for US CEOs nearly US$12 million per year, executive compensation has become more complicated and important to understand than ever. Understanding pay-for-luck dynamics in the oil and gas industry can also shed light on what happens in other businesses where luck plays a less obvious, but often equally important, role.
Lucas Davis is professor at the Haas School of Business at University of California, Berkeley. Catherine Hausman is assistant professor of public policy at University of Michigan. This commentary first appeared on The Conversation.