You have to make your own luck, allegedly, but it really helps when stuff just goes your way. And it really really helps if you can somehow combine favorable vagaries with a little fortune-engineering of your own.
Such alchemy is practiced in the c-suites of an industry with a Vegas-like affinity for the lucky: oil.
Intuitively, bosses get paid well when money is flowing in, whether it’s from selling oil or smartphones. While a CEO can really influence the pricing power of that phone, though, the average oil executive can’t do much about what their favorite product fetches (yes, they can put on hedges, but work with me). So good times for an oil company depend to a large extent on things way above even the bosses’ pay-grade, such as how easy credit is in China, how many homes are being built in the U.S. or who’s fighting a war with whom. Which raises a question for shareholders: Are they paying executives for just being lucky?
An influential analysis published in 2001 concluded they were, and now two academics have updated and greatly expanded upon that. In a paper published Tuesday, Lucas Davis of UC Berkeley and Catherine Hausman of the University of Michigan conducted a statistical analysis of compensation for 934 executives at 80 large exploration and production companies over the period 1992-2016. Their headline finding is that a 10 percent increase in oil prices raises compensation by 2 percent. That really adds up when you consider oil prices have increased by more than 160 percent since early 2016.
The critical element here is the close relationship between oil-company valuation and the oil price, where the authors find an almost one-for-one relationship for their sample over the period . This strong link feeds into bosses’ pay via another strong link: stocks and options. Linking pay with share prices is widespread, of course, but more so in the oil business, where non-salary components accounted for more than 70 percent of compensation for the average executive in 2016; up from about 60 percent 20 years ago and higher than for virtually every other sector, according to the paper. The chart below shows just how lucky oil executives are relative to their peers elsewhere:
To be clear, the authors measure the value of stocks and options at the time they’re granted, so their impact on the analysis isn’t just a mechanical function of their value changing over time as oil prices rise or fall afterward.
The more red-blooded capitalists among you may be tempted to say “So what?” After all, how could any oil company worth its salt recruit the best and the brightest without them having the opportunity to make a windfall when things go well?
Look back at the chart, though, and you may notice a certain asymmetry between what happens to executive compensation when oil prices go up and when they go down. Pay is more sensitive to the luck of oil prices when that luck is good. And the authors found this sensitivity was stronger for those executives paid above the median for the group, which also undermines the hypothesis that this is all about retaining the proverbial talent.
So much about the oil sector is pro-cyclical, with booms characterized by frenzied land acquisition, drilling, borrowing and inflation of all kinds. This tees up the inevitable bust. And while those with a great sense of timing (or just plain luck) can win big in the boom, the experience of the past decade or so shows what it does to returns in this business (short take: nothing good).
Yet executive compensation encourages this cycle, with things like growing production and reserves featuring far more prominently in the pay criteria than cutting costs and debt or boosting return on capital. Now layer on the evidence for those executives also disproportionately being paid for good luck and being shielded from the bad kind – including some really egregious examples – and you have ideal conditions for the extraction of rents rather than the creation of value on shareholders’ behalf. Looked at that way, for the bosses involved, luck really has nothing to do with it.
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This looks credible. The correlation coefficient for the S&P Composite 1500 Oil & Gas Exploration & Production Sub-Industry Index and the Nymex WTI crude oil price between 1996 and 2016 is 0.915, using year-end readings, according to data compiled by Bloomberg.
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Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal’s Heard on the Street column and wrote for the Financial Times’ Lex column. He was also an investment banker.
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