For much of the early part of this century, the oil and gas industry was in volume growth mode. The scramble to maximise output led to over-investment in high capital intensity projects, and declining financial returns across the industry, despite oil prices buoyant over $100. Since being exposed by the 2014 oil price crash, the rhetoric has shifted to focus on capital discipline and the delivery of strong returns on investor capital.
At the moment, every company seems to think it will be able to grab the last chair when the music stops. In aggregate, these plans just do not add up.
Furthermore, there is the challenge presented by the need to cut fossil fuel use as soon as possible in order to meet – or get anywhere close to – our Paris climate commitments. Fortunately, there is increasingly the means to make that goal possible, including the falling costs of renewables and rising interest in electric vehicles.
The energy transition does not necessarily spell overnight doom for fossil fuel companies. However, uncertainty over the future does imply that producers’ focus should be on extracting maximum economic benefits from their opportunity set, rather than relying on ever-increasing consumption of their products. Demand doesn’t even need to fall in absolute terms to force a speedy realignment of business priorities – it grew by 3% over 2014-2016, yet a 2% excess of supply resulted in the S&P Global Oil Index falling 51% peak to trough.
Given this backdrop, you might think that oil and gas company remuneration structures would not reward executives for simply growing for growth’s sake. However, the vast majority – over 90% of major listed companies in 2017 – do just that, paying executives based on volumes of production growth, reserve and resource additions, or both.
On top of these obvious growth metrics, there are a whole host of more subtle measures that have a financial element but could still be seen as incentivising volume growth. For example, a CEO might decide that the easiest way to hit earnings targets would be to increase leverage and acquire assets that generate income over and above the additional debt service costs – but that does not mean value has been created for shareholders. Carbon Tracker’s latest report shows that the more executives were incentivised for growth via their 2013 bonus, the worse the returns for their investors in the years following.Executive remuneration has been something of a hot topic among climate-concerned investors of late, and both Chevron and Shell have recently announced that they will link emissions performance to management pay in future years. Chevron’s targets relate to methane emissions and flaring reductions only, whereas Shell’s will include other sources and in particular scope 3 emissions – those produced when using the oil or gas, and by far the bulk of life cycle emissions relating to fossil fuels.
Such incentives to reduce pollution are of course a good thing, but there remains a more fundamental issue. The ‘carbon budget’ of emissions that can be released while meeting our climate commitments is finite, yet both of these companies currently incentivise their management to continue increasing production of oil and gas. Theoretically, the very lowest cost producers may be able to keep output flat or even increase it while demand falls overall. However, this is likely to only apply to a select number of companies, and other producers will have to cut their production even more to make up the difference. At the moment, every company seems to think it will be able to grab the last chair when the music stops. In aggregate, these plans just do not add up.
There are plenty of other performance measures that remuneration committees can use which don’t require continued growth, for example: return on capital employed. Pay practice is an area where investor pressure can have a clear effect, and indeed has already driven something of a trend towards these metrics regardless of any environmental concerns. A 2015 shareholder resolution resulted in BP’s remuneration committee agreeing that their target relating to reserves replacement did “not fit with the group’s strategic focus on ‘value over volume’”, and it was accordingly dropped from the company’s 2018 incentive structure.
In fact, over a quarter of companies disclosed that they had initiated or increased emphasis on financial returns metrics in 2018 compared to 2017. Hopefully there will be further signs of this continuing through the 2019 reporting and AGM season, but the continuing and widespread use of such growth incentives means that investors have much further to go in their scrutiny.
Abandoning the pursuit of fossil fuel expansion will probably require a fundamental shift of mindset among producers. This may well be a protracted process, but it will almost certainly be quicker if management aren’t paid to do the exact opposite.
Andrew Grant is a Senior Analyst at the think tank Carbon Tracker. You can read his latest report here.