Oil and gas companies that have pursued production or reserve growth have underperformed companies that have instead focused on shareholder returns, even if that meant slower growth.
More to the point, companies that have executive compensation tied to these growth metrics have also fared worse. “Most oil and gas companies incentivise their management to pursue growth, rather than focus solely on shareholder returns,” Andrew Grant, a senior analyst at Carbon Tracker, wrote in a new report.
Carbon Tracker argues that these incentive packages result in companies engaging in “value-destroying behaviour.”
Oil executives are rewarded for growth due to an array of incentives, including production or reserve replacement targets. There are also more subtle incentives, such as rewards based on cash flow or earnings.
That may not sound problematic, but earnings can be gamed in such a way as to create the semblance of financial improvement, while in reality reckless growth puts the company at risk. Earnings or cash-flow-based metrics “do include an element of value,” Carbon Tracker notes, but “they still incentivise production growth – for example, the easiest way to boost earnings might be to increase leverage and acquire more assets.”
Instead, oil and gas companies should de-link executive compensation with growth, Carbon Tracker argues. Very few companies have actually done this. As of 2017, 92 percent of oil and gas companies had policies in place that directly incentivized growth in fossil fuel development. Carbon Tracker singled out Anadarko, Cabot Oil & Gas, Canadian Natural Resources, and Oil Search.
Meanwhile, only three companies – Galp Energia, Diamondback Energy and Origin Energy – did not include production or reserve growth in their incentive structures. In 2018, BP and Equinor scrapped these incentives, joining the other three in the small group of companies that are not blindly pursuing growth. For instance, BP got rid of its incentive metric for reserve replacement growth while adding an incentive for returns on capital employed.
Of those five, only Diamondback Energy had no incentives linked to growth at all. The other four had some subtler indirect growth incentives.
Still, the trend is starting to change. After years of red ink, even though production soared, shareholders began to wise up. In the last few years, investors have put more pressure on companies to focus on profits rather than production growth. Between 2017 and 2018, 10 companies “introduced or increased emphasis on returns measures,” according to Carbon Tracker.
Why does all of this matter? The prospect of peak oil demand means that companies that are currently pursuing aggressive reserve or production growth could be destroying value. These assets may eventually become stranded due to weak demand and lower prices. Ultimately, if the world is to get serious about climate change, oil and gas production will have to decline and a lot of reserves will have to remain undeveloped.
Demand doesn’t even need to peak for this to be destructive behavior. It merely needs to slow, putting some higher cost reserves out of reach. Carbon Tracker pointed out that the oil market bust of 2014-2016 stemmed from a rather minor 2 percent excess of supply, which resulted in a 51-percent decline in prices.
“The transition risk to the oil and gas industry is therefore likely to be that of overinvesting, and wasting capital on projects that turn out to deliver poor returns and destroy value,” Carbon Tracker warned. “While some exceptionally low-cost producers may be able to keep production steady or even grow it against a backdrop of weak or falling demand, this would need to be made up by greater reductions in production from other producers elsewhere.”
However, this isn’t merely a theoretical problem with consequences that lie far off into the future. Even today the growth strategy falls short. In the two years following the oil market downturn in 2014, the U.S. companies “with a lower proportion of reserves or production incentive in their annual bonuses outperformed more growth-oriented companies by 7% CAGR,” Carbon Tracker concluded. “Shareholder returns exhibited a negative correlation with production and reserves-related annual bonus metrics, but a positive correlation with financial returns metrics.”