Daily Management Review

Why salaries of oil companies' executives affect the entire oil industry


06/01/2016


Heads of oil companies have traditionally been considered one of the highest paid managers in the world. And, as it turned out, their remuneration’s model is so wrong that it harms the entire sector.



Maxime Felder
Maxime Felder
What if workers would not receive the money not for produced goods or a comparable coefficient, but just for time spent in the office. Then they would probably prefer to watch TV and eat dinner there. Some would even stay to sleep at work. None of this is helpful to the employer, but then workers can receive a larger salary.

Sounds absurd? But so many oil companies are working like that now, at least with regard to their management.

In the last decade, a significant number oil companies’ managers discovered that their salaries are not tied to their companies’ income, value, or the production level in there. Even now, when prices fell and production in some regions has been reduced, remuneration of executives is paid based on the performance of oil production.

The problem with this approach is that current oil prices are not inviting for large-scale production now. Currently, enhanced production is destroying shareholder value.

Therefore, managers need to reduce costs and optimize production, while maintaining maximum potential. This may seem obvious, but many oil companies are choosing another way.

For example, management of Continental, Devon and Chesapeake, the largest oil shale companies in the United States, in 2015 received a significant portion of bonuses basing on performance and production of oil, rather than profit. 

According to the Wall Street Journal, 30% in bonus of Devon’s General Director, 40% in that of Continental’s CEO, and 34% in bonus of Chesapeake’s manager were associated with oil production.

Chesapeake’s General Director Doug Lawler last year earned $ 1.56 million due to exceeding targets for production and reserves. Chesapeake’s production during this period increased by 4.9% compared with the target of 2%.

However, production growth will not help shareholders. Profit fell during the year, and Chesapeake share’s price collapsed by 77% in 2015.

Chesapeake is not the only company that practices a such an approach towards its shareholders.

Remuneration for the production growth helps explain why mining in the United States falls so slowly even at low oil prices. Production is unprofitable to a vast majority of companies now, so it would be more logical to go to the long-term survival mode, while maintaining profitability. However, oil production in the US has fallen by only 9% from record highs.

Of course, problem is more complex than the wrong leadership bonuses alone. Wall Street analysts have traditionally leant in favor of industrial companies with significant growth prospects, rather than current income. It encourages companies to look for ways to increase production and reserves, not than profit.

Now, maximum increase in volumes of produced and sold oil makes little sense, but analysts of large banks realized this too late.

Most oil companies are dependent on banks, as there are no other ways of funding. In turn, banks grant loans primarily secured by existing reserves. Again, a deposit is worth money only if the oil can be produced at all.

It turns out that the companies, analysts and banks have destroyed value of true development model, deforming the oil market, holding back production at higher levels and, in the end, not allowing prices to recover.

source: wsj.com






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