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Changes to CEO pay structure could attract investors back to oil, gas sector

General investors could flock back to the underperforming energy sector if oil and gas companies make changes to the way they compensate CEOs in annual bonuses and long-term pay incentives, analysts from Evercore ISI said during an Aug. 8 webinar.

If producers and integrated oil and gas companies adopt corporate governance and shareholder alignment practices similar to those used by other "cyclical" sectors of the S&P 500 their returns and valuations could improve and lead to better shareholder outcomes, the Evercore analysts said.

"Energy underperformed all 10 S&P sectors with 10-year performance, its worst on record. Investors doubt that energy's relative performance will improve until energy boards require change in the CEO pay incentives and behaviors that drove poor performance in the first place," Evercore integrated oil analyst Doug Terreson said during the company's "Energy Shareholder Alignment Review."

Energy stocks account for just 5% of the S&P 500, down from 14% ten years ago, the analysts noted.

Peaking above 12,000 in mid-2014, the S&P Oil and Gas E&P Index plunged as low as 3,600 in early 2016. As crude prices and companies' profits rose, the index rose back above 6,600 in fall 2018 before sinking nearly 40% in December 2018 as oil prices declined again.

Most oil and gas companies utilize a CEO compensation structure that includes incentives based on cash flow levels, or for meeting health and safety targets as well as environmental and production goals. According to the analysts, a majority of big oil and E&P CEOs they assessed received payouts in excess of 100% of target pay despite total shareholder returns lagging not only the sector but also the broader energy and the equity market as a whole.

"The problem is that when the industry is in value-destruction mode as Big Oil and E&P were during the past decade, CEO compensation can remain high as long as management teams destroy less value than peers," the analysts said.

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Energy company boards should not allow CEOs to make or exceed annual target pay levels year after year, the Evercore analysts said. "Otherwise, annual pay is a quasi-salary element, and the boards' annual compensation process lacks credibility," Terreson said.

With a bonus and incentive plan for delivering on various targets that included the completion of an aggressive two-year $30 billion divestment program at the end of 2018, Royal Dutch Shell PLC's CEO Ben van Beurden's 2018 remuneration more than doubled to $23 million.

While implementing a more demanding remuneration policy in recent years, BP p.l.c. CEO Bob Dudley's total pay package increased to $15.1 million in 2017, up from $13.4 million in 2016, as the London-based major's share price improved.

In 2018, although BP's earnings more than doubled, Dudley's remuneration for the year was down almost 3% to $14.7 million, according to the company's 2018 annual report released at the end of March, due to a reduction in Dudley's annual pension and bonus since the major missed its operating cash flow targets.

During their presentation, the Evercore analysts said annual CEO pay factors should correlate with total shareholder returns, or TSR, and more challenging performance goals. CEO performances should be linked to absolute, value-based performance metrics such as return on capital employed and economic value added, or EVA, which connect to intrinsic value in the equity market.

EVA is an estimate of a company's economic profit. "EVA is not used by any energy company as a CEO pay incentive, which may explain the significant decline in returns and valuation in energy during the past five and 10 years, and poor equity market performance too," the analysts said.

"Value and return-based metrics better capture whether investment and specifically upstream development is being achieved in a value accretive way and should play a more prominent role in chosen performance metrics," Terreson added.