Hank Williams Sr. once sang, “Now I got rockin’ chair money, but I got it the hard, hard way.” Just like Hank, the executives of America’s natural gas drillers received “rockin’ chair money” in recent years. And they also got it the hard way–because it can’t be easy convincing your comp committee to reward you when your company is mired in a natural gas glut. Or is it?
Even though natural gas prices hit ten-year lows in 2012–and even while the shares of companies exposed to natural gas have generally underperformed over the past five years—most CEOs in the sector have done fine. Of the nation’s top four natural gas producers–ExxonMobil, Chesapeake, Anadarko, and Devon Energy—all regularly grant their chiefs annual pay packages with target values at or above $15 million.
The stark drop in natural gas prices from an all-time high of more than $15 per 1,000 cubic feet in 2005 to near $4 today results from a range of factors including the global economic downturn, competitive coal prices, unusually warm winters, the improvement of hydraulic fracturing (“fracking”) drilling techniques, and the production of natural gas as a byproduct when drillers frack for petroleum.
But is there another factor to be found in the proxy statements of these drillers? An examination of the compensation strategies of Devon Energy during the years 2005 through 2011 suggests that non-formulaic and non-performance-based incentive structures may fail to protect shareholders in the face of a commodity glut.
As disclosed in the proxy statement filed in advance of its 2006 shareholder meeting, in 2005 the Devon board paid CEO J. Larry Nichols a $1.1 million salary, a $2.2 million bonus (based on a non-formulaic assessment of performance), and stock and options with an aggregate grant-date value of more than $7 million (none of which was tied to performance measures). Devon shares ended 2005 above $60 (near where they currently trade).
The following year, the board again used a non-formulaic approach to bonus determination but disclosed that it considered performance against targets measuring production volumes; reserve replacement rates; development costs; operating expenses; G&A costs; property acquisitions; environmental, health and safety performance; relationships with regulators; collaboration among departments; competitive position; and leadership development.
Also, the company disclosed the peer group it used to benchmark bonus and long-term incentive amounts. Unfortunately for Devon shareholders, the group included Chesapeake Energy (the board of which would grant then-CEO Aubrey McClendon a $75 million bonus in 2008) and Chevron and ConocoPhillips, two firms much larger than Devon.
Mr. Nichols received a $2.6 million bonus in 2006, plus $1.2 million in salary and stock and options valued at $4.4 million. The company’s production mix was 65% natural gas (which had an average price of more than $6 per 1,000 cubic feet, down from $7 the prior year) and 35% oil and natural gas liquids.
In 2007, when natural gas prices were still near $6 and Devon shares hit the $90 mark, Mr. Nichols again received $1.2 million in salary and a $2.6 million bonus. His equity awards increased in value to $5 million in order to keep up with the peer benchmark.
In 2008, demand for natural gas crashed, as did Devon shares (from $120 to $60). But Mr. Nichols’ chair kept rocking. He received a salary bump to $1.4 million, a $3 million bonus (awarded pursuant to the non-formulaic approach), $6 million in restricted stock and nearly $6 million in options (with a strike price of $65), 20% of which vested immediately. The increase in equity awards was granted to all Devon’s top execs. In the 2009 proxy filing, the board stated the increase “was appropriate based on the long-term value created by the addition of significant production and reserve potential in emerging natural gas plays.” The increase in Mr. Nichol’s bonus was based in part on the company’s 6% increase in oil and gas production.
In 2009, Devon shares rebounded to roughly $75 by year’s end but lagged several peers. The board, noting this underperformance as well as the company’s increased production a reserve replacement, granted Mr. Nichols a $2.1 million bonus. And he received another $10 million in stock and options.
In June 2010, Mr. Nichols was succeeded as CEO by John Richels and took the title of executive chairman. Nevertheless, his bonus was bumped back up to $3 million and he again received $1.4 million in salary and stock and options valued at more than $11 million. (Mr. Richels’ awards were at similarly high levels.) The bonus increase was based in part on Devon’s sale of its offshore assets and another above-target production year.
At the 2011 annual shareholder meeting, the company’s initial say-on-pay vote nearly failed, receiving 56% approval. In response to shareholder feedback, the company revamped its executive compensation program by introducing a formulaic bonus scheme (which included metrics based on TSR, production, expenses, and margins), conditioning equity awards on performance metrics (relative TSR and absolute cash flow), and reducing Mr. Nichols’ salary by one-third.
Following these reforms, Mr. Richels received bonuses of $2.3 million and $1.2 million in 2011 and 2012, respectively.
While Devon’s reaction to the 2011 say-on-pay provides positive evidence that boards can and do respond effectively to a negative vote, its failure to alter its pay programs prior to that point as natural gas prices sank suggests that owners of companies whose fortunes are closely tied to commodity prices should be wary of lax compensation structures. Given the non-formulaic nature of the former bonus structure and the lack of performance conditions on equity grants, it is unclear whether Devon management was in any manner incentivized to steer Devon clear of the natural gas glut by lowering production or associated costs. Rather, it appears that compensation was tied more closely to production levels than natural gas prices during 2008 through 2010.
As for Mr. Nichols, just like Hank sang, he’s rocking down the line. In December 2012, with shares trading slightly above $52 (a level where many long-term shareholders were in the red), Mr. Nichols sold $50 million in Devon stock.