(Today’s post is co-authored by Catherine Hausman, an assistant professor at the University of Michigan and Ph.D. graduate of UC Berkeley.)
New Energy Institute study finds that U.S. oil and gas executives are “paid-for-luck,” with executive compensation increasing significantly during periods of high oil prices.
Crude oil prices are now near $70 per barrel, higher in 2018 than in the three previous years, and oil and gas companies are earning large profits. But how much should oil and gas executives be rewarded for this good fortune?
In many industries, the decisions executives make can impact the prices their companies can charge. For example, Apple’s ability to charge $1,000 for an iPhone X reflects in part the skills of CEO Tim Cook and other Apple executives at developing a desirable product and marketing it.
But in a global commodity market like oil, U.S. executives have zero control over price. No matter how talented they are, or how hard they work, C-suiters can’t move oil prices.
Yet, in a new Energy Institute working paper available here, we find that U.S. oil and gas executives are rewarded handsomely when oil prices go up. Using data on 900+ executives over the period 1992-2016 we find strong evidence of “pay-for-luck,” with executive compensation increasing significantly during periods of high oil prices. Put simply, there are large rewards for energy executives who happen to be in the industry at the right time.
What Do Executives Do?
Before getting to the evidence, it is helpful to step back and remember what executives do, and how they should be compensated. CEOs and other executives make important strategic decisions. If they make good decisions, the company is more likely to be successful and earn bigger profits. Oil and gas executives, for example, make critical decisions about where, when, and how much to invest.
In the parlance of economics, hiring an executive is a “principal-agent” problem. The board of directors (the “principal”) hires an executive (the “agent”) to act on its behalf. The principal wants the agent to work hard and to make good decisions, but it is hard to measure this effort. So, instead, executive compensation typically includes incentives like bonuses, stock options, and other forms of pay, designed to align the interests of the executive with the interests of the company.
Nobel Prize-winning economist Bengt Holmstrom pointed out, however, that it makes no sense for executive compensation to depend on what other scholars have since called “observable luck.” Tying compensation to luck just makes compensation more volatile, which makes both the executive and company worse off. Research by Holmstrom and others has shown that it is easy to remove luck from compensation by, for example, basing compensation on a company’s performance relative to its competitors.
Paying for Luck
Oil prices are the classic example of “observable luck.” We looked, in particular, at U.S. oil and gas production companies, because they are most impacted by oil prices. We excluded companies engaged partially or exclusively in oil refining — including Valero Energy, Chevron and ExxonMobil, because the impact of oil prices on that line of business is less clear.
We found that a 10 percent rise in oil prices increases the market value of these oil and gas production companies by 9.9 percent — almost a 1-for-1 relationship. Perhaps in no other industry are so many companies’ fortunes driven by a single global price.
More surprising, however, we determined that executive compensation also follows the price of crude. In particular, a 10 percent rise in oil prices increases executive compensation by 2 percent. That is, we find strong evidence of “pay-for-luck.”
We found pay-for-luck to be widespread across the different individual components of compensation. This includes not only stocks and options, but also bonuses and long-term cash incentives.
We also noticed that the pattern is asymmetric. Executive compensation rises more with increasing oil prices than it falls with decreasing oil prices. In other words, U.S. oil and gas executives reap big rewards when prices go up, and they aren’t punished that much when prices fall.
This asymmetric pattern is consistent with anecdotal evidence that the criteria used for executive compensation changes over time – from more quantitative measures like profit and revenues during “boom” times to more qualitative measures like employee morale during “bust” times.
Why is this Happening?
Everyone in the industry understands that oil prices are highly variable and completely out of the control of executives. So why aren’t compensation practices designed to remove luck?
It seems likely that executives have co-opted the pay-setting process. Economists call this “rent extraction.” That is, at least to some degree, executives are exercising influence over the board of directors — extracting compensation packages that exceed what would be expected in a competitive labor market.
Consistent with this interpretation, we find more pay-for-luck at firms where more seats on the board of directors are occupied by executives themselves (or family members), rather than independent directors. When the board of directors has a conflict of interest like this, it can be easier for executives to push through lucrative compensation packages, particularly during boom times when oil prices are high.
Total compensation of all oil and gas executives in our sample is almost $1 billion per year, so the dollar value at stake here is substantial. Understanding pay-for-luck dynamics in oil and gas can also shed light on other industries where luck is less obvious, but often equally important, such as other commodity or energy industries, or industries with significant trade exposure.
More broadly, our results raise important questions about corporate governance. Across all industries, median pay for U.S. CEOs is now nearly $12 million per year, and 74% of Americans think CEOs are paid too much relative to the average worker. Are boards of directors really doing their jobs?
It is up to boards of directors to push back against overly generous compensation packages for executives. Boards of directors have a responsibility to make sure that salaries reflect competitive market conditions and that executives aren’t rewarded with large windfalls just because oil prices happen to go up.
This blog is available on The Conversation.
For more information see Davis and Hausman, “Are Energy Executives Rewarded for Luck?“, Energy Institute Working Paper #293, September 2018.
Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas.
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.