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Article | Executive Pay Memo North America

Energy sector hit by double black swan events

Executive Compensation

By John Rhew and Andrew Neidinger | June 22, 2020

History may repeat itself as the energy sector stabilizes to a new normal.

Starting in 2014 OPEC’s unwillingness to reduce production levels pushed the West Texas Intermediate (WTI) benchmark to nearly $25 per barrel, an unprecedented price at that time. The result was an uptick in bankruptcy filings and the consolidation of mid-market companies throughout the sector. We expect the recent oil price downturn to produce similar results, unless the WTI benchmarks rise to profitable levels soon.

We have learned from past downturns that exploration and production (E&P) companies and oilfield services (OFS) companies are most at risk to the downturn of commodity prices. The E&P subsector consists of stalwarts in the S&P 500 that have moved to a more vertically integrated portfolio, while the OFS subsector is heavily dependent on production and providing associated services to well sites.

Most recently, because of the imbalance between supply and demand, we observed the WTI drop more than 300%, finishing the day below $0 for the first time in the benchmark’s history. In layman’s terms, U.S. storage capacity is approaching its limit. WTI May contract holders were forced with a decision to pay a third-party existing contact rate, which is well above the current WTI price, or risk significant fines/penalties for improper storage/contracts cancelations. All signs point to a dramatic fall in oil prices once again when June contracts begin to expire, as neither catalyst, production nor U.S. storage capacity has been alleviated. We note that Saudi Arabia and Russia recently agreed to lower production by 10 million barrels of oil per day. While it’s a move in the right direction, the effect of this will not be seen for months.

Figure 1. WTI crude price in 2020
Figure 1. WTI crude price in 2020

Figure 1 illustrates the dramatic drop in price of crude oil, represented by the WTI benchmark, as May contracts expire.

Financial outlook for 2020

Private equity, banks and other lending institutions are now more scrupulous than ever in providing company-saving capital injections within this industry. Previously lenders have chalked up downturns to externalities and turned over more resources to existing industry leaders with distressed assets. These same institutions have been putting more pressure on seeing a healthy balance sheet and ultimately shareholder return but the expectations for the remainder of 2020 are grim.

Energy sector

Measures Actual 2019 performance Revised expectations 2020
Income statement (through Jan. 20, 2020) (through May 31, 2020)
Revenue growth – 1.1% 3.6% – 24.9%
Earnings before interest and taxes (EBIT) growth – 28.2% 16.2% – 90.6%
Earnings per share growth – 51.9% 9.1% – 95.1%
Balance sheet
Return on equity 0.0% 6.9% – 1.5%
Cash flow
Cash-flow growth – 3.9% 6.5% – 39.1%
Figure 2. Change in 2020 expectations for energy sector

Source: S&P's Capital IQ database

Figure 2 showcases analysts’ expectations on key financial measures at the beginning of the year and change in expectations caused by COVID-19 and the plummeted WTI price.

Given that capital investors have grown sour on the industry, a clear-cut indication that energy is no longer a part of a growth-centric industry, the question becomes whether we will see compensation changes that reflect this new reality. Historically, energy companies are reluctant to change or reduce pay levels.

Our view is that the industry has reached an inflection point where companies will be forced to change to regain confidence from investors that have fled the sector. The evolution of the sector from growth to mature will manifest itself over time in a redesign of compensation programs, with annual incentive plan performance goals revolving around measures such as earnings before interest, taxes, depreciation and amortization; free cash flow; return on invested capital; and environment, social and governance measures. Modifications in executive incentive plans since 2014 have not really improved or aligned compensation with shareholder returns; before the crisis took a turn for the worst, we were still witnessing depressed share prices across the industry.

Human capital response

Companies have demonstrated vastly different responses to the current crisis. It is important that companies protect their brands, and the way they manage people and reward programs in a downturn is an important part of protecting those brands. How you treat employees now will go a long way in getting employees back when the current environment improves. Organizations are wagering that the current culmination of events will not result in the generational bifurcation that has happened in past downturns. There is a growing perception of millennials and generation Z individuals seeing this as a “dirty” business — a highly volatile and less desirable sector in which to build a career. Let’s not repeat history; rather, let’s consider changing the playbook with a primary lens on our human capital. We offer some fundamental objectives to keep in mind:

  • Maintain focus on purpose and business strategy.
  • Continue to engage employees through effective incentives and fair pay.
  • Maintain accountability to achieve mission-critical goals.
  • Be mindful of the employee experience: Invest in good faith.
  • Balance human capital decisions with affordability and cash conservation tactics.
  • Consider changes in compensation programs that align with investor expectations.

Communication to all stakeholders, but particularly employees and shareholders/investors, will be a key component of managing through these challenging times and stabilizing to a new normal as the dust settles.


Senior Director, Executive Compensation (Houston)

Associate Director, Executive Compensation (Houston)

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