Designing Incentive Programs To Attract, Retain, And Motivate E&P Professionals

Nov. 9, 1998
The market for exploration and production personnel has been strong for the last 2 years, requiring many companies to review the incentive plans designed to attract, retain, and motivate E&P professionals and managers. Now, stock prices have collapsed, leaving many companies with little or no "golden handcuff" on key personnel.
John McMillan
Towers Perrin

Bill Montgomery
Towers Perrin

The market for exploration and production personnel has been strong for the last 2 years, requiring many companies to review the incentive plans designed to attract, retain, and motivate E&P professionals and managers. Now, stock prices have collapsed, leaving many companies with little or no "golden handcuff" on key personnel.

Designing effective incentive plans for E&P companies involves, first, recognizing that two different businesses, exploration and production, exist within most E&P companies and that significantly different types of incentives may be appropriate for the two businesses. Second, it requires balancing individual versus team performance.

Incentives and bonuses within the production functions are usually based upon achieving annual production targets and upon achieving annual operating cost objectives compared to predetermined targets. The exploration side of the business is long term and has evolved a range of creative incentive alternatives that can be effective in attracting and motivating experienced personnel. The key is to align exploration incentives with the long run economic benefit of the shareholders.

Developing incentive plans in the exploration business is complex for a number of reasons.

First, the business is inherently long term: Wildcat exploration projects may take years to develop and once drilling has begun, even if successful, may not be fully delineated for years. Until that time, the value of the discovered reserves is not fully known. As a result, paying explorationists based on the value of reserves discovered involves a tradeoff between accuracy and timeliness.

Companies must either wait a very long time to determine the actual value of reserves discovered, or if payments are to be made soon they must use the estimated value of reserves.

Second, exploration is more than ever a team effort in which it is impossible to measure the contribution of individuals with precision. This is especially true of exploration teams working in the deepwater Gulf of Mexico and internationally. As a result, individually assigned interests are more difficult to use than in the past.

Third, it is critical that exploration incentives stimulate decisions and behavior that build the long run economic value of the enterprise. Incentive plans based on a percentage of gross production may encourage expenditures on marginal projects, which will generate production but which may not generate a sufficient return. An old compensation adage applies here: "Before we motivate our people, let's make sure they are headed in the right direction."

This article will examine several incentive techniques used in the U.S. and explore how closely they align with shareholder interests.

The techniques include assigned overriding royalty interests, net profits interests, carried working interests, phantom overrides, reserves-added plans, and stock options. Table 1 [56,269 bytes] compares various features of these plans from the employer's standpoint.

Assigned interests

Of all of the incentive plans in use, one of the most interesting is the assigned-interest program, in which individual employees are legally assigned an interest in oil and gas production revenue of individual properties.

These programs typically involve recording each employee's interest alongside the company's interest in each mineral lease the employee has worked on. The employee receives direct ownership in assets, parallel to the company's ownership.

Contrary to widespread belief, there is no legal restriction on use of assigned interests by public companies. In fact, a number of public companies grant them. Parker & Parsley (now Pioneer), Noble Affiliates, Houston Exploration, and many others have recently disclosed these types of plans in their proxy statements.

Conceptually, granting an assigned interest is analogous to granting a stock option. Both assigned interests and options represent actual ownership. An assigned interest conveys direct ownership rights to specific properties, whereas a stock option conveys an indirect ownership of all properties.

Many smaller companies want to motivate explorationists on what they produce individually; assigned interests are appropriate for these companies. Most larger companies want to provide incentives based upon team results and the growth in total reserves; they tend to use pool plans, based on division-wide or company-wide exploration results, or traditional bonuses and stock options.

Growth in value of an explorationist's assigned interest depends on the performance of those specifically assigned properties only. Pool plans are often based on division results. Growth in the value of stock options depends on the cumulative performance of all the company's projects.

Whether a company uses assigned interests, pool plans, or stock options, the employee receives equity in the company's future reserve growth. From the motivational standpoint, the difference is in rewarding explorationists based on their specific results versus rewarding them based on division-wide or company-wide results (Fig. 1 [70,304 bytes]).

Overriding royalty

The overriding royalty is the most common type of assigned interest.

An overriding royalty is a nonoperating interest, usually expressed as a fixed fraction or percentage of gross production: e.g., 1% of production revenue. Overriding royalties measured by gross production are commonly referred to as royalties, overrides, or overriding royalty interests (ORIs).

With the override assignment, the employee's name is simply added to the division order, and the override assignment is recorded with the county. By granting a percentage of production directly to the employee, the company realizes lower revenue and correspondingly lower expense as the override payment never flows through the company.

Override payments to employees are not included in the employee's income subject to federal tax withholding and reported on Internal Revenue Service Form W-2; instead, the employee receives a year-end IRS Form 1099.

The determination of which employee is to receive the override is difficult. Some smaller companies grant senior exploration executives a fixed percentage on all prospects. Typically, an individual explorationist gets a fixed percentage on all prospects he or she originates; in some cases the interest may be split between the originating geologist and others active in the exploration program, such as landmen and exploitation geologists.

Because oil and gas wells can produce for 10-15 years or more, explorationists receiving overrides for many years can build up layers of income reflecting the accumulation of overrides granted over their years of service. In some cases, the total build-up can be sufficient to make salaries almost meaningless.

From the standpoint of the individual receiving the override, a drawback is that it may take a long time to produce significant income. An override may not produce significant income during the delineation and development period, which may extend over several years. This delay can be even longer in gas wells in remote areas, where no gathering pipeline yet exists, and in offshore production where it may take years to build production and transportation facilities.

However, the employee can sell the override assignment. This has two advantages to the employee. First, all or part of the override can be sold even before drilling, so the employee can spread the risk and realize some income even if the exploration prospect is unproductive. Second, after the well is drilled and reserves are discovered, the override can be sold so the explorationist can realize immediate income without waiting for actual production.

Explorationists place a very high value on assigned overrides-and for a good reason. However, they can create major issues for the company. The main problem is that an override pays on gross production revenues, not just on profitable production. Many feel that overrides encourage drilling recommendations in marginal situations since the override owner is paid from first production regardless of drilling or completion costs, production costs, or whether the well ever reaches payout.

A second problem is that explorationists are placed in a position of competing for drilling budgets. This competition may compromise the impartiality of employees and create different objectives for the shareholders and the employee.

Net profits interest

Overriding royalties may also be assigned with payout determined by net proceeds. These are called net profits interests (NPIs).

Because net profits are used, the percentage assigned is usually much higher-often 5% or so. Considerable flexibility exists in specifying the type of costs or charges included in calculating net proceeds: e.g., operating cost only, development costs and operating costs, overhead allowances, and interest on capital employed.

While revenues and costs attributable to multiple properties may be aggregated in computing net proceeds, the IRS takes the position that all the burdened leases must be owned by the assignor and identified in the conveyance at the time the interest is created. As a result, an assigned NPI may not be possible in every situation.

Because payments to NPI holders are made only to the extent the company recognizes net income (i.e., after recovery of exploration and development investment and after operating costs), the NPI is an excellent incentive. It produces substantial alignment between the interest of the award holder and the shareholders.

However, NPIs have one very large problem. They are almost unimaginably complex to administer in most companies. While it is easy to track override payments, it is extremely difficult to track net profits on a well-by-well, lease-by-lease, or even prospect-by-prospect basis. As a result, these plans are extremely rare.

Carried, undivided interests

In the case of the carried working interest (CWI), the company may carve out an interest for an employee in which the company agrees to bear operating costs for a specified period or until a specified event occurs (such as the completion of a productive well). Following the specified event, the working interest holders bear their pro rata shares of subsequent costs and operating earnings.

From the employee's standpoint, this approach can be very attractive. The employee does not have to incur considerable project front-end costs or risks but maintains a portion of the upside potential of the project.

In an undivided working interest, the corporation allows the employee to invest his or her own money and own an operating interest parallel to the company's interest, sharing costs and revenues proportionately. From the standpoint of the company, on an individual prospect, this interest is very much aligned with the shareholder.

The problem with carried or undivided working interests for employees is adverse selection. If employees are allowed to choose prospects in which to participate, the stockholders are left paying the full fare on the other prospects. The employees clearly could be accused of participating only in the best prospects.

The two primary approaches to controlling adverse selection are to require across the board participation or to limit participation to a small number of prospects per year.

Tax, accounting treatment

Assigned interests provide several unique tax and accounting advantages for companies wishing to minimize their charges to earnings for financial reporting purposes. While the details of the tax and accounting rules are very complex and beyond the scope of this article, the basic advantages are:
  • No ongoing charges to earnings. Because the employee's interest has been assigned, the company no longer owns the employee's interest. As a result, the (potentially very large) payments to employees never flow through the company's income statement or balance sheet, and the ongoing payments do not represent a charge to earnings for the company. Of course, the company's reported revenue is lower as well.
  • Low or no initial charge to earnings. Nearly all companies make the assignment of interest before drilling begins. Because the drilling results are unknown, many companies claim there is no value to the assignment, and therefore no charge to earnings is recorded. This very aggressive position was the norm under the old pool-of-capital doctrine, but the IRS has held this doctrine does not apply in the typical employer-employee relationship. Nevertheless, a number of companies continue to take the position that there is no value (and hence, no charge to earnings) for the normal prespud assignment.
Even where companies do ascribe a value to the assigned interest at the time of assignment, however, the value is invariably low because the volume of reserves is unknown (and highly speculative) before drilling begins. As a result, assigned interests invariably avoid any significant charge to earnings at the time of assignment. And, as noted above, once the assignment is made, there is no future charge to earnings either.
  • Favorable tax treatment for the executive. Typically, if a value is ascribed to the initial assignment, the employee recognizes ordinary income in the year the assignment is made. However, both the value of the initial assignment (if any) and the continuing payments (if any) represent ordinary income subject to the greater of cost depletion or percentage depletion. As a result, income from assigned interests is likely to be taxed at a much lower rate than salary or bonus payments. Moreover, employees disposing of assigned interests generally recognize capital gain or loss.
It is very important that companies or employees considering assigned interest programs consult their tax counsel; tax and accounting treatment varies widely.

Phantom participation and pool plans

The override, net profits interest, and other types of payments previously described all confer an actual property right. Many companies do not wish to convey an actual property right to employees, but they want to be competitive and provide highly entrepreneurial incentives.

These companies often set up phantom plans, which operate like assigned interest plans but which are actually bonuses included in the employee's W-2 income in the year payments are received.

Unlike assigned interest programs, phantom plans frequently involve vesting and may require the employee to continue to work for the company indefinitely to receive future payments.

In many cases, companies decide to use phantom plans because of flexibility available in establishing plan provisions (especially vesting requirements, the possibility of pooling of performance by district or division, and the use of minimum profitability hurdles) without triggering tax problems for employees (Fig. 2 [72,057 bytes]).

The primary forms of phantom participation plans are outlined below.

Phantom override

Individual employees may be granted a phantom override, a percentage of production paid as a cash bonus, usually with specified vesting requirements.

Payments are made as production is realized, which means that employees become eligible for significant deferred compensation, which may be subject to forfeit if they leave. This creates a powerful tool-commonly called golden handcuff-for retaining key staff.

Unlike an assigned override, the phantom override is a cash bonus. The company receives all revenue from production and calculates the appropriate payment to the employee. Payments to employees are included on their W-2 income, and the company treats payments as compensation expense deductible as paid. The employee recognizes no income upon grant of a phantom override.

Phantom overrides differ from override assignments in that payments are generally contingent on continued employment. Other than that, the phantom involves the same layering effect (delayed payment and slow build-up) and long term payout as the assigned override.

Phantom overrides involve the same disadvantages as assigned overrides. These plans pay on all production-not just profitable production. They may encourage scattershot drilling and may place override holders in conflict of interest with stockholders.

In the case of the phantom override, the company has kept the revenue and expense of the interest and therefore incurs both a charge to earnings and a tax deduction to the extent the phantom override generates payments to employees. Also, because phantom override payments run through the payroll system, they increase an employee's W-2 income, and pension, profit-sharing, or other benefits keyed to W-2 income levels.

Phantom override pool

Under phantom override pools, a predetermined percentage (normally 2-4%) of production revenue is assigned to an employees' pool. Each employee's share in the pool is based either on a predetermined sharing percentage (e.g., division manager 15% of pool) or formula (e.g., based on salary and service or performance rating).

Separate pools may be formed each year, and pools may span the company or specific divisions. Generally, employees leaving the company forfeit nonvested rights under the plan, and their portions would be redistributed to remaining employees or revert back to the company.

Phantom override pools overcome a key disadvantage in individually assigned override or phantom override plans-the difficulty of determining who contributed what on an individual prospect. In most division or district exploration offices, work is often a team effort, and the pool concept recognizes this aspect well. Once the employee's share of the pool is assigned, there is less reason for hoarding of prospects, as can occur where prospects are assigned individually. Also, special provisions can be established by which a percentage of the pool is held back initially by management to be awarded on a discretionary basis at year-end based upon participant performance.

Phantom override pools can be highly effective. They can be structured to provide enough of the override benefit to the plan (and therefore they can be effective in hiring staff), but they also retain management discretion.

Reserve-addition pools

With reserve-addition pools, the company sets aside a predetermined percentage of the value of reserves added in the year. This amounts to a cash bonus pool for the exploration group based on success of the year's exploration program, as measured by reserve additions.

To encourage a local team effort, reserve-addition pools are often established by division. Payment is generally in cash at year-end or with a portion deferred a limited number of years.

As a pool type of plan, a predetermined percentage of reserve additions funds the total pool. In some cases, the amount varies based on finding cost or other profitability measures. Distribution from the pool to individual employees is based on either a predetermined percent of the pool for each employee or a formula relating to position, salary, or service.

In some cases, a portion of the pool is held back to be awarded at the end of the year. Due to wide swings in reserve additions, there is often a maximum percent of pay allowed, generally 100% of pay or more. Frequently, payments are made over 2-4 years so that reserve estimates can settle before the entire amount is paid.

The primary advantage of these plans over other phantom arrangements is that they reward today's performance today: Those responsible for a major discovery receive their reward over 2-4 years rather than the 15 years other types of reward might need. Also, companies adopting these plans are not encumbered with 15 years of continuing plan administration (i.e., until the last well is depleted, as with regular phantom override or override pool).

However, reserve-addition plans have potential problems as well. Their most significant disadvantage is that reserve estimates are subject to substantial revision based on subsequent drilling, development, and operation of the field. They generally require payment in the early years of a discovery, when delineation of the field is incomplete. To overcome this drawback, some companies base payments on total reserve additions, including those added by (or subtracted due to) reserve estimate changes.

Stock options, bonuses

Many companies do not want to get involved in either assigned-interest or pool plans. Using either approach tends to create two classes of employee: oil-finders and all others.

Companies not wanting to create these distinctions typically use a combination of stock options and annual cash bonuses. In theory, this combination should be able to provide a highly entrepreneurial pay program.

With this approach, a portion of the annual cash bonus can be tied to quantity or value of reserve additions, finding costs, reserve placement ratios, and similar measures. In most cases, though, these plans get diluted with additional company goals, such as operating income and cash flow. In addition, they almost invariably include bonus targets and caps, which many oil-finders resist.

Most importantly, stock options and bonuses generally involve a largely discretionary allocation by management at the end of the year on how much each employee receives. Although these plans can, and generally do, pay out as much as the average override or net profits interest does, they tend to be less attractive to prospective new hires, especially experienced oil-finders. Where possible, separate "pool" plans can be used to offset this disadvantage.

In addition, companies with target bonus plans tend to grant stock options. Options give employees the right to buy shares of company stock at a fixed price (generally the price on the date the option is granted), with the option exercisable most frequently for 10 years from the date of grant. Options typically vest-or become exercisable-over the first 3-4 years (Fig. 3 [82,005 bytes]). Two types of options are commonly used:

  • Nonqualified stock options (NSOs). With these, the employee must pay ordinary income tax for the year in which options are exercised. For example, if the option were granted in 1998 at the current market value of $10 and exercised 5 years later when the price was $18, the employee would be liable for ordinary income tax on $8 in the year of exercise.
However, with NSOs the company gets to deduct this $8 gain against its income taxes, even though the gain is not required to be charged against earnings for financial reporting purposes. Thus, the employee gets a free ride on the stock gains (no up-front investment is required), and the company gets a free tax deduction (a tax deduction with no charge to earnings). Options are not free to shareholders, of course, since options cause shareholder dilution.
  • Incentive stock options (ISOs). With these plans, the employee does not have to pay ordinary income tax upon exercise. So long as the employee holds the option stock 1 year, tax is generally deferred until the employee sells the stock. This is a major advantage from the employee's viewpoint. Moreover, when the stock is sold after 1 year, it qualifies for long term capital gain treatment (maximum 20% if the stock has been held more than 18 months-a second major advantage).
However, offsetting these advantages to the employee, the company loses its tax deduction. This may not be a major loss for E&P companies, which often can drill up their profits.

In either case, stock options can theoretically share the value of reserve growth with employees. However, there are three major problems in practice.

First, stock options reflect total company operations, both all exploration and all production (plus whatever else the company may do). As a result, the impact of any one oil-finder is widely diluted even in a small company. This is one reason why individually assigned interests or pool plans are highly valued by good explorationists.

Second, options tend to be granted just once or twice a year in most E&P companies. In a small company, granting an oil-finder an option after the stock price has risen on news of his discovery is not an effective motivator. Granting the option just before the announcement may cause other problems.

In a large company, news of an individual discovery is not likely to be an effective motivator either, since most discoveries are not enough to move the stock price significantly (even if a large number of options are granted before the news is out).

The bonus and option approach is used almost exclusively in large companies where the emphasis is on very large prospects and prospect teams and where teamwork is paramount.

Third, as we have seen this year, stock options may become worthless due to broad stock market declines, even though the exploration program continues to be very successful. Assigned interests or pool plans are not affected by the stock market.

Developing an incentive program

As shown in Table 1, no single plan meets all of the objectives a company or executive might have. The plan must be developed to meet the most important and highest-priority objectives in each company's situation.

Assigned-interest programs tend to be used in privately held and small public companies. These companies tend to focus on specific prospects rather than major plays. In this environment, individual explorationists or small teams usually take the lead, and success or failure is largely on their shoulders. This is the environment in which individually assigned overrides, net profits interests, or carried working interests can be used very effectively for an individual or small team. Stock options also can be very effective in rewarding large discoveries made by small public companies.

Division pool plans tend to be used in large companies where there are still a limited number of key personnel assigned to an area for an extended time. Often, the team is located in a local district or division office. While the assigned interest program could be used, most large companies have decided to use cash plans, but they still want to focus on local rather than company-wide results. In companies this size, each division often represents less than one quarter of the total size, and individual discoveries may not increase the total company value. As a result, options probably would not provide adequate reward.

A combination of cash bonuses and stock options tends to be used in the largest companies. Two characteristics of these companies make individually assigned or small team incentives less appropriate than they are in smaller firms.

First, the companies are often pursuing large international or deepwater plays, each of which requires organization-wide teamwork and commitment; no one individual can claim full credit for discoveries in these types of programs. Second, much time is spent extending known reservoirs, exploring known areas at new depths, or developing large secondary or tertiary recovery projects. In these situations, it is very difficult to assign individual credit.

While there are units within large companies that probably could use division pool plans effectively, in most cases the companies want to have a single incentive approach for all employees in a job category.

Regardless of the type of plan is used, there are three other aspects of developing an effective incentive plan that are important but often overlooked:

  • Process. It is critical that the process used to develop the plan be right. Top management must be directly involved, of course, but it is also very important to get input from the supervisors and professionals who are supposed to be motivated by the plan. Too often, the explorationists first hear of the new plan when it comes down as the new plan to motivate them. Explorationists should be involved both in the early stages of plan development and in the later stages of plan review and dry run.
  • Communication. It is critical that any new or revised plan be communicated fully, clearly, and repeatedly. No matter how well-designed, the plan will not work if the explorationists don't understand it. New plans should be explained both verbally and in writing, with clear and straightforward examples. Then, after the initial communication, there should be personal follow-up to make sure questions have been answered. If the design of the new plan permits, there should be regular communication of the performance results and impact on the plan payouts.
  • Administration. The plan should be administered to maximize its motivational impact. Incentive awards should be communicated and discussed before the bonus checks are delivered. (Yes, many employees first learn of their incentive awards from the check.) Bonus checks should be separate from regular paychecks. (Yes, in some companies employees have had to subtract their last regular paycheck amount to find out how much incentive they earned.) Poor administration can turn a positive experience into a negative one.

Effective incentives

Exploration and production companies can use a number of specialized incentive plans to attract, retain, and motivate explorationists.

While the individually assigned override is what most explorationists want, phantom override pools or reserve addition plans with continued employment requirements are generally preferable from the company standpoint.

Regardless of the specific plan used, specialized E&P incentives can be very effective in attracting, retaining, and motivating top-flight explorationists.

The Authors

John McMillan is a senior executive compensation consultant in Towers Perrin's Houston office. He has advised exploration and production companies on compensation issues for more than 25 years. McMillan received BS and master's degrees in business administration from Northwestern University.
Bill Montgomery is the energy practice leader for the Towers Perrin Strategy & Organization business. He has 20 years of upstream consulting experience. Montgomery received an honors degree in economics from the University of Michigan and a master's degree in business administration from Harvard University.

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