different perspective Taking a An alternative approach to executive reward in the oil and gas sector The current state of play

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1 Taking a different perspective An alternative approach to executive reward in the oil and gas sector Oil and gas prices, production capacity, sector consolidation. These are just three of the big unknowns facing the oil and gas sector for the rest of 2009 and beyond. It will continue to be a difficult time for all industry players, who will be tested not only on their ability to survive the current turbulence but also on their ability to position themselves to take advantage of the upturn, when it occurs. So are the reward and incentive structures that were put in place during times of record-high oil prices still appropriate? This report suggests some alternatives that may better serve companies needs in the current climate and beyond. There are always dangers with the one size fits all approach. The current state of play It is tempting for Remuneration Committees to follow the crowd. After all, it makes life easy with investors and means that the board agenda can move on rapidly. However, there are always dangers with the one size fits all approach and this is certainly true for the oil and gas sector. The reward and incentive model that most companies in the sector adopted during the good times of the late nineties and early noughties was based on comparisons with peer companies facing similar strategic, operational, market and economic challenges. Given that the share prices of the industry players are strongly correlated with the current and expected future price of oil, this makes sense as a way of assessing the value added by management. When voting on remuneration, traditional UK investors like to see relative total shareholder return (TSR) as a long term performance measure as they believe this ensures rewards are linked to superior returns. Generally, in assessing returns, investors will look at similar businesses that are competing for capital with each other and which are exposed to external economic and cyclical factors: typically this means companies in the same sector. It is therefore not surprising that 90 per cent of active long term incentive plans in the oil and gas sector use relative TSR as a measure of performance. Around a third use an Earnings Per Share measure, whilst a quarter of plans incorporate another measure of financial and/or operational performance Hay Group. All rights reserved

2 2 Standing out from the crowd 100% Frequency of LTI performance measures 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% TSR Earnings Other financial metrics *These percentages add up to more than 100 per cent as some plans use more than one measure. An alternative approach to executive reward in the oil and gas sector Given the cyclical nature of the oil and gas industry and the significant impact of external market and economic factors on performance, relative TSR can be a good measure of performance in the sector if properly used. There are, however, a number of issues which we examine in turn below. Relative TSR can be a good measure of performance in the sector if properly used. Rewarding volatility over sustained performance? One issue with relative TSR is that rankings measured over rather short time periods (such as the three year period which is now used by virtually all UK companies) can be very volatile and may thus bear little resemblance to actual performance. This will be particularly exacerbated for companies in the oil and gas industry that tend to have volatile share prices. The chart on page three illustrates that the FTSE 350 Oil and Gas Index has the second highest price volatility (measured over the past three years) in the FTSE 350 (overtaken only by the FTSE 350 Mining Index). This means that peer selection becomes even more important, as extending the comparator group beyond the closest peers could produce arbitrary results. For a company in trouble, using a relative TSR metric may not focus executives on critical business issues.

3 3 70% 60% 50% 3 year volatility to June 09 40% 30% 20% 10% 0% Beverages index Chemicals index Construction and materials index Electronic and electrical equipment index Food producers and processors index Food and drug retailers index General retailers index Household goods and textiles index Mining index Oil and gas index Software and computer services index Support services index Tobacco index Travel and leisure index Timescales In accordance with standard UK (and, increasingly, international) practice, long-term incentive awards are typically structured to pay out depending on performance over a three-year period. Oil and gas is a long-term industry and a standard three-year period may not be sufficient time to judge whether management has succeeded or not. Given typical five-year lead times, the impact of decisions taken now on the value of the business might take longer than this to materialise. One size fits all? The global recession with the corresponding drop in oil demand and the collapse in oil prices has taken its toll on the sector. On the one hand, the oil majors have relatively low borrowings and have reacted to falling prices by reducing their capital expenditure in the short term, rather than taking on debt. However, at the other end of the scale, some of the smaller players have taken a lot of debt to service their expansion during the boom times. With the scarce availability of finance, some of these companies have turned to survival mode. For a company in trouble, using a relative TSR metric may not focus executives on critical business issues. Remuneration Committees and their advisors therefore need to identify those factors (e.g. cash generation/conservation, cost cutting, reduction of debt levels) that will turn round the business. In such situations, it is difficult to see why a relative TSR metric would be appropriate: with the focus on survival, the performance of other businesses becomes irrelevant. However, companies need to exercise caution not to neglect long-term value drivers. Looking at absolute TSR in conjunction with a business/operational metric (or relative TSR where appropriate) would be an alternative way of doing this. The nature of a business also becomes important when determining performance metrics. For mature producers, it makes sense to look at performance in comparative terms. But for companies focused on exploration it makes more sense to consider the progress made and the absolute level of performance Hay Group. All rights reserved

4 4 Standing out from the crowd Looking to the future Oil and gas companies are inherently global businesses, competing for resources, talent and finance on a truly global level. However, those listed in the UK have often adopted plain vanilla UK reward arrangements in relation to: the structure of reward and the balance between fixed and variable pay (see chart below) the timescales over which performance is measured the choice of performance metric. There are alternative ways to create better longer term alignment to value creation. 100% 80% Balance of reward elements LTI Bonus Salary 60% 40% 20% 0% UK USA At Hay Group we believe that there are alternative ways to create better longer term alignment to value creation, better suited to the individual needs of each business. Examples might include: implementing an added value plan reintroducing share options alongside performance shares although these have become out-of-fashion they have a much stronger link to absolute value creation and can therefore be particularly effective in certain situations combining performance metrics in a more sophisticated way (e.g. in an interdependent matrix) combining absolute and relative TSR measures making peer groups more relevant by looking at an index (which may be weighted by relevance rather than market cap) or weighted ranking considering qualitative (non-financial) performance metrics that will drive future value or reward the achievement of specific corporate objectives/milestones implementing longer vesting periods and/or requiring executives to hold a portion of vested shares for significantly longer periods of time.

5 5 Breaking down the barriers to change There is a belief amongst some advisers and Remuneration Committees that change is not possible because shareholders will veto it. This is not our experience. The risk of shareholders voting down a well thought through, properly communicated proposal that takes account of the factors shown in our strategic review model (see table below) is actually very low. Our conversations with non-executive directors tell us that they over estimate this risk, sometimes encouraged by their advisers. And the voting advisory bodies do not necessarily expect an amber top or vote against ranking to lead to a plan or Remuneration Report to be rejected. We have put in place highly bespoke, company specific reward structures that have passed the shareholder test. For example: In the oil and gas sector Heritage Oil plc In the mining sector Xstrata plc In any case, the declining ownership of UK plc by the traditional institutions and the changing nature of investors mean that intelligent proposals often meet an intelligent response. To provide some perspective, traditional institutional investors now own just one quarter of the UK market, down from approximately 50 per cent a decade ago. Another barrier to change is the commonly stated belief that there is no need or appetite to change what we are doing. Our use of the strategic model, applied in this difficult economic time, tells us that this is simply not the case, as illustrated below. Strategic review model Strategy and business funding Refinancing has become more difficult. Even good, well run businesses risk going to the wall. Strategies need to be highly commercial. Reward that does not reflect these realities will increase risk for the company. Investor expectations Good fund managers want reward to reflect what the business needs to do to be successful. The ABI and Risk Metrics have been at pains to emphasise their willingness to be consulted. Investors will listen to well thought through proposals. Executive perspective and history Executives do not always value their long term incentives. Companies with compliant but sub-optimal structures have failed. Would a focus on cash and the business itself not have worked better? Executives need to feel reward is meaningful and specific to their business. Pay markets Pay practice in all markets is varying more from company to company than it has done for a decade. There are potentially richer rewards available in environments other than the UK plc listed sector. Pay levels need to be appropriate and performance targets must be achievable for policy to work. We believe that reward should reflect the individual nature of each business, its strategic position, its funding situation and the executive team running it. We recommend that remuneration committees invest in getting reward right Hay Group. All rights reserved

6 6 Standing out from the crowd Reward benchmarking Explicitly stated or otherwise, much reward benchmarking in your sector is based on the relative market capitalisation of one company versus others, and a comparison being made with other executives with similar titles rather than similar jobs. The main problem with this is that market capitalisation can vary significantly at different times and an increase or decrease in market capitalisation does not mean that a directly proportional increase or decrease in job complexity has occurred. The following tables show annual reward levels in the UK for oil and gas businesses for the latest available financial year. Market data has only been shown where there are sufficient data-points to enable the calculation of s and/or median values. In our opinion too many companies base their reward levels on market capatalisation. Base salary ( ) Role FTSE 100 FTSE 250 FTSE 350 CEO 1,040, , , , , , , , ,000 CFO 525, , , , , , ,000 Other executives 670, , , , , , , , ,000 Total cash ( ) Role FTSE 100 FTSE 250 FTSE 350 CEO 2,760,000 1,765,000 1,021, , , ,000 1,375, , ,000 CFO 1,093, , , , , , ,000 Other executives 1,768, , , , , , , , ,000 Total Direct Compensation ( ) Role FTSE 100 FTSE 250 FTSE 350 CEO 5,202,000 2,440,000 1,738,000 1,731,000 1,002, ,000 3,256,000 1,361, ,000 CFO 1,894, , , ,000 2,170, , ,000 Other executives 3,478,000 1,137, , , , ,000 1,257, , ,000

7 7 At Hay Group, we combine the use of market data sorted on the basis of company size with our world leading job evaluation methodology to ensure that reward levels for executives reflect not just job title, but also the complexity of the job an executive does. In our opinion, too many companies base their reward levels solely on market capitalisation, which in turn is dependent on a potentially volatile share price, as is particularly the case in the oil and gas sector. Furthermore, the talent market in the oil and gas sector is genuinely global. Recruiting and retaining talent, from specialist engineering roles to senior executive positions, is a constant challenge for the global industry within a relatively scarce talent pool. Whilst in the short-term some of these pressures are weakening with lower oil prices leading to exploration projects being axed and a reduction in supply, the competition for talent will intensify when the global economy bounces back. Our pay databases and methodology give you the opportunity to make comparisons with the right talent markets in different geographies and sectors and better deal with the differences in reward structures in different countries (as illustrated earlier in this paper) Hay Group. All rights reserved

8 About Hay Group Hay Group is an independent global consulting business. Our UK executive remuneration team advises the Remuneration Committees of a wide number of companies, ranging in size from FTSE 100 to AIM, to those backed by private equity. We have over 2600 employees working in 85 offices in 47 countries. For over 60 years, we have been renowned for the quality of our research and the intellectual rigour of our work. We transform research into actionable insights. We give our clients breakthrough perspectives on their organisation, and we do it in the most efficient way to achieve the desired results. Authors Peter Boreham Jon Dymond George Makris For further information please contact: Peter Boreham UK head of executive reward t e peter.boreham@haygroup.com