On the occasion of economist Ronald Coase’s 100th birthday celebration, our conversation turned to the 2009 financial crisis. We marveled at how fast markets were adjusting. Everyone in the world simultaneously hit the “sell” button, and prices plummeted. Professor Coase observed that this is a product of technology, which cheaply and instantaneously updates billions of market participants. The necessary result of global interconnectedness is that markets adjust more quickly to new information.
Five years later, the oil price crash looks like another example of accelerating market cycles. From the 2014 peaks to the 2015 troughs, oil lost almost two-thirds of its value. Coveted assets at $100 oil were practically worthless by the middle of 2015. In some cases, there were literally no buyers at any price. While larger companies had sufficient cash flow to survive, smaller companies – leveraged with debt and holding acreage-intensive positions – were failing in rapid succession.
In Issue #1 of the Gaille Energy Blog, I described the important role that smaller companies played in the American shale revolution. Their employees were enticed away from high-salaried and stable positions at ExxonMobil and other majors by valuable stock grants. Even in good times, small company equity tends to have binary outcomes. Employees either make a lot, or lose it all. Everyone understands this risk going in, but management teams believe they are controlling their own destinies. They choose the acreage and well locations and are confident that their wells will be successful.
This optimism can make management less focused on commodity risk. Start-ups are heavily invested in acreage and light on production. It takes several years for a start-up to raise capital, hire a management team, acquire acreage, drill its first wells, rollout a development, and then sell its assets for a profit. These companies usually take on a lot of debt, and little, if any, of their portfolios can be hedged.
If technology is accelerating market cycles, price swings are likely to occur more frequently than in past decades. This means that more start-ups will be caught in downturns. While investors can manage volatility by diversifying across many companies, employees do not have such a luxury. They face the loss of their jobs at a time when no one is hiring – and also the evaporation of their equity compensation. Employment contracts offer only false security. Their generous severance packages are rendered worthless by bankruptcy.
As new startups look to launch, how can energy employees seek to insure themselves against commodity price declines? Forms of insurance might include:
- Pre-paid severance. When a start-up commences, a portion of employees’ severance could be paid into escrow accounts, with directions to pay employees if they are terminated without cause or as a result of bankruptcy. One concern with pre-paid severance is that it protects employees not only from commodity-driven bankruptcies, but also potentially those of their own making.
- Put options. Oil put options could be purchased and given to employees as a sign-on bonus, which would generate profits to offset a declining oil price.
- Fund-guaranteed hardship payment. In the case of private equity-funded companies, management teams could receive a contractual “hardship” payment (guaranteed and paid by the investor fund) should oil prices decline.
- Mandatory 10b5-1 plans. In the case of smaller public companies, employees could receive an additional sign-on bonus in the form of a stock grant that mandatorily liquidates via a 10b5-1 plan, with the cash proceeds being invested in a money market during the term of employment.
To the extent that commodity collapses are perceived as more frequently occurring, it raises the question of how the risk of price-driven bankruptcies should be allocated between investors and employees. Employees may have been willing to bear more of this risk when the event was once every decade or two, but what if it’s twice a decade? If so, compensation structures may need to provide employees with insurance (even if partial) to stabilize their incentive to join smaller firms.
Scott Gaille lunching with Nobel laureate Ronald Coase at the University of Chicago Law School.
About the Gaille Energy Blog. The Gaille Energy Blog discusses innovative proposals in the field of energy law, with a new issue being posted each Friday at http://www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of two books on energy law (Shale Energy Development and International Energy Development).