Devon Energy (DVN)

success. When executives remain with us over the long-term, they cultivate meaningful, long-term relationships with key employees. This enables them to positively impact our performance by continually developing our personnel, fine-tuning business processes, and creating a high-performance, effective culture. In addition, stability at the executive level helps us attract and retain managers and other employees who possess valuable technical expertise and an understanding of the oil and gas industry.

 

In order to attract and retain key executives who will successfully manage the business over the longer-term, we must compensate executives in a manner that is competitive with the market for executive talent. Annually, the Committee reviews peer group compensation information prepared by the Compensation Consultant to ensure that our total executive compensation program is competitive. The survey data used by the Committee as a guide in determining our executive compensation includes information from companies in the energy industry and the broader market in which we compete for key executive talent. Companies against which our executive compensation is measured include Anadarko Petroleum Corporation, Apache Corporation, Baker Hughes Incorporated, Chesapeake Energy Corporation, Chevron Corporation, ConocoPhillips, Dominion Resources, Inc., Duke Energy Corporation, El Paso Corporation, EnCana Corporation, Enterprise Products Partners, L.P., EOG Resources, Inc., Halliburton Company, Hess Corporation, Kerr-McGee Corporation (now a part of Anadarko Petroleum Corporation), Marathon Oil Corporation, Murphy Oil Corporation, Nabors Industries Ltd., Occidental Petroleum Corporation, Schlumberger Limited, Tesoro Corporation, Transocean Inc., Valero Energy Corporation and Williams Companies, Inc. A significant portion of the long-term compensation awarded to our executives is subject to a vesting schedule, which, in addition to attracting executive officers and aligning them with the goal of maximizing stockholder value, motivates executives to remain with us over the long-term.

 

Pay for Performance

 

We believe that an executive officer’s compensation should be tied to a combination of our overall performance, performance of his or her business function or area and individual performance, with the primary driver of value being our financial success and long-term value creation for stockholders. Generally, we try to reward executives with incentive pay when we are successful and stockholder value is created.

 

With respect to individual performance, our operating strategy requires a goal-setting and performance management process that promotes and rewards executive behaviors and decision-making methods that help the organization achieve its near-term and longer-term objectives. The goal-setting and performance management process consists of setting:

 

 

This approach to compensation not only motivates executives to deliver near-term financial and operating results, but also provides incentives for them to develop internal talent, cultivate key relationships with managers, ensure positive relationships with regulators, landowners and other stakeholders, refine business processes and build a culture of mutual respect and teamwork focused on creating long-term stockholder value.

 

Compensation Weighted Toward Incentive Pay

 

We believe that the proportion of an employee’s total compensation that varies based on performance should increase as the scope of the individual’s ability to influence our results increases. Since executive officers have the greatest influence over our results, a significant portion of their overall compensation consists of incentive pay that is “at risk,” and the potential value of incentive awards provided to executives increases at higher levels of responsibility. In 2006, for example, approximately 90% of the total direct compensation (the sum of salary, bonus and long-term incentive compensation awards granted in 2006) of our Chief Executive Officer was at risk against near-term and long-term performance goals. The total direct compensation at risk against near-term and long-term performance goals in 2006 for all other named executive officers

ranged from approximately 81% to 86% of their total direct compensation. This approach also helps to align our compensation expenses with the cyclical nature of the oil and gas industry.

 

Balancing Pay for Near-Term and Longer-Term Performance

 

To reinforce the importance of balancing the goals of delivering near-term results and creating long-term stockholder value, executive officers regularly are provided both annual and long-term incentives. We believe that properly allocating near-term and longer-term incentives is critical in motivating executives to effectively carry out our two-pronged operating strategy. Overall, the value of an executive’s total compensation opportunity is weighted in favor of long-term incentives.

 

Consideration of Tax Implications

 

Section 162(m) of the Internal Revenue Code (the “Code”) disallows, with certain exceptions, a federal income tax deduction for compensation over $1,000,000 paid to the Chief Executive Officer or any other named executive officer. One exception applies to “performance-based compensation” paid pursuant to stockholder-approved employee benefit plans (essentially, compensation that is paid only if the individual’s performance meets pre-established objective performance goals based on performance criteria approved by our stockholders). Although we have generally attempted to structure executive compensation so as to preserve deductibility, we also believe that there are circumstances where our interests are best served by maintaining flexibility in the way compensation is provided, even if it results in the non-deductibility of certain compensation under the Code. A portion of the payments made under our current annual cash compensation program are not deductible in accordance with the provisions of Section 162(m). However, the Committee has determined that the benefit of enhanced flexibility in program design outweighs the value of the lost deduction.

 

A portion of the stock options we granted to our executives are incentive stock options, which allow the executives to defer the payment of certain taxes upon exercise of the options and provide for the characterization of certain gains as long-term capital gains. These tax advantages can be partly offset by the alternative minimum tax.

 

Section 422 of the Code limits the amount of incentive stock options that may vest for any one employee each year. Section 422 provides that, to the extent the aggregate fair market value of stock with respect to which incentive stock options become exercisable each year exceeds $100,000, such stock options will be treated as nonqualified stock options. We take this $100,000 limit into consideration when granting incentive stock options to our employees, so that their incentive stock options will not be recharacterized as nonqualified stock options.