The economic crisis brought on by the COVID-19 pandemic has exacerbated the disparity between U.S. shale executives' compensation and shareholders' long-term interests, according to a private equity firm with a history of shareholder activism.

"The compensation structure for U.S. [exploration and production] companies has been completely asymmetric, and all it does is result in this procyclical bias for the business," said Mark Viviano, a managing partner and portfolio manager at Kimmeridge Energy Management Company LLC, during a Dec. 3 interview.

Kimmeridge said in a Nov. 17 white paper arguing for compensation reform that executive pay in the oil and gas industry continues to rise even though it is one of the worst-performing sectors.

"In the eyes of [company] directors, the CEOs can do no wrong because anything negative that happens is simply blamed on the commodity price," Viviano said.

Viviano said that mentality has to change in order for the industry to address its myriad challenges, but he expects resistance. "Nobody willingly pays themselves less," he said. "There has to be a real threat of dismissal at both the board and CEO level to really see the change that we're talking about."

The white paper is one of several that Kimmeridge has released this year calling on producers to reform their operating model and to address environmental performance.

Shareholders must be the driving force for reform, Viviano said, calling their advocacy "the fastest and most efficient way to catalyze change. If you try to do it from a top-down policy perspective, I'm skeptical that you'll see any degree of meaningful change in a reasonable amount of time."

Viviano said investors should push for outside expertise on company boards, "particularly when you talk about environmental matters and the risks associated with the energy transition," he said, citing the "insular nature" of oil and gas boardrooms. By his estimation, 70% of producers' board members are former industry executives who lack the "context" for managing through "such an existential threat as we're seeing from the energy transition," a challenge Viviano called "unprecedented through the course of most careers in the energy industry."

"Look at some of these boards that have three, four, or five core members that have been on the board for a decade. ... Are they really looking after the shareholder or are they looking after the interest of the CEO who they've been working with for so long?" Viviano asked. "We think it's going to take refreshment of the board and greater representation of shareholders so it's not the case where everybody on the board was nominated and put there by the CEO."

Other reforms that Kimmeridge proposed include making company stock a greater proportion of compensation and offering higher change-in-control payments as a means of incentivizing consolidation.

Ian Keas, a principal at executive compensation consulting firm Pearl Meyer & Partners LLC, agreed with some of the Kimmeridge paper's main points, but he also challenged some of its assertions. He noted in a Dec. 3 interview that the oil and gas industry is moving forward on some of the issues Kimmeridge has raised.

Incentives "should be an extension of [company] strategy," Keas said. "But to focus on just reported compensation numbers … doesn't tell the whole story."

Keas said "there's a greater relationship ... between take-home pay and company performance" than the reported data show. That nuance also applies to the value of company stock executives hold. Kimmeridge used data to show that the value of company stock held by oil and gas executives represents a small fraction of their annual compensation, arguing executives do not have enough skin in the game. But Keas said that insider stakes may represent a larger percentage of their take-home compensation.

Kimmeridge also called for companies to compare themselves to a broad group of companies, rather than a narrow group of industry peers, to determine the relative total shareholder return benchmark that is often a key component of incentive plans.

Keas said that model "is quickly going out of practice" as more companies rely on broad market indexes to assess performance. In other cases, companies are attempting to balance relative performance incentives by introducing hurdles and caps, Keas said.

Companies also are increasingly tying environmental and sustainability goals to executive compensation. For example, several companies have explored tying methane emissions intensity targets to short-term incentives for 2020, Keas said. "It's maybe not as prevalent in 2020 ... as what I suspect it will be in 2021. I suspect you're going to see a pretty good adoption rate in fiscal 2021 of this broader focus on [environmental, social and corporate governance issues] around executive incentives," he said.

The unfolding economic crisis "only accelerated the day of reckoning for the U.S. shale industry," Viviano said. "The silver lining in that is there's now broader recognition of the need for reform. I see fewer management teams ... who are thinking they can ignore the growing risks around the energy transition and the terrible ESG profile of the sector."

Boards often look to peer groups when determining compensation by studying pay levels, composition, incentive structure and the rate of change of compensation from year to year, Keas said. Although compensation committees also weigh investor sentiment, he said it is too early to measure the impact Kimmeridge's white paper is having, given the timing of its release.

Viviano said he has heard anecdotally that the company's white paper "has sparked a lot of conversations in the boardroom," but he has yet to see a company announce "comprehensive reform ... that's aligned with what we discuss."