When the Peer Group Shrinks: Executive Compensation in Oil & Gas

Jake: In this season of Pearl Meyer Unscripted, we're looking at executive compensation through an industry lens. Our co-hosts, Mark Rosen and Aalap Shah, are joined by several colleagues who specialize in different industries, including technology, healthcare, oil and gas, and more, to examine the aspects of compensation design that are unique to each.

We're now turning to the oil and gas industry, where consolidation, capital discipline, evolving investor expectations, and continued commodity price volatility are reshaping the executive compensation landscape. In this episode, Mark and Aalap are joined by managing director Malcolm Adkins, who is based in Houston and leads Pearl Meyer's oil and gas practice.

Malcolm advises boards and management teams across the sector on executive and director compensation, incentive plan design, peer group development, pay-for-performance alignment, governance matters, and compensation issues arising from mergers and acquisitions. Together, they discuss how compensation committees are navigating a smaller public company universe, rethinking peer group design, and evaluating whether traditional approaches to performance measurement still fit today's oil and gas market.

Mark: Welcome Malcolm, really excited to hear your perspective today. Thanks for participating in our podcast.

Malcolm: Yeah, absolutely. Thanks for having me.

Mark: Just to jump right in, the oil and gas industry looks a lot different than it did just five and ten years ago. What are some of the biggest changes you've seen and how are those impacting executive comp?

Malcolm: Yeah, it has looked a lot different. Things have changed over the last ten years. You used to see a lot of focus on production, capital spending, growth. Now you're seeing more capital discipline returns. And with that, companies aren't drilling new holes, they're buying other companies. So, more consolidation, fewer public companies, which presents a lot of challenges when it comes to exec comp consulting.

Mark: And is that consolidation a result of investor expectations?

Malcolm: I think investors, they want to see a focus on free cash flow and returns. So, putting capital into new sites is a little bit tougher. You're seeing more and more share buybacks and dividends, that cash flow being distributed. So, being disciplined around capital is more important to investors than ever.

Aalap: Yeah, and Malcolm, we're definitely seeing that trend in other sectors as well. But I think you mentioned consolidation. So, one of the biggest consequences of consolidation is that companies simply have fewer peers to work with. What challenges is that creating for boards and compensation committees?

Malcolm: Yeah, that's a great question. Traditionally, you had the rule of thumb that you wanted your compensation benchmarking peer group to be twelve to twenty companies. That’s easier said than done these days. It's particularly the most important thing when it comes to compensation benchmarking, we can talk about performance benchmarking later, but when it comes to comp benchmarking, the size of the companies that you're including is very important, making sure whatever data we're gathering is relevant to your size. Ideally it would be companies that are similar in business model and where they operate. But now we're dealing with the much smaller universe.

If we were to look at the services sector where there's been a ton of consolidation over the years, you might be happy with ten peers—ten peers that you could really feel like they're competing for the same talent. But sometimes there's even fewer than that. E&Ps, you know, there's a little bit more out there, but that sample is quickly shrinking.

Mark: Yeah, for performance, might be different than compensation benchmarking. Do you care about it like an E&P, do you care about what basin they're operating in?

Malcolm: Yeah, I mean for compensation peers, we try to start with commodity mix, but oftentimes that's becoming harder and harder to do. If you're primarily gas, it's becoming harder to find E&Ps that are also heavy in gas; it's definitely doable.

But I think regardless, whenever you expand the peer group, Mark, and a lot of the clients that we work on together, if you expand the peer group it doesn't mean you can't focus on your direct competitors either. The mistake that comp committees can often make is "okay, we expand this group to be twelve to fifteen companies, and we only look at those twelve to fifteen companies on a consolidated basis when we're looking at market data."

We forget that, well really there's these three to five that are our key competitors. Can we call that out? And really what are they doing? An overlay of the actions that they're taking on top of the broader peer group. That’s something that that we need to do more of.

Aalap: Malcolm, can you explore that a little bit more? I think what you're saying is that if you have a group of twelve to fifteen companies, they may be an imperfect group, but it would be good to look at that data in the aggregate as well as a subset that is closer to your business. So, when you think about that, how are you balancing business relevance and size, in terms of peer group? Could an argument be made that, well, if the main focus is just those three to four companies, why not just use those three to four companies and forget about the twelve to fifteen?

Malcolm: What makes it tough is, with the smaller sample size, there's less relevance across your executive team. It’s going to be harder to benchmark your full top five to your peer group, specifically if you're only working with five or six companies. For example, if you got a general counsel you might not find five good matches in your five peers. So that's the benefit you get by expanding it—it is being able to apply that market across more of your executive team members.

I think when it comes to directionally what's happening from a comp perspective, you can talk about what are the comp trends going on with our three to five key competitors. What are they doing from an incentive design perspective, which I think is important. That can be as relevant as any broader data set. What are our competitors focusing on from an incentive design perspective?

Mark: Malcolm, as you look at your peers, how do you think about cross sector? How do you think about E&P vs. services vs. a midstream? And do you ever use some of those other sectors that are size appropriate, but they're different sectors, so do you discount that, or how do you think about that?

Malcolm: So, services and E&Ps, they operate very differently. You know, if you're a services company including E&Ps in your peer group, they're just going to pay a lot differently, they incentivize different things, and conversely, E&Ps is going to have the same issue with midstream. I think there's a little bit more relevancy, but there's very few midstream companies that makes it difficult.

I would say that if you're broadening your data set for a services company, we often look at industrials or some other market E&Ps, that's really tough to look at industrials or any other broader industry.

Aalap: So, it sounds like Malcolm, and not to give you more work, but it does sound like if you're going to go for this broader group that may include multiple subsectors, it's not only important to call out the most relevant peers, but it probably is important to call out any sort of trend differences between the subsectors so that the committee can be informed about, "okay, this is how this subsector is potentially impacting the overall data set." Would you agree with that?

Malcolm: Yeah, absolutely. We talk about this during our monthly oil and gas team calls—what are the subsector trends? It's something we do in the summer as we're looking at the proxies, getting a macro look at, what are all the services companies if we lump them all together, and how does that differ from the E&Ps? It gives us a perspective on how different things can be year-in and year-out. And really the services, E&P, and Midstream, all operate very differently despite being within the same cyclical market.

Mark: How do you think about that when you're looking at performance peer groups? You might broaden your look for assessing the levels of compensation, but when you're looking at say relative TSR, or I know it's quite prevalent in services to look at return on capital type measures. How do you do that when you're struggling to find a significant number of direct competitors?

Malcolm: This is actually an area where I think it's easy to make the mistake of treating it the same as the comp peer group. Expanding outside of your industry to broader indices or including companies that aren't necessarily relevant from a performance perspective. This is where, I think, a lot of companies could look at alternatives that aren't necessarily traditional. We mentioned that the market has been changing dramatically over the last ten years. Perhaps our solutions should change as well.

Maybe the idea that you've got to have, 10 to 15 companies in your relative TSR peer group is outdated. I mean, it's great if you can find that many that are relevant, but to the extent you can't, how can we work with a peer group that's only five companies? I think there are solutions out there. There's different TSR designs, there's outperformance designs that we could use, alternatives to the traditional broad TSR peer groups.

Mark: But there are some indices. You mentioned oil field services, just use the OSX. What's wrong with you doing that?

Malcolm: It's funny, you know using an index like the OSX isn't a silver bullet, that's still a peer group that's being chosen for you that's supposed to be relevant. But let's really look at that specific index. There's companies, L&G shipping companies within that, for a services company, is that really relevant to your market? Yeah, it makes it easier because somebody else is making that decision for you, but is that a better solution?

Aalap: So, what's bugging me a little bit, is that when you think about this is that balancing the relevance vs. the broader. So, you mentioned you may have a performance peer group that is five companies. How do you deal with that issue of continued consolidation then?

Malcolm: Yeah, I think right now, to your point, most companies could pick out five relevant companies. But if we continue to see consolidation, we might need to think about if PSUs, relative, you know, PSU performance is even the right answer at all. I think we should have a discussion around, if we're with the comp committee, around what are all the alternatives? Let's think about all the alternatives, and one of those could be moving to a 100% RSUs and extending the vesting period. 

When we really think about the problems that type of thing solves, that structure. It really does solve a lot of the problems around cyclicality and goal setting. That always becomes an issue with strict performance-based PSUs. And it doesn't mean that you have to take performance out of the equation. It could be that we do a longer-term vesting, but we adjust every year based on that executive's performance. Almost like it's tied to how your annual incentive program pays out and then you get RSUs that vest a longer period of time. We always see three years, what about something that vests over five years or more?

Mark: Are we overanalyzing this, Malcolm? I get that it's easy to look at, let's just take E&Ps, some that operate internationally, some that operate just in the permian, for example, and comparing those can be somewhat problematic because there's lots of differences between international and domestic. But as an investor, do I care? Isn't it okay to compare those two from let's say a TSR perspective? Because we're competing for the same capital.

Malcolm: Yeah, I know. I think from a TSR perspective, we got to think about where we're competing for investor dollars. As an investor, that's certainly something you might be looking at. You might be looking at investing in E&Ps with more international exposure, depending on what your strategy is.

But in the end, I think we have to truly think about how relevant the comparisons are. So, if I'm a domestic E&P company, how relevant is the comparison to a big international operating E&P? Because those two things can trade very differently.

One other direction I would take as I think about it, is we could look at services and there's something very relevant to that discussion going on right now. You have some fracking companies that are getting into power delivery and energy infrastructure which trades much, much differently than a traditional fracking company.

So, if you are a traditional fracking company and you've got some of these companies like Liberty or Propetro in your peer group that are doing extremely well, trading wise, how relevant do they become, even though they've been peers for years?

Mark: Well, but as an investor, I want my company to outperform those other companies. So, I think there's an argument that we should include those, but I can certainly see the argument going the other way that says, "look, these guys are drifting from their core business, and it might make sense now, but what will happen in the future?" But clearly investors are rewarding some of these very creative ideas for utilizing their capital and their expertise. So, I think what we're looking at here is that there can be some very specific issues that need to be addressed and you've got to evaluate all the options, just not the standard approach.

Malcolm: Yeah, we've talked a little bit here about the changes that have been going on in the last ten years and make no mistake, things will continue to change. So, we've got to constantly revisit these programs and think about is the traditional way of doing things still the right way to do things?

Aalap: Malcolm, I mean peer groups are always complex, and I'd say probably the second most emotional conversation when it comes to compensation is the peer group development, the quantum of compensation being the most emotional. But I think you've given us a lot to think about. What’s one thing companies should be thinking about differently when it comes to peer group design?

Malcolm: I think the first piece of that is, thinking about what's the purpose of this peer group? We talked about two very, very different purposes for the way peer groups can be used—there's compensation and there's performance. And within each of those we should be talking about what are we really trying to do here?

For comp, we're trying to get a feel for what the market for talent looks like. And for performance, we're trying to get a feel for relative performance, which makes a lot of sense in a cyclical industry. A common mistake is when things have changed, and they will continue to change, we're not taking a look back and just visiting all options. We’re kind of focused on what are our peers doing, and what are the traditional ways of solving these issues that come up.

I think we need to take a hard look at, what are some of the alternatives? What are the issues we're trying to address? And what are some of the out-of-the-box thinking that we might not have precedent for, but really tick a lot of boxes in terms of providing a link between pay and performance.

Aalap: I really like this sort of concept that you brought up about temporarily including a company in your peer set, for a set period of time. Because I think that can provide some specific formulation of concepts and design but that may not be something that you want to have for a longer period of time.

So, I think that creative thinking around peer sets and then to assume that they're not locked in, is some great counsel. So really appreciate the time, Malcolm.

Mark: Yeah, thanks for coming in.

Malcolm: Absolutely. Thanks for having me, guys.

Jake: Thanks again to Malcolm for his thoughtful perspective on how oil and gas companies are rethinking peer group formulation in this evolving landscape. On the next episode of our oil and gas series, we'll explore how effective compensation design requires building flexible, disciplined programs that can continue to motivate executives through commodity cycles, without rewarding windfalls or punishing uncontrollable downturns. Until then, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thanks as always for listening, and we'll meet you back here next week.