Volatile commodity prices, the collapse of capital markets and mounting regulatory interventions are testing energy companies and their boards of directors in new and, in some cases, unforeseen ways. Further, company directors are aware of growing scrutiny of executive compensation and unprecedented shareholder demands for more transparent governance.

Questions such as, “What is the board doing about risk?”, “How is the board disclosing its activities?”, and “How is the board accountable to shareholders?” have become part of the vernacular of institutional and activist shareholders.

These questions arise not only as external pressures for governance accountability are mounting, but also at a time when answering them requires a new level of due diligence, a renewed focus on the potential and limits of board oversight, and a commitment to recruiting new, informed voices to the board.

How will the business lessons of 2009 impact energy-company boards in the year ahead? Expect five challenges to unfold as key agenda items.

• Energy-company boards will continue to drill down on enterprise risk.

• External forces—regulatory, environmental, transnational and political—will continue to consume more board agenda time.

• New directors will need to bring significant skill sets such as global industry experience, a long-range view and diverse perspectives.

• Energy boards will be more proactive on “hot button” issues such as executive compensation structure and disclosure, accountability, strategy, risk assessment, transparency, shareholder communications and effective governance structures and practices.

• Directors will dive deeper into management talent to calibrate chief executive options and rigorously approach executive talent development.

Enterprise risk management

Today there is little cover for boards that can only summon a paltry, “We didn’t see this coming,” when media or shareholders ask about breakdowns in governance or outright failures of management oversight.

Yet, directors may risk double jeopardy if—perhaps even during a formal deposition—they disclose information concerning an enterprise’s strategy and operations and that may be privileged. Directors must balance accountability for external communication with the need for significant discretion to protect corporate interests.

When addressing enterprise risk management, energy boards occupy unique ground. Boards across all industries are focusing on risk oversight, but the risks inherent in exploration, drilling and production present unique challenges. Among these are the increasing magnitude of capital investments and the timing to bring new energy resources into production.

“There’s no other business that could take a $100-million investment, and, if things go badly, see it worth absolutely zero,” says John R. Butler, chairman and chief executive officer of J.R. Butler & Co., an engineering consulting company in Houston, and a member of the boards of Anadarko Petroleum Corp. and Breitburn Energy Partners L.P. “Directors need to be aware of the risk profile of the company, but the second-guessing of business tactics, risk strategy and policy—issues that boards are being held more and more accountable for—deters some risk-taking.”

Not all risk-taking is inherently bad, adds Butler. He suggests that externally driven over-reach regarding risk exposure could tamp down the kind of calculated risks that energy companies, more than most, need to pursue.

Christine B. LaFollette, partner in charge of the Houston office of law firm Akin Gump Strauss Hauer & Feld LLP, and National Association of Corporate Directors Houston chapter board member, says boards will continue to invest even more time in understanding the complex mix of variables impacting the business and shareholders.

“I see boards taking a continued and closer look at enterprise risk management,” she says. “It’s definitely front and center for the directors. What we’ve seen is a shift more to the top-down kind of enterprise-wide team approach, versus the traditional silo approach to assessing exposure.”

In the energy business, she adds, directors have taken “quite seriously” the challenges their companies and boards have been forced to wrestle with, from the major swings in commodity prices to financial liquidity and access to investment capital.

Says Charles J. Pitman, a member of the Apache Corp. board, “Risk management is an issue where I think you’re going to see changes in board makeup. People who have a greater acumen in terms of managing risk from a financial point of view will be in demand.

“Directors need to be aware of political and operational risk, yes, but especially when companies are hedging, I think financial acumen is a skill set that boards will be looking to add.”

The bottom line, according to LaFollette: “Most board members view their role as one of oversight of the operation, not day-to-day operation, and they strive to help a company make sure they are looking at the risks that company faces and addressing them properly.”

Staying current with the company’s risk profile and being proactive when it comes to assessing potential liabilities have become best practice for today’s boards. The right board with the right chemistry, skills and information should be equipped to ensure that risks are identified and matched with the strategy and business model, as well as continually qualified, quantified and monitored.

External forces

Energy boards should expect even more pressure from external forces in 2010—and increasing politicization of a variety of issues that were once their exclusive domain.

The U.S. Senate and House of Representatives continue to churn through legislation concerning a wide range of board-governance issues, from proxy access and disclosure practices relating to strategy, pay, and plurality versus majority voting, to tenure and staggered versus annual board terms.

The volume of governance-related bills in Congress and the implications of their passage suggest energy boards will need to work diligently to understand compliance issues and identify areas that may call for adjustment from Washington.

The Dodd Bill, for example, sponsored by Sen. Christopher Dodd (D-Connecticut), chairman of the Senate Banking Committee, includes corporate-governance provisions that would require a majority voting standard in uncontested elections of directors, enable shareholders to nominate directors using a company’s proxy materials and, among other reforms, require companies to explain why they have chosen to separate or not separate the roles of chairman and chief executive officer.

Anadarko and Breitburn board member Butler says that in an increasingly litigious environment, the federal government will exert more pressure on energy companies—on issues ranging from taxation and natural resource access to permitting and drilling.

Whether government pressure relates to the reduction of federal lease terms, pay practices and related disclosures, or regulatory maneuvers having the effect of forcing up the cost of domestic production, “The government is getting more and more into our business…and I think it’s a little more uncomfortable for U.S. energy-company board members,” he says.

Further, he questions whether the domestic oil and gas industry isn’t being put at a significant disadvantage in competing globally. “We used to dominate the seismic industry,” he says. “Today there are no major U.S. seismic companies. Now they’re Norwegian, French and Chinese, and there are some Canadians, but there are really no big players based in the U.S.”

Other countries also have a competitive advantage in land access and natural resources, says Butler. “As a result, I think more market leadership in the future will probably come from foreign companies, like the Russians, Brazilians and the Chinese.”

Add to that the on-again, off-again political focus on the “tremendous profitability” of U.S. energy companies, and the full panoply of pressures on energy boards and directors becomes clear, says Butler.

Apache’s Pitman acknowledges that energy companies, like others, have had to increase spending on compliance with governance issues relating to Sarbanes-Oxley, and have had to add new staff to tackle environmental reporting. Some companies, however, haven’t had to alter significantly the management of their businesses in response to increased regulation.

Changing director profiles

The bar on board director talent and responsibility is rising as the energy industry, like others, learns from the harsh lessons unfolding from governance debacles in other sectors. There is a broad consensus in governance circles that management should maintain a much more balanced eye with regard to meeting short-term versus long-term objectives. That is especially true for energy boards.

The much-maligned management-by-quarterly-numbers approach to running a business and reporting corporate financial results to Wall Street has raised shareholders’ ire and resulted in compensation payouts that have governance activists abuzz.

Energy boards have watched others’ mistakes in this regard. From Anadarko director Butler’s point of view, although energy companies may be less susceptible to short-view management because of the dynamics of permitting, exploration and other factors, it would be unwise not to stress the value of a board’s long-range stewardship role.

“The Street kind of rewards your production profile today rather than long-dated successes,” Butler observes. Nonetheless, these longer-term successes are vital to drive shareholder value. “The net of it is you have to have people around for the long term who understand this long-term time horizon that energy companies, particularly exploration companies, are involved with.”

Akin Gump’s LaFollette concurs. “For the health of any business, you can’t focus on near term or long term. It has to be both. It has to be a balance.” She says the energy-company board is like a mosaic, with each board member bringing an important piece to the table.

New directors will need to bring deep industry experience as well as an inquisitive approach to help the board surface potential risks and problems before they spiral out of control. They should have an appreciation for long-term capital investment and returns, but also an understanding of how the business cycle and other forces impact the business.

Further, they should have a clear vision into the company’s financial background and risk profile as well as an appetite for digging into operations, regulatory affairs and cash flow to provide meaningful management oversight.

Butler notes that it takes longer for a board member from outside the energy industry to make a real contribution than someone who knows the business, the challenges and the risks. For that reason alone, he suggests, energy companies will likely defer to known energy-industry leaders to fill seats on their boards.

However, there is an increasingly recognized need for a broader range of perspectives, diverse views and informed voices from wherever directors hail.

“We’re also looking for people who have a broad international perspective, who are world-wise and who can weigh operational issues outside a strictly U.S. business context,” says Apache Corp. director Pitman. “You need board members who know the world, and you need diversity. Unquestionably, women and minorities can make important contributions to board effectiveness.”

Using a skills matrix can help identify the qualifications and experience of existing directors, the gaps, and the resulting needs.

Before the crises at Enron and WorldCom, friends and business associates were asked to serve on energy-company boards, often because they were good people, they were known to the CEO and other board members, and could opine on issues, assess business operations and anticipate risk. But because they tended to go along with what the CEO wanted, they weren’t always the right people to have on the board when it came to governance.

After the passage of Sarbanes-Oxley, the pendulum swung the other way, and energy boards moved to recruit outsiders who could focus on governance and accountability. Yet these directors had trouble assessing strategy and risk because of the steep learning curve they faced regarding energy.

Today, independent directors with the time to commit to a board and its committees are taking the time to attend NACD programs and university-sponsored director education programs, and they’re combining the knowledge gained from such programs with their industry knowledge and objectivity. Because they can understand the strategy and the risks, they can be a confidant and mentor for the CEO and senior management and play a significant role in helping the company reach its potential.

More directors are becoming certified directors and are contributing to compensation, governance and risk-management transparency to provide shareholders with the data they need.

Anticipating ‘hot-button’ issues

“There’s not a company in America that hasn’t had to deal with the anger about Wall Street and the public reaction to hefty bonuses that raised taxpayer, shareholder and the administration’s focus on governance and how that reality meshes with economic reality,” LaFollette says.

A variety of “hot-button” issues relating to perceptions of excessive risk-taking and compensation have fueled public debate about executive severance, perks, tax gross-ups, golden parachutes and re-pricing of stock options. “It’s prudent for compensation committees to review their practices in light of that,” LaFollette says, especially given the “withhold the vote” campaigns that marked the 2009 proxy season.

Steering clear of hot-button issues requires a simple yet sustained commitment to company stewardship before issues arise calling into question corporate governance and threatening corporate reputations.

The Boy Scouts’ motto to be prepared will serve energy-company boards and directors well in avoiding unnecessary and potentially damaging dustups with media, shareholders and employees.

The issues about which boards have felt so much heat can often be traced back to a sheer lack of open communication and continuous dialogue between boards and shareholders.

Developing talent

Preparation and careful planning will also serve energy-company boards and directors well in confronting a potential shortage of specialty-skilled talent and experienced senior management to replenish a graying workforce.

“The recruitment of people for the board itself has become an increasing challenge because our pool of technically trained leaders does not appear to be growing,” says Butler.

Pitman agrees. “Finding and retaining people is an area that will have greater emphasis at the board level. It’s a corporate issue in the energy sector. Figures on the average age of employees in the sector point that out very clearly.”

Prime among the board’s leadership responsibilities is the effective creation of succession planning for the CEO.

“I think energy companies—as other companies do—rank CEO succession as a very important issue for them to address…I see directors taking a more active role on succession in the energy business,” says LaFollette.

“I think boards appreciate they have to have these critical discussions about succession. You have to have good management to deal with unexpected events, commodity swings or perhaps a well blow-out. Today, it is an environment that requires a lot of forward-looking strategy for long-term growth, and part of that is identifying the talent and skills you need in your next CEO.”

Though it may sometimes be uncomfortable to talk about CEO succession, LaFollette adds, especially if a company has a high-performing CEO, it is incumbent on the board to engage in an in-depth discussion of succession at least once a year. It must identify candidates and have a succession process in place if needed. The reduced tenure of management leaders alone suggests the need for more succession due diligence, she says.

While CEO succession remains an imperative, there is increasing recognition that boards and directors also have to take a deeper look at the development of management talent.

“I think energy companies are going to have to work extremely hard at creating bench strength. I think the pool for CEO talent that’s out there, if you’re going to recruit from the outside, is pretty thin. Companies of size better be attendant to creating their succession plans internally,” Butler says.

“We’re constantly looking at our CEO succession in general and really the depth of our bench. The tenure of CEOs is getting shorter and shorter, and that’s especially consequential in the energy business because we have to be long-term oriented,” he adds. “The industry has been created by people who were very entrepreneurial and who’ve had to live with their successes and their failures.”

Apache’s Pitman adds, “Getting and retaining people and developing people you have for more senior management roles is really important because you have to have bench strength. The principal responsibility there is management’s, but the board’s role is to make sure there’s an adequate leadership-development process in place ahead of having to make decisions about top leadership roles.”

Given these factors, the CEO should provide a detailed succession plan to the board on an annual basis so directors can assess potential succession risk factors and the extent to which current management is preparing for effective leader transition.

Now more than ever, the board must be versed in compensation and succession planning and committed to creating the right fit, the right compensation package and the right structure for the CEO, to help land a successful candidate, whether from the outside or within.

In 2010 and likely for years to come, the board’s continual oversight of nominating, talent development and succession practices across the enterprise will set the stage for effective governance and transparency, as well as meaningful shareholder disclosure and mutual trust.

David Preng is a director of Cal Dive International, board member of the Houston chapter of NACD and leader of the board search practice of Preng & Associates, an executive search firm with offices in Houston, London and Moscow.