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Risk Management in Oil and Gas

Oil and gas risk management is key aspect of an oil and gas company’s strategic planning and decision-making.

What are the varying amounts of risk inherent in the available asset investment options?

This oil and gas risk management module addresses how oil and gas companies plan for and evaluate the various risks in this wide set of options.

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Labor-Intensive Versus Capital-Intensive Industries

Industries such as auto manufacturing and homebuilding are considered labor-intensive, that is, it takes a high number of employees to produce and assemble the product.

A few parts of the oil and gas industry are also labor-intensive such as the engineered equipment manufacturing sector of oilfield services.

However, the entire oil and gas value chain requires much more capital than labor to produce results, so it is termed a capital-intensive industry. For the purposes of this module:

A very high capital requirement is in billions of U.S. dollars.
High is considered to be $U.S. 500 million to 1 billion.
Medium is a range of millions of US Dollars to $U.S. 500 million.

The Capital-Intensive Industry chart shows the range of capital requirements and asset lifetime frames for the upstream, processing, and marketing, and transportation segments of the industry.

The ranges on the chart should be considered representative, because capital requirements also change as a project works through its asset life, for example:

Upstream oil and gas capital requirements for seismic and geological studies are estimated at $U.S. million. An exploration well can be $U.S. 100 to 200 million, but the development of the producing field (especially offshore) can be in the $U.S. billions over the 50 to 60-year life of the field.

Processing facilities are projected in $U.S. billions: a single gas-to-liquids (GTL) plant in Qatar, the largest in the world, was initially estimated to cost $U.S. 5 billion. However, the final cost has been expected to reach as high as $19 billion.

Marketing, on the other hand, has a relatively low capital requirement. Even though a good retail service station location can be quite costly, it is inexpensive compared to the other oil and gas investments.

Transportation assets can cost in the range of $U.S. 100 million (for a vessel) to $U.S. billion for a new pipeline.

The length of the asset life time frame is another major factor affecting project risk because most oil and gas projects consist of long decision cycles.

Balancing Investment Options

Historically, integrated oil and gas companies invested in several different business segments to stabilize their financial results, because each segment often experienced a different commodity cycle in price and margins.

What was desirable was an integrated investment portfolio that offset these price-margin variations.

In the Balancing Investment Options diagram, low gas prices equal low returns for upstream oil and gas profits, but good returns for a chemical plant, because gas is used as the plant feedstock.

Therefore, a balanced portfolio of chemical plants and gas production could provide stability, because gas price variations would offset each other.

In reality, there is not a one-to-one correspondence in investment profiles, which makes it difficult to stabilize financial results with this simplified strategy.

Risk vs Return in Oil and Gas Investments

A key aspect of today’s oil and gas risk management, planning, and decision making is accounting for the varying amounts of risk inherent in the wide range of asset investment options available to companies (refer to the graph, Illustrative Risk-Return Investment Profile).

The higher the risk, the higher is the potential return on successful projects.

However, with this elevated risk comes a higher possibility of large financial loss.

Oil and Gas Risk Management - Managing Project Risk

There are three types of risk to manage in all oil and gas industry projects: economic risk, political risk, and environmental risk.

These risks apply to all large, long lead-time industry capital projects, such as:

Onshore drilling rigs
Offshore drilling drillships or semi-submersibles
Engineered equipment manufacturing facilities
Oil and gas production platforms
Refineries
Gas-to-liquids plants

Additionally, Exploration & Production (E&P) development projects have another large item, geological risk.

The chart, Managing Risk Across the Oil and Gas Industry, is an index of the relative size of economic risk as it translates into capital and expense and affects a company's financial performance.

Every risk in an oil and gas project needs to be quantified as part of the project planning and investment evaluation decision process.

Oil and Gas Risk Management and Fractional CFO Services

EKT Interactive has partnered with leading experts who have decades of experience providing fractional CFO and risk manager services to energy companies.

Whether you need valuation and financial modeling services or hedging and risk management, the team at EKT Capital can evaluate your company's needs and develop a plan that suits your needs.

Click here to learn more about our services and schedule a meeting.

Economic Risk

Economic risk on international projects includes:

Oil prices collapse
Capital cost overruns
High operating costs
Loss of demand from the facility

Some overlap occurs with political risk in assessing the factors that also can affect the economics of a project:

Stability in the tax system (regime)
Ability to repatriate earnings
Currency exchange rate stability

Political Risk

Political risk is a detailed evaluation of all the risks of doing business inside a particular country.

A change in country management or political philosophy can often result in a new evaluation of a host country’s oil, gas, and commodity reserves. Some examples of possible changes are as follows:

Renegotiation of economic terms
Change in royalty payment and tax rate structure
Revisions to production shares
Ability to repatriate interest, profit, and dividends

History has shown that there is a direct correlation between the value of the commodity or resource and the host country’s relationship with the oil and gas companies.

As the resource value increases, the host countries take a stronger position in controlling their commodity assets.

The best deals for the international oil and gas companies seem to be made when the price of a resource is low; however, the agreements are often re-negotiated when resource prices increase.

The ultimate political risk is the possibility of expropriation of assets, where the host government takes over the investment, with or without compensation.

There have been multiple examples of major oil asset expropriation in the past.

Venezuela has a long history of expropriating oil assets under former President Hugo Chavez (but continuing in the new regime).

More recently, Russia and Ecuador have also used this technique to gain control of energy resources.

Environmental and Safety Risk

The other major factor is environmental risk. Environmental impact statements are a pivotal part of new projects, including detailed attention to the project’s carbon footprint.

In addition to what is normally considered an environmental risk, such as pollution or inattention to the ecological surroundings, other items, such as personnel safety, damage to equipment, fire, flood, and disaster, are also important.

All environmental risks that can affect project economics need to be considered and quantified.

Another substantial environmental impact item in the upstream today is what the host governments are calling a “zero-flare tolerance.”

Basically, the operator cannot produce the oil unless an outlet is found for the associated gas which is often flared, or burnt off, at the well.

The environmental policy of zero-flare has become a significant capital and expense item in developing new production prospects.

However, this policy is also driving research in uses for this wasted resource. Currently, diesel generators often provide the electric power needed to run pumps and other equipment at the well site.

Using the available natural gas to power this equipment could save significant amounts of money while reducing emissions.

Many companies now have applied environmental risk assessment technology and resultant economic measurements to every international business decision.

Geological Risk

In evaluating geological risk, it is important to remember that there is a very high degree of uncertainty in E&P, that is, the lack of true visibility on the oil or gas reservoir.

What can only be estimated by maps and seismic data is actually of great importance to the success of the future project.

Even with all of today's seismic and evaluation technologies and very sophisticated computer modeling, the prospect could still contain:

Poor source rock
No reservoir rock
No cap rock
Faulted or poorly consolidated reservoir
Tight sands

All these factors affect the well's ultimate productivity economics.

However, none of these factors are well known until the money is spent to drill exploratory and development wells, each of which can cost in the tens of millions of dollars.

Risk vs. Return Profiles

The risk-return profiles for an oil and gas company vary greatly by the type of assets in their existing and planned portfolio.

These are some general assumptions:

An asset with a regional business driver and regulated rates, such as a pipeline, has a low-risk profile and gathers a lower, but stable, return.

Assets impacted by global events like refineries, GTL plants, and liquefied natural gas (LNG) facilities, which are affected by supply-demand and commodity price fluctuations, have a higher risk profile.

E&P projects are considered one of the highest risk options in the industry and can provide high returns, if successful.

Commodity trading is unusual. Because it depends on knowledge assets, it is considered a very high risk. It is difficult to forecast or depend on the ability of individuals and groups to correctly forecast and act on future market direction.

Oil and Gas Risk Management and Decision Making

Today, corporate planners use asset portfolio optimization principles and sophisticated mathematical models to assess various risk-return relationships.

Corporate metrics and quantitative tools are common and available.

Data indicate that planners and decision-makers who evaluate risk with a probability profile rather than a single-point estimate make better investment decisions.

Modeling Risk

As the chart Multiple Analysis Approaches Used indicates, oil and gas companies employ three basic analysis approaches to develop risk profiles for the various asset categories and to consistently tie the project analysis to the company’s long-term business strategy.

The analysis approaches rank from more subjective methods to more quantitative.

Scenario planning was introduced by the Shell Oil Company in the 1960s to help account for the uncertainty inherent in speculating about the future. In practice, it consists of three steps:

Formulating scenarios
Identifying “robust” strategies
Developing specific strategic actions or changes in strategy as events unfold

This technique is the most subjective.

However, it is becoming an increasingly popular concept and tool, because most of the drivers affecting the industry's economic results are outside the control of the traditional oil and gas participants.

Quantitative modeling is the most common technique used by oil and gas and oilfield services companies when they evaluate physical plants and facility assets.

The basic concept of quantitative modeling, often called “rank and cut”, is to:

Evaluate each project with a consistent set of assumptions
Use the same tool and metric to quantify and rank the economic return potential of each project
Budget those projects for which the company has the available capital

Portfolio management simulates varying combinations of proposed projects, and especially the interaction among the projects.

In this method, all potential E&P projects are characterized consistently and objectively with regard to reserves, cash flows, and investments costs.

However, a likely outcome of the analysis is expressed as a probability distribution of returns—not a single point, or range of returns—which would be generated in more traditional approaches.

This method is much more sophisticated and demanding, but leads to better long-term accuracy for E&P assets than the traditional, “rank and cut” technique.

More on Quantitative Modeling

Time value of Money

As project investment options are analyzed, an important concept is the time value of money.

The basic premise of this concept is that the revenue or cash flow achieved in the future needs to be discounted because it is not as valuable as cash today.

The first step in conducting this type of analysis is to develop a profile of the future, cumulative, cash flow from the project.

As the More on Qualitative Modeling chart shows:

In the early years of project investment, the annual cash required to fund the project makes the cumulative cash flow negative.

As the project is completed and comes onstream, net revenue (cash) is generated.

In the case of E&P projects, the cash generated deteriorates over time as the field production decline curve takes effect. The cash flow is also affected by changes in crude oil prices and natural gas prices as well as unforeseen events that affect production rates, such as hurricanes and political turmoil.

The cash flow stops when the asset is retired or sold.

Corporate Metrics

Typical corporate planning metrics to analyze the forecasted cumulative cash flow from a project are:

Net Present Value (NPV) is the point where the cumulative cash flow from a project is discounted using a percentage factor set by the company. An investment is attractive if the NPV is greater than zero. Projects are ranked from the highest NPV (most attractive) to the lowest during the budgeting process.

Discounted Cash Flow Return (DCF) or Internal Rate of Return (IRR) is the discount rate where cumulative cash flow from a project equals zero. An investment is attractive if its rate of return is greater than the corporation's cost of capital, or a hurdle rate return. DCF and IRR measure the return of an investment relative to the company's cost of capital.

Return on Investment (ROI) is where the cumulative cash flow is divided by cumulative capital (plus any overhead on capital, such as interest cost). ROI describes how much profit is generated per unit of capital investment.

More on Portfolio Management

In E&P companies today, there are typically more assets to choose from than can be developed with the available capital.

In the context of the long-term corporate strategy, companies must consider which assets to invest in, when to invest, and how much to invest.

The sheer number of project options is usually a major challenge.

For example, an organization with even a modest base of 200 E&P assets is faced with over 1,000 possible options to analyze.

The most important principle in E&P portfolio management is the emphasis placed on quantifying risk in the individual asset and the interaction among assets.

Monte Carlo Simulation

Monte Carlo simulation is the most common tool used to help quantify the risk in E&P projects.

The name refers to Monte Carlo, Monaco, known for casinos where the roulette wheels, dice, and slot machines exhibit random behavior.

The random behavior in casino games is similar to how a Monte Carlo simulation selects variable values at random to simulate an E&P portfolio model.

When rolling a die, it is known that either 1, 2, 3, 4, 5, or 6 will come up, but which number will occur for any particular roll is unknown.

This is very true for E&P variables affecting a project.

Variables have a known range of values, but value for any specific time or event is uncertain, such as:

Crude oil prices or natural gas prices
Production decline rate
Exploration success rate
Asset investment cost
Foreign tax and royalty rates

Simulation refers to any analytical method meant to imitate a real-life system. This method is used when more traditional analyses are too mathematically complex or too difficult to reproduce.

A simulation produces a distribution of results, as shown in the graph, Monte Carlo Simulation, which is a probability profile of the potential project value.

A quantitative or spreadsheet model generating a single-point result is no longer robust enough for good decision-making in today’s E&P business environment.

Business Planning Cycle

Although the decision process among all these different types of investment options seems complex, global oil and gas industry planners say the objective, in reality, is fairly simple – to figure out the right mix of investments to help the company consistently meet its financial and performance goals.

That is no small feat considering the increasing volatility in oil and gas markets and the inherent risk, especially in E&P.

To integrate the tools and corporate metrics into an annual oil and gas planning and decision process, most oil, and gas corporate planners first translate a set of corporate strategies into guidelines to advise the business units as they develop projects.

Some examples of corporate strategies include:

Percent annual earnings growth
Reserve additions
Minimum finding costs
Minimum returns on facility and process investments
Debt-to-equity ratio targets

In most companies, the projects are generated in respective business units.

Systematic evaluation of projects is especially complex when the company operates and/or has assets in diverse global locations.

A key planning principle in oil and gas is that the portfolio composition and interactions among the projects cannot be determined at the business unit level.

Responsibility for ranking and selecting projects and evaluating different portfolio combinations relative to the corporate strategies usually resides at a central planning group.

Often, an interactive process involving negotiations among business units and planning ultimately leads to assignments of projects or groups of projects to each business unit.

The central group also assesses performance (compared against forecasts) and feeds these results back to each business unit to improve planning in the next cycle.

Typical Industry Planning Timeline

Long and Short Range Planning

Most oil and gas companies use two separate but interrelated planning processes throughout the year:

The long-range plan is used to forecast capital requirements for 5 to 10 years and has a planning horizon that matches the life of the asset under evaluation (25 to 30 years).
The short-range plan examines the impact of the long-range plan assumptions on the business in the next 12 to 24 months. This plan is used to set short-term business unit and personal performance targets.

The Typical Industry Planning Timeline (Long-Range) chart shows a typical timeline and activities for a long-range plan, called the planning cycle, as follows:

June/July: The corporate planning group develops a set of price, volume, and market condition assumptions to develop the long-range plan. These assumptions are commonly called the planning bases.
August/September: Each business unit puts together its strategic plans, that reflect the planning bases, and proposes projects to meet the business unit targets.
October: The planning group conducts reviews of the proposed projects across all business units to ensure all capital requirements needed to make the project successful have been identified.
October/November: The long-range plan, consisting of a list of those projects with the highest return or probability of success, is consolidated and presented to the appropriate approval body. Once projects are approved, a financial plan to fund the projects is developed and the business units with successful projects are notified to begin project development.

For the short-range planning cycle shown in the Typical Industry Planning Timeline (Short-Range) chart, the key steps are:

October/November: The best estimate is made of the current year's financial results. The impact of the recently competed financial plan is incorporated with these results to make a one-to-two year short-term forecast of financial targets.
January/February: The financial targets for the business units are translated to operational statistics for use by the management team.
Numerous formats are used throughout the oil and gas industry to convert these targets to individual performance scorecards. The objective is to ensure that everyone in the organization knows how they can contribute to the success of their specific business unit (refer to the Feedback Important figure).

Importance of Feedback in Oil and Gas Risk Management

Very long-term improvement in shareholder value as measured by continuous improvement in portfolio quality.

These sophisticated quantitative and portfolio management tools help experienced management teams to ask better questions.

Closing the Loop

Consistency and feedback are very important parts of the process. Corporate planners provide guidance to management using tools that will help the company meet its goals every year.

The investor community rewards companies that consistently deliver what they say they will.

It is difficult to achieve consistency and improvement in business results without feedback on capital investment efficiency, especially in oil and gas investments.

The project development and implementation cycle can often outlast the human element associated with the initial project decisions.

Measuring Success in an Oil and Gas Portfolio

Two major indicators, described in the next two charts, Return on Capital Employed (ROCE) and Capital Discipline Rewarded, are used as feedback measures by companies and external analysts.

ROCE is the most common indicator used as a measure of the efficiency of capital investment across the oil and gas industry.

As the chart explains, ROCE is net income divided by the average capital employed in the business unit or corporation.

This statistic is often reported in a company’s annual report and used for comparison purposes by industry analysts.

Oil and Gas Risk Management Summary

The most important principle in E&P portfolio management is the emphasis placed on quantifying risk in the individual asset and the interaction among assets.

The risk-return profiles for an oil and gas company vary greatly by the type of assets in their existing and planned portfolio.

To integrate the tools and corporate metrics into an annual oil and gas planning and decision process, most oil and gas corporate planners first translate a set of corporate strategies into guidelines to advise the business units as they develop projects.

Most oil and gas companies use two separate but interrelated planning processes throughout the year:

The long-range plan is used to forecast capital requirements for 5 to10 years and has a planning horizon that matches the life of the asset under evaluation (25 to 30 years).

The short-range plan examines the impact of the long-range plan assumptions on the business in the next 12 to 24 months. This plan is used to set short-term business unit and personal performance targets, called scorecards.

Return on Capital Employed (ROCE)is the most common indicator used as a measure of the efficiency of capital investment across the oil and gas industry.

ROCE is net income divided by the average capital employed in the business unit or corporation.

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