LAST WORD

Up­stream ex­ec­u­tives and in­vestors have to be able to stom­ach risk and un­der­stand it

Alberta Oil - - CONTENTS - BY PETER FIND­LAY

How com­pa­nies can man­age un­cer­tainty while po­si­tion­ing for the up­turn

GOOD TIMES AND BAD HAVE BEEN A

fact of life for en­ergy pro­duc­ers since the first On­tario and Penn­syl­va­nia wells were drilled more than 150 years ago. Oil and gas for­tunes are won and lost, and stocks rise and fall, in re­mark­ably short time frames. This is be­cause few in­dus­tries have to con­front as much un­cer­tainty in their fore­casts as up­stream pro­duc­tion, with trans­for­ma­tive changes in price, tech­nol­ogy, ge­o­log­i­cal un­der­stand­ing, regulation, la­bor costs and mar­ket ac­cess oc­cur­ring seem­ingly ev­ery decade. Few fore­told with any cer­tainty that the global crude price would in­crease more than five­fold af­ter 2000; that the es­ca­lat­ing light, tight oil and ro­bust Middle East­ern sup­plies would col­lapse the global crude price; that nat­u­ral gas prices would fall by more than half; or that propane in Ed­mon­ton would be es­sen­tially worth­less in 2015.

IT IS A SOBER­ING EX­ER­CISE TO AN­A­LYZE

stock price trends for Cana­dian-fo­cused, in­de­pen­dent pro­duc­ers (both large and small) since the price rout be­gan in June 2014. The av­er­age share price de­cline is roughly 75 to 80 per­cent as of early 2016 (if we ex­empt those with oil sands or sig­nifi- cant down­stream as­sets). Nat­u­rally, there are stand­outs – a num­ber of com­pa­nies whose value dropped only 20 to 40 per­cent, a rather im­pres­sive feat con­sid­er­ing the fall in com­mod­ity prices. Cer­tainly, many fac­tors go into share price be­hav­ior, such as op­er­at­ing ca­pa­bil­ity, debt load, cap­i­tal ef­fi­ciency and the qual­ity of the rock, just to name a few. But over time, and look­ing back in ret­ro­spect, it is clear that the abil­ity to make in­formed de­ci­sions amid un­cer­tainty is a salient com­pet­i­tive ad­van­tage.

Cul­ture is crit­i­cal. The un­com­pro­mis­ing pres­sure to grow that is placed on pro­duc­ers of all sizes can thwart at­tempts to build a risk-con­scious cul­ture. The value of decades of up­stream ex­pe­ri­ence span­ning mul­ti­ple boom and bust cy­cles should not be un­der­es­ti­mated. How to an­a­lyze un­cer­tainty should not be a short-term ver­sus long-term de­bate (en­tre­pre­neur­ial small­cap pro­duc­ers can be jus­ti­fi­ably short-term fo­cused for ex­am­ple), but rather, there should be a com­mit­ment to un­der­stand­ing risk-re­ward trade-offs across a range of po­ten­tial sce­nar­ios.

But cul­ture and ex­pe­ri­ence only go so far when eval­u­at­ing pro­ject and deal eco­nom­ics. Hav­ing a thor­ough method­ol­ogy to iden­tify un­cer­tain fac­tors and sub­se­quently quan­tify them through Monte Carlo sim­u­la­tions, de­ci­sion trees or oth­er­wise, typ­i­cally yields coun­ter­in­tu­itive in­sights that lead to a bet­ter de­ci­sion or a more ac­cu­rate bid price. De­ci­sion-mak­ing method­olo­gies vary sub­stan­tially across pro­duc­ers – both in the steps fol­lowed and the an­a­lyt­i­cal tools used. The most ef­fec­tive method­olo­gies in­cor­po­rate scru­tiny from a va­ri­ety of ex­perts (ideally those not di­rectly in­volved with the pro­ject or deal). This ex­er­cise should con­tem­plate cor­po­rate fi­nan­cial sta­bil­ity and busi­ness case as­sump­tions across a va­ri­ety of in­dus­try dy­nam­ics, dig­ging dili­gently into the fi­nan­cial mod­els as nec­es­sary.

From a mod­el­ing per­spec­tive, inherent un­cer­tainty and com­plex­ity ham­pers the up­stream in­dus­try’s abil­ity to plan and op­ti­mize to the same de­gree as man­u­fac­tur­ing and process in­dus­tries have learned to. The most com­mon mod­el­ing ap­proach for fu­ture crude price is to use a low, medium and high strip whereas in the real world, oil and gas price be­hav­ior is highly sto­chas­tic and cor­re­lated with other com­plex in­put as­sump­tions. Though fi­nan­cial mod­els across all in­dus­tries are er­ror prone, the na­ture of oil and gas pro­duc­tion adds com­plex­ity that can be dif­fi­cult to val­i­date and de­rive in­sights from un­der tight time­lines. For ex­am­ple, op­er­at­ing man­agers typ­i­cally com­pare type curves across a se­lec­tion of pro­posed gas wells to de­ter­mine which to drill next, with­out be­ing able to con­sider pro­cess­ing con­straints and eco­nom­ics to op­ti­mize over­all cash flow, un­less more ad­vanced nu­mer­i­cal meth­ods are used.

In th­ese trou­bled times, and for the health of our econ­omy, man­ag­ing un­cer­tainty is even more crit­i­cal – whether it’s sur­viv­ing the next 12 to 24 months, squeez­ing value from ex­ist­ing as­sets or trawl­ing for the best ac­qui­si­tion bar­gains. The idea is to avoid get­ting caught while po­si­tion­ing one­self for the big­gest pos­si­ble wind­fall when in­dus­try dy­nam­ics take a turn for the bet­ter.

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