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