Prices go up, prices go down. The key point is that they do go up.
In fact, significant, sustained downswings of oil and gas prices have never failed to be superseded by a turnaround of whatever magnitude, and this time should be no different. The world does still run on oil and gas, and you can't "fill'er up" with dot.com.
Volatility, however, is a fact of life in the petroleum milieu, where NYMEX traders on Wall Street set the commodity prices, and what matters most of all is movement -- in either direction.
So how do savvy companies position themselves to cope with the relentless uncertainty?
For starters, a case can be made for an "out with the old, in with new" mindset.
Look at reserves replacement planning, for instance. It's been practiced for many years, but the old approach to the process lacks the sophistication required to maximize the results.
"In the 1970s, an oil company's value was measured by its reserves, but after oil prices dropped in the mid-'80s it was not enough to just replace barrels," said John Howell, president of Portfolio Decisions. "You had to have profitable barrels."
Managing risk is the name of the game, but it's a hard sell to folks who rely on what they deem to be the tried and true methods to conduct business, particularly during the lean times.
"Companies say ‘prices are low, we can't afford to do anything new.' And we say ‘prices are low, you can't afford not to look at risk,'" said Jerry Brashear, managing director of The Brashear Group LLC.
"I'm convinced the low prices of the past year make explicit risk management at both the project and portfolio level critical for survival."
Brashear's opinion is shared by other industry veterans.
"The last time, we came through the downturn by doing a better job on the geotechnical side, like 3-D and such," said Lee Hightower, president of Economic Analysis Systems, "but this time I see it more by companies doing a better job managing their portfolio."
Companies have a penchant for rank-ordering projects by a pre-determined rate of return or other indicator. They then go down the list as far as the available capital will take them to select the projects for the year.
That methodology almost always maximizes risk, according to Brashear.
"They say they have a minimum threshold of 15 percent for projects, and yet the industry average rate of return for the 20 largest oil companies from '87 to '96 in real terms was 3.35 percent," he noted.
He cites a variety of reasons for this phenomenon, such as:
- Oil and gas prices, which can -- and often do -- fall.
- Tax break changes.
- Technology that doesn't work as well as projected for certain projects.
- Uncertain reservoir conditions.
They all denote risk, which he says is excluded in the rank ordering exercise, where everyone looks only at the return aspect of the projects or portfolio.
Risky Business
To manage risk at the decision-making level, myriad uncertainties must be incorporated into the workflow to construct the desired project portfolio.
Look at the geological, geophysical and engineering data, for instance. These valuable raw data are compressed, or summarized, as they move through the workflow, which, in essence, minimizes the risk factors that are indigenous to the raw data.
"What we're trying to do is to capture that and pull it into the risk analysis itself," Brashear said, "so uncertain quantities are plowed right into the economics of the respective projects and, through the projects, to the overall portfolio."
Other equally important risks that must be plugged into the equation include the numerous above-ground uncertainties, including prices, product demand, environmental regulations, technology advances and pipeline networks, among others.
The industry's segmentation into exploration, exploitation and acquisition business units impacts portfolio planning. Each has distinctly different risks and different correlations among projects, the effect of which can only be fully examined by combining all three segments into a single portfolio.
Brashear employs a "scenario" model to describe the interplay of the different complex risk characteristics of the below- and above-ground data, and how projects in the portfolio interact.
These become critical components in project and portfolio evaluations.
Interaction
The focus of portfolio theory, according to Howell, is on optimizing how projects interact with one another. In fact, some companies view portfolio optimization, or the optimum plot of the values versus risk of all possible portfolios (combinations of projects), as the be-all-end-all goal of portfolio management.
Not so, according to Craig Narum, the planning coordinator at Mobil E&P U.S (MEPUS).
"Portfolio optimization is not an exact science," Narum said. "Small changes in the underlying assumptions can give you drastically different results.
"If you're only trying to get to that end, you're missing the point a bit," he added. "Optimization is one piece of management, but having a system to look at data many different ways for typical tasks is a big part of an overall portfolio management system."
While in the past, the lack of computer power and the requisite software were roadblocks to implementing portfolio management, MEPUS didn't waste time once these obstacles disappeared.
Using the TERAS software program developed by Hightower's company, it was the first to apply the process on a large scale. It has completed the first full year of what Narum describes as a two- to three-year journey. The first year was spent getting the requisite tools into people's hands and training them, and building hundreds of project evaluations.
"We were then able to look at more data at more levels in the organization than we'd ever looked at it before to understand things like volatility of earnings and cash flow and volatility of production projections on a whole asset base," he said.
The power of such a data assembly is readily apparent, considering it allowed MEPUS to look at the array of fields to determine if they were impaired (values less than book value) in approximately an hour, as opposed to the weeks it would have taken otherwise.
Thus far, they have used the information acquired from the portfolio management process in many practical ways, such as to make decisions on capital allocation and where to focus resources while positioning for portfolio optimization analysis.
Understanding how projects interact with each other and maximizing that interaction is crucial to achieve the right mix. A prospect can be excellent in its own right, yet of no value if it adds excessive risk in the context of the portfolio.
A caveat: A passel of projects destined to hit a grand slam when prices are up isn't the recommended way to go.
"A balanced portfolio will maintain a certain percentage of investments in those assets that proved a reasonable foundation of cash generating properties if prices fall," cautioned Howell at Portfolio Decisions.
Getting Up to Date
So, maybe it's time to take another look at the trend du jour of shedding non-core assets.
"In the '90s, many companies were conservative until the last three years, when they said growth is it and began dumping non-core properties," Howell said. "Many biased portfolios toward strong growth programs like Africa, the deep water and such, and nobody questioned ‘if prices go soft, what will we look like?'"
He emphasized the need to anticipate price fluctuations and plan portfolio and corporate objectives accordingly. A portfolio that is fairly resilient to price swings must not only have some exposure to big growth projects but contain a percentage of the less glamorous properties as well.
In other words, consider the growth-generating projects to be the small-cap stocks of The Patch, which will serve you well in times of escalating prices, while the "old-shoe" properties that plod along at a steady rate provide the financial cushion of a bond when prices dip.
The Lamont Portfolio Management Consortium at Columbia University's Lamont Doherty Earth Observatory is testimony to industry's current interest in portfolio management.
The consortium, which is headed by Howell, has 11 oil and gas company members. Its goals are to arrive at a common definition and understanding of portfolio management, and to develop improved tools to use in managing portfolios. It also provides an interactive environment where oil companies and consortium leaders can come together and focus on issues associated with portfolio management.
"It's been said we use year 2000 technology to find oil and gas and use 1960s business practices to manage assets," Howell said. "With portfolio management, we're trying to bring more robust business logic into play."
Procrastinators, take heed.
"Those adopting these techniques, I believe have an enormous competitive advantage," Hightower said. "Those early-in are exploiting the power of this tool."