Risk analysis and its mitigation are vital to nay organization, but risks are particularly of concern for companies operating within the upstream sector of the oil and gas industry. Even with the use of best seismic technology and geological expertise, exploration still presents considerable uncertainty. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. Extracting oil or gas demands greater investment, additional expertise, and greater exposure to possible liabilities and compliance requirements. International economic and political events increasingly affect all businesses yet such issues have long been concerns for oil and gas companies.
Operating a business in the petroleum, natural gas, and electricity industries are particularly susceptible to market risk-or more specifically, price risk -as a consequence of the extreme volatility of energy commodity prices. Derivative contracts transfer risk, especially price risk, to those who are able and willing to bear it. Derivatives have also been associated with some spectacular financial failures and with dubious financial reporting. Oil and gas companies place more emphasis on managing assets and streamlining business processes to maximize profitability. Although the price per barrel has increased dramatically, the industry is aware of the current high prices and due this the reserves in oil and money are being shored up. The challenge for Oil & Gas industry is to manage the political and other risks that are unavoidable in the industry with effective returns.
Risk management is a systematic way of protecting the organization's resources and income against losses so that the aims of the business can be achieved without interruption. It is the process of defining all the risks that an organization faces and building a framework to monitor, assess and mitigate those risks and to increase shareholder value. The point of risk management is not to eliminate it but to mitigate it.
Upstream projects today are getting larger and more complex. The attraction of upstream profits is also driving many companies to consider expanding their investments, moving from investor to operator, or entering into the space from adjacent energy sectors. Simultaneously, the graying of experienced project managers is reducing available capabilities. These factors combined increase the level of project-related risk within the sector. Unless a company follows a strategy of complete risk avoidance and stays solely within its national boundaries, it will be faced with the need to consider political risk when investing outside its home country. The challenge therefore is to manage the political and other risks that are unavoidable in the industry
1 Introduction
1.1 Risk analysis and its mitigation are vital to any organization, but risks are particularly of concern for companies operating within the upstream sector of the oil and gas industry. Even with the use of best seismic technology and geological expertise, exploration still presents considerable uncertainty. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. Extracting oil or gas demands greater investment, additional expertise, and greater exposure to possible liabilities and compliance requirements. International economic and political events increasingly affect all businesses yet such issues have long been concerns for oil and gas companies.
Operating a business in the petroleum, natural gas, and electricity industries are particularly susceptible to market risk-or more specifically, price risk -as a consequence of the extreme volatility of energy commodity prices. Derivative contracts transfer risk, especially price risk, to those who are able and willing to bear it. Derivatives have also been associated with some spectacular financial failures and with dubious financial reporting. Oil and gas companies place more emphasis on managing assets and streamlining business processes to maximize profitability. Although the price per barrel has increased dramatically, the industry is aware of the current high prices and due this the reserves in oil and money are being shored up. The challenge for Oil & Gas industry is to manage the political and other risks that are unavoidable in the industry with effective returns.
1.2 Risk & Uncertainty
Exploration and production of hydrocarbons is a high-risk venture. On one hand, geologic concepts are uncertain with respect to structure, reservoir seal, and hydrocarbon charge and on the other hand, economic evaluations contain uncertainties related to costs, probability of finding and producing economically viable reservoirs, and oil price. Even at the development and production stage the engineering parameters embody a high level of uncertainties in relation to their variables like infrastructure, production schedule, quality of oil, operational costs, reservoir characteristics, etc. These uncertainties originated from geological models and coupled with economic and engineering models involve high-risk decision scenarios, with no guarantee of successfully discovering and developing hydrocarbons.
The petroleum industry is a classic case of decision-making under uncertainty as it provides an ideal setting for the investigation of risk corporate behavior and its effects on the firm's performance. Comapnies continuously face important decisions regarding the allocation of scarce resources among investments that are characterized by substantial geological and financial risk and uncertainty. In the oil and gas sector, managers have started using decision-analytic techniques to help them in making these decisions. The wildcat drilling decision has long been a typical example for the application of decision analysis in classical textbooks.
The future trends in oil and gas resource availability depend largely on the balance between the outcome of the cost-increasing effects of depletion and the cost-reducing effects of the new technology. Based upon that scenario new forms of reservoirs exploitation and its management appear and decisions models are its important ingredients. Particularly, this trend is seen during the last two decades. The new internationally focused exploration and production strategies were driven in part by rapidly evolving new technologies. Technological advances allowed the exploration in well-established basins as well as in new frontier zones such as ultra-deep waters or the Antarctic region. The technology-driven international exploration and production strategies combined with new and unique strategic elements represent important components of a series of investment decisions.
Oil and gas exploration is a complicated open system that needs huge investment and long gestation period. There are many risk factors that could affect the system, and the relationship among these risk factors is very complex. Exploration of oil and gas is uncertain - which means:
that uncertainty is faced by geologists and geophysicists in analyzing the possibility of oil and gas reserve in a certain area
that there is uncertainty in the possibility of finding the oil and gas storage
that there is uncertainty whether the discovered oil and gas could be exploited economically is unknown.
Project Managers have to apply the knowledge of risk management and its mitigation to avoid or divert or reduce the risks or share them with other participants. The major risk analysis methods for oil and gas exploration include subjective probability method, three-phase risk assessment and Monte Carlo method, etc., but they suffer from some defects:
These methods cannot construct the whole frame of the researching problems as they were not able to combine the knowledge of decision-makers, exploration supervisors and technicians with exploration system analysis knowledge. They could not indicate the relations among stochastic factors in the exploration process. Thus, it is not convenient for system analyzers to communicate with decision makers and specialists, and amend the models according to new issues emerging during the system analysis process.
There are insurmountable difficulties for resolving correlation problems between risk factors. Some methods could simplify correlation problems to single problems, but this is actually based on assumptions. Only additive operation or multiplicative operation will occur between factors relative to total risks. The multiplicative factors are independent, and the additive factors are independent or linear correlation. Therefore, the results based on these assumptions will have some deflection.
These methods could not indicate the important influences of latent variables which are not included in the model studied or do not have a proper mathematical expression. Furthermore, while using traditional risk analysis methods, risk analysts are required to enumerate risk variables of the project and the relationship between them. However, a mass of deep-seated random variables which will affect risks are not included in the mathematical models, and they are only equivocally included in risk evaluation.
1.3 Risk analysis can be used as a powerful tool for some engineering processes where decision under uncertainty is involved. For drilling operations, a variety of applications have been developed even though are not being used extensively. Cowan stated that the two distinctive characteristics of oil and gas exploration are - high uncertainties involved and significant amount of capital expenditures. Thus, possible outcomes from reserves should be analyzed carefully and risk analysis and its mitigation should be implemented on exploration prospects to measure the effects of uncertainties on the financial outcome. Cowan proposed a risk analysis model that could be used to quantify the elements of risks associated with exploring and developing a hydrocarbon prospect. The model is able to handle five different phases of prospect operation.
The first being the 'exploration period', which incorporates the cost of the exploration studies in a given field. The second involves the analysis of wildcat drilling and analyzes the chance of finding hydrocarbon resources in a given location. If the chances of success in 'drilling the wildcat' are high, then the model accounts for the third phase, which is 'delineating the field'. Target rate and preliminary economic evaluation on development program are carried out in this stage of the model. Then, if the field has some potential value, the 'developing the field' and 'producing the field' are undertaken. These last two phases are analyzed based on increasing production, stable production and declining production cases.
Cowan pointed out the superiority of using probabilistic methods compared to single value estimates. Probabilistic solution method helps to display possible outcomes depending on variation of various input elements and uncertainties and allows a more realistic analysis. Newendorp pointed out that the awareness of industry on risk analysis increases with the increasing trend of the exploration activities towards smaller, harder to find traps, challenging environments and improved new technologies. There could be various ways for implementing risk analysis techniques for a drilling prospect and the paper aimed to classify them in five categories, Level 1 being the most basic one with two possible outcomes and Level 5 being the most comprehensive Monte Carlo simulation analysis. He suggested, based on the available data, using one of the five risk analysis models to analyze drilling prospects. He considered the first three models (Level 1, Level 2 and Level 3) as 'discrete-outcome models' while the latter two models (Level 4 and Level 5) are 'continuous-outcome models'. Initially, because of the lack of information, Level 1 can be used and one of two possible outcomes (hydrocarbons or no hydrocarbons) can be analyzed. When data becomes available, Level 2, which accounts for four possible outcomes, (three possible reserve values and no hydrocarbons), can be used. Level 3 provides six possible discrete outcomes; five being possible reserve values and one being no hydrocarbons.
According to Newendorp, to go beyond the five possible reserve outcomes, the model should be converted to a continuous outcome model so that the entire reserve distribution could be characterized. Level 4 is similar to Level 3 except by the fact that geology related probability distribution functions are determined using simulation and economic factors are obtained using deterministic methods. Finally, Level 5 is the most sophisticated model accounting for uncertainties in both geologic data and economic uncertainties. He stated that, depending on the risks accounted and uncertainties available, each level of risk analysis model provides valuable information in different stages of a drilling prospect analysis. He suggested using a higher level of risk analysis model as more data is obtained from the activities being implemented.
Another application aims to solve a common dilemma present in certain drilling operations. The author proposed a technique to determine whether the minimum cost while drilling is attained by:
drilling the hole further with the drilling fluid currently in the hole,
with weighted drilling fluid,
quitting drilling and setting the casing to that depth, or
even by abandoning the well if this is indicated due to safety and borehole integrity considerations.
Newendorp pointed out that, during actual drilling operation these four options are always available. If it is decided to drill further, then it is always possible to experience a kick or loss of circulation which depends on formation pressures. This risk analysis model stated that, since all the decisions are related to the formation pressure and other drilling parameters, expected costs will also be ultimately related to the same factor i.e. the formation pressure. Using a Monte Carlo simulation technique, Newendorp developed a way to evaluate the risks associated with the given set of drilling parameters. With the help of this technique, it would be possible to estimate quantitatively the cost of drilling further with existing mud, weighted mud, setting a casing, abandoning the well and sidetracking.
Exploration and Production (E&P) is the business of finding petroleum and getting it out of the ground. It is a risky business in that most exploration projects are total failures while some are highly successful. The best possible management of risk is crucial in such a scenario. In the 1930s and 1940s, the development of seismic data collection and analysis substantially reduced the risk in finding petroleum. The resulting geology and geophysics (G&G) revolutionized petroleum exploration. Decision analysis has traditionally been applied to the information derived from G&G to rank projects hole by hole, determining on an individual basis whether or not they should be explored and developed.
Risks can be defined in three ways:
Risk as Opportunity - "Any uncertain event that could significantly enhance or impede a company's ability to achieve its current or future objectives, including failure to capitalize on opportunities……". It means the possibility of good things not happening
Risk as Uncertainty - It is the potential that actual events will not equal anticipated outcomes
Risk as Hazard - The threat of bad things
In general there are two broad categories of risk
Systematic Risk - It influences a large number of assets. A significant political event, for example, could affect several of the assets in a portfolio. It is virtually impossible to protect against this type of risk.
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect from unsystematic risk.
1.4 Generally there are six general types of risk that are faced by all businesses:
1. Market risk - related to unexpected changes in interest rates, exchange rates, stock prices, or commodity prices,
2. Credit or Default risk - is the risk that a loss will be incurred if counter party does not fulfill its financial obligations in a timely manner.
3. Operational risk - related to equipment failure, fraud etc,
4. Liquidity risk - the inability to buy or sell commodities at quoted prices or the risk that the Bank may not be able to meet cash flow obligations within a stipulated timeframe etc.
5. Political risk - relates to new regulations, expropriation etc.
6. Foreign Exchange risk- relates to changes in exchange rates.
2 Risks in Oil and Gas Industry
2.1 Risks are inherent in every forward-looking business decision and there has been a great deal of work done and resources invested in risk management in the oil and gas industry in recent years. Financial and regulatory risks have been the focus of much of this effort. But more recently, companies have started including operational risks, prioritizing them and thinking about how they can manage and monitor all risks in a coordinated way. In collaboration with Oxford Analytical, Ernst & Young examined the strategic risks facing oil and gas companies. This study was a structured consultation with industry leaders and subject matter professionals from around the world. The risks highlighted by this study were:
1. Human Capital Deficit: The growing human capital deficit in the sector has become a significant strategic threat to the industry.
2. Worsening Fiscal Terms: This may be due to energy nationalism or purely the result of political opportunism and high prices. Tax regime changes can spur additional oil and gas industry restructuring.
3. Cost Controls: This threat is the inability to control costs. This threat was considered great enough to have a strategic impact, and a failure to manage the threat could undermine the competitiveness of oil and gas companies. Participants agreed that the problem extends from exploration all the way through the value chain, impacting everything from refinery build costs to pipeline construction.
4. Competition for Reserves: Competition for reserves by national oil companies (NOCs) is a major threat to international oil companies (IOCs).
5. Political Constraints: Estimates suggest that NOCs control majority of the proven global oil reserves, making these companies the gatekeepers of the world's oil and gas supplies. Unlike unexpected shocks, this has been well publicized in recent years. For the major IOCs, this could pose a greater strategic and competitive threat than that resulting from supply disruptions.
6. Uncertain Energy Policy: An increasing risk for the oil and gas industry is the uncertainty of energy policy. Energy policy goals should include security of supply and climate change considerations and commercial goals such as affordability and meeting demand growth.
7. Demand Shocks: Demand shocks could be triggered by a number of global economic crises. Economists now believe that systemic risks in finance have increased dramatically and one can expect greater international economic volatility.
8. Climate Concerns: Climate predictions are based on models and the scenarios communicated to the policy world are the scientifically conservative scenarios yet scientifically conservative scenarios may not happen. It is possible that the hazard is actually more imminent than is commonly understood.
9. Supply Shocks: Another risk for the industry is that of sudden and unexpected disruptions to global energy supplies. This is a major challenge which takes the form of extreme price volatility, global recession, ill-considered regulatory responses and potential competitive impacts on affected firms.
10. Energy Conservation: The energy intensities of developing countries are higher than in most of the Organization for Economic Cooperation and Development (OECD) countries. Thus, the scope for improving energy efficiency and switching away from oil is potentially very large. Energy conservation is considered as a powerful tool available to policymakers and often it is the most underexploited. The uncertainty is not so much one of policy failure but of policy success.
According to Ernst & Young in its annual report on the top 10 risks for the global oil and gas sector released in September 2011, access to reserves is currently the biggest risk for oil and gas companies. This is up one place from the 2010 report, replacing uncertain energy policy, which moved to number two. "While limits on access are not new, a combination of factors has pushed this to number one: political unrest in North Africa and the Middle East; high oil prices and the growth of new government-backed rivals." said Dale Nijoka, Global Oil & Gas Leader for Ernst & Young, in a press statement.
2.2 Risk Mitigation
Risk mitigation is a systematic way of protecting the organization's resources and income against losses so that the aims of the business can be achieved without interruption. It is the process of defining all the risks that an organization faces and builds a framework to monitor and mitigate those risks and to increase shareholder value. The concern for risk mitigation is not to eliminate it but to manage it. Organizations need to manage their risks because of the following reasons:
Uncertainty in Enterprise
Growing Complexity in Business Environment
Statutory Obligations
Contractual Obligations
Social Obligations
High Profile Corporate Failures
The risk management process consists of a series of steps that, when undertaken in sequence, enable continual improvement in decision-making. These are:
Communicate and consult - It aims to identify who should be involved in assessment of risk and includes identification, analysis and evaluation and treatment of risk. It should engage those who will be involved in the treatment, monitoring and review of risk.
Establish the context - When considering risk management within a small business, it is important to first establish some boundaries within which the risk management process will apply. It includes establishing the internal context, external context, risk management context, develop the risk area and define the structure for risk analysis. For example, the business owner may be only interested in identifying financial risks; as such the information collected will pertain only to that area of risk.
Identify the risk - The aim of risk identification is to identify possible risks that may affect, either negatively or positively, the objectives of the business and the activity under analysis. There are two main ways to identify risk - retrospectively or prospectively. Retrospective risks are those that have previously occurred, such as incidents or accidents.
Retrospective risk identification is often the most common way to identify risk, and the easiest. There are many sources of information about retrospective risk like hazard or incident logs or registers or audit reports, customer complaints, accreditation documents and reports, past staff or client surveys, newspapers or professional media, such as journals or websites.
Identifying prospective is difficult as it includes these are things that have not yet happened, but might happen sometime in the future. The rationale here is to record all significant risks and monitor or review the effectiveness of their control. Methods for identifying prospective risks include brainstorming with staff or external stakeholders, researching the economic, political, legislative and operating environment, conducting interviews with relevant people and/or organizations, undertaking surveys of staff or clients to identify anticipated issues or problems, flow charting a process, reviewing system design or preparing system analysis techniques.
SWOT analysis is an effective method for prospective risk identification to undertake a strengths, weaknesses, opportunities and threats analysis. A SWOT analysis is a tool commonly used in planning and is an excellent method for identifying areas of negative and positive risk at a business level.
Analyze the risks - During the risk identification step, a business owner may have identified many risks and it is often not possible to try to address all those identified. The risk analysis step will assist in determining which risks have a greater consequence or impact than others. This will assist in providing a better understanding of the possible impact of a risk, or the likelihood of it occurring. It involves combining the possible consequences, or impact, of an event, with the likelihood of that event occurring.
Evaluate the risks - The business owner must determine the level of risk that a business is willing to accept. Risk evaluation involves comparing the level of risk found during the analysis process with previously established risk criteria and deciding whether these risks require treatment. The result of a risk evaluation is a prioritized list of risks that require further action. This step is about deciding whether risks are acceptable or need treatment. Acceptable means the business chooses to 'accept' that the risk exists because the risk is at a low level and the cost of treating the risk will outweigh the benefit, or there is no reasonable treatment that can be implemented. This is also known as ALARP - as low as reasonably practicable.
Treat the risks: It involves considering options for treating risks that were not considered acceptable or tolerable. Risk treatment involves identifying options for treating or controlling risk in order to either reduce or eliminate negative consequences or to reduce the likelihood of an adverse occurrence. Risk treatment should also aim to enhance positive outcomes. A business owner should aim to choose, prioritize and implement the most appropriate combination of risk treatments.
7. Monitor and review: A business owner must monitor risks and review the effectiveness of the treatment plan, strategies and management system. Risks need to be monitored periodically to ensure changing circumstances do not alter the risk priorities. Very few risks will remain static, therefore the risk management process needs to be regularly repeated, so that new risks are captured in the process and effectively managed. A risk management plan at a business level should be reviewed at least on an annual basis. An effective way to ensure that this occurs is to combine risk planning or risk review with annual business planning.
2.3 Risk Analysis Implementation
Implementation of risk analysis involves three basic steps:
Identifying an opportunity (or event) where the tool can be applied,
Quantifying the consequences of various possible decisions and
Assessing, within the possible outcomes, the estimated best economic or operational result
The first step was considered the simplest part of the process as it is recognized that many are the decisions under uncertainty occur during well drilling operations. The second and third steps are more complex and involve issues related to data availability and reliability, cost analysis, probability determination and economic assessment.
A well cost estimation engineer who is involved in well planning and budgeting knows how sensitive this subject could be. A poorly prepared well budget or AFE (Authorization for Expenditure) will have effect on the company's internal functioning as well as in its relation with possible partners. The accounting department will rely on the recommendation from engineers to prepare the company's budget internally. From an external angle, partners will do the same and, only to a certain extent will allow deviation from the proposed AFE. Normally, in certain high-risk exploration ventures, it is very common for oil companies to look for partners to share the risks involved, potential losses and the possible gains.
Using risk analysis and risk mitigation for oil and gas investment decisions is a common procedure in all major oil companies. The use of decision methods along with risk analysis requires reliable database and a careful analysis of the possible outcomes. However, once the method is implemented, its use is simple and will provide great benefits for the company. The main problem with risk management in the industry is the lack of tool usage to help in the automation of the risk processes being used. Oil exhibits annualized price volatility of 40% to 50% per year, making it among the highest of any commodity. Deregulation and globalization of energy markets are bringing the need for active management of risks. The markets are becoming more price sensitive with the rapid dissemination of price and market information.
The need to automate risk management now exists out of competitive necessity. Fortunately, the effectiveness of available risk management tools is more established and the knowledge base wider. Growing commercial ties between Persian Gulf producers and Asian consumers seem inevitable, especially as the giant US market shifts away from the Middle East to a greater dependence on Latin American producers. The key issue is the growing Asia Pacific dependency on Middle Eastern sources of crude and the growing need for additional risk management instruments to be developed and utilized in the Asian markets. With about half of world oil growth projected to continue to be in the Asia Pacific region, rising product demand and tightening fuel quality standards driven by rising environmental awareness, the need for managing energy price risk seems poised for explosive growth over the next several years.
This has taken an inordinately long time to get started in the region compared to the North American and European experiences, particularly because of the more protectionist Asian economies. Sour crude barrels will come from Mexico and the United States. Moreover, product import dependency is also rising at an astounding rate. Changing markets and oil trade patterns presage rising price volatility. Deregulation is a market driver The most significant political driver of the market in Asia is the deregulation effort underway in the energy sector in most countries. This movement to freer competitive markets will mean that risk will increasingly be shifted to energy companies and away from government protection.
Petroleum storage requirements are another area affected by deregulation and are a growing area for risk management. Singapore, as an active regional transshipment center, has already undergone more storage capacity increases. Subic Bay in the Philippines is another strategic location. China, India, South Korea, and Thailand have all large-scale storage projects underway. These and other projects are an attempt to reduce the transshipment costs of Singapore facilities. Another reason is the need for strategic stockpiling of oil and products for energy security reasons, which is still a dominant part of the Asian energy puzzle.
While the Asia Pacific oil trade is still centered on security of supply rather than price risk management, the Asia Pacific markets are just beginning to emerge as the next opportunity for growth for the markets in energy. The highly publicized financial debacles in recent years, such as Enron, WorldCom, and others, have focused attention on risk management, creating more interest in hedging and the use of energy risk management tools. New risks need to be intelligently managed. Consequently, risk management is now a key management tool. Once considered a peripheral concept, effective risk management can be essential to achieving industry leadership.
In the Asia Pacific markets, there is actually less uncertainty than previously on the regulatory side as countries are making their deregulation plans known. Nonetheless, market, credit, and operational risks remain pervasive in the Asian markets. Most importantly, a company's risk tolerance must be identified, particularly since oil and gas and power are the most volatile commodities traded. The objective of using risk management tools is simply to achieve corporate goals. These goals can include lower fuel costs, securing market share, reducing earnings volatility or increasing margins. The key is reduction of risk, not risk elimination.
3 Conclusion
Upstream projects today are getting larger and more complex. The attraction of upstream profits is also driving many companies to consider expanding their investments, moving from investor to operator, or entering into the space from adjacent energy sectors. At the same time, the graying of experienced project managers is reducing available capabilities. These factors combined increase the level of project-related risk within the sector. Unless a company follows a strategy of complete risk avoidance and stays solely within its national boundaries, it will be faced with the need to consider political risk when investing outside its home country. The challenge therefore is to manage the political and other risks that are unavoidable in the industry.
How well these risks are analyzed and managed is the key to a project's success. Classic political risk in the form of expropriation and nationalization remains a threat, although it is not as prevalent as it once was. Political risk can be managed through insurance, strategic alliances and partnering, it can also be minimized, by taking some actions, which may seem obvious, but are too often ignored. Effective techniques include keeping a low profile, maintaining close relationships with the host government, anticipating change and working with it, avoiding geographical concentration, being a good corporate citizen and utilizing local suppliers and personnel to the greatest extent possible so as to create an economic link with the host country that establishes a national constituency with a stake in your continued political survival..
