Investment Risk – Oil and Gas Evaluations
Understanding proper oil and gas (“O&G”) investment risk analysis is at the core of a successful long-term investment strategy. Truthfully, this can be complicated and intimidating…and as boring as watching grass grow. So, what’s an investor to do?
Here is a macro look at the evaluation process and its importance in performing accurate risk analysis. But prior to jumping headfirst into this process, it is essential to understand two things. First, this assessment process is usually long, capital intensive, and the last analysis piece that includes many technical (engineering and geologic) and financial (accounting and modeling) assessment processes. Doing these accurately is how oil and gas companies prioritize and allocate funds, projects areas, and ongoing development of these assets. Second, no other industry has the varied exposure to so many different risk types that exist beyond just a single/simple economic evaluation of the assets only. Quantifying and understanding these risks are crucial…done right…can save an investor much heartache.
Risk Analysis: Capital Intensity
What makes O&G investments different from other industries is how capital intensive they generally are. Within the industry, capital intensity can also vary tremendously by asset type like onshore or offshore, exploratory, developmental, drilling, infrastructure, legacy well redevelopment, or processing facilities. Most have multiple asset types in each investment project. Because of this, O&G companies often rely on a multifaceted risk analysis to ensure the right projects get funded.
According to Deloitte, during the last decade the industry registered net negative free cash flows of $300 billion, impaired more than $450 billion of invested capital, and saw more than 190 bankruptcies. What gives?
Historically, oil and gas companies would diversify investment capital into multiple revenue streams and asset areas to offset market variations…while systematically and methodically developing and hi-grading those assets. But the US shale revolution and oil prices over $100/bbl, threw caution to the wind with massive capital inflows into the industry, prompting inaccurate and euphoric project evaluations, fueled by inexperienced investors as well as O&G industry professionals.
As the industry experienced the incoming and outgoing tides of commodity variations, Warren Buffets infamous saying became a reality…”Only when the tide goes out do you discover who’s been swimming naked.”
Risk Analysis: Quantifying Risk Types
Today, those remaining in the industry are reverting to time tested methods and strategies to evaluating projects and quantifying risk, but with a new ESG twist. Let us explore these different risk types.
A projects political risk can be impacted by federal, state, and local forces. Any change in government policies, regulations, taxes, permitting, and restrictions should promote a re-evaluation of economics, timing, and ultimately whether a project is worth doing at all. O&G companies should demonstrate an understanding and history of identifying these risks and ways of properly planning for them.
Environmental risk impacts include worker safety, local ecology, natural resources, and waste management. This must be factored into a projects risk analysis. Spills, worker incidents, accidents, property damage, and local water and habitat impacts are the biggest source of financial risk…second to none. Any prudent O&G assessment should involve a detailed review of these impacts, proper insurance coverages and detailed plans of compliance measures in each jurisdiction like spill response (SPCC plans) and regulatory certification (Tier II & Quad O). In the new age of ESG investing, methane emissions and flaring plans need to be disclosed and quantified.
Minimizing technical risks requires project teams to employ a diverse set of skills like Geologists, Engineers, Project Managers, Procurement Specialists, and Business Development. Each discipline requires a wide range of tools and data used to develop interpretations of existing features like faults and legacy production or create exploratory predictions of new assets using seismic or taking physical cores of the rock. This information is then used to estimate project costs, materials, and infrastructure necessary to implement and bring online a project’s hydrocarbon production potential.
Because the required O&G capital investment is so large, economic analysis on returns, capital & operating expenditures, and sensitivity analysis of oil and gas pricing needs to be highly understood and accurately modeled. This modeling is complex, can be highly subjective, and can yield a wide range of non-unique outputs depending on the experience and background of the modeler.
Evaluation Analysis: Modeling Risk
So, how can you verify your O&G investment is a good deal? O&G companies use a variety of ways to qualify their data to ensure their estimates are accurate including economic modeling and statistical sensitivity assessments.
With over 15 different inputs, economic forecasting and modeling is the foundation and most preferred approach to evaluating risk. However, each input can have accumulating effects to predicting returns and are subject to how aggressive or conservative a company’s mentality is. These inputs, over time, can also be escalated, held constant, or varied depending on these outlooks. Each input is built on real data sets, which they themselves need to be processed, qualified, and risked. A more aggressive company may treat one input set differently than another…which can lead to wide differences in project outcomes.
Running statistical sensitivity analysis takes economic models a step further by creating, quantifying, and testing risk parameters. This concept is applied to every aspect of the risk process, data, modeling, time value of money, cash flow, and ultimately quantifying the project uncertainties and full implications of each action a company makes.
Good investment decisions start with quantifying the risk types, understanding the modeling, and evaluating how aggressive or conservative a company applies and tests its project ideas. The complexity of O&G risk factors is intimidating but can be overcome by inquiring into each of these different facets of analysis. Having a team with the technical skill set and experiences to draw upon is essential to a profitable oil and gas investment.