Sandeep_dissertation Report on Risk Analysis in Oil and Gas Sector

A Dissertation Report

On

“RISK ANALYSIS IN OIL & GAS SECTOR: A SPECIAL FOCUS ON UPSTREAM” A Dissertation report submitted in partial fulfillment of the requirements for

MASTERS OF BUSINESS ADMINISTRATION (OIL & GAS MANAGEMENT) Of

UPES, DEHRADUN, UTTARAKHAND, INDIA By:

SANDEEP KUMAR

Roll No. R020207053 Under the Guidance of: Mr. Ambuj gupta ASSISTANT PROFESSOR, CMES

College of Management and Economics Studies University of Petroleum and Energy Studies Dehradun

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CERTIFICATE This is to certify that the dissertation report on “Risk Analysis in Oil & Gas Sector: A Special Focus on Upstream” completed and submitted by Sandeep Kumar in partial fulfillment of the requirements for the award of degree of Masters of Business Administration (Oil and Gas Management), is a bonafide work carried out by him under my supervision and guidance. To the best of my knowledge and belief the work has been based on investigation made, data collected and analyzed by him and this work has not been submitted anywhere else for any other University or Institution for the award of any degree/diploma.

Mr. Ambuj Gupta Assistant Professor CMES, UPES Dehradun

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DECLARATION

This dissertation report is entirely my own work. It has not been submitted in any previous application for a degree. All quotations in the report have been distinguished by quotation marks, and the sources of information specifically acknowledged.

Signed: Sandeep Kumar MBA (Oil and Gas Management) CMES, Dehradun

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ACKNOWLEDGEMENT Action springs not from thought, but from a readiness for responsibility.

I would like to express my deep gratitude to Mr. Ambuj Gupta and for engaging me in different responsibilities and guiding all through the project. Special thanks to Dr. Shalinder Pokhriyal for providing me with this opportunity to work in this project.

I also take this opportunity in expressing my sincere gratitude to my friends and class fellows for their opinions and maintaining a cordial and helping environment. I hope with all your best wishes and blessings i deliver my best to any responsibility assigned.

I would thank you from the bottom of my heart, but for you all my heart has no bottom

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Table of Contents Topic 1. 2. 3. 4.

Page No.

Introduction Literature Review A New Era in Petroleum Exploration and Production Management Risk And Uncertainty 4.1 Risk and uncertainity Defined 4.2 Types Of Risks 4.3 What is Credit Risk? 4.4 What is Liquidity Risk? 4.5 What is Operational Risk? 4.6 What is Political Risk? 4.7 What is Market Risk? 4.8 Foreign Exchange Risk and Risk Management

5. Top Ten Risks in Oil and Gas Industry 6. Risks in Exploration & Production Projects in Oil and Gas Industry 6.1 Risk Analysis: Exploration 6.2 Risk Analysis: Field Appraisal and Development 6.3 Decision Making Process, Value of Information and Flexibility 6.4 Portfolio Management and the Real Options Valuations 7. Risk Management

01 03 08 09 10 11 11 11 12 12 13 13 14

19 19 21 22 23 25

7.1 Need for Risk Management 7.2 The Risk Management Process 7.3 Types Of Risk Management

25 25 36

8. Investment Decision in Oil and Gas Projects Using Real Option and Risk Tolerance Models 8.1 Introduction 8.2 The integrated model 8.21 NPV of the project’s cash flow 8.22 Optimal working interest (W) 8.3 Analysis of a capital-intensive project 8.31 Estimation of the risk of the project 8.32 The optimal rule of investment (F, K, V*) 8.33 The optimal working interest in the project (W) 8.4 Discussions and implications

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38 40 40 40 44 45 50 52

9.

Use and Implementation of Risk Analysis 9.1 Example of Application - Well Cost Estimation 9.2 Analysis of Results 9.3 Conclusions and Final Remarks

55 55 56 56

10. Risk assessment & management crucial to thrive amidst uncertainty (Upstream Focus)

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11. Conclusion

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12. Bibliography

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List of Figures 1. 2. 3. 4. 5. 6. 7. 8.

Market Risk – The viewpoint of Three participants Threats: Oil And Gas Industry Risk Management Process Stakeholders In Small Business Cumulative Frequency Of The NPV And Project’s Risk Level Sensitivity Of NPV, F And K To Project Current Value Sensitivity Of RAV To Optimal Working Interest (W) Sensitivity of rav to optimal working interest: different values of Corporation’s tolerance 9. Cumulative Distribution for AFE

13 15 26 27 46 49 51 51 56

List of Tables 1. 2. 3. 4. 5. 6. 7. 8. 9.

Risk and uncertainity Defined Examples of risk criteria for a project in small business Effects of diversification on portfolio risk and return level Analogy of the determinants of financial and real-option pricing models Geological, technical and economic characteristics of the project Inputs of decision-making based on real-options models Results from the two valuation and decision models Authorization for Expenditure Range of Costs

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10 30 41 44 45 47 53 57 58

PREFACE Assessing and managing risks are essential functions for any organization, but they are particularly vital concerns for companies operating within the upstream sector of the oil and gas industry. Even with the best seismic technology and geological expertise, exploration presents considerable uncertainty. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. Extracting that oil or gas demands greater investment, additional expertise, and greater exposure to possible liabilities and compliance requirements. While international economic and political events increasingly affect all businesses, such issues have long been concerns for oil and gas companies. There are five general types of risk that are faced by all businesses: market risk (unexpected changes in interest rates, exchange rates, stock prices, or commodity prices), credit/default risk; operational risk (equipment failure, fraud); liquidity risk (inability to buy or sell commodities at quoted prices); and political risk (new regulations, expropriation). Businesses operating 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. How they transfer risk is complicated and frequently misinterpreted. Derivatives have also been associated with some spectacular financial failures and with dubious financial reporting. The Forex market behaves differently from other markets! The speed, volatility, and enormous size of the Forex market are unlike anything else in the financial world. Today, Asian oil and gas companies are placing more emphasis on managing assets and streamlining business processes to maximize profitability. Although the price per barrel has increased dramatically in recent months, the industry remembers the downtimes in the ‘90s and is wary of the current high prices. Because of this, 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.

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Chapter 01 INTRODUCTION Introduction Exploration and production of hydrocarbons is a high-risk venture. Geologic concepts are uncertain with respect to structure, reservoir seal, and hydrocarbon charge. 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 critical variables (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. Corporate managers continuously face important decisions regarding the allocation of scarce resources among investments that are characterized by substantial geological and financial risk and uncertainty. For instance, in the petroleum industry, managers are increasingly using decisionanalytic techniques to aid in making these decisions. In this sense, the petroleum industry is a classic case of decision-making under uncertainty; it provides an ideal setting for the investigation of risk corporate behavior and its effects on the firm’s performance. The wildcat drilling decision has long been a typical example for the application of decision analysis in classical textbooks. The future trends in oil resources availability will 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 managing will appear where the contributions of risk and decisions models are one of important ingredients. This trend can be seen in 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. Those technology-driven international exploration and production strategies combined with new and unique strategic elements where risk analysis and decision models represent important components of a series of investment decisions. In this sense, this introduction covers a brief review of previous applications involving the following topics: (1) Risk and Decision Analysis in Petroleum Exploration; (2) Field Appraisal and Development, and Production Forecast under Uncertainty, (3) Decision Making Process and Value of Information and (4) Portfolio Management and Valuations Options Approach. This introduction describes some of the main trends and challenges and presents a discussion of methodologies that affect the present level of risk applications in the petroleum industry aimed at improving the decision-making process.

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Oil and gas exploration is a complicated open system that needs high investment and long running term. There are many risk factors that could affect the system, and the relationship among these factors are very complex, so oil and gas exploration is an uncertain process that means: (1)Geologist and geophysicist have to analyze the possibility of oil and gas reserve in a certain area. (2)The possibility of finding the oil and gas storage must be determined. (3)Whether the discovered oil and gas could be exploited economically is unknown. Therefore, by applying the knowledge of risk management, project managers could avoid, divert and reduce the risks, or share them with other participants. Now the major risk analysis methods for oil and gas exploration are include subjective probability method, three-phase risk assessment and Monte Carlo method, etc., but they have following defects: (1)These methods cannot construct the whole frame of the researching problems. They could not combine the knowledge of decision-makers, exploration supervisors and technicians with exploration system analysis knowledge; they could not dig out geological, project and economic factors relative to the whole exploration process which includes oil and gas storage evaluation, exploitation evaluation, project evaluation and economy evaluation; they could not indicate the relations among stochastic factors in the exploration process. So 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. (2)There will be 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. (3)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, when 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.

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Chapter 02 LITERATURE REVIEW Risk analysis is a very powerful tool for certain engineering processes where decision under uncertainty is involved. Specifically for oil well operations, a number of articles have been presented illustrating how risk analysis methods can be used to maximize the possibility of adopting, for a certain operation, the correct decision. For drilling operations, even though not extensively used, a variety of applications have been developed. In this section a review of those important applications is presented. Newendorp and Root2 conducted a pioneer study on the possibility of using risk analysis methods while deciding on drilling investments, which involves a dedication of significant amount of capital under highly uncertain conditions. Authors suggested that, instead of reaching decisions qualitatively under the influence of subjective observations in a personal and intuitive process, a decision theory technique could be used making possible to asses and estimate the risks associated with drilling investments, quantitatively. Since risks associated in drilling investments contain uncertainties due to geological and engineering factors that affect profitability of investment, it is wiser to estimate range and distribution of possible outcomes of a drilling investment to investigate the profitability of a prospect. Authors stated that the method would minimize subjective decisions and conclusions for a drilling investment project. With the use of the method, effects of unlimited number of variables on drilling prospects can be analyzed, sensitivity analysis can be conducted and variables highly affecting the profitability could be isolated and better analyzed. The proposed method is much more sophisticated, objective and precise for assessment of drilling prospects than the type of qualitative analysis commonly used by the time of publication of the article. Even though the article did not deal specifically with any particular drilling process or operation, it presented a method to handle uncertainties that clearly could be extrapolated for situations faced regularly on ordinary well operations. Risk analysis can clearly examine various possible outcomes and compare different options for investment with different levels of risk and uncertainties. Cowan stated that the two distinctive characteristics of oil and gas exploration are high uncertainties involved and significant amount of capital expenditures. For that reason, possible outcomes from reserves should be analyzed carefully and risk analysis 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. Again, this article was not specifically aimed at 3

drilling operations, but certainly pointed out some directions that would be used later on drilling engineering problems. The proposed model combined probabilistic geological, engineering and economic data to produce possible distribution functions related to potential outcomes of exploiting new reserves. The model is able to handle five different phases of prospect operation. First of these phases is the “exploration period” which incorporates the cost of the exploration studies in a given field. Following, comes the second phase which involves the analysis of wildcat drilling and analyzes the chance of finding hydrocarbon resources in a given location. If the chance of success in “drilling the wildcat” is 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, phases 4 and 5 are applied. These phases are “developing the field” and “producing the field”, respectively. 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 enables to display possible outcomes depending on variation of various input elements and uncertainties and allows 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 are many different 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. Based on the available data, he suggested 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, due to lack of information, Level 1 can be used and one of two possible outcomes (hydrocarbons or no hydrocarbons) can be analyzed. As more data becomes available, Level 2 which accounts for four possible outcomes (three possible reserve values and no hydrocarbons) can be used. Level 3 provide six possible discrete outcomes; five being possible reserve values and one being no hydrocarbons. Newendorp stated that to go beyond 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. The author 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. 4

Another very interesting application, this one directed to a much common dilemma present in certain drilling operations. The author proposed a technique to determine whether the minimum cost while drilling is attained by (1) drilling the hole further with the drilling fluid currently in the hole, (2) with weighted drilling fluid, (3) quitting drilling and setting the casing to that depth or (4) even by abandoning the well if this is the most indicated due to safety and borehole integrity considerations. He pointed out that, during actual drilling operation these four options are always available. In the case that it is decided to drill further, then it is always possible to experience a kick or loss of circulation depending 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 (the formation pressure.) Using a Monte Carlo simulation technique, the author developed a way to evaluate the risks associated with the given set of drilling parameters. Using the 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. It should be noted that, the risk analysis model developed is very sensitive to cost distribution of the intractable kick and degree of uncertainty in formation pressure. For that reason, these two variables should be accounted accurately in order to estimate precisely the expected mean value, or loss, (EMV) of different drilling situations. Ostebo et al.6 presented a study on an area where qualitative and quantitative risk assessment can be implemented to a great extend. After the Piper Alpha accident, Norway and UK issued new regulations in which risk analysis has great importance. Knowing that offshore operations have potential safety and operational problems and after experiencing the Piper Alpha accident, neither the countries nor the companies would risk having another similar experience. As a result of that, risk analysis became a very useful tool in the process of decision making to enhance platform layout, operational procedures and orderliness together with safety and cost. Authors analyzed the regulations issued by the Norwegian Petroleum Directorate (NPD), to promote use of risk analysis techniques in offshore operations. They have defined and explained the Concept Safety Evaluation (CSE), which is a method of quantified risk analysis. CSE is being applied to all production platform design in Norway and its main goals are to determine areas where problems might occur and evaluate those areas to reduce the possibility of accidents. In addition, the authors showed different ways of applying risk analysis in the areas of reliability and availability analysis, safety management techniques and human and organizational factors during offshore operations. Ottesen et al.7 developed a new wellbore stability analysis method, which combines a classical mechanical wellbore stability model with viability operational limits, for example, hydraulics necessary to allow efficient cuttings transport in highly deviated wells. Those limits are determined by quantitative risk analysis (QRA) principles. The authors have defined the limits for failure and success and generated a limit state function to create a link between classical wellbore stability model and operational failure. The proposed wellbore stability analysis method is not only capable of quantifying the risks associated with the operational failure but also enables the engineer to choose the appropriate mud density to avoid wellbore instability problems. 5

Liang8 presented a method to determine pore pressure and fracture gradient using quantitative risk analysis (QRA). It was stated on this study that it is possible to approximate the probabilistic distribution of pore pressure, equivalent mud weight and fracture gradient using Gaussian distribution, which would be possible due to the randomness of the statistical ranges of those parameters at any given depth. By using probabilistic distribution functions for pore pressure, fracture gradient and equivalent mud weight, risks associated with taking a kick or loss-return can be analyzed quantitatively. QRA methods presented in the paper makes possible to identify risks associated to having a kick or circulation loss. Such risks can be minimized or controlled by changing some of the drilling parameters such as mud weight, mud rheological properties, flow rate, tripping speed, penetration rate, etc. In addition, more realistic information for casing design and more accurate selection of casing shoe depth is attained using pore pressures and fracture gradients calculated with QRA approach. McIntosh9 emphasized the need for use of probabilistic methods to manage well construction performances effectively under challenging conditions where uncertainties exist all the time. As more exploration activities are taking place in increasingly hostile areas such as deeper waters and remote locations, risks and uncertainties associated with the operations are also escalating and operators should look for more reliable and cost-effective models for oil well drilling activities. Compared to deterministic models, probabilistic modeling/processing does not only take into account the planned order of events, but also accounts for unplanned/undesired events. By doing so, operators are able to manage most critical and unexpected events, and “nonproductive time” decreases effectively. It is also possible to model the applicability of new technology and compare the possible outcome of new technologies with the conventional methods for a given project. It is recommended to build a probabilistic model at the early stages of the operation and evolve the model continuously as more data is obtained from successive operations. As a result of that, actual events in well-construction operations are described more precisely, numbers of unexpected events are decreased and consequently better development/execution can be achieved. With the increasing use of risk analysis to analyze problems closely related to drilling operations, more specific applications started to be developed. Thorogood et al.10 presented a riskanalysis based solution to the subsurface well collisions problem. The method included a mathematical analysis of the probability of collision combined with a decision tree to describe the consequences. The results of the collision risk analysis can be compared with the predefined limits on the probabilities of the various outcomes, which depend on the assessment of the tolerable risk. For daily use, the drilling engineers can plan their well operations with a flow chart of the directional-drilling procedures. Clearly defined levels of risk can be properly established.

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Virine and Rapley11 presented a practical approach to use risk analysis toolsets in economic evaluation applications for the oil and gas industry. They described the integration of decision and risk analysis tools with economic engineering application. This chapter emphasized the importance of data input as well as analysis result. An example case was presented. Alexander and Lohr12 summarized seven essential elements for a successful risk analysis project. They emphasized that the commitment and endorsement from both management and technical teams are essential to the risk analysis progress. A good risk analysis process is always supported by well prepared guidelines, adaptable evaluation software, good understanding of dependency between variables and the proper result interpretation. Even though risk analysis can not replace professional judgment, it can improve the evaluation and help to reach the correct decision. Coopersmith et al.13 described applications of decision-tree analysis in the oil and gas industry through a case study where a deepwater production system was analyzed. After defining some parameters of the project, such as reservoir size, production rates, number of wells and drilling schedule, the high-level decision trees were constructed for two different designs. Through the comparison of final NPV calculations of both designs under consideration the one with the best result could be chosen. For the case presented the key uncertainty was the reservoir size and the most important factor influencing the investment payback was the development timing steps. Using decision tree analysis, the oil company could analyze the range of possible outcomes.

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Chapter 03 A NEW ERA IN PETROLEUM EXPLORATION AND PRODUCTION MANAGEMENT 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 a few are tremendously successful. Thus the best possible management of risk is crucial. In the 1930’s and 1940’, 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. Today this “ole-istic”approach is being challenged by a holistic one that takes into account the entire portfolio of potential projects as well as current holdings. This portfolio analysis starts with representations of the local uncertainties of the individual projects provided by the science and technology of G&G. It then takes into account global uncertainties by adding two additional G’ : geo-economics and geo-politics. It thereby reduces risks associated with price fluctuations and political events in addition to the physical risks addressed by traditional G&G analysis. The holistic approach is based on but not identical to the Nobel-prize winning portfolio theory that has shaped the financial markets over the past four decades. Portfolio thinking in petroleum E&P is based on understanding and exploiting the interplay among both existing and potential projects. It does not provide all the answers, but encourages E&P decision-makers to ask the right questions, such as: • • • • •

If we want a long-term expected return of, say, 15% on our investment, how can we insure against a cash flow shortfall over the first three years while minimizing our long-term risk? What should we pay for a new project, given the projects already in our portfolio? How would oil projects, as contrasted from gas projects, affect the impact of price uncertainty on my portfolio? What projects should we be seeking to reduce the effects of political instability in a given part of the world? What are the effects on financial risk and return if we insist on a minimum of, say, 40% ownership of any project?

As we shall see, analytical models can help in directly addressing these and similar questions once decision-makers in the petroleum industry become comfortable with the holistic perspective.

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Chapter 04 RISK AND UNCERTAINITY “Any uncertain event that could significantly enhance or impede a Company’s ability to achieve it’s current or future objectives, including failure to capitalize on opportunities……” The possibility of good things not happening (risk as opportunity) The potential that actual events will not equal anticipated outcomes (risk as uncertainty) The threat of bad things (risk as hazard)

4.1) Table 4.1 shows the definitions of risk and uncertainity as given by different authors

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Table 4.1: Risk and uncertainity Defined

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4.2) TYPES OF RISKS: In general there are TWO broad categories of risk Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself 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 yourself from unsystematic risk. (We will discuss diversification later in this tutorial). specific types of risk that are faced by all businesses….. 1. 2. 3. 4. 5. 6.

Credit risk Liquidity risk Operational risk Market risk Political risk Foreign exchange risk

4.3) CREDIT RISK: Credit Risk is the risk that a loss will be incurred if counterparty does not fulfil its financial obligations in a timely manner. This is one of the most critical aspects of business. 4.4) LIQUIDITY RISK It is the risk that the Bank may not be able to meet cash flow obligations within a stipulated timeframe. The purpose of the Bank’s liquidity risk management is to maintain suitable and sufficient funds to meet present and future liquidity obligations whilst utilizing the funds appropriately to take advantage of market opportunities as they arise. Liquidity Risk - Factors. Liquidity risk factors include competition among commercial banks for larger market share in deposits, an unstable or potentially violent domestic political situation, the fluctuation of the Rupee-Dollar, and implementation of government policies which may affect capital movements in and out of India.

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OPERATIONAL RISK 4.5) Operational Risk is the risk of potential losses from a breakdown in internal processes and systems, human error, or management or operational failure arising from external causes. The objective of the operational risk management framework is to ensure that the Bank has in place appropriate policies, processes and procedures, and gathers relevant information relating to operational risks so as to avoid operational failures and minimize relevant losses; while enabling the Bank to quickly respond to and pursue new business opportunities under appropriate risk controls and monitoring. Operational Risk - Factors. Significant operational risk factors include: • Operational processes which may have flaws or weak control systems. • Inadequate staffing which may make it difficult for staff to perform their work effectively and efficiently. • Technological developments which may affect the security of Bank data or information held on behalf of customers. • Malfunctions in information processing systems. • Potential fraud by outsiders in terms of robbery, cheating, computer hacking, document falsification, credit and debit cards fraud, etc. • Catastrophic events. 4.6) POLITICAL RISK The likelihood that political forces will cause drastic changes in a country's business environment that will adversely affect the profit and other goals of a particular business enterprise. In general, there are two types of political risk, macro risk and micro risk. Macro risk refers to adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas micro risk refers to adverse actions that will only affect a certain industrial sector or business, such as corruption and prejudicial actions against companies from foreign countries. All in all, regardless of the type of political risk that a multinational corporation faces, companies usually will end up losing a lot of money if they are unprepared for these adverse situations.

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4.7) MARKET RISK Market Risk is the potential loss in value in a security from changes in market factors such as interest rates, foreign currency value, and/or prices of commodities and equities.

Fig. 4.7. market risk

4.8) FOREIGN EXCHANGE RISK AND RISK MANAGEMENT Crude oil prices are generally set in US dollars, while sales of refined products may be in a variety of currencies. Fluctuations in exchange rates can therefore give rise to foreign exchange exposures, with a consequent impact on underlying costs.

Currency Risk Management Currency risk arises because the value of the Indian Rupee or any domestic currency fluctuates due to the market forces of supply and demand.

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Chapter 05 TOP TEN RISKS IN OIL AND GAS INDUSTRY

Risks are inherent in every forward-looking business decision. As a result, 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 not a random selection exercise but rather a structured consultation with industry leaders and subject matter professionals from around the world. What follows are the top 10 identified strategic risks for oil and gas companies.

1. Human Capital Deficit

The growing human capital deficit in the sector has become a significant strategic threat to the industry. One study participant set out the issue: “The ability of the oil and gas services sector to expand sufficiently to meet future demand growth is questionable, not least in terms of staff. Project delays and abandonment are as much a result of capacity constraints as financial calculations, although the two are intimately linked.”

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Fig 5.1 threats: oil and gas industry

2. Worsening Fiscal Terms Worsening fiscal terms are seen as a high risk. In some cases, this is due to energy nationalism, although in others it is purely the result of political opportunism and high prices. Tax regime changes can spur additional oil and gas industry restructuring in countries such as Canada, Venezuela, Russia, and Algeria. The impact of political opportunism and high prices is a device that has been seen in both the developing and non developing world.

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3. Cost Controls The third operational 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. The Upstream Capital Costs Index, which measures cost inflation in oil and gas projects, has gone up by 79% since 2000, with most of that increase coming since May 2005. 4. Competition for Reserves Competition for reserves by national oil companies (NOCs) is a major threat to international oil companies (IOCs). Again, the problem is one of strategy: “Western IOCs will find it hard to compete as deals are struck not through bidding or tenders but at a state-to-state level, bundled with development aid, for example,” wrote one study participant. This observation follows evidence of such deals in the market. 5. Political Constraints on Access to Reserves Recent estimates suggest that NOCs control 75% of proven global 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. This was defined by one participant: “Energy policy goals include security of supply and climate change considerations, as well as more commercial goals such as affordability and meeting demand growth. The noncommercial goals will shape policy and result in increasing intervention in the market in areas such as carbon pricing, strategic reserve requirements, and subsidization of favored sources of energy.” Another participant, a Harvard University-based economist, contended, “Social value regulation in the form of measures designed to reduce risk and achieve health, safety, and environmental goals can lead to a regulatory regime that ignores cost/benefit analysis to the detriment of business.” 7. Demand Shocks Demand shocks could be triggered by a number of global economic crises. A global financial meltdown emerging from derivatives and hedge funds was the threat rated highest by the economists who participated in the study. One comment, that echoed a frequently made observation, was that “credit disintermediation has replaced international banking as a finance source with a range of specialized credit instruments held widely with risk exposures that 16

regulators find it difficult to assess.” Several economists believed systemic risks in finance have increased dramatically and, consequently, it would be prudent to expect greater international economic volatility. A global recession could also be triggered by an energy supply disruption. “A [price] spike, especially if it lasted for a few months, could plunge the global economy into severe recession,” wrote one analyst. Another participant highlighted how further social or political threats could contribute to a demand shock. “China’s sustained expansion in recent years has underpinned robust world growth but is producing tensions both internally and externally. An event that throws the country off track would have a big impact on expectations of future oil and gas demand growth.” 8. Climate Concerns Our oil and gas panel may have been encouraged to rank the rise of climate change concern as a significant risk by the sobering comments of one of our subject matter experts, a specialist in science and international affairs: “[Current] climate predictions are based on models and, naturally, the scenarios communicated to the policy world are the scientifically conservative scenarios [i.e., the ones that most scientists agree are likely]. Yet, scientifically conservative scenarios are not necessarily what will happen; it is possible that the hazard is actually more imminent than is commonly understood. In this case, we may see physical climate surprises, as well as an increased policy response that is more abrupt than most firms are currently planning for.” 9. Supply Shocks Another risk for the industry is that of sudden and unexpected disruptions to global energy supplies. While our participants did not agree on what the most likely cause of such a shock would be, they did agree that unexpected shocks could pose a severe challenge. Possible consequences include extreme price volatility, global recession, and ill-considered regulatory responses, as well as potential competitive impacts on affected firms. 10. Energy Conservation Not unexpectedly, the group voted for the possible success of energy conservation as the number 10 risk. Perhaps this ranking was swayed by the opinions of one of the subject matter experts, an energy economist, who wrote, “The energy intensities of developing countries are very much higher than in most of the Organization for Economic Cooperation and Development (OECD) countries. Thus the scope for improved energy efficiency and indeed switching away from oil is potentially very large.” An oil and gas analyst appeared to agree, noting that, “The most powerful tool available to policymakers is energy conservation and it is the most under exploited. While there are no ‘silver bullets,’ energy conservation comes close. The uncertainty is not so much one of policy failure but of policy success.”

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It is important to note that this is only a snapshot and risks are subject to change at any time. These are not predictions, but considering them can help companies to prepare. Working through scenarios and impact studies can result in opportunities to tighten processes and controls, leading to dialogue and action plans that deliver value.

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Chapter 06 RISKS IN EXPLORATION & PRODUCTION PROJECTS IN OIL AND GAS INDUSTRY 6.1) Risk Analysis: Exploration The historical origins of decision analysis can be partially traced to mathematical studies of probabilities in the 17th and 18th centuries by Pascal, Laplace, and Bernoulli. However, the applications of these concepts in business and general management appeared only after the Second World War (Covello and Mumpower, 1985; Bernstein, 1996). The problem involving decision-making under conditions of risk and uncertainty has been notorious from the beginnings of the oil industry. Early attempts to define risk were informal. The study by Allais (1956) on the economic feasibility of exploring the Algerian Sahara is a classic example because it is the first study in which the economics and risk of exploration were formally analyzed through the use of the probability theory and an the explicit modeling of the sequential stages of exploration. Allais was a French economist who was awarded the Nobel Prize in Economics in 1988 for his development of principles to guide efficient pricing and resource allocation in large monopolistic enterprises. Allais´s work was a useful mean to demonstrate Monte Carlo methods of computer simulation and how they might have been used to perform complex probability analysis had they been available at that time instead of the simplifications for risk estimation of large areas. During this period, there were several attempts to define resource level probabilities at various stages of exploration in a basin using resources distribution and risk analysis (Kaufman, 1963; Krumbein and Graybill, 1965; Drew, 1967; Harbaugh et al., 1977; Harris, 1984, Harbaugh, 1984; Harris 1990). At that time governmental agencies were also beginning to employ risk analysis in periodic appraisals of the oil and gas resources. During the 1980´s and 1990´s, new statistical methods were applied using several risk estimation techniques such as: (1) lognormal risk resources distribution (Attanasi and Drew, 1985), (2) Pareto distribution applied to petroleum field-size data in a play (Crovelli, 1995) and (3) fractal normal percentage (Crovelli et al., 1997). During the 1960´s, the concepts of risk analysis methods were more restricted to the academia and were quite new to the petroleum industry when appear the contributions of Grayson (1960), Arps and Arps (1974), Newendorp (1975, edited as Newendorp and Schuyler, 2000) and Megill (1977). During this period Newendorp emphasized that decision analysis does not eliminate or reduce risk and will not replace professional judgment of geoscientists, engineers, and managers. Thus, one objective of the decision analysis methods, as it will be discussed later in this paper, is

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to provide a strategy to minimize the exposure of petroleum projects to risk and uncertainty in petroleum exploration ventures.

The Utility Theory provides a basis for constructing a utility function that can be employed to model risk preferences of the decision maker. If companies make their decisions rationally and consistently, then their implied risk behaviors can be described by the parameters of a utility function. Despite Bernoulli’s attempt in the 18th century to quantify an individual’s financial preferences, the parameters of the utility function were formalized only 300 hundred years later by von Neumann and Morgenstern (1953) in modern utility theory. This seminal work resulted in a theory specifying how rational individuals should make decisions under uncertainty. The theory includes a set of axioms of rationality that form the theoretical basis of decision analysis and descriptions of this full set of axioms and detailed explications of decision theory are found in Savage (1954), Pratt (1964); and Schailfer (1969). Cozzolino (1977) used an exponential utility function in petroleum exploration to express the certainty equivalent that is equal to the expected value less a risk discount, known as the risk premium. Acceptance of the exponential form of risk aversion leads to the characterization of risk preference (risk aversion coefficient), which measures the curvature of the utility function. Lerche and MacKay (1999) showed a more comprehensible form of risk tolerance that could intuitively be seen as the threshold value whose anticipated loss is unacceptable to the decision maker or to the corporation.

An important contribution that provides rich insight into the effects of integrating corporate objectives and risk policy into the investment choices was made by Walls (1995) for large oil and gas companies using the multi-attribute utility methodology (MAUT). Walls and Dyer (1996) employed the MAUT approach to investigate changes in corporate risk propensity with respect to changes in firm size in the petroleum industry. Nepomuceno et al. (1999) and Suslick and Furtado (2001) applied the MAUT models to measure technological progress, environmental constraints as well as the financial performance associated with exploration and production projects located in deep waters.

More recently, several contributions devise petroleum explorations consisting of a series of investment decisions on whether to acquire additional technical data or additional petroleum assets (Rose, 1987). Based upon these premises the exploration could be seen as a series of investment decisions made under decreasing uncertainty where every exploration decision involves considerations of both risk and uncertainty (Rose, 1992). These aspects lead to a substantial variation in what is meant by risk and uncertainty. For example, Megil (1977) considered risk an opportunity for loss. Risk considerations involve size of investment with regard to budget, potential gain or loss, and probability of outcome. Uncertainty refers to the range of probabilities that some conditions may exist or occur.

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Rose pointed out that each decision should allow a progressively clearer perception of project risk and exploration performance that can be improved through a constructive analysis of geotechnical predictions, review of exploration tactics versus declared strategy, and year-year comparison of exploration performance parameters. These findings showed the importance of assessing the risk behavior among firms and managerial risk attitudes. Continued monitoring of the firm’s level of risk aversion is necessary due to a changing corporate and industry environment as well as the enormous contribution generated by the technological development in E&P. Over any given budgetary period, utilization of an established risk aversion level will result in consistent and improved decision making with respect to risk.

6.2) Risk Analysis: Field Appraisal and Development During the exploration phase, major uncertainties are related to volumes in place and economics. As the level of information increases, these uncertainties are mitigated and consequently the importance of the uncertainties related to the recovery factor increases. The situation is more critical in offshore fields and for heavy-oil reservoirs. In the preparation of development plans, field management decisions are complex issues because of (1) number and type of decisions, (2) great effort required to predict production with the necessary accuracy and (3) dependency of the production strategy definition with the several types of uncertainty with significant impact on risk quantification. In order to avoid excessive computation effort, some simplifications are always necessary. The key point is to define the simplifications and assumptions that can be made to improve performance without significant precision loss. Simplifications are possible, for instance, in the modeling tool, treatment of attributes and in the way several types of uncertainties are integrated. One of the simplest approaches is to work with the recovery factor (RF) that can be obtained from analytical procedures, empirical correlations or previous simulation runs, as presented by Salomão (2001). When higher precision is necessary, or when the rate of recovery affects the economic evaluation of the field, using just the recovery factor may not be sufficient. Techniques such as experimental design, response surface methods and proxy models were used by several authors (Dejean, 1999) in order to accelerate the process. Another possible approach is to use faster models such as streamline simulation as proposed by Hastings et al. (2001), Ballin et al. (1993), Subbey and Christie (2003) . The integration of risk analysis with production strategy definition is one of the most time consuming tasks because several alternatives are possible and restrictions have to be considered. Alternatives may vary significantly according to the possible scenarios. Schiozer et al. (2003†) proposed an approach to integrate geological and economic uncertainties with production strategy using geologic representative models to avoid large computational effort. 21

The integration is necessary in order to (1) quantify the impact of decisions on the risk of the projects, (2) calculate the value of information, as proposed by Demirmen (2001) and (3) quantify the value of flexibility (Begg and Bratvold, 2002). The understanding of these concepts is important to correctly investigate the best way to perform risk mitigation and to add value to E&P projects. Therefore, risk analysis applied to the appraisal and development phase is a complex issue and it is no longer sufficient to quantify risk. Techniques today are pointing to (1) to quantification of value of information and flexibility, (2) optimization of production under uncertainty, (3) mitigation of risk and (4) treatment of risk as opportunity. All these issues are becoming possible due to hardware and software advances, allowing an increasing number of simulation runs of reservoir models with higher complexity (Gorell and Basset 2001).

6.3) Decision Making Process, Value of Information and Flexibility Making important decisions in the petroleum industry requires incorporation of major uncertainties, long time horizons, multiple alternatives, and complex value issues into the decision model. Decision analysis can be defined on different and embedded levels in petroleum exploration and production stages. Decision analysis is a philosophy, articulated by a set of logical axioms, and a methodology and collection of systematic procedures, based upon those axioms, for responsibly analyzing the complexities inherent in decision problems (Keenney, 1982, Keenney and Raifa, 1976; Howard, 1988, Kirkwood, 1996). In the last two decades, the theoretical and methodological literature on various aspects of decision analysis has grown substantially in many areas in the petroleum sector, especially in applications involving health, safety, and environmental risk. Many complex decision problems in petroleum exploration and production involve multiple conflicting objectives. Under these circumstances, managers have a growing need to employ improved and systematic decision processes that explicitly embody the firm’s objectives, desired goals, and resource constraints. Over the last two decades, the advances in computer-aided decision making processes have provided a mechanism to improve the quality of decision making in modern petroleum industry. Walls (1996) developed a decision support model that combines the toolbox systems components to provide a comprehensive approach to exploration petroleum planning from geological development through the capital allocation process. An effective way to express uncertainty is to formulate a range of values, with confidence levels assigned to numbers comprising the range. Although geoscientists and engineers may be willing to make predictions about unknown situations in petroleum exploration and production, there is a need to assess the level of uncertainty of the projects. So, it’s necessary to define the value of information associated with important decisions such as deferring drilling of a geologic prospect or seismic survey. Information only has value in a decision problem if it 22

results in a change in some action to be taken by a decision maker. The information is seldom perfectly reliable and generally it does not eliminate uncertainty, so the value of information depends on both the amount of uncertainty (orthe prior knowledge available) and payoffs involved in the petroleum exploration and production projects. The value of information can be determined and compared to its actual cost and the natural path to evaluate the incorporation of this new data is by Bayesian analysis. As the level of information increases, the decision making process becomes more complex because of the necessity of (1) more accurate prediction of field performance and (2) integration with production strategy. At this point, the concept of Value of Information (VoI) must be integrated with the Value of Flexibility (VoF). Therefore, risk may be mitigated by more information or flexibility in the production strategy definition. Reservoir development in stages and smart wells are good examples of investments in flexibility. The decision to invest in information or flexibility is becoming easier as more robust methodologies to quantify VoI and VoF are developed.

6.4) Portfolio Management and the Real Options Valuations Asset managers in the oil and gas industry are looking to new techniques such as portfolio management to determine the optimum diversified portfolio that will increase company value and reduce risk. Under this approach employed extensively in financial markets, projects are selected based upon quantitative information on their contribution to the company long-term strategy and how they interact with the other projects in the portfolio. This theory of financial market and efficient portfolio was proposed by Markowitz (1952), winner of the 1990 Nobel Prize in Economics. This work has been adapted for the petroleum industry. A portfolio is said to be efficient if no other portfolio has more value while having less or equal risk, and if no other portfolio has less risk while having equal or greater value. The most important principle in portfolio analysis theory is that the emphasis must be placed on the interplay among the projects (Ball and Savage, 1999). The original idea states that a portfolio can be worth more or less than the sum of its component projects and there is not one best portfolio, but a family of optimal portfolios that achieve a balance between risk and value. As the number of project opportunities grows, the petroleum industry is faced with an increasingly difficult task in selecting an ideal set of portfolios. Mathematical search and optimization algorithms can greatly simplify the planning process and a particularly well suited class of algorithms has been developed recently for the oil and gas applications in portfolio management (Davidson and Davies, 1995; Chorn and Croft, 1998, Orman and Duggan, 1998; Fichter, 2000; Back, 2001; Erdogan and Mudford, 2001). Garcia and Holtz (2003) combined optimal portfolio management with probabilistic risk-analysis methodology, thus helping to guide managers in evaluating a portfolio of exploration prospects, not just according to their value, but also by their inherent risk. 23

For several decades in the petroleum industry, the most common form of asset valuation has been the standard discounted cash-flow (DCF) analysis. However, over the past few years, an increasing number of institutions and organizations have been experimenting with the use of other valuations approaches to overcome some limitations imposed by the DCF approach. The real options approach is appealing because exploration and production of hydrocarbons typically involve following several decision stages, each one with an investment schedule and with associated success and failure probabilities. For example, in exploration phase the project can be viewed as an infinitely compounded option that may be continuously exercised as the exploration investment is undertaken. Traditional methods based upon discounted cash flow (DCF) reported in the finance literature are always based upon static assumptions - no mention about the value of embodied managerial options. Kester (1984) was the first to recognize the value of this flexibility and Mason and Merton (1985), and Myers (1987), among others, suggested the use of option-based techniques to value implicit managerial flexibility in investment opportunities, such as those of abandonment reactivation, mothballing and timing. Some important earlier real options models in natural resources include Tourinho (1979), first to evaluate oil reserves using option-pricing techniques. Brennan and Schwartz (1985) applied option techniques to evaluate irreversible natural resources assets and McDonald and Siegel (1985) developed similar concepts for managerial flexibility. After the real options theory became widely accepted in financial markets, applications in the oil industry followed rapidly. Paddock et al. (1988) evaluated offshore oil leases. By the mid 1990’s, several textbooks had been published (Dixit and Pindyck, 1994, Trigeorgis, 1996, and Luenberger, 1998) and the range of applications had widened to include applications in several economic sectors. Bjerksund and Ekern (1990) showed that it is possible to ignore both temporary stopping and abandonment options in the presence of the option to delay the investment for initial oilfield development purposes. Galli et al. (1999) discussed real options, decision-tree and Monte Carlo simulation in petroleum applications. Laughton (1998) found that although oil prospect value increases with both oil price and reserve size uncertainties, oil price uncertainty delays all option exercises (from exploration to abandonment), whereas exploration and delineation occur sooner with reserve size uncertainty. Chorn and Croft (2000) studied the value of reservoir information.

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Chapter 07 RISK MANAGEMENT

Risk management is “A systematic way of protecting the concern’s resources and income against losses so that the aims of the business can be achieved without interruption” • • • •

Risk Management is the process of defining all the risks that an organization faces Building a framework to not only monitor and mitigate those risks but to use risk management to increase shareholder value The point of risk management is not to eliminate it; that would eliminate reward The point is to manage it………

7.1) NEED FOR RISK MANAGEMENT •

Uncertainty in Enterprise

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Growing Complexity in Business Environment

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Statutory Obligations

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Contractual Obligations

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Social Obligations

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High Profile Corporate Failures

7.2) THE RISK MANAGEMENT PROCESS The risk management process consists of a series of steps that, when undertaken in sequence, enable continual improvement in decision-making. The elements of the risk management process are summarized in Figure 7.1 .

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Fig. 7.1 risk management process

Step 1. Communicate and consult This is shown in Figure 7.1 by the arrows against each step. Communication and consultation aims to identify who should be involved in assessment of risk (including identification, analysis and evaluation) and it should engage those who will be involved in the treatment, monitoring and review of risk. As such, communication and consultation will be reflected in each step of the process described in this guide.

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As an initial step, there are two main aspects that should be identified in order to establish the requirements for the remainder of the process. These are communication and consultation aimed at: • eliciting risk information • Managing stakeholder perceptions for management of risk. Eliciting risk information Communication and consultation may occur within the organization or between the organization and its stakeholders. It is very rare that only one person will hold all the information needed to identify the risks to a business or even to an activity or project. It is therefore important to identify the range of stakeholders who will assist in making this information complete. To ensure effective communication, a business owner may decide to develop and implement a communication strategy and/or plan as early as possible in the process. This should identify internal and external stakeholders and communicate their roles and responsibilities, as well as address issues relating to risk management. Consultation is a two-way process that typically involves talking to a range of relevant groups and exchanging information and views. It can provide access to information that would not be available otherwise. Managing stakeholder perceptions for management of risk There will be numerous stakeholders within a small business and these will vary depending upon the type and size of the business (Figure 7.2).

fig. 7.2 stakeholders in small business Stakeholder management can often be one of the most difficult tasks in business management. It is important that stakeholders are clearly identified and communicated with throughout the risk management process. They can have a significant role in the decision-making process, so their 27

perceptions of risks, as well as their perceptions of benefits, should be identified, understood, recorded and addressed. Stakeholder communication should incorporate regular progress reports on the development and implementation of the risk management plan and in particular provide relevant information on the proposed treatment strategies, their benefits and planned effectiveness.

Step 2. 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. 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. A five-step process to assist with establishing the context within which risk will be identified. 1. Establish the internal context As previously discussed, risk is the chance of something happening that will impact on objectives. As such, the objectives and goals of a business, project or activity must first be identified to ensure that all significant risks are understood. This ensures that risk decisions always support the broader goals and objectives of the business. This approach encourages longterm and strategic thinking. In establishing the internal context, the business owner may also ask themselves the following questions: • Is there an internal culture that needs to be considered? For example, are staff resistant to change? Is there a professional culture that might create unnecessary risks for the business? • What staff groups are present? • What capabilities does the business have in terms of people, systems, processes, equipment and other resources? 2. Establish the external context This step defines the overall environment in which a business operates and includes an understanding of the clients’ or customers’ perceptions of the business. An analysis of these factors will identify the strengths, weaknesses, opportunities and threats to the business in the external environment. A business owner may ask the following questions when determining the external context: • What regulations and legislation must the business comply with? • Are there any other requirements the business needs to comply with? What is the market within which the business operates? Who are the competitors? • Are there any social, cultural or political issues that need to be considered? Establishing the external context should also involve examining relationships the business has with external stakeholders for risk and opportunity. Establish the risk management context Before beginning a risk identification exercise, it is important to define the limits, objectives and scope of the activity or issue under examination. For example, in conducting a risk analysis for a new project, such as the introduction of a new piece of equipment or a new product line, it is 28

important to clearly identify the parameters for this activity to ensure that all significant risks are identified. Establishing the parameters and boundaries of the activity or issue also involves the determination of: • Timeframe (e.g. how long will it take to integrate a new piece of equipment?) • Resources required • Roles and responsibilities • Additional expertise required • Internal and external relationships (e.g. other projects, external stakeholders) • Record-keeping requirements • Depth of analysis required. The amount of analysis required for this step will depend on the type of risk, the information that needs to be communicated and the best way of doing this. To determine the amount of analysis required consider the: • Complexity of the activity or issue • Potential consequence of an adverse outcome • Importance of capturing lessons learned so that corporate knowledge of risk associated with the activity can be developed • Importance of the activity and the achievement of the objectives • Information that needs to be communicated to stakeholders • Types of risks and hazards associated with the activity. 4. Develop risk criteria Risk criteria allow a business to clearly define unacceptable levels of risk. Conversely, risk criteria may include the acceptable level of risk for a specific activity or event. In this step the risk criteria may be broadly defined and then further refined later in the risk management process. It is against these criteria that the business owner will evaluate an identified risk to determine if it requires treatment or control. Where a risk exists that may cause any of the objectives not to be met, it is deemed unacceptable and a treatment strategy must be identified. The table below (Table 4.1) provides a number of examples of risk criteria for a project.

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Table 7.1. Examples of risk criteria for a project in small business Define the structure for risk analysis Isolate the categories of risk that you want to manage. This will provide greater depth and accuracy in identifying significant risks. The chosen structure for risk analysis will depend upon the type of activity or issue, its complexity and the context of the risks. Examples of risk categories for a particular risk analysis are provided in the following case study.

Step 3. Identify the risks Risk cannot be managed unless it is first identified. Once the context of the business has been defined, the next step is to utilize the information to identify as many risks as possible. 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. Answering the following questions identifies the risk: There are two main ways to identify risk: • Retrospectively • Prospectively. Identifying retrospective risks 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. It’s easier to believe something if it has happened before. It is also easier to quantify its impact and to see the damage it has caused. There are many sources of information about retrospective risk. These include: • Hazard or incident logs or registers • audit reports 30

• Customer complaints • Accreditation documents and reports • Past staff or client surveys • Newspapers or professional media, such as journals or websites. Identifying prospective risks Prospective risks are often harder to identify. These are things that have not yet happened, but might happen some time in the future. Identification should include all risks, whether or not they are currently being managed. 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. Risk categories will help break down the process for prospective risk identification. It is important to remember that risk identification will be limited by the experiences and perspectives of the person(s) conducting the risk analysis. Problem areas and risks can be identified with the help of reliable sources. SWOT analysis An effective method for prospective risk identification is to undertake a strengths, weaknesses, opportunities and threats (SWOT) 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.

Step 4. 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, in order to make a decision about committing resources to control the risk. What is risk analysis? Risk analysis involves combining the possible consequences, or impact, of an event, with the likelihood of that event occurring. The result is a ‘level of risk’. That is: Risk = consequence x likelihood This is discussed further later in this section. So how is the level of risk determined? 31

Elements of risk analysis The elements of risk analysis are as follows: 1. Identify existing strategies and controls that act to minimize negative risk and enhance opportunities. 2. Determine the consequences of a negative impact or an opportunity (these may be positive or negative). 3. Determine the likelihood of a negative consequence or an opportunity. 4. Estimate the level of risk by combining consequence and likelihood. 5. Consider and identify any uncertainties in the estimates. 1. Identify existing strategies and controls that act to minimize negative risk and enhance opportunities To provide a clear understanding of the possible impact of a risk, existing control measures should first be identified and then the risk analyzed to determine the amount of ‘residual risk’. For example, the risk of theft from a business is reduced by the employment of a security camera. However, this has not eliminated the risk – a residual risk remains. 2. Determine the consequences of a negative impact or an opportunity (these may be positive or negative) Consequences are the possible outcomes or impacts of an event. They can be positive or negative, and can be expressed in quantitative or qualitative terms and are considered in relation to the achievement of objectives. It is necessary to estimate the impact of a risk or opportunity on the identified objectives. For example, the consequence of failing to maintain a major piece of machinery may be major injury requiring hospitalization, or possible death, of an employee. 3. Determine the likelihood of a negative consequence or an opportunity Likelihood relates to how likely an event is to occur and its frequency. An example is the likelihood that a non-maintained piece of machinery will malfunction and result in major injury requiring hospitalization, or possible death, of an employee. * Likelihood = probability x exposure Likelihood relates to the probability of a risk occurring combined with the exposure to the risk. This means that although the probability of a risk resulting in a negative outcome may be deemed rare, a higher frequency of exposure to that risk can increase the overall likelihood of a negative outcome. For example, based upon experience, the probability that an experienced courier company will encounter an increased accident rate is low when delivering within regional areas. However, this probability increases considerably when exposed to heavier traffic, e.g. if the business decides to relocate to a larger city. Estimate the level of risk by combining consequence and likelihood As previously introduced, to determine the level of risk, risk analysis involves combining the consequence of a risk with the likelihood of the risk occurring: Risk = consequence x likelihood* 32

This is known as the ‘risk analysis equation’. Techniques for determining the value of consequence and likelihood include descriptors, word pictures, or mathematically determined values. These are further described later in this section. Most commonly, the overall level of risk is determined by combining the identified consequence level with the likelihood level in a matrix (Figure 3.4). Consider and identify any uncertainties in the estimates In all estimates of likelihood and consequence, uncertainties will exist. This is a common limitation of the risk management process. It is important therefore to consider and identify any uncertainty. It may not be necessary to act on that uncertainty, but be aware and monitor any increases in the risk level. Analysis techniques The purpose of risk analysis is to provide information to business owners to make decisions regarding priorities, treatment options, or balancing costs and benefits. Just as decisions differ, the information needed to make these decisions will also differ. Not all businesses or even areas within a business will use the same risk analysis method. For example, a doctor’s clinic will have very different types of risk from a software developer. As such, the risk analysis tools need to reflect these risk types to ensure that the risk levels estimated are appropriate to the context of the business. Types of analysis Three categories or types of analysis can be used to determine level of risk: • Qualitative • Semi-quantitative • Quantitative. The most common type of risk analysis is the qualitative method. The type of analysis chosen will be based upon the area of risk being analyzed. More information regarding the semiquantitative and quantitative techniques can be found within the Australian and New Zealand Standard Risk Management Guidelines (HB 436:2004). Qualitative risk analysis This form of risk analysis relies on subjective judgement of consequence and likelihood (i.e. what might happen in a worst case scenario). It produces a word picture of the size of the risk and is a viable option where there is no data available. Qualitative risk analysis is simple and easy to understand. Disadvantages include the fact that it is subjective and are based on intuition, which can lead to the forming of bias and can degrade the validity of the results. Methods for qualitative risk analysis include: • brainstorming • Evaluation using multi-disciplinary groups • Specialist and expert judgement • structured interviews and/or questionnaires • Word picture descriptors and risk categories.

Step 5. Evaluate the risks 33

As discussed in Section 3.3, it is important to be able to determine how serious the risks are that the business is facing. 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. Risk acceptance Low or tolerable risks may be accepted. ‘Acceptable’ means the business chooses to ‘accept’ that the risk exists, either 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). A risk may be accepted for the following reasons: • The cost of treatment far exceeds the benefit, so that acceptance is the only option (applies particularly to lower ranked risks) • The level of the risk is so low that specific treatment is not appropriate with available resources • The opportunities presented outweigh the threats to such a degree that the risk is justified • The risk is such that there is no treatment available, for example the risk that the business may suffer storm damage.

Step 6. Treat the risks Risk treatment is about considering options for treating risks that were not considered acceptable or tolerable at Step 5. 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. It is often either not possible or cost-effective to implement all treatment strategies. A business owner should aim to choose, prioritize and implement the most appropriate combination of risk treatments. Figure 3.5 overviews the risk treatment process, including what needs to be considered in choosing a risk treatment. Treating the root cause Before a risk can be effectively treated, it is necessary to understand the ‘root cause’ of a risk, or how risks arise. Options for risk treatment The following options may assist in the minimization of negative risk or an increase in the impact of positive risk.

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Avoid the risk One method of dealing with risk is to avoid the risk by not proceeding with the activity likely to generate the risk. Risk avoidance should only occur when control measures do not exist or do not reduce the risk to an acceptable level. Uncontrolled or inappropriate risk avoidance may lead to organizational risk avoidance, resulting in missed opportunities and an increase in the significance of other risks. Change the consequences This will increase the size of gains and reduce the size of losses. This may include business continuity plans, and emergency and contingency plans. Share the risk Part or most of a risk may be transferred to another party so that they share responsibility. Mechanisms for risk transfer include contracts, insurance, partnerships and business alliances. It is important to note that risks can never be completely transferred, because there is always the possibility of failures that may impact on the business. Transfer of risk may reduce the risk to the original business without changing the overall level of risk. Retain the risk After risks have been reduced or transferred, residual risk may be retained if it is at an acceptable level. Identifying appropriate treatments Once a treatment option has been identified, it is then necessary to determine the residual risk; that is, has the risk been eliminated? Residual risk must be evaluated for acceptability before treatment options are implemented. Conducting a cost–benefit analysis Business owners need to know whether the cost of any particular method of correcting or treating a potential risk is justified. Considerations include: • Number of treatments required • Benefit to be gained from treatment • Other treatment options available, and why the chosen one has been recommended • Effectiveness of the treatment timeframe • Total cost of treatment option • Total reduction in residual risk • Legislative requirements. Business owners are required by law to provide a safe workplace. If existing work environments need to be upgraded to fully meet codes of practice and standards, a risk management approach should be adopted to demonstrate due diligence. A staged action or risk treatment plan can be used to document the risks and to outline a remedy. Appropriate consultation with stakeholders should also occur.

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Risk treatment plan A risk treatment plan indicates the chosen strategy for treatment of an identified risk. It provides valuable information about the risk identified, the level of risk, the planned strategy, the timeframe for implementing the strategy, resources required and individuals responsible for ensuring the strategy is implemented. The final documentation should include a budget, appropriate objectives and milestones on the way to achieving those objectives. Risk recovery Although uncertainty-based risks are difficult, if not impossible, to predict, there are ways in which businesses can prepare for a significant adverse outcome. This is known as risk recovery. Businesses should consider adopting a structured approach to planning for recovery. This planning may take many forms, including the following: • Crisis or emergency management planning The business anticipates what might occur in a crisis or emergency, such as a fire or another physical threat, and then plans to manage this in the short term. This will include listing emergency contact details and training staff in evacuation and emergency response procedures. • Business continuity planning The business moves beyond the initial response of a crisis or emergency and plans for recovery of business processes with minimal disruption. This might, for example, include ensuring that there is sufficient documentation of processes if a key staff member is unavailable to return to work and another staff member is required to fulfill that role, identifying options for alternative premises if the existing premises are damaged, or documenting alternate suppliers for key supply material if a key supplier does not fulfill their contract. • Contingency planning Contingency planning can be a combination of the above. A contingency planning tool can help to identify what should be done to minimize the impact of a negative consequence on key business processes arising from an uncertainty-based risk. This would include the initial response (crisis management) and the delayed response (business continuity).

Step 7. Monitor and review Monitor and review is an essential and integral step in the risk management process. A business owner must monitor risks and review the effectiveness of the treatment plan, strategies and management system that have been set up to effectively manage risk. 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.

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7.3) TYPES OF RISK MANAGEMENT Operational risk management: Operational risk management deals with technical failures and human errors Financial risk management: Financial risk management handles non-payment of clients and increased rate of interest Market risk management: Deals with different types of market risk, such as interest rate risk, equity risk, commodity risk, and currency risk Credit risk management: Deals with the risk related to the probability of nonpayment from the debtors Quantitative risk management: In quantitative risk management, an effort is carried out to numerically ascertain the possibilities of the different adverse financial circumstances to handle the degree of loss that might occur from those circumstances Commodity risk management: Handles different types of commodity risks, such as price risk, political risk, quantity risk and cost risk Bank risk management: Deals with the handling of different types of risks faced by the banks, for example, market risk, credit risk, liquidity risk, legal risk, operational risk and reputational risk Nonprofit risk management: This is a process where risk management companies offer risk management services on a non-profit seeking basis Currency risk management: Deals with changes in currency prices Enterprise risk management: Handles the risks faced by enterprises in accomplishing their goals Project risk management: Deals with particular risks associated with the undertaking of a project Integrated risk management: Integrated risk management refers to integrating risk data into the strategic decision making of a company and taking decisions, which take into account the set risk tolerance degrees of a department. In other words, it is the supervision of market, credit, and liquidity risk at the same time or on a simultaneous basis. Technology risk management: It is the process of managing the risks associated with implementation of new technology Software risk management: Deals with different types of risks associated with implementation of new softwares 37

Chapter 08 INVESTMENT DECISION IN OIL AND GAS PROJECTS USING REAL OPTION AND RISK TOLERANCE MODELS 8.1) Introduction The valuation and decision making of capital-intensive projects have been a topic of concern for large corporations and governments in the oil and gas business, in part because the resource is finite and investment is high - for example, irreversible investments in the development phase may reach billions of dollars. Several studies concerning modern investments theory, such as those in the oil and gas industry, have three important characteristics according to Dixit and Pindyck (1994): 1 uncertainty over the future operational cash flow 2 irreversibility of the investment 3 value of the timing or some leeway to implement decisions. The irreversibility of investment gives rise to implications in the financial status of corporations, depending on capital exposed to risk and the magnitude of budget of the company. For example, consider an investment of US$ 100 million in a risky oil project. For a company with a budget as high as US$ 1 billion, this risky investment might be tolerated. On the other hand, for a firm with a budget of, say, US$ 300 million, managers might postpone this risky project or sell a share of this project, since the potential loss is too high compared to its budget. Since unsuccessful results of an investment may give rise to serious financial impacts on the corporation, the irreversibility of investment is one of the main driving forces of investor’s risk aversion. The irreversibility of most part of the investment is a frequent characteristic of the capital intensive industries. For example, in case of a crisis in the oil industry, equipments such as rigs, platforms, infrastructure, etc. will have a large reduction of value in a secondary market. Even equipment of more general applications will experience a value reduction due to a decrease of the oil-related assets. In order to manage a project under a scenario of future uncertainty, coupled with investment irreversibility, the manager needs managerial flexibilities (real options) to adapt the project to new market conditions. This is clearly stated in Trigeorgis (1996) that without this managerial proactive role, uncertainties will tend to generate a symmetric distribution for Net Present Value (NPV), whereas, with active management, the NPV will have an asymmetric distribution to the right. This positive asymmetry in the NPV generated by managerial flexibility has value and can be properly estimated using option pricing methods. If the management has the option to choose the time to invest, this flexibility has value and must be considered in the model of valuation and decision making. Since the option to invest is alive until the time the decision is implemented, if the corporation invests today, it kills the opportunity of investing in the future, when the market conditions, technology, as well as other market components may be better. Then, by investing today, the corporation incurs in an 38

opportunity cost by not waiting to allocate this capital in the future. In addition, because the corporation invests in a capital-intensive project, there is a long period of time (which may reach 20 years or more) of cash-flow exposure to risk, so that firms may prefer to participate with less than 100% in the project. Therefore, in the process of investment valuation and decision making, corporations must consider, in an integrated way, the process of valuation, strategic decision making and tolerance to risk exposure. Three questions are of paramount importance: 1 What is the current cash flow value of the investment? 2 What is the optimal decision rule to invest, that is, should the corporation invest now or in the future? 3 What is the optimal working interest for the project? The solutions to these questions have been achieved using the traditional model of valuation and decision making, based on the NPV of the project’s cash flows, that is, invest as long as NPV is positive and incur in 100% of working interest. But, contrarily, McDonald and Siegel (1986), Dixit and Pindyck (1994), Trigeorgis (1996) and Copeland and Antikarov (2001) pointed out that results from the traditional model do not properly account for the role of uncertainty, irreversibility and managerial flexibilities. Alternatively, they suggest the use of option-pricing techniques. In addition, real-world practice shows that most large projects are financed by a pool of companies, what is different from suggestions from the NPV approach. A model to find the optimal working interest (W) is suggested by Cozzolino (1980), Walls (1995), Walls and Dyer (1996), Lerche and Mackay (1996) and Wilkerson (1998) for petroleum exploration and production projects. But, these two approaches have been applied in a separate way. Costa Lima (2004) suggests the use of an integrated model considering Monte Carlo simulation, option-pricing and optimal working-interest to give decision makers more realistic information to make their choices. The risk of project is estimated by considering uncertainty in future cash flow inflow and outflow through Monte Carlo simulation. The strategic decision rule is achieved according to the optionpricing model. The optimal working interest in joint venture projects is found according to the optimal working interest from concepts of preference theory. This chapter is structured in three sections. Section 1 presents some details on the integrated methodology for valuation and strategic decision making. Section 2 applies the model to decision making of capital-intensive project for heavy-oil deep-water production. Section 3 presents some discussions and implications.

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8.2) The integrated model 8.21) NPV of the project’s cash flow The first step in the process of investment decision making is the estimation of indicators from the project’s future cash flows. Traditionally, the NPV is the main indicator for investment valuation and decision rule, since it has been recognized in financial literature (Brealey and Myers, 1992) as theoretically correct to measure the creation of value for stakeholders. If a project generates over time a stream of operational cash flow (X(t)) and requires a stream of investments (I(t)), its NPV is (Equation (1)): N E[X t-I t] NPV=∑ ------------- ……………………………………(1)

t=0 (1+µ) t Where µ is capital cost of each cash flow. Equation (1) provides the expected value of the NPV under static scenarios for price, cost, production, etc. Since there is uncertainty about the future, the NPV may change as long as fluctuations in price, cost, production rate, etc. take place. Then, NPV is a random variable whose future values will come from a probabilistic distribution. Equation (1) gives the expected value of the NPV, but this is not sufficient to make a decision since this indicator does not account for the impact of uncertainty on future cash flows, except via risk premium of the discount rate. In order to estimate the risk of the project, a Monte Carlo simulation of the NPV may be carried out. The traditional decision-making model according to the NPV only considers the risk of a project by means of a premium in the discount rate - the riskier the project, the lower the NPV. This model has three main drawbacks: 1 the potential gains from the positive side of uncertainty are not taken into account 2 the value of waiting to invest in the future if current market conditions are bad is ignored 3 the optimal working interest is always 100%, irrespective of magnitude of investment. These issues will be discussed over the next sections. 8.22) Optimal working interest (W) In order to discuss the problem of optimal working interest in a risky project, consider an example involving the allocation of US$ 600 million between two alternative investments: 1 Invest all of the money in one large project with an expected NPV of US$ 300 million and a standard-deviation (risk) of US$ 141.42 million. 2 Invest all of the money in five projects, that is, the corporation allocates 20% of its budget to each project. In this case, the corporation’s rate of return will have the following return/risk profile2: E[NPV] =US$ 300 million and σ [NPV] = US$ 63.25 million.

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These two alternatives have the same expected return, but different risk levels. Just by increasing the number of non-correlated projects, the return of portfolio remains the same and its global risk drops - this is the remarkable role of diversification. In Table 1, the effects of diversification through different working interest values on risk and return of portfolios are shown.

Table 1

Effects of diversification on portfolio risk and return level

Number of projects

Working interest (W)

1 2 10

100.00% 50.00% 10.00%

Portfolio risk (US$ * 10 6) 141.42 100.00 44.72

Portfolio return (US$ * 10 6) 300 300 300

The choice of working interest depends on the investor’s risk tolerance, since all portfolios give the same return of US$ 300 million. The investor’s risk tolerance will depend on the amount exposed to risk compared to the investor’s total stock of wealth and his risk preference characteristics. The theoretical foundations of decision making involving choices under uncertainty (such as selecting working interest in a project of high CAPEX) is the preference theory developed by Von Neumann and Morgenstern (1953) which advocates that the usefulness of things determines their attractiveness. Basically, choices under uncertainty or risk attitudes of decision makers are organized into three main groups: 1 risk-neutral 2risk-averse 3 risk-prone According to Luenberger (1998), the risk-neutral individual is one to whom uncertain outcomes are valued as expected values, paying no attention to the potential of gains and losses. A risk-prone individual is one to whom uncertain outcome is valued by more than the expected value. A risk-averse investor has more concern with the potential of loss than that of gains and, therefore, this individual values uncertain outcome by less than expected value. In this paper, to find the optimal working interest in this model, it is assumed that individuals as well as corporations are risk-averse in capital-intensive projects. This is the case of large heavyoil projects, where investment irreversibility contributes to motivate management towards limiting risk exposure by taking, for example, less than 100% working interest in the project, depending on the interaction among project risk profile, magnitude of the corporation’s financial budget and decision maker’s risk attitudes (Campbell et al., 2001; Cozzolino, 1980; Nepomuceno et al., 1999; Newendorp and Schuyler, 2000; Walls and Dyer, 1996). For the petroleum industry, Cozzolino (1980) and Walls (1995) suggest the use of the exponential utility function to model the choices made under uncertainty. The complete exponential utility equation is: 41

U(x) = a-b*e –X i / T ……………………………………………………(2) where a and b are constants, X is the random monetary quantities and T is the corporation’s risk tolerance. The absolute value of utility (positive or negative) is just a number without much significance and is not enough for taking decisions. On the other hand, utility values are suitable for comparisons - for example, if U(X) = 11 and U(Y) = 8, then, X is preferable to Y.

On the other hand, the certainty-equivalent or Risk-Adjusted Value (RAV) is the main concept to estimate the optimal level of financial participation or working interest (W). According to Luenberger (1998), RAV is that value whose utility is equal to the expected value of utility of K possible monetary outcomes (X i) with probability p i .from Equation (2), if a = 0 and b = 1, the RAV is found from: K - (RAV/T) -e = ∑ p i (-e - (W*X i/T) ) ………………………………………………..(3) i=1 Where T is the corporation’s risk tolerance. From Equation (3), we get: k RAV = -T*ln [∑ p i * e -((W*X I )/T) ] ……………………………………………………(4)

i=1 The model to estimate the optimal working interest is given in Equation (4), that is, the decisionmaker should select W that maximize the RAV. In practice, W is found numerically. The use of Equation (4) requires two inputs: 1 corporate risk tolerance (T) 2 probability distribution of X i ---for example, the NPV of the project. 2.3 The optimal investment decision-rule The optimal investment decision rule must take into account not only the expected future cash flows but also the strategic or operational options that are available for management over the life of a project. As in the case of financial options, these real options are understood as a right, but not as an obligation to be implemented and have value to be added to the traditional NPV. As described by Trigeorgis (1986), the true project value is always equal to or greater than its traditional NPV. Most modern investments in exploration and production share the following characteristics: 1 future uncertainty in variables such as cost, price, exchange rate, etc. 2 irreversibility of investment, leading to new considerations in the process of the project’s acceptance and management of risk exposure 3 timing or strategic real option to implement decisions.

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Dixit and Pindyck (1994) consider that such investments should be analyzed using the flexible approach of real-option pricing. Costa Lima and Suslick (2002) pointed out that the interaction of uncertainty and timing may aggregate value to the project, in part because the investor’s loss is limited to the irreversible investment, whereas the upside potential is theoretically infinite. The first step in valuation and decision-rule from the option-pricing model is the modeling of the dynamics of the asset’s future price. Following Black and Scholes (1973), we assume that the changes in the present value of future cash flows evolve as a risk-neutral geometric Brownian motion: dV =(r-δ) V d t +σVd Z …………………………………………………………….(5)

Where V is the present value of project’s cash flow, r is the risk-free interest rate, δ is the dividend rate, σ is the volatility and dZ is Wiener’s increment or white noise. In order to find the optimal investment decision-rule, let F(V) be the value of the option to invest in an oil and gas project. If we assume that option maturity is at least four years, the investment option can be regarded as independent of time. Then, by following standard procedures in financial economics, McDonald and Siegel (1986) and Dixit and Pindyck (1994) showed that, under the assumption of market efficiency and non-arbitrage opportunities, F(V) must satisfy the following ordinary differential equation (PDE) ½ σ 2 V 2 F”w (V) + (r-δ)VF’v (V) – rF(V) = 0 -------------------------------------------------(6) In order to use Equation (6), the following boundary conditions are considered: F (0)

= 0 ……………………………………………………………………………..….(7)

NPV (V*) = F (V*) = V*-I

F’v (v) = 1

……………………………………………………………….(8)

………………………………………………………………………………………………………………………(9)

Equation (7) means that if V = 0, F(0) = 0, that is, there is no chance of increase in V in the future, which is considered an absorbing property of the GBM. Equation (8) means that the corporation should invest as long as V reaches a trigger value (V * ) and not merely V ≥ I. Equation (9) is the smooth-pasting condition or the last boundary condition for optimization. The solution of F(V) is: β = 1/2 – (r-δ)/σ2 + {{(r-δ)/σ2-1/2}2 + 2r/σ2}1/2 …………………………………………………….(10) V* = β/ (β-1) * I ……………………………………………………………………………….. (11) F (v) = (V*-I/ (V*) β) * Vβ

if VI. The volatility of projects plays a very important role in both option valuation (Equations (12) and (13)) and decision making (Equation (11)). According to the classic investment theory, project value is represented by its NPV and the optimal decision is: invest as long as V > I, that is, a positive NPV. Contrarily, in the real-options model, the investment right is exercised as long as V ≥ V* and both F and NPV have the same value, that is, the strategic value of the option to invest (F) and the intrinsic option value (NPV) are equal. Then, F may be considered as the intrinsic option value plus its time value. Another understanding is: when V = V *, we have that F (V*) = V * - I and, Consequently, V * = F (V *)  I, that is, we can see F as part of the cost to invest now instead of waiting for a better opportunity in the future. Therefore, because of volatility, we always have V* > I and not V * ≥ I. From Equation (1), the NPV is US$ 391.38 million and, according to traditional decision making, the corporation should invest right now. On the other hand, from Equation (12), the option value, which captures the value of the flexibility to invest not only now, but also in the future, is US$ 491.29 million and clearly the option value is above the NPV stand alone. In the real option pricing model, F (investment option) and K (value of waiting option) are nonnegative functions, whereas the NPV can be negative if I > V. The entire results of both approaches in valuation and decision making can be seen in Figure 2 through a sensitivity analysis of the NPV, F and K (option value) to project current value.

Figure 2 Sensitivity of NPV, F and K to project current value

As the current value of project increases, Figure 2 shows an increase of NPV, F and a decrease in K. There are three important regions for decision making: • I: 0 ≤ V ≤ US$ 887.02 million. The intrinsic value of the option (NPV) is negative and the corporation will not invest. Meanwhile, F is positive. Why? Since the future is uncertain - volatility of project is 51%, there is a potential that project value increases to US$ 1821.09 million or more. Then, the investment option is much higher than the intrinsic value. • II: US$ 887.02 million ≤ V < US$ 1821.09 million. The NPV is positive, but not sufficiently high. Once again, the effect of irreversibility and uncertainty implies that the optimal policy to maximize the option value is to wait until the project value 49

•

reaches the value of US$ 1821.09 million. The option value is still high, but the option should therefore be exercised in the future. III: V ≥ US$ 1821.09 million. The investment option must be exercised immediately. Observe Figure 2 to confirm that the option value of waiting (K) has no more value if V is above US$ 1821.09 million.

In general terms, the results of valuation and decision making for this project, synthesized in Figure 2, are in agreement with the literature. For example, Costa Lima (2004) has shown that for some oil projects, V* is on the average 2.14 times the investment cost. In addition, it is worth mentioning that for reasonable input parameters of the real options model, particularly volatility and dividends, V* may be two times the investment cost or even higher.

8.33) The optimal working interest in the project (W) In many cases, even though the project value is sufficiently above its investment cost, many corporations prefer to develop it in partnership (such as a joint venture), which seems to contradict the optimal decision rule of the option-pricing theory. But this practice in capital-intensive projects has some reasons due to the following characteristics: 1. the magnitude of investment cost 2. technology availability to develop the project alone 3. search for synergy among different business units. In such situations, a common question is: What is the optimal level of financial participation (working interest) in this project? The answer cannot be found through pure NPV analysis since, from this approach, the corporation should incur in 100% of investment and revenue as long as the NPV is positive. An alternative solution can be found using the theory of finding the optimal working interest to maximize the RAV in Equation (4). This equation requires two main inputs: 1. the probabilistic distribution of NPV 2. the corporation risk tolerance (T). The corporation risk tolerance is difficult to estimate. Wilkerson (1988) argues that T can be estimated as a fraction of, for example, corporation market value, budget and other strategic variables. Walls (1995) show empirically that T is around 25% of the capital allocated to petroleum explorations. Meanwhile, for other phases in the E&P chain, T may assume different values. In this chapter, it is assumed that the corporation budget is US$ 300 million and its risk tolerance is US$ 120 million, that is, T = 40% of the budget. From Equation (4), the analyst can estimate the RAV for this project, considering different assumptions and characteristics of the corporation and of the project. As shown in Equation (4), RAV depends on utility function, corporation risk tolerance and project risk profile - in some cases, the RAV is an increasing function of W, whereas, in others, it is a decreasing or even constant function. The main objective is to estimate 50

W, numerically or analytically, in order to maximize the RAV, given the corporation’s profile. For this case study of oil project, the sensitivity of RAV to W is shown in Figure 3. As shown in Figure 3, an increase in W will increase the satisfaction of decision maker up to around 44.38%. Higher values of W reduce the satisfaction of decision maker through the decrease in RAV. In addition, if W is higher than 93%, the RAV becomes negative. Over the interval between 0 and 100%, the RAV is a non-linear and concave function of W. The theory of maximizing the RAV shows that, contrarily to the traditional view, the “corporation will not take 100% working interest in the project’s cost and revenue, but only 44.38% because this value gives the highest RAV”. Note that the curve of the RAV to W takes into account the uncertainty in price, production and operational cost together with the corporation’s utility function. Nevertheless, it is important to observe that, in order to get realistic results, it is important to search for the best estimation of T because of its impact on W, that is, an increase in T tends to increase W in the project and viceversa. In Figure 4, an extended sensitivity of the RAV to W for different values of T is presented.

Figure 3 Sensitivity of RAV to optimal working interest (W)

Figure 4 Sensitivity of RAV to optimal working interest: different values of corporation’s tolerance

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Note that, in the base case, T = US$ 120 million and W = 44.38%. If T increases to US$ 200 million, W is also increased to 75%. Analogously, if T decreases to US$ 80 million, W is also reduced to only 30%. In terms of valuation and strategic decision making, by taking W = 44.38%, the company will spend around US$ 393.66 million in the investment and receive a NPV of only US$ 173.69 million. If a negative outcome occurs, the amount under risk is limited to that fraction of the investment, that is, US$ 393.66 million. This policy of reduction in the project’s NPV may be understood as the price to limit risk exposure or as a hedge scheme against possible catastrophic losses. The result from preference theory and risk-adjusted analysis intends to complement the results of the NPV and option pricing because of two main reasons: 1 the investment cost may be quite high if compared to the corporation’s budget 2 even in the case of a project with a current value equal to two or more times its cost, it may become profitless since volatility over the future may, for example, generate a scenario of high cost and low prices. In this case, a rational policy intended to reduce the risk of losses and, consequently, of financial troubles, may be the choice of a small fraction of the project investment and revenues. This practice is very common in the oil exploration and production business and this framework may be a valuable tool for the decision process in capital-intensive projects. Finally, by taking a working interest of less than 100% in the project, the corporation may invest in more than one project and, consequently, reduce the corporation’s portfolio risk. 8.4) Discussions and implications The proposed model provides a complement to results of the classic NPV in valuation and decision making. It integrates valuation, risk quantification, strategic flexibilities and decision making, using theories of preference and real option pricing. Although more sophisticated, this integrated model requires two input parameters that are difficult to estimate: corporation risk tolerance (T) and project volatility (σ). In the present case study, we have pointed out the need to complement results of the traditional cash flow when analyzing investment in capital-intensive projects, such as those of oil and gas industry. Table 5 presents a comparison between the traditional and the proposed valuation and decision model.

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Table 5 Subjects Valuation and risk

Decision Making

Optimal Decision

Results from the two valuation and decision models (some approximations have been used to the nearest round number) Main indicators V (million US$) I (million US$) NPV (million US$) F (million US$) Risk (%) NPV (million US$) V* (million US$) W (%) V *F

Traditional approach 1278.41 887.02 391.38 30.95% 391.38 887.02 100.00% Since NPV is positive, invest now and take 100% working interest

Proposed model 1278.41 887.02 276.07 452.34 30.95% 491.29 1821.09 44.38% Even though NPV is positive invest in the future (when V is US$ 1821.09 million) and incur in a working interest of 44.38%

According to the traditional cash flow model, the NPV is the indicator for valuation and decision making. The project NPV is US$ 276.07 million and the corporation should invest immediately and incur in 100% of the project. The proposed model has a complementary structure, where F is the valuation indicator and the decisions are made according to the results of V* and W. The numerical analysis summarized in Table 5 shows that, although the NPV is positive, the option to invest is not deep-in-the-money. Therefore, the optimal decision is to wait for an increase in V to, at least, US$ 2.10 billion. This may happen, for example, due to oscillation in price, costs and production, as well as in other strategic variables. By choosing only projects whose V is at least equal to V*, the corporation follows a more conservative and risk-limiting policy, which is an advance and is radically different from the traditional NPV. Nevertheless, this procedure does not assure that the option exercise is profitable, because the result of the exercise of real options, contrary to financial options, is not immediate, but depends on a cash flow from many years of operations. In this context, since the project’s investment is high compared to the corporation’s risk tolerance, the corporation’s optimal working interest is 44.38%, whereas other partners must fund the remaining 55.62% of the investment. This framework derives from the chosen parameters, which may not be constant over time. If some of them undergo oscillations, for example, volatility or operational cost, global output may be very different, requiring that the analysis must be updated continuously in order to improve the corporation’s valuation and decision making in the search for an efficient resource allocation and value creation for stockholders.

This chapter presented an integrated framework, combining theories of real-options and preference, useful for valuation and decision making under uncertainty for capital-intensive 53

projects. The outputs of the real-options model may be used to complement those of the traditional NPV, especially by incorporating the value of uncertainty and irreversibility. The results from the preference theory allow the corporation to estimate its optimal level of financial participation in a risky project that is compatible with the utility function of the decision maker. This integrated model represents a significant gain when compared with the traditional one (based solely on expected values) by considering the relationship among irreversible investment, risk tolerance, timing and risk-aversion. In addition, findings from this new model is that its results tend to diverge from the traditional valuation and decision-making model as the level of uncertainties increases as in the case of heavy-oil in deep water projects where the timing and frequency of the unknown technologies for cost reductions are speculative and not fully dominated by oil industry.

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Chapter 09 USE AND IMPLEMENTATION OF RISK ANALYSIS 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 since it is recognized that many are the decisions under uncertainty occurring 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. In the next section an example of application is presented

9.1)Example of Application - Well Cost Estimation Engineers involved in well planning and budgeting know how sensitive this subject is. 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. Internally, the accounting department will rely on the recommendation from engineers to prepare the company’s budget. Externally, 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, of course, the possible gains. In this case, following clauses established in a Joint Operating Agreement (JOA), an AFE will have to be approved by all partners before drilling operation takes place. It is regular in these cases to allow a 10% over spending on the planned costs. Any amount above this limit will require mandatory approval from the partners, which may cause operational delays and doubts about the operating partner’s technical proficiency. Since cost estimation for drilling operations naturally carries a great deal of uncertainty, this area appears to be suitable for risk analysis application. Table 1 presents an actual AFE for a vertical offshore well. The total estimated cost is $6,456,000. Let us assume now that the engineer in charge of well planning has uncertainties related to 16 items (see Table 2) on the proposed AFE. The normal approach, of considering a “best case” with all the lower costs occurring at the same time and a worst scenario with all the higher costs happening simultaneously cannot be applied here. There is no guarantee that, let us say, rig costs, will be in the lower side at the same time that supervision and P&A costs reach a minimum. Assuming that all cost variations are independent, which may not be the case with certain related item like casings with different diameters, we can further assume that the costs will vary according to a triangular distribution where the minimum, maximum and mode value are known (as given in Table 2). From that premise, a Monte Carlo simulation can be performed, with all uncertain costs being randomly varied combined with the other costs. The simulation is run consecutively, every time taking one possible cost from the distribution of each of the 16 uncertain variables. Those values are added with the fixed costs, variables where no uncertainty exist, resulting in a total

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cost for the well. In this case the simulation was repeated 500 times and the results used to form a cumulative distribution function (CDF) for the well. The resulting CDF is presented in Fig. 1.

Figure 1 - Cumulative Distribution for AFE

9.2) Analysis of Results After establishing the distribution of possible costs for the well, the engineer now has a much more reliable tool to be used on the AFE’s preparation. Notice that the analysis itself does not substitute the engineer’s evaluation or company’s policy. On the other hand it provides the professional with means to best estimate contingency costs and determine P(10), P(50) and P(90) costs, in our case, $6.32, $6.54 and $6.83 millions.

9.3) Conclusions An overview on most important works relating use of risk analysis applications for drilling operations was presented. Use of risk analysis on oil and gas investment decision is a common procedure in all major oil companies; however, use of QRA methods as an auxiliary tool for decisions under uncertainty in well engineering process is not as prevalent as it should be. A simple example for application in well cost estimation was presented. Monte Carlo simulation was used to determine a cumulative distribution function for the expected well costs.

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Use of decision methods with risk analysis required reliable database and careful analysis of possible outcomes. However, once the method is implemented, its use is simple and will provide great benefit for the company. TABLE 1 - Authorization for Expenditure (AFE) Preliminary Estimate for a 9000 ft Straight Hole, Precompletion Estimate Included DRILLING COST

ESTIMATED INTANGIBLE COSTS Surveys and Permits/Environmental Location Cleanup

Rate

Days

PRECOMPL. Cost

TOTAL AFE

$20,000

$5,000

$25,000

$525,000

$0

$525,000

Days

Rig Move (Mob. & Demob.)

$75,000

7

Drilling - Daywork

$75,000

31

6

$2,325,000

$450,000

$2,775,000

Fuel, Lubes and Water

$2,000

31

6

$62,000

$12,000

$74,000

Rental Equipment

$3,000

31

6

$93,000

$18,000

$111,000

$50,000

$5,000

$55,000

31

6

$400,000

$0

$400,000

$4,000

$0

$4,000

$130,000

$50,000

$180,000

$40,000

$25,000

$65,000

$350,000

$0

$350,000

$15,000

$0

$15,000

Drill Bits Drilling Mud & Chemicals Mud Logging

$800

5

Cement & Squeeze Services Casing Crews & Tools OH Logging+MWD/LWD Cores & Analysis Transportation Labor + Dock Charges

$13,100

31

6

$406,100

$78,600

$484,700

$2,000

31

6

$62,000

$12,000

$74,000

Supervision

$850

31

6

$26,350

$5,100

$31,450

P&A Costs

$120,000

5

0

$600,000

$0

$600,000

$25,000

$10,000

$35,000

Pipe Inspection Overhead

$750

31

6

$23,250

$4,500

$27,750

Insurance

$570

31

6

$17,670

$3,420

$21,090

Communications

$300

31

6

$9,300

$1,800

$11,100

$5,183,700

$680,500

$5,864,100

TANGIBLE COSTS $/FT. Drive Pipe

800

30"

220

$72,600

$0

$72,600

Conductor

1,600

20"

60

$96,000

$0

$96,000

Surface Casing

3,500

16"

16

$56,000

$0

$56,000

Intermediate Casing

6,000

9-5/8"

30

$180,000

$0

$180,000

Production Liner

3500

7-5/8"

13.5

$0

$47,250

$47,250

$120,000

$20,000

$140,000

Wellhead Equipment TOTAL TANGIBLES

$524,600

$67,300

$591,900

TOTAL AFE COSTS

$5,708,300

$747,800

$6,456,000

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TABLE 2 - Range of Costs

Total Rig Cost Fuel, Lubes and Water Rental Equipment Drilling Mud & Chemicals Mud Logging Transportation Labor + Dock Charges Supervision P&A Costs Insurance Communications Drive Pipe Conductor Surface Casing Intermediate Casing Production Liner

Total Cost

Total Cost

Total Cost

Base Case

Lower Limit

Higher Limit

$3,080,000

$3,960,000

$64,750

$77,700

$92,500

$122,100

$350,000

$500,000

$3,250

$4,500

$299,700

$499,500

$55,500

$81,400

$27,750

$33,300

$550,000

$675,000

$18,500

$22,570

$9,250

$12,210

$3,300,000 $74,000 $111,000 $400,000 $4,000 $484,700 $74,000 $31,450 $600,000 $21,090 $11,100 $72,600 $96,000 $56,000 $180,000 $47,250

$69,300

$75,900

$80,000

$104,000

$49,000

$59,500

$168,000

$198,000

$40,250

$52,500

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Chapter 10 RISK ASSESSMENT & MANAGEMENT-TO THRIVE AMIDST UNCERTAINTY (UPSTREAM FOCUS) Assessing and managing risks are essential functions for any organization, but they are particularly vital concerns for companies operating within the upstream sector of the oil and gas industry. Even with the best seismic technology and geological expertise, exploration presents considerable uncertainty. Actuarial analysis is needed to project the life spans of discovered reserves and their market value over several decades. Extracting that oil or gas demands greater investment, additional expertise, and greater exposure to possible liabilities and compliance requirements. While international economic and political events increasingly affect all businesses, such issues have long been concerns for oil and gas companies. Due to such factors, the upstream sector of the oil and gas industry presents a higher degree of inherent risk than most industries, and companies operating in that sector generally maintain higher risk profiles than most corporations. Maintaining a higher risk profile, however, also heightens the importance of assessing and managing risks to ensure that any potential internal or external threats an entity faces do not exceed its risk appetite. The upstream oil and gas industry shares with some other businesses, such as the pharmaceutical industry and aerospace engineering, typically long payback periods. Payback is defined as the length of time between the initial investment in a project by the company and the generation of accumulated net revenues equal to the initial investment In the oil industry, this period is typically between ten to fifteen years Shortages compel Asian upstream sector to focus on risk management The Asian oil and gas industry is facing difficult times, particularly in resource availability. The main problems are the steel shortage, experienced labor shortage (all levels), and even space in fabrication yards across the region. These problems, coupled with reserves becoming more difficult to locate and more expensive to develop, have caused the industry to begin implementing detailed planning and risk management. Today, Asian oil and gas companies are placing more emphasis on managing assets and streamlining business processes to maximize profitability. Although the price per barrel has increased dramatically in recent months, the industry remembers the downtimes in the ‘90s and is wary of the current high prices. Because of this, reserves in oil and money are being shored up. Getting oil fields and equipment (onshore and offshore installations) working as fast as possible is important. With this in mind - and a strong risk management knowledge base - most Asian oil and gas companies are now practicing risk management at the highest professional levels. 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.

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This article will explore the current problems the Asian oil and gas industry are facing and how risk management is helping to solve those problems. It will also touch on the technology that can help managers automate the process of identifying and mitigating risk. Asia Pacific oil and gas markets The Asia Pacific region is now recognized as the major growth area for energy demand. Oil, gas, and electric power take center stage for investment in this growing and emerging market. This region has vastly inadequate local crude oil production relative to its expanding needs and will need increased imports from outside the region. Coupled with governmental policy changes encouraging deregulation, privatization, and foreign investment, the future appears bright. Yet risk prevails. Deregulated markets bring competitive risks not previously experienced and energy risk management rises in importance dramatically changing market environments such as these. Oil is still the key fuel of the industrial world. In the Asia Pacific region, the overriding concern has always been security of supply rather than price risk. In this environment, the use of energy risk management tools, particularly on futures exchanges, has repeatedly failed. Risk avoidance - rather than risk management - has long been the operative word in Asian oil markets. That is about to change due to the twin engines of deregulation and privatization driving competition. 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. Oil markets The importance of the Asia Pacific region in terms of world oil demand and refining cannot be understated. Since 1985, Asia has accounted for more than 70% of total world oil demand growth. This area has surpassed Europe and will soon eclipse North America as the primary region of world oil demand. The Asia Pacific region continues to be the most dynamic oil market in the world with demand at 25.4 million b/d in 2005, with projections of 29.4 million b/d in 2010. Most of this increased consumption will be sourced from the Middle East from where over 70% of the supply currently originates. It is estimated that 80% of Persian Gulf oil production will be exported to China, India, Japan, South Korea, Taiwan, and the Association of Southeast Asian Nations (ASEAN) countries by the year 2010. 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. By 2006, Japan, South Korea, China, India, Taiwan, Thailand, and Singapore are expected to be importing oil at over one million b/d each. While some Atlantic Basin crude oil from West Africa and the North Sea may supply some of the older, less flexible Asian refineries that have 60

an appetite for those sweet crudes, the key issue is the growing Asia Pacific dependency on Middle Eastern sources of crude. This increased dependency on oil presages an era of continued price volatility and the growing need for additional risk management instruments to be developed and utilized in the Asian markets. China became a net oil importer during 1993 and its needs will continue to grow. Indonesia, an OPEC member and current oil exporter, seems to be slipping from being a global supplier to being a net user of petroleum. 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. However, it 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. Asia will need more imported crude oil in the coming years as output declines in Indonesia and only some oil production increases in China, despite the expected short-term increases in output from Australia, Malaysia, Papua New Guinea, and Vietnam. 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 as 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.

Fundamental changes in Asian oil markets For refiners and traders, petroleum storage requirements are another area affected by deregulation and are a growing area for risk management. Many storage expansions have been announced throughout the region. 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 announced that large-scale storage projects are 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. In fact, regional storage seems to be taking hold as evidenced by Chinese oil stockpiling this year. 61

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. Fed by growing oil demand in the region and the growing interest in making Singapore the energy derivatives center for Asia, it seems likely that this is the beginning of the change to a more financial rather than physical orientation in energy trading. As they move towards deregulation, political changes in Asian countries should bring increased trade activity in both futures and derivatives. 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, gas and power are the most volatile commodities traded. The objective of using risk management tools is simply to achieve corporate goals. There is no cookie cutter approach of “one size fits all.” 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 (since that is impossible).

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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 will often be 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. Remember, that expropriation or nationalization does not in and of itself violate international law, provided there is prompt, fair and adequate compensation to the investor. Risks of contract repudiation such as was experienced by Enron in India, and so-called "creeping nationalization" as evidenced by punitive taxation, burdensome labor and environmental regulations, price and monetary controls, pose a greater and probably more likely risk today. While 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. However, no form of political risk insurance can protect a company if it engages in bribery or corruption, or pollutes the environment. Such actions would probably void any political risk insurance that was obtained.

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BIBLIOGRAPHY Energy Price risk by Tom James Coping with strategic uncertainty, Sloan Management Review Journal of Business Finance and Accounting, June, volume 27 Journal of Petroleum Technology A financial calculus: An introduction to derivative pricing Journal of Political Economy Harvard Business Review Risk and Uncertainty, proceedings of a conference held by the International Economic Association, Macmillan, New York Thinking small about oil, Management Today Applications of Risk Analysis and Investment Appraisal Techniques in Day to Day operations of an upstream oil company, submitted in partial fulfillment of the degree of Master of Business Administration, University of Aberdeen. Derivatives and Risk management in Oil & Gas industries by KPMG Caspian Oil and Gas: Mitigating Political Risks for Private Participation Shortages compel Asian upstream sector to focus on risk management by : Steve Cook Risk Management in Oil & natural Gas industry by NYMEX. The London International Petroleum Exchange (IPE) Asian Petroleum Price Index: Tapis Crude & Dubai Crude

www.bseindia.com www.nseindia.com www.dghindia.org www.ey.com

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