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Meet the Expert
Professor and Director - Division of Economics and Business, Colorado School of Mines
- Professor and Director of the Division of Economics and Business at the Colorado School of Mines specializing in the areas of strategic decision making, business strategy, and risk management, with a particular emphasis on applications in the petroleum sector.
- Main research interests are in the areas of petroleum valuation, corporate risk management, and the integration of decision analysis and portfolio management in the corporate context.
- Relying on technical developments in the areas of decision analysis, finance and business strategy. provides clients with the ability to improve their decision quality and create value.
- Clients include: Amoco, Anadarko Petroleum, BP Exploration, Cabot Oil and Gas, ExxonMobil, Hess Corporation, Occidental Petroleum, Penn-Virginia Oil Company, Petrobras Petroleos Brasiliero, Phillips Petroleum, Schlumberger, Texaco
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Risk Management and Strategic Decision Making for the Petroleum Industry
Professor and Director - Division of Economics and Business, Colorado School of Mines
- There is a growing emphasis on training employees in advanced risk analysis and strategic decision-making methods.
- During the last 15 to 20 years, firms have taken a much more aggressive approach to training their employees in more advanced risk management, risk assessment, decision-making methods and decision models. The oil and gas industry is characterized by multiple degrees of uncertainty, and by very expensive projects. There's a lot of capital at risk, especially on the upstream or exploration side of the business. It’s crucial for employees to know how to characterize the risks, how to communicate about them, and how to analyze them in an organized systematic way. This sort of training almost always improves the quality of the decision-making for the firm. It also helps to foster a culture where people think more probabilistically.
When companies experience dramatic losses or expose a lot of capital that doesn't work out, this can be a motivator. They want to know how this happened. But when they try to do an analysis after the fact, it's often too late. It's very hard to determine what actually happened. When risk analysis is part of the process overall, it's much easier to spot where something went wrong.
Not every firm is as sophisticated as the next, and this is not necessarily related to size. One might expect major oil companies to be more inclined to use state-of-the-art methods, but that's not necessarily true. Often, it's the smaller and more independent companies that are further along on this continuum.
- More firms are including portfolio management as part of their capital allocation process.
- Over the past 5 to 10 years, there’s been a general trend for firms to take more of a portfolio management approach to the capital allocation process. They're thinking about their suite of assets rather than analyzing each project individually. As with a stock portfolio, the goal is diversification that generates an increase in the return without increasing the risk. When the mix is optimal, there's a balance between manageable risk and a better return overall. Within a specific business unit, portfolio analysis can drive real benefit. At the corporate level, it means balancing the entire portfolio, including marketing, refining, upstream, distribution, and also any green or alternative technologies.
Some organizations are putting effort and money into more sophisticated risk management practices. Others still make most of their decisions on the basis of their own experience or "by the seat of their pants." Companies that are adopting a more probabilistic approach have recognized that we live in a very uncertain world. To make quality decisions, it’s important to understand and measure that uncertainty.
- The key risks and uncertainties have changed as companies shift their focus from conventional to unconventional resources.
- In the oil and gas sector, risk management has historically focused on trying to recover conventional oil and gas resources. The key uncertainty was the probability of geologic success – the probability that a pay zone or reservoir actually exists. Based on the geological data, companies could estimate the likelihood of a particular kind of trap or trapping mechanism in the subsurface. With the more traditional oil and gas projects, this is still the way it works.
In the U.S. today, however, the focus has shifted to unconventional resources. It's all about tar sands and shale plays, and the risks are very different. It's not a matter of wondering if the reservoir will be there. There's almost no uncertainty in that regard. The risk now lies in estimating the deliverabilities, and also the water issues, which are two-fold: Water factors into production in a big way, and water is also an environmental issue.
This is a fairly new trend. It's become more important in just the last 10 years. Companies are still grappling with it. Many of the techniques and methodologies are similar, but there’s been a big change in emphasis and it's affecting all of the big oil companies.
- There is a growing need to understand the risks associated with hydraulic fracturing.
- Hydraulic fracturing, or "fracking," dominates the shift to unconventional resources. When companies conduct large hydraulic fracturing, it involves a lot of water. There’s a serious environmental concern, some of which is founded in science, and some of which is not.
Hydraulic fracturing has been going on for about 40 to 50 years, but it's come to the forefront because it's being used a lot more, and there’s been a big increase in the size of these fracturing jobs. Many of these projects are huge compared to what they used to be.
Firms have to understand the risks associated with hydraulic fracturing and how to work with the affected communities. They have to cultivate relationships locally in order to develop these resources in a way that has real economic value. There’s a tradeoff between that and what the local concerns are in terms of the impact on water quality and the environment.
This actually goes beyond a risk management issue. The laws vary by state, and so do the politics. In Colorado, for instance, some communities have passed laws to forbid hydraulic fracturing. The court has thrown out some of those cases because it falls under a state vs. local jurisdiction, but there’s increasing political pressure. There's discussion on the federal level as well. Very few want fracking to happen in their back yard. Of course, for the oil companies, it would be a nightmare if every community could decide how they were going to develop their oil and gas resources, so there’s a big risk there.
With hydraulic fracturing, the science is still not very good. Many of the impacts are still unknown, and in the popular press, most of the news is bad.
- Oil and gas firms are more aware of the need for improved communication about risk and risk-taking.
- Firms are doing what they can to foster better communication within the organization about risk and risk-taking. This really ties back to the first trend because many companies are also training their employees to communicate more effectively. Managers need to be able to act on some sort of written policy. If there's no discussion as to what is meant by risk or what the risk tolerance is within a firm, it's very hard for the managers to have any real understanding.
This still has a ways to go. Different divisions tend to have different ideas about risk. The VP of exploration may consider the firm a low risk taker. But if you walk down the hall and ask the VP of finance, he might say, “Oh, we take huge risk.” It all depends on your perspective. There’s often a silo culture in these organizations with each unit focused very vertically on one specific area. It’s important to create an awareness that can transcend across divisions as to what is meant by risk, and for the various managers to have the ability to communicate about it in an organized fashion. The company can then can be more rational in its decision making.
The use of more advanced decision-making techniques and methodologies can help. They're designed to get the various divisions to be more consistent in their communication and analysis. They force the different divisions to engage and everyone has to have a clear understanding of what is meant by risk. This constitutes a cultural change and can be a challenge to implement. On the one hand, there’s the very independent shoot-from-the-hip type who was once possibly once a wildcatter, and on the other, the more analytical methodical risk-averse financial and accounting personality. Then there are also the scientists, the engineers and geologists. It’s a very diverse mix with a lot on the line, so it’s not an easy task to get them all on the same page.
- General trends in petroleum risk management are difficult to define because each company tends to approach the problem differently.
- In terms of risk and risk management, it's hard to map any one trend that cuts across the entire industry. Every company approaches the problem differently and tends to focus its effort on certain kinds of projects and prospects. While there are some common characteristics, there are also big differences in how these companies approach the problem. It makes it necessary to customize the solution.
A recent study compared risk tolerance at the majors with the big independent oil companies. It revealed some very significant differences. Relatively speaking, the big players like Exxon Mobil or Chevron Texaco were pretty conservative in their risk-taking compared to a big independents like Anadarko Petroleum or Devon. It’s all “relative” because the majors have a lot more capital to work with.
On an absolute basis, it may look like they're taking more risk, but relative to how big they are, and how much they have to spend, they're actually being much more conservative. The general corporate culture around risk-taking tends to vary tremendously from one company to the next. Some are more entrepreneurial while others are very centralized and are structured so that all the big decisions are made at the top.
Risk Management and Strategic Decision Making for the Petroleum Industry: Key Trends