Why Do Petroleum Risk Assessment?
Authors: Mireault R. 
Published: March 2010

Introduction

The answer to the question could become painfully obvious in the upcoming months. Your job and your company's health, even its survival, depend on it. For proof, consider the industry's current situation. Some companies did not survive 1998 and even more will not survive 1999 if low oil prices and potentially lower gas prices continue. However, not all companies will cease operations. Companies who considered the possibility of low prices in their past investment decisions and took steps to mitigate the associated financial risk will not suffer to as great a degree as those who didn't. They may even prosper as the financial plight of some companies produces bargain acquisitions for others.

Most people intuitively understand the importance of assessing financial risk when the investment is so large that failure immediately jeopardizes the company, but few recognize that a series of "small," unprofitable investments can be just as crippling to financial health. The industry routinely performs exhaustive studies for international investments that involve large dry hole costs, but it does not regularly assess the risks associated with domestic exploration. The industry pays even less attention to the financial risks of development even though it is the most travelled road to bankruptcy. Going broke by discovering and producing uneconomic oil is less spectacular and takes longer than via the dry hole route, but either way the final destination is the same.

Economists call low prices a "market reaction" to an oversupply situation and tell us that it is a predictable part of the commodity price cycle. As an oil industry professional, your reaction should be no more than to adjust the investment portfolio and company operations accordingly. Like it or not, professionals in the oil industry get paid to consistently increase the value of the company irrespective of what the price of oil and gas are doing. The investment community's expectation is consistent for professionals in all industries. Bankers deal with interest rate fluctuations; manufacturers and retailers with varying pricing and consumer demand. In fact, bankers post record profits when interest rates are low. And bank loans have no upside potential. That's quite a contrast to the oil industry, isn't it?

Market Cycles and Petroleum Investment

So how does an oil professional cope with and profit from these market cycles? The economist's answer is by substituting equity financing during the periods when it is available at a lower cost than debt financing. A company's ongoing source of investment capital is its internal cash flow. Equity and loans are onetime sources of capital that are used to supplement internal cash flow as required for specific investments, but the market is fickle. The investment community is generally eager to put capital in the oil business when prices are high and reluctant when prices are low.

The market equity that was obtained and invested over the last few years of high prices should be generating substantial additional cash flow by now, with at least 15 - 20% hurdle rates of return even at the low end of the price scale.