Investors can minimize risk in upstream oil, gas projects

Sept. 22, 2003
Investors should know what they are getting into before they spend millions on oil and gas projects, but as we have seen in recent months, there are too many instances in which investor due diligence has been inadequate.

Investors should know what they are getting into before they spend millions on oil and gas projects, but as we have seen in recent months, there are too many instances in which investor due diligence has been inadequate.

Corporate malfeasance, inadequate analysis, poor management, and sloppy due diligence, however, are not new phenomena born of a recent investment frenzy.

Poor decision-making has plagued oil and gas investors since the industry's inception. This article looks at some recent examples of readily avoidable mistakes.

In each case, investors lost hundreds of millions of dollars. Sometimes losses stemmed from inadequate due diligence despite readily available information. In other instances, inappropriate technology was used and poor operating procedures followed.

Also, poor management controls were used or incentives created that put operating partners at odds with their investors.

Data evaluation failures

When Texaco Inc. and Exxon Corp. joined forces to bid at an Offshore Texas lease sale in 1968, it was assumed that lease structures resembled oil-bearing formations at Spindletop. In fact, as a result of drilling by Shell Oil Co. and others, considerable data existed that revealed the lease area to be primarily a gas province. But despite that evidence, Texaco and Exxon paid exorbitantly for leases and lost millions of dollars.

Similarly, in the 1997 Venezuelan apertusa concession sale, some companies overpaid for concessions and were compelled to withdraw. Enron Corp., Pennzoil Corp., and others abandoned pricey concessions, with Pennzoil losing nearly $65 million on three of them.

The likely culprits of these unsuccessful ventures were the failure to conduct a comprehensive preinvestment project assessment and not building a statistical risk model based on a thorough analysis of risk factors.

There is a long list of big losers in Russia, but one example illustrates the point.

The first joint venture in Russia, White Nights Joint Enterprise, was with Veroiganneftegaz near Raduzhnyy in the Tyumen region of Western Siberia. After signing a contract with Veroiganneftegaz, White Nights promoters secured an investor, oil trader Phibro Energy Inc. (later to become part of Salomon Smith Barney Inc.), with no prior upstream oil and gas experience.

The Russians pushed for an early start, which was acceded to by White Nights without full field evaluation. Ultimately, the venture lost in excess of $130 million, due to unprofitable levels of recoverable reserves. Subsequently, Veroiganneftegaz, allegedly to compensate for the poor performance of the first joint venture, offered the White Nights partnership a project near Raduzhnyy called Golden Mammoth.

Before committing to this venture, the investors sought the participation of a large oil company, which furnished a team of experts to properly evaluate the prospect. Their evaluation revealed insufficient reserves to justify participating in the venture. Further losses were avoided by doing the proper homework.

Why mistakes are made

Assuming investors and operators are intelligent people, how can such monumental mistakes occur?

There is a pattern to the recurring mistakes. In nearly every instance, these mistakes can be avoided with modest expenditures.

Some factors that contribute to less-than-optimal operating performance have existed since the industry's inception; others reflect current economic conditions.

Here are some of the common prelaunch and operating problems that have been encountered:

  • Explorationists and dealmakers become enamored with project potential and do not fully anticipate all of the development and marketing costs. They do not develop an economic risk model to guide them in assessing all costs and risks of a prospect.
  • Contracts are negotiated before project evaluation is complete, i.e., the cart is put before the horse, locking companies into ultimately untenable positions.1
  • Projects are started without properly evaluating geological data; optimizing drilling equipment, casing programs, or drilling fluids; and adequate location preparation for roads and offshore platforms.
  • Turnover of key personnel with reorganizations and downsizing reduce overall staff experience.

Combined staffing, experience, and knowledge deficiencies have contributed to:

  • Applying inadequate experience to unfamiliar geophysical or international operating conditions.
  • Relying too heavily on the recommendation of service companies that are motivated to sell the service they offer—which may not be the best solution.
  • Reacting too slowly or not at all to evolving conditions that can erode project economics.
  • Failing to demand or implement adequate financial controls, thus increasing susceptibility to graft and corruption.
  • Employing improper reservoir wellbore stimulation techniques (acidizing, fracturing, and sand control), resulting in reduced production and recovery. This typically stems from inadequate knowledge of, and experience with, available technologies.
  • Relying on outmoded technologies or inadequate familiarity with new technologies.
  • Utilizing gathering and processing equipment, operating procedures, and lifting techniques that do not maximize efficient oil and gas recovery.
  • Utilizing poorly designed and monitored secondary recovery techniques (waterfloods, for example) or instituting unnecessary secondary recovery projects to increase the forecast of recoverable reserves.

This occurred in the former Soviet Union. When a field was discovered, the recoverable reserves were often forecast by assuming there would be a waterflood project. However, there were instances when strong natural water drive made a waterflood unnecessary.

Waste was compounded because the waterfloods were poorly designed and monitored, and the equipment and materials needed were unavailable.

  • Commencing projects with inadequate available capital resources.
  • Implementing poorly designed incentive plans that skew decision-making. For example, if management is paid a bonus for reserves booked, there may be a temptation to book noneconomic reserves.
  • Utilizing inefficient management and reporting systems that force decision-making too far up the chain of command.

Comparing same-field operators

Examining the performance of operators working in the same field (on different leases) helps compare multioperator performance results.

In the following examples, one operator had a financial interest in a second lease operated by another entity, making it possible to meaningfully compare costs and production results for both leases.

One company placed recent engineering graduates in charge of rig operations. The neophytes were required to seek guidance on every decision from a local office that, in turn, passed many decisions up to a head office three time zones away.

A second company enhanced efficiency by using operating veterans in the field supported by a strong local engineering staff. Decisions were quickly made in the field or in consultation with the local office.

Guess which company's costs were significantly lower?

Comparing results due to differing technical or engineering approaches under similar conditions can also be accomplished via same-field comparisons. Here is an example with two operators in the same field in the Gulf of Mexico, one having an interest in the lease of the other. The same circumstances apply.

In this instance, well costs for one operator were double those of the nearby competitor. A study revealed that the main cost differences were:

  • Considerable rig down time due to pump repairs because desanders were not used.
  • Whipstocks were used when jet deflection techniques were a better choice.
  • Mud weight was overbalanced by as much as 2 ppg greater than required to control formation pressure.

Although in these examples the operators were large publicly traded companies, none of the data required by Securities and Exchange Commission or generally accepted accounting principles accounting rules would have revealed this information.

Similarly, reserve calculations prepared by an outside reservoir consultant may leave something to be desired: Oil companies are not required to publish the disclaimers presented by the reservoir consultant. And private companies do not have to adhere to the same reporting standards as their publicly traded counterparts.

In a world in which data, analysis, experience, procedures, and motives have become suspect, what can be done to reassure management, investors, and shareholders?

Different groups, different needs

One impediment to finding a comprehensive risk-management solution is that the needs of shareholders, investors, management, operators (both large and small) are not as congruent as we might imagine.

Let's look at the needs of each group.

Large companies, whether they utilize them efficiently or not, typically possess all resources necessary to tackle any project. For them, the issues are:

  • Systems—Are fully efficient analysis, incentive, reporting, and management systems in place?
  • Operating assessments—Are practices and procedures continually reviewed, and are investors and shareholders adequately informed and assured of best practices?

Addressing these questions may require little more than a second opinion—an affirmation of practices and choices.

Small and midsize operating companies also confront these issues but occasionally require additional third-party horsepower to augment in-house capabilities.

Shareholders and investors, on the other hand, may have limited capabilities for assessing project risk or the performance of operating partners and management teams. Risk for them is magnified if they must rely solely on the capabilities and reporting of partners or management, or assume that success in one province or operating environment means probable good results in another.

It is not prudent for shareholders and investors to rely solely on the self-evaluation of those who spend their money. However, when third-party assessments are suggested, the response is often, "Look at how much money we're making! We had a 25% return on investment (ROI) on the last project. Outsiders would slow us down and mess things up, because they don't do it our way."

But, what if ROI could have been 30% or even 45%?

There is no company large or small, independent or integrated, domestic or foreign, that cannot improve decision-making or operating efficiency. Arms-length evaluation and coaching by integrated teams of independent experts are the best means to reliably affirm practices and risk assessments.

Independent operating assessments

In the wake of the Enron and other industry debacles, investor wariness of managerial self-evaluation is warranted.

Self-interest and survival instincts justify impartial second opinions about an operating partner's risk assessments and project development plans. Historically, these tasks have been left to independent consultants, but we believe this approach leaves something to be desired.

We contend that for end-to-end analysis—from precommitment evaluation and investment analysis at the start, through geophysical and technical evaluation, to setting exit strategy parameters at the end—consultants who are controlled and coordinated directly by operating management are probably not sufficiently independent. There are other problems.

Typically, engaged consultants have a narrow technical or engineering focus, and their area of expertise becomes the "stovepipe" of their influence and involvement. For example, consultants may be experts in reservoir engineering, facilities design, petrophysics, production, or construction engineering.

The consultant's stovepipe of expertise implies a noncurrent familiarity with all the analytical, financial, and operational disciplines required by an upstream project.

Even when employed in packs, consultants are essentially "singletons" with their coordination controlled by a management to whom they owe their allegiance and livelihood.

In fact, consultants are usually hired specifically because they share the client's operating paradigm—they actually may be former employees. Return engagements seldom come to consultants who bear bad tidings or who are too critical of a client's operating practices.

In short, there are three issues with a traditional consulting paradigm:

  • It is not a sure bet that guidance will be impartial and objective.
  • When the knowledge stovepipes converge at the operating-management team—the information nexus for all project analysis, evaluation, and financial performance—there is an opportunity for data manipulation, or "spin."
  • Very few consultants have sufficient multidiscipline experience to qualify them to render project-wide risk assessments.

The need is for integrated, multidiscipline, independent guidance and assessment.

And because every project involves several constituencies, addressing their diverse needs requires broad risk assessment and project management experience, including extensive top and bottom-line financial responsibility.

  • Multidiscipline technical and engineering experience and familiarity with the latest advanced technologies.
  • Extensive domestic and international project management experience.
  • Experience in financial analysis pertinent to evaluating upstream project ROI.
  • Adaptability or "configurability" to meet specific project requirements. With too-narrow or rigid a capability, you likely get a solution looking for a problem, or a "one-trick-pony."
  • Unbiased response to management, shareholders, or capital partners.

In addition there should be:

The criteria suggest the need for independent consulting teams led by highly experienced senior industry executives with extensive project management experience. Furthermore, consulting teams should be configured according to each project's unique requirements.

Truly independent entities could offer one-stop shopping—an array of services—to every upstream project, such as:

  • Precommitment evaluation of a project's technical assumptions and the ROI forecast presented by the seller or operator.
  • Risk assessment, planning, and procedure "checkups," or second opinions.
  • Project monitoring to ascertain potential areas of improvement. Monitoring becomes more important if thorough precommitment evaluation was not performed.
  • Evaluation of incremental project investments and exit strategy triggers; this becomes important if the project deviates from original forecasts.
  • Impartial guidance and advice that is reliable, pertinent, and cost-effective and is not dependent on corporate politics or investor relations.

Why hasn't it been done already?

There are several reasons why broadly capable, independent teams do not yet exist. First, few companies have been eager to have a third party thoroughly review their operating practices and project data.

Second, management may be insecure about what an independent assessment could reveal to shareholders and investors.

Third, the impetus simply did not exist prior to recent widespread disclosures of corporate malfeasance.

Reduce risk, increase efficiency

Whether an investment is onshore, offshore, foreign, or domestic, there is an overriding, indisputable operating principle: Optimize efficiency and reduce risk, or unnecessarily jeopardize investment returns.

This is achieved by putting experienced, well-coordinated horsepower in the right place at the right time.

Will the in-house talent of an operating partner or investor always suffice? No.

History and recent events suggest that independently managed, third-party audit teams are the next step in a logical progression toward reducing risk and enhancing operating efficiency.

At the very least, independently managed operating assessments are inexpensive insurance against wasted capital resources: ROI insurance. Furthermore, it is confirmation that all reasonable and prudent efforts have been made to safeguard shareholder and investor interests.

Efficiency and peace of mind will be enhanced.

Reference

1."Operators must apply hard lessons learned in Russia," World Oil, January 1999.

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The authors
H. Merle Myers (hmerle1@ att.net), owner of HMM Oil Management in Houston, has been an independent consultant for the last 12 years. He has more than 38 years of oil field experience in engineering, operations, and senior management for ExxonMobil Corp., Royal Dutch/Shell Group, and others. Myers has extensive experience in both US and international operations and has worked on a number of projects in the former Soviet Union since 1990. He holds BS and MS degrees in mechanical engineering from the University of Kentucky.

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Dennis Futchik (dennis@ att.net) is an investment-banking consultant based in Naples, Fla. He has 27 years of oil field experience working in operations, marketing, contract negotiations, and management. For the past decade, he has worked on a variety of international and domestic structured financing, merger, acquisition, and management projects for entities engaged in oil and gas, telecommunications, software, and real estate development.