Preparing for the unknown
THE NEXT PHASE OF PORTFOLIO MANAGEMENT
ANDY BROGAN, EY, LONDON
THE GLOBAL OIL AND GAS INDUSTRY has a long history of capital project delays and cost overruns. Too many companies fail to achieve commercial excellence and experience a lack of value delivery over the full life cycle of their projects. In fact, the average project cost escalation sits at 59%. During the period of high oil prices those overruns were damaging-now they could be fatal.
The drop in oil price put portfolio optimization back at the top of the boardroom agenda. What followed were countless news headlines of projects being deferred or canceled. But the reality is that portfolio management isn't enough to thrive. The future is too uncertain to plan effectively. A portfolio that's optimized for a US$100/barrel oil price world is unlikely to be optimized for a US$60/barrel oil price world. And in today's world, you never know with any certainty which scenario you'll face. More than ever before, companies must marry portfolio management with flexible and adaptable operating and financial models: they need optionality.
Optionality helps bridge the gap between the industry's long-term investment horizon and sudden changes in the market. It enables a company to quickly and efficiently shift its focus from underperforming businesses, assets and projects to better-performing ones.
Optionality, or flexibility, has always been important in the industry. Even with a relatively benign environment over the past decade, projects reported disappointing returns. Now, going forward, companies face greater geopolitical, government policy and commodity price uncertainty. The stakes are higher.
Despite the consensus that flexibility contributes to a company's ability to succeed, it's quite difficult to be flexible in the oil and gas world. Assets that make up a portfolio are often inflexible, with long lead times and 20- to 30-year capital commitments. Once you turn them on, it's hard to turn them off again.
Flexibility is made all the more difficult by the fact that investors often have a very short-term investment horizon. Investors expect companies to optimize the business for the world that they see, not one down the road. That's where one of the biggest challenges lies: in trying to reconcile the capital provider's time horizon with that of the project.
It's important for companies to look beyond the economic returns and think about what commercial decisions mean for optionality. They then need to communicate how those decisions are made - especially where short-term value creation is being sacrificed to preserve optionality.
Where can companies embed optionality into their organization? Optionality can be embedded at the corporate, portfolio, and project levels. Creating an adaptable legal and capital structure, a strong balance sheet, and access to a wide range of financing options ensures flexibility at the corporate level. At the portfolio level, companies should assess project or asset decisions in both absolute and relative terms - against specific criteria and each other - to enhance optionality. And at the project level, optionality depends on a commercial and capital structure that allows for flexibility at the outset.
Portfolio management is made all the more effective with optionality. Companies can respond quickly and easily to sudden changes in the market. That ability to be agile is essential. Equally as important is undertaking frequent and effective reviews to identify possible symptoms of portfolio inertia early before business performance is significantly hindered and then take steps to address the issues.
EY recommends the following five-step approach for managing a portfolio:
STEP 1: ASSESS ASSETS ON A REGULAR BASIS
The decision to divest, invest, or retain an asset should be made regularly. Retaining an asset should always be a conscious decision - not a convenient one. Doing nothing is often a higher-risk strategy.
STEP 2: EVALUATE PORTFOLIO DECISIONS
It's important to look at portfolio decisions in both absolute and relative terms - against set criteria as well as other decisions, for example. At the same time, decisions should be looked at on both a stand-alone and aggregated level. It's important to know the full story before acting.
STEP 3: RETAIN DECISION-MAKING FLEXIBILITY
Making a major decision doesn't mean it is set in stone. Focus on retaining optionality to be able to respond quickly to unforeseen events.
STEP 4: ENSURE QUICK AND FLEXIBLE DECISION-MAKING
Flexibility goes a long way in preparing for the unexpected. It's important to have options or alternative strategies in place or, at the very least, a process for developing and approving them quickly.
STEP 5: PREPARE TO MAKE TOUGH DECISIONS
Be prepared to take action while keeping the broader portfolio in mind. Tough times force tough decisions, like shutting down or amending a project that does not meet objectives even if it has substantial sunk costs.
Volatility has been a consistent feature of the global oil and gas industry. It is very difficult to predict the long-term future state of the industry, let alone the next 12 months. Some analysts predict a slow, U-shaped recovery, while others believe that prices will rebound more quickly. What is certain is the importance of preparing for the unknown. Companies that embed optionality into the foundation of their organization will be best-positioned to survive and thrive in any future market state.
ABOUT THE AUTHOR
Andy Brogan is EY's Global Oil & Gas Transactions Advisory Services Leader. Brogan has been with EY for over 25 years and has advised oil and gas companies on a variety of public and private transactions covering both upstream and downstream operations in more than 30 countries. His clients have ranged from large global enterprises to independent resource companies and he has also worked for various Governments in connection with transactions in the oil and gas industry. He holds a BSc from Imperial College of Science, Technology and Medicine (London) and is a UK Chartered Accountant. He is based in London.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.