“There are all sorts of things that we don’t know well enough, but…we need to optimise the way to move forward.”
The May edition of The Actuary (the monthly publication by the Institute and Faculty of Actuaries) featured insight from Peter Naylor, head of Decision Risk Analysis (DRA) at BG Group, on dealing with uncertainty in the oil and gas industry. In his article he highlights some of the key challenges facing the industry, both in terms of general decision making, and in light of the current turbulent environment.
Dealing with the risk
"The nature of the beast which is oil and gas requires heavy investment far in advance of knowing what the return might be."
As highlighted in Peter’s article, the nature of the beast which is oil and gas requires heavy investment far in advance of knowing what the return might be (let alone receiving the return); dealing with the risk requires a solid understanding of how returns can evolve over time, and managing potential variability.
Navigating the decision making process should involve avoiding subjectivity where possible, placing financial values on possible decisions, assessing the probability of associated outcomes and assessing the value that may be gained from further analysis.
Investing in expertise
While these sorts of practices are key to decision making in the financial services industry, and a giant like BG may have set up a DRA centre of excellence, our experience has shown many smaller oil and gas firms have not invested the same level of expertise in this area.
There are multi-million dollar decisions being made using greater subjectivity than for a typical mortgage application. To some extent, this is unavoidable given the profound and complex nature of the uncertainties involved, particularly in the domains of geological scientists and reservoir engineers.
There will always be a strong dependence on expert judgment, which brings its own set of problems related to unacknowledged, implicit assumptions, optimism bias, and the difficulties of combining expert opinions from many different disciplines into an integrated, reliable risk model.
Application of statistical analysis
Our experience suggests that the oil and gas industry’s decision making, cost estimation and capital allocation could benefit significantly from more in-depth application of statistical analysis. When there are so many different variables which can affect returns it is crucial to understand how they behave (and misbehave!), how they interact, and what their potential impact could be, optimised at project, portfolio and company level.
"There are multi-million dollar decisions being made using greater subjectivity than for a typical mortgage application."
We encourage our clients to incorporate state of the art analysis of these essential aspects into the workflows which form their understanding. We tackle this by valuing decisions through the use of quantitative analysis, drilling down into the nature of the factors affecting the ultimate outcome. We model inputs and outputs stochastically, the value criteria used, for example, in making a decision to select a project for acquisition or investment sanction, and analysing the robustness of decisions.
Understanding risk to attract investment
We think this is particularly important in the current volatile, low oil price environment. Many investors are seeking much more assurance of the value in a project than they may have done in the past: clients able to demonstrate excellence in risk analysis, validated by financial professionals and integrated into the decision making process may attract much greater appetite for investment.
I head up our Oil and Gas consultancy services, drawing on my many years of experience in the industry, and we offer tools to oil and gas companies, their contractors and investors to help assess the risks involved in decision making and valuation.
As Peter’s article mentions, the ideal skill set in this area requires a mix of soft skills and hard technical skills. With our wide base of actuarial expertise and consultancy experience we are well placed to help any stakeholders needing insight into this area.
Eva Gibson contributed to the writing of this blog