Planning is not Forecasting

Oil and Gas companies face an uncertain time (yet again): they should avoid more scenarios and take more action

In times of uncertainty, many corporations, especially major oil firms, use scenarios as a key tool for developing strategies to deal with the range of futures ahead of them.

Scenarios are a range of plausible, speculative fictions about how the world ahead of us will look based on how some key variables or events turn out – in the oil and commodity world these variables are typically product prices, blended with key issues such as regional politics and global policy-making on trade or technical issues.

In their main form three to four world outcomes are then built around a base or standard case – one or two tending toward an upside eg in political breakthroughs or price stability, and one or two in the opposite direction to a problematic downside.

Used well, these devices can broaden corporate viewpoints, and help avoid groupthink and corporate myopia about the world ahead.

Misused, they tend to reinforce company beliefs, and heavily discount unpopular or uncomfortable future states. This latter risk has become more prevalent as companies publicise scenarios more prominently, but try to avoid painting too dismal a future that may un-nerve investors or employees. Hence recent scenarios have become more conservative, avoiding tail risks and the potential for significant downturns.

For example, in many key industry publications such as BP’s Energy Outlook or Statistical Review of World Energy, emerging trends such as US shale oil production, although noted, are often under-scrutinised (as in the 2013 version here), with limited mention for example of its potential impact on pricing via increased supply.

Overall, this may have left the industry intellectually unprepared for the current collapse in oil price.

And its not just oil price where the passive scenario planning has occurred – another major industry issue – climate change – has caused commodity firms to take a similar approach.

BHP Billiton’s  response to the impact of the Paris COP21 2°C agenda has been to use scenarios to test the robustness of its project portfolio based on what may happen in terms of decarbonisation policies. It is to be applauded on one level, as it is starting to take the issue seriously in its strategic planning. BHP’s current project portfolio is tested under a Global Accord scenario (orderly transition) through a Shock Event alternative (sudden transition) concluding that profitability remains robust under all of them. But the conclusion drawn seems highly optimistic, with ROI numbers healthy and vigorous no matter what scenarios prevail.

Given the current oil price impact on BHP’s profitability, strategy and dividend policy right now, it provides more evidence that scenario planning is becoming more marketing than hard-edged scrutiny, tending to produce acceptable outcomes over a series of imagined futures.

If scenarios are becoming more hype than analytical insight, what other approaches are taking place that can help guide firms on the way ahead?

Another path taken is that by Woodside Petroleum.

In its latest results discussion with analysts – here – its has avoided discussion on a range of futures and plumped for a single number for the oil price – $35/bbl – as its planning basis.

An iron law of the oil industry is that you cannot forecast the oil price in the future – it has made fools of anyone and everyone who has tried.

That law is incorrect.

Add it to other rigid certainties such as – shale oil production will collapse when oil prices fall, and wind energy cannot be used for baseload power; the oil industry has too many of these “laws” that shut in thinking.

What Woodside have created is their own cast-iron accurate oil price of the near future – $35/bbl.

As its CEO Peter Coleman makes clear, this is NOT a forecast of oil price – they have tested other prices. But it is their central planning assumption. One can argue that this is an oil price scenario by another name – but the tone is very different. There is no narrative of world states or scenarios – only the naked oil price is to be used to test current projects and future business modeling. And to drive actions and inaction.

If the world somersaults and oil soon reaches $200/bbl no doubt the thinking will have to alter – but in a tighter range of futures, Woodside will be using $35/bbl – and that is clear to partners, investors, buyers and sellers.

Woodside also believe the oil price change is structural rather than cyclical.

This may be self-serving for Woodside who have hesitated on a whole range of capital investment decisions over the years eg the Israeli Leviathan gas project and the ever-receding Browse Floating LNG. An openly-declared structural $35/bbl investment hurdle usefully gives the company space to reconsider and renegotiate current pricey projects with partners.

But there is a solid logic here.

The impact of oil price on project economics and cashflow is beyond any company control – but mostly when projects are already fully underway – at this point legally-enforceable contracts are in motion, cashflows sanctioned, workforces mobilised to multiple sites and so on: in the Execute phase in the industry argot. All projects are then at the mercy of what the oil price does to overall economics, and what has been negotiated into sales contracts. Woodside’s fellow oil company in Australia Santos is living this tough reality in their Gladstone LNG project, where during the price fall they were caught executing a megaproject that has badly over-run and saddled the mid-size firm with potentially fatal levels of debt.

But before any money or resource or contracts are properly committed, all companies have choices they can control, future states they can define. They can decide to go ahead based on all sorts of criteria – economics, technology, strategy, market entry and so on – most often a combination. Setting a new low oil price condition precedent attempts to steer choices into lower-cost projects, automatically filtering out higher risk options, closing out creeping commitments and recycled debates.

Woodside have declared this is the new world, and this is the future where they are now living.

It will be argued this is a strategy that suits them and their particular set of circumstances and capital profile. And if they refuse to take on moderate project risks, they will lose out on growth opportunities and start to lose scale and revenue sources.

But that assumes the previous world logic prevails. For Woodside, the key now is to make good on its discipline, and use it to find innovative ways to make seemingly uneconomic projects become lower cost (as argued in previous posts – see Beating Betteridge’s Law), rather than wait passively for some price level to rescue them.

Put another way, if an oil company finds that its portfolio can only break-even at $60/bbl – as some have openly stated – then what scheme does it have to manage a structural to change to a lesser number? Incredulity at the current oil price is not a plan. Sober reflection and a set of actions to cancel or innovatively re-design the current group of projects is the more effective response – and the sooner the better, before large-scale investments are set in motion.

The oil industry prides itself in taking the long view. That does not mean, however, it can assume everything will revert to a preferred previous model or balance. A new – long-term – equilibrium may now have been established due to shale oil production techniques, and the constant advance of renewables technology and energy efficiency.

Of course, this provides an uncomfortable and painful prediction of the future – but its one that needs increasingly to be taken more seriously, and acted upon, and not dismissed as an unmarketable scenario.

Some firms are realising that.