Risk Analysis: Economic Evaluations of Oil and Gas Investment

Risk Analysis: Economic Evaluations of Oil and Gas Investment

The growth potential for oil and gas investments is substantial, provided that companies perform proper risk analysis first. The industry is still the primary source for the world’s power even as exploration into alternative sources continues. But to be profitable, companies should be willing and able to conduct calculated risk analysis in order to accurately estimate project payouts.

To do this, companies often turn to economic evaluations whose results will ultimately drive their investment decisions. The evaluation is usually a final step in a lengthy analysis of financial and technical motives and assessments that must be performed prior to making any investment. This is how oil and gas companies are able to explore potential assets and decide how to prioritize projects, allocate funds, and progress in the industry.

Here’s a closer look at the evaluation process at large and its role in performing accurate risk analysis.

Risky Business: The Importance of Risk Analysis

Industries typically fall into one of two categories: labor-intensive and capital-intensive. For industries like automotive or manufacturing, there’s a heavy emphasis on the labor portion, meaning it takes a sizeable workforce to produce parts or products in order for a business to thrive.

Most of the oil and gas industry is capital-intensive, meaning it requires large sums of money to invest in new technologies and equipment, explore new markets, and initiate projects. For example, a geological or seismic study can easily reach into the millions of dollars, while processing facilities could surge into the billions over the lifetime of the facility. Though labor is also an important resource, there’s a heavier emphasis placed on the monetary portion.

Because of the intense capital investments required, oil and gas companies often rely on risk analysis to ensure they’re funding the right projects and markets.

Traditionally, oil and gas companies would invest in multiple revenue streams and business arenas to create a more stable financial profile. Each segment would experience different highs and lows in pricing and margins, and when one is down, the others could help to offset the pricing variations.

Today’s approach is a little different. Companies are planning and making decisions based on the varying amounts of risk in the assortment of investment options. Generally speaking, the higher the risk, the higher the potential ROI. However, high-risk projects typically also carry a potentially large financial loss, one that companies will need to weigh carefully before pursuing any specific path.

Exploring the Major Risks in Oil and Gas

Most oil and gas projects are assessed on several levels of risk including: environmental risk, economic risk, political risk, and technical risk. Each type of risk applies to all major, long-term projects, including:

  • Onshore and offshore exploration drilling
  • Infrastructure installation or refurbishment
  • Old field redevelopment
  • Oil and gas production platforms
  • Processing facilities

Let’s look at each of these different risk levels:

Environmental Risk

The total environmental impact and overall safety are major considerations for projects. This includes not only attention to both the level of pollution produced and the local ecology, but also to employee safety, fire hazards, equipment damage, and other potential dangers.

There’s also the risk associated with the zero-flare tolerance policy, which means that companies cannot produce oil unless they can find an outlet for the gas that is burned out or flared at the well site. This has added a major expense and complication to the production process.

Economic Risk

Given the large capital investments required in oil and gas projects, economic risk largely focuses on the monetary returns, operating costs, and potential factors that could influence oil and gas prices. There’s a lot of overlap here with political risk, as many political factors can influence the profitability of a project (e.g. tax rates, currency exchange rate).

Political Risk

Political risk refers to any risk of doing business within a given location. Any change in the area’s government could bring the potential for re-evaluation of the current oil and gas regulations, taxes and payments, and production.

Technical Risk

A project’s technical merits are immensely important to its overall success or failure. Due to the wide range of tools and data sources used by oil and gas engineers and geoscientists, combined with the diversity of backgrounds and skill sets of the various professionals charged with interpreting the data, developing accurate predictions of a project’s hydrocarbon production potential can be quite challenging. Finding a strong technical team will have a significant effect on minimizing the technical risk of your project.

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Common Approaches to Oil and Gas Risk Analysis

With the above types of risk, companies use a variety of approaches to hedge their bets and make accurate, data-driven decisions, including modeling, quantitative risk assessments, and scenario planning.

Modeling remains one of the most preferred approaches to risk analysis. Companies can build models that use real data sets to predict relative outcomes and effects, such as after-tax cash flow, inflation rate assumptions, abandonment costs, health and safety impacts, working interest and capital adjustments, and other economic factors. Oil and gas projects are often influenced by multiple economic indicators, which is why modeling remains one of the most powerful tools in the arsenal.

Quantitative risk assessments take into account the concept of the time value of money. The idea behind this concept is that the cash flow or revenue earned in the future will need to be discounted because it will not be as valuable as the cash today.

Scenario planning takes this concept a step further by exploring various scenarios that could impact cash flow. As a baseline, many companies predict that cash flow will not change, but scenario analysis addresses this shortcoming and evaluates instances of uncertainty. For example, a scenario analysis may include a baseline along with minimum and maximum values, standard deviations, and expected values. It explores several possible outcomes so that companies can understand the full implications of their actions.

How an Upstream Consultant Can Help

Risk accompanies every investment in the oil and gas industry, but understanding and evaluating those risks can help companies to make informed, calculated decisions that will help them achieve the right results. The industry has a complicated set of variables that need to be carefully considered, which is why many companies turn to upstream consultants for high-level expertise, research, and assessments.

Upstream consultants collect and interpret as much scientific data as possible and conduct risk assessments on your behalf so that you can feel confident when making investment decisions. We can help you examine all capital possibilities so that economic predictions are accurate and informed, allowing you to move forward when the time is right.

Contact us today to learn more about our processes and how we can help you increase the profitability of every project you undertake.

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