Portfolio Management, Upstream Oil&Gas (part 1/2)

How to Optimize Your Oil & Gas Upstream Portfolio; Upstream Portfolio Management (part 1/2)

Portfolio management or optimization of the portfolio is being referred to by several leaders in energy sector. This article presents an introduction to the topic and intends to introduce how portfolio management is done in E&P sector.

Part 1/2: Asset Level Optimization

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Background and the business context

Portfolio management in investment world is a risk mitigation tool (or approach) against market fluctuations. Modern portfolio theory (MPT was developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance) has had an impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. In the other words the overall risk of the portfolio would be lower than the risk of individual investments (e.g. stocks).

Short/mid/long term outlook of global economic growth shape energy supply-demand, and in turn will have a direct or indirect impact to the E&P sector. That’s why oil and gas companies constantly watch the global economy, rivals (including OPEC), discoveries (where, how big), emerging technologies and try to forecast the oil and gas supply, demand, price and other shaping factor of their strategic landscape. The commodity price forecast is a single risk that can have a major impact on the economy of the upstream projects and ultimately a factor that can reshape the investment portfolio. Other risks that oil and gas companies need to manage are exploration risk, political risk, cost/schedule uncertainty, subsurface risk, technology risk etc.

Asset mix

The energy sector is providing energy to the global economy. In a value chain prospective the sector can be split to upstream, mid-stream and down-stream. Not all companies are integrated to cover the full value chain (from discovery to delivery). Some companies have a focus on gas only (e.g. BG) so they will be more vulnerable to gas price versus fluctuations in oil price. Some companies hold portfolios which are heavy on unconventional plays such as Canadian companies focusing on Oil Sands or the ones developing shale-gas. While a single focus might bring execution synergies, these type of companies might be exposed to the risks associated to the plays that they are heavily dependent on. In the context of portfolio management companies which have a diverse portfolio of projects (oil, gas, LNG, unconventional, global footprint, etc.) are less exposed to risk than the ones with single asset base.

Nevertheless, the concept of the portfolio management is applicable and is being used by most of the companies irrespective of the diversity of their asset-mix as always there is one simple question to answer “is this the best investment opportunity that we should invest in?”

Governance and process

The oil and gas companies start the budget season around August every year. Initial proposals go through multiple reviews at asset and business unit level and then will roll up and consolidate on different classes such as areas and sectors (oil vs. gas, or upstream, vs. mid/downstream, etc.). The budget will be forwarded to the attention of the senior management for decision around Oct/Nov and usually is approved and in place in December. Usually a centralized process governs the budgeting process to make sure that the business cases developed for each investment opportunity (associated economic KPIs, risks and other attributes) are done unbiased. This groups is usually called Corporate Planning and Economics. The same team owns the portfolio and usually would take the advantage of the budgeting season to assess the effectiveness of the portfolio. With close collaboration of the external advisers (management consultant to provide global market trends, commodity price forecast, etc.), senior management and business development team the proposed budget will be optimized to support short and midterm strategies of the company.

Asset and BU level optimization

Bigger and global organizations are usually structured around geographical map where projects with common fiscal regime and geo-political risk are managed by the same business unit. Despite of the geo-market segmentation usually the oil and gas companies rank and compare the investment opportunities based on the liquid mix too (oil vs gas). This would enable them to understand how the portfolio can benefit from the oil or gas price forecast and its sensitivity to midstream solutions (i.e. supply, market access, takeaway capacity, etc.). To take the advantage of the organizational skills and know-hows and synergies between projects in a common geo-market the projects are run by focused development teams who for example focus on heavy oil, or unconventional gas and so on. Upstream companies call them Asset Management Unit (AMU), or Business Units (BU), e.g. gas BU. With this background we should mention that some preliminary work on the portfolio of projects usually starts in the BU. For example the asset team in charge of the heavy oil assets in Western Canada will develop a base case and uncertainty scenarios (risked scenarios) for each of the investment opportunities before entering the cases to the portfolio tool. This interim stage has some advantages. The advantage to the overall profitability of the BU’s portfolio is that the projects’ inter-relations and synergies can be analyzed and assessed at the BU level. There is a risk that the same task is done in a mechanical fashion if left to the portfolio optimization at the corporate level.

When a risk modeling and probabilistic uncertainty analysis is done on each project (e.g. through Monte Carlo iterations; P10, P50 and P90; P for Probability of success, or occurring) the cases will be optimized at BU level. The focus of this stage of the optimization is more on the synergies among several similar plays (e.g. oil sands assets) on infrastructure, field operating team, midstream solutions and so on. The optimized BU package will be passed on to corporate planning for inclusion into the portfolio optimization engine.

 

Continue to part 2/2

 

More to read:

Modern Portfolio Theory: Why It’s Still Hip

Upstream Evaluation, An Introduction

 

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