Rising costs erode oil industry's profits

From the Financial Times

By Ed Crooks in London

Published: September 3 2008 23:36 Last updated: September 3 2008 23:36

Oil companies’ profitability fell last year as rising costs eroded gains from the rise in oil prices, an industry study has found.

The companies’ return on capital from their oil and gas production fell to 19 per cent, 3.5 percentage points lower than in 2006, according to the study from IHS Herold, a research firm, and Harrison Lovegrove, a corporate finance firm owned by Standard Chartered bank.

The study of 232 leading quoted oil and gas companies also found that they had not increased their total reserves last year, and raised production only slightly.

Rodney Schmidt of Standard Chartered suggested that if oil prices continued to fall, oil companies could face growing difficulties. “We are now at a point of greater uncertainty...where there are questions about demand and about where prices will end up. At the same time, profit margins have not been increasing.”

Company profits have been squeezed because costs have risen along with revenues, and governments of resource-holding countries have been taking a greater slice of the proceeds through tax increases or contract renegotiations.

Although big companies have still been making record profits, they have also had very high levels of capital expenditure. Organic capital spending, excluding acquisitions, has soared from $139bn in 2003 to $342bn last year, the study found.

The result has been that, in spite of the steep rise in oil prices over the decade, profitability has risen only slightly from 16.5 per cent of cumulative capital costs in 2003 to 19.1 per cent last year.

The difficulties facing the industry are also reflected in slow production growth, which averaged just 1.3 per cent last year. Production increases in the US, Russia and the Caspian area and the Asia Pacific region were offset by declines in Canada, Europe, and South and Central America.
Companies also found it hard to add to their reserves: proved oil reserves dropped by 1.5 per cent, while gas reserves rose 3.3 per cent, reflecting a shift by many international companies away from oil towards gas, which is often more difficult to extract and market profitably.

Copyright The Financial Times Limited 2008

Things occupying my mind

What makes risk management interesting

The challenges in financial risk management is keeping up with changes within the organization and assessing that impact to risk management; in other words moving on with times. The demands by multiple stakeholders in terms requires you to shift thinking caps and the learning curve for me and for my team is very steep in order for us to stay at par with organizational change, if not ahead, and simulatenously meet the demands of the stakeholders i.e. senior management, OPUs and HCUs.

Things occupying my mind categorized but not necessarily in the order of importance.

Integrated Financial Risk Management

• Pilot company compliance checklist report
• Supporting guidelines that needs to be re-written, both in terms of documentation and content
• The review with CFO of the pilot company
• The remaining 1st phase OPUs for CFP roll-out
• The risk council meeting this 23rd September
• Sharing session with Group Risk Management on CFP implementation
• Revised timeline for all of the above

Measurement and Reporting

• Getting to a total view of FX Risk exposure
• Revised Dashboard to incorporate having a total view of FX
• Framing the context of foreign exchange exposure for the group of companies
• Risk systems transition and implementation
• Progress in implementing stress testing framework for financial risk exposures
• A framework for FX Risk Management for the upstream OPU

To be continued.......

Asset Liability Management

Compliance and Control

Initiatives deadline

Perspectives in Currency Risk of a Non Financial Corporation - Part 1

How do you frame the context of foreign exchange risk in a non-financial corporation?

Setting objectives

The objectives of risk management must be clearly articulated in terms of risk and return. The objectives set must be able to answer the concern of volatility of risk factors and how the corporation is impacted by this volatility. The metric upon which this volatility impacts the organization must also be defined. For example :

• Is the corporation concerned with the volatility of its cash flows impacted by risk factors such as foreign exchange and commodity prices?
• How does cash flow volatility impact the corporation's strategic business objectives? Will cash flow volatility exposure to risk factors left unmanaged will cause the corporation to reject potential business investment opportunities?
• What are the corporation's growth strategies and will cash flow volatility result in expensive ignorance of profitable opportunities?
• Linking this to performance reviews, how does cash flow volatility impact the firm's return on invested capital and more importantly, how does a firm gets the assurance that these risks are managed?

Knowing what is at risk : Economic exposure vs. accounting exposure

In setting objectives, we should also be clear on whether we are concerned about managing volatility of economic exposures or volatility in accounting exposures. This clearly will have some bearing especially if reported numbers through the strategic planning group relies heavily on accounting numbers. These two concepts will result into risk exposures that are very different. Economic exposure in general refers to the economic realities of the extent a corporation is affected by exchange rate changes. Accounting based foreign exchange gains and losses typically gets reported and many senior management are typically preoccupied with these numbers.

In making the distinction between economic vs. accounting exposure, one can use a few examples to illustrate. From an exposure recognition perpective, a revenue flow is recognized in accounting terms when an invoice is issued and the sales is recorded with a corresponding record of the account receivable consistent with the accrual accounting method. The economic exposure however would already be recognized at the bill of lading date, where a provisional invoice is issued, and the amount and timing of cash flows is still uncertain.

Similarly for expenses. Say if a project has been sanctioned and a contracting strategy has been developed. The economic exposure would recognize the impact of exchange rate changes in the project economics stage and once sanctioned, the impact of exchange rate changes in the expected future cash flows of the project. The accounting exposure would follow liability recognition rules, where liability is recognized when services have been rendered or goods have been received.

In a nutshell, the time pattern of an economic exposure happens much earlier than that of the accounting exposure, and that should be basis for exposure recognition in risk management.

Knowing what is at risk : Defining the metric

Accounting exposure focuses on the impact of exchange rates on reported earnings and in shareholders' equity, dependent on accounting rules that dictate how a transaction is recognized in the accounting books or how subsidiary balance sheet translation impacts that of the parent company.

Economic exposure focuses on the underlying cash flows of the firm; in this context the impact of exchange rate changes in the expected future cash flows of the firm.

In this regard, the expected future cash flows of the firm sensitivity to exchange rate changes or risk factors can be viewed in terms of its impact to the firm value (i.e. present value of future cash flows) or in terms of real operating exposure. Real operating exposure refers to the impact of exchange rate fluctuations on future revenues and costs i.e. its operating cash flows.

The link between operating cash flows and firm value

Getting a total view of the impact of exchange rate fluctuations onto operating cash flows

To assess the impact of exchange rate fluctuations onto operating cash flows requires a detailed understanding of the firm's core business operations and its cash flows and in a large organization such as ours requires also understanding the inter-company linkages. Once these cash flows have been identified, the risk exposure, whether in terms of sensitivity of cash flows to exchange rate changes or a more sophisticated measurement method of assessing the volatility of exchange rate risk factors onto the cash flows, therefore cash flow at risk, can then be performed.

To be continued

What I am reading this past few days

We will never have a perfect model of risk

http://www.ft.com/cms/s/0/edbdbcf6-f360-11dc-b6bc-0000779fd2ac.html

SEC plans for global accounting standards

http://www.ft.com/cms/s/0/93d5193c-746b-11dd-bc91-0000779fd18c,dwp_uuid=745008c6-741e-11dd-bc91-0000779fd18c.html

Risk Management Watch - CROs remain hot commodities

http://blog.aefeldman.com/2008/08/05/risk-management-watch-cros-remain-hot-commodities/

Merrill Painfully Learns the Risks of Managing Risks

http://www.nytimes.com/2007/10/12/business/12insider.html?_r=1&scp=10&sq=risk%20management&st=cse&oref=slogin

US Oil Production vs. Consumption

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Don't Risk using Normal Distribution

From the Financial Times

Don't risk using normal distribution
By Lisa Goldberg


It feels as though financial extremes have become everyday occurrences. Oil prices have doubled in the past year and there is disagreement about whether they will revert to previous levels.

US mortgage giants Freddie Mac and Fannie Mae are under severe strain. The value of the euro relative to the dollar is at a record high. Damaged financial markets attempting to recover from the subprime mortgage crisis may be destined for more turbulence.

There is reason to believe that extreme losses may occur more frequently than they once did. The size, complexity and interconnectivity of financial markets are greater than ever before. A minor mishap can propagate through counterparty relationships, generating an impact of unprecedented proportion. Complicated securities engineered to specific risk profiles have unintended exposures that come to light only after they have generated substantial losses.

Nevertheless management of extreme risk remains outside the scope of current investment practice, which relies on volatility to measure risk.

Volatility is the average dispersion of future portfolio returns and, to an investor, greater volatility means greater risk. But volatility also determines a normal distribution that is used implicitly in many financial models to price exotic securities. Is this advantageous, harmless or dangerous?

The normal distribution plays an important role in the physical and social sciences. However, it is not the right forecasting model for every situation and it is a severe mismatch to financial markets: it substantially underestimates the likelihood of extreme market moves. This can translate into a severe mismatch between the model price of a derivative security and its market price.

Furthermore, the portfolio with the greatest volatility need not be the portfolio most likely to experience a large loss. There are many facets to risk and it is impossible for a single number to address them all.

To manage extreme risk, an investor has to measure the magnitude and likelihood of a crisis.

At first, this might seem impracticable. A crisis is a singular event and does not provide any information about when the next crisis is coming or how to avoid it.

Yet, there is a well-established quantitative theory of extremes and it is not too different from the volatility-based normal theory that is currently used by financial practitioners. It is just a little more flexible.

The key to measuring extreme risk is to ignore the everyday ups and downs and to concentrate on large losses. A useful measure of financial risk called expected shortfall is the typical loss to a portfolio in a turbulent market.

To illustrate, suppose that you have $1bn invested in an index fund that closely tracks the MSCI USA Index. It is a terrible day in the market - the worst in 100 - and your manager asks for your best estimate of how bad your losses will be. Using expected shortfall as your measure, based on historical data back till 1972, you estimate your expected loss is about $35m.

Had you used normal distribution as a measure, you would have forecast an estimated loss of just $26m, potentially leaving you with a huge gap to explain. Normal distribution forecasts are too low to guide allocation to capital reserves and rainy-day accounts. The historical estimate of expected shortfall is better at reflecting events since 1972, a period during which there have been several extreme losses.

For example, since January 1972, there have been eight one-day losses exceeding 5 per cent for the MSCI USA Index, 12 for the MSCI UK Index and 13 for the MSCI Japan Index. For the USA, four of these occurred in the first half period (before April 1990), mostly connected to Black Monday in 1987. The other four occurred in the recent half period.

In other words, there is at least one reason to believe that extreme risk has been present all along and recent turbulence in the market has opened our eyes to it. This suggests that a very long history may be a relevant and stabilising ingredient to forecasts of extreme risk.

Expected shortfall is not part of the investment process for most financial practitioners. Data constraints, obscure mathematical formalism and the spectre of new technology prevent many from benefiting from insights that a broader risk management paradigm can provide.

However, a fast-growing group of early adopters from hedge funds to investment banks and pension funds rely on non-normal estimates of extreme risk to allocate funds, to select securities and to measure performance.

A new generation of risk management tools is on the horizon and it can provide reliable economic forecasts - even in the throes of market turmoil.

Lisa Goldberg is executive director of MSCI Barra