national oil companies creating value under pressure

7/31/2019 National Oil Companies Creating Value Under Pressure

1/12

Global Risk & Trading

CREATING VALUE UNDER PRESSURE:WHY NATIONAL OIL COMPANIES NEED RISK MANAGEMENT

IN A SHIFTING ENVIRONMENT

By Mark Robson


2/12

While it is not unusual for successful companies to be challenged to

manage risk when making critical decisions regarding new investments,

existing projects, and operations, for NOCs the stakes are even higher.

Their actions can potentially change the futures of their countries. If NOCs

wish to continue funding their governments visionary strategies in this

new environment, they must develop sound risk governance practices.


3/12

National Oil Companies (NOCs) in te Middle East are under pressure. Volatile crude oil

prices, massive inrastructure programs, and rising domestic demand or energy relative

to GDP are canging teir competitive landscape. And wile it is not unusual or successul

companies to be callenged to manage risk wen making critical decisions regarding new

investments, eisting projects, and operations, or NOCs te stakes are even iger. Teir

actions can potentially cange te utures o teir countries. I NOCs wis to continue

unding teir governments visionary strategies in tis new environment, tey must develop

sound risk governance practices.

Most o te critical variables tat NOCs consider in teir strategic planning process ave

become more unpredictable. Te pace and scale o events introducing uncertainty into

earnings are increasing. Risks suc as volatile commodity prices ave become more important,

and supply cains ave become more comple. Add to tis te recent instability o sovereign

nations, Arab Spring events, and Iranian treats and it is easy to understand te importance o

developing an astute recognition o risks as well as te opportunities tat tey may present.

States are increasingly ocused on understanding wat drives te level and volatility o

NOC earnings. Teir concerns are justiied. Suc organizations can make critical strategic

miscalculations i eecutives do not understand te net impact o te risks embedded in

inputs, outputs, overall operations, and te markets in wic tey operate. State owners

objectives can also be dierent rom tose o a NOCs management team. Tis can create

problems in deining value and determining te organizations appetite or risk.

ExhIBIT 1: ThE SEVEN STAGES OF RISK MANAGEMENT

INSURANCE AND

COMPLIANCE

CORE RISK

MANAGEMENT

2

6

5

4

Degree of Sophistication

ValueAddedforCompany

RISK TRANSFER VIA

INSURANCE

Risk managementequals buying insurance.

OVER-RELIANCE ON

CHECKLISTS, FALSE

SENSE OF SECURITY

Regulators aredemanding riskmanagement activities

(i.e., SOX)

SPECIFIC RISK

QUANTIFICATION

We need to know theeconomic impact of our

largest risks.

RISK AND GROWTH

APPETITE DEFINED,

RISK DYNAMICALLY

MEASURED AND

AGGREGATED PROPERLY

Shareholders demand

a risk/return framework.

RISK-ADJUSTED

RESOURCE

ALLOCATION

AT ALL LEVELS

Decision-making

across the firm islinked to building

economic value.

QUALITATIVE RISK

MANAGEMENT

We need a sustainable

process for monitoringall our risks.

OVER-CONTROL BY

CENTRALIZED RISK

MANAGEMENT,

INITIAL QUANTIFICATION

MODELS TOO PRIMITIVE

Risks need to be

quantified comprehensively.

Typical development path Enhanced development path

1

7

3

RISK-RETURN

OPTIMIZATION

Source: Oliver Wyman

Copyrigt 2012 Oliver Wyman 3


4/12

Most organizations realize tis. But ar too oten te underlying risk management process

as no real connection to te organizations strategic or inancial management. Instead, its a

costly, resource-intensive, compliance-driven, bottom-up evaluation eercise tat oten results

in lists containing undreds o risks. Te process is designed to be compreensive rater

tan to ocus on te ew key risks and opportunities tat can and should be managed.

Compounding te problem, parallel or overlapping risk management programs are oten

scattered across organizations witout any real coordination. Treasury, operations, engineering,

procurement, legal all o tese unctions manage key risks to te organization, oten in isolation

and using completely dierent measurements. A companys inancial planning and analysis

(FP&A) group considers te variability in te inancial orecast, wile internal audit develops its own

plans or risk. Strategic planning groups are let to create teir own quantitative and qualitative

assumptions o te risks over te medium and long term, i tey are eplicitly considered at all.

Te result? Inconsistent and insuicient risk approaces emanate rom weak governance

and controls. Many NOCs ail to recognize te impact o tis in part because o te barriersto competition tey beneit rom. Neverteless, all too oten, inancial planning and capital

decisions remain disconnected rom risk management. Multiple projects are pursued wit

little understanding o ow risk lows troug te portolio o projects. At te same time,

overly optimistic assumptions catc management teams by surprise and put strains on teir

organizations available cas low. Tis as been particularly evident in many o te regions

real-estate projects tat ave recently been placed on old.

Tere is a better approac. NOCs need to develop a clear risk appetite statement and use

dynamic inancial planning as a top-down, strategic eamination to address te drivers

and core material risks across teir organization suc as te price o oil, te availability o

talent, and te rapidly epanding portolios o projects. Consider: Saudi Aramco currentlyas $230 billion committed to two projects wit Sinopec and Dow alone. And te United

Arab Emirates and Saudi Arabia will ave to train undreds o nuclear tecnicians or up to

seven years in order to operate te acilities planned in teir nuclear programs.

Te potential rewards are substantial: A management team can optimize a companys returns

because it will be able to quickly, easily, and accurately evaluate te impact on inancial

statements o dierent scenarios involving multiple risks. Suc an approac recently elped

a state-owned airline avert massive edging losses. In a similar asion, a major state-owned

railroad company signiicantly boosted its return on capital ater an evaluation o te

organizations key risks revealed te need to renegotiate its power contracts.

Implementing dynamic inancial planning requires a multi-stage eort. Oliver Wyman

usually recommends tat a company start by using tis process to address its most pertinent

issue. Is te company at risk o running out o unding? Does a key strategic decision need



5/12

to be made? Alternatively, a company may wis to ocus irst on applying dynamic inancial

planning to a large capital project or critical business unit. Tat way it can determine

weter or not te risks involved are aligned wit its overall appetite or risk.

Maintaining a brisk pace on a irst, sort, and ocused dynamic inancial planning initiative is

important because quick wins elp build momentum. Early improvements make it easier

or eecutives to etend te ramework across te organization, eventually resulting in a

more ocused risk-return culture.

In our eperience, organizations must take our steps to successully incorporate dynamic

inancial planning into key enterprise-wide decisions:

DEFINE A RISK APPETITE

A risk appetite statement is an agreement reaced between te board o directors and

senior management about wic risks sould be managed and wic risks sould be

avoided. Metrics are deined or tose risks tat need to be managed to establis wen a

management team sould escalate an issue to te board.

In developing tese metrics, a management team may not agree on wic risks are acceptable

and at wat level. But te process o developing a risk appetite statement can provide clarity

around suc issues. It can also acilitate alignment among management team members as to

wat risks te organization sould address at wat level.

hOW A NOC DEFINED ITS RISK APPETITE

A NOCs management team wanted to develop a long-term strategy. But the executives could not agree on

which asset classes and projects the organization should focus on. The list of potential initiatives was long. It

included options from every stage of the oil value chain. The team was considering pursuing significant new

ventures in everything from natural gas, to petro-chemicals, to renewables. In addition, they were contemplating

whether the NOC should focus on domestic or international programs. International investments could entail

further complications since the organization might need to carry them out with a partner.

While executives generally agreed that most of these investments were on-strategy, they disagreed over how

much of the NOCs entire investment portfolio to devote to each type of project. To reach a consensus, the board of

directors developed a risk appetite statement that broke down the potential risks involved into four key components:

Commodity price risk (measuring the risk in the revenue stream), technical risk (measuring the NOCs ability to

work with new technologies), project execution risk (measuring the complexity and ability to run the construction

project), and country/partner risk (measuring the risk of managing non-controlling, domestic relationships).

By comparing each potential set of investments against this newly defined risk appetite in portfolio and scenario

models, the board and management team were able to rule out a number of potential investment combinations.

Ultimately, the NOC chose the most profitable strategy for the amount of risk that the organization wanted to assume.



6/12

Organizations tat align teir risk appetite wit teir risk-bearing capacity can determine more

easily i tey are being too conservative in areas were tey migt be more aggressive. Or

conversely, tey can determine i tey are being too aggressive in areas were tey migt be more

conservative. By deining wic risks are on-strategy and wic are o-strategy, organizations

can minimize activity on tose tat are less important (or move risks to anoter entity, as

NOCs are sometimes able to).

PRIORITIZE CORE RISKS

To realize value rom dynamic inancial planning, eecutives must irst agree on te most

important risks to teir entire organization. Typically, 10-15 risks account or rougly 80%

o a companys total risk eposure. Yet organizations oten waste a lot o time and eort

developing risk maps and risk registers illed wit risks tat ave limited meaningul impact.

Ideally, organizations measure te impact o a ew dozen key risks, at most, on a continuous

basis under dierent market conditions.

Eecutives must tereore agree on te metrics used to measure success or te entire

company. Tey sould identiy wic inancial metrics are most important: Cas low?

Earnings per sare? Net debt ratio? Te risks tat are most likely to cause te company to

not meet tese key metrics or, conversely, to perorm well against tem, are te risks tat

must be most actively measured.

Ater reacing tis consensus, eecutives can ten develop a common understanding o te

greatest operational, inancial, and strategic risks to tese metrics as well as te underlying

issues tat drive tem. Indeed, its oten more eective to assess and quantiy te risk drivers

because tis yields a better understanding o ow a risk could ultimately maniest itsel.

ExhIBIT 2: DYNAMIC FINANCIAL PLANNING FRAMEWORK DESIGN

Operational Risk

Financial Risk

Strategic Risk

Risk categories

Pre-requisites

Former integration

Risk-adjusted

Decisions

Large ProjectManagement

CapitalBudgeting

StrategicPlanning

PerformanceMeasurement

Mergers,Acquisitions& Divestitures

Decision making

bodyExecutive Management

Risk Appetiteand Governance

1.Risk Analytics

2.Risk Resources

3.


Tis same inormation sould also inorm longer-term strategic initiatives suc as acquisitions,

large projects, and capital investments. Suc plans can be better assessed, prioritized, and

monitored wit consistent risk-return reviews.



7/12

AGGREGATE RISKS

Wile prioritizing risks is important, it is still insuicient. Since te activity takes a simple

view o te sources o risk, it oten ails to identiy tose issues o greatest concern: Te risks

tat move inancial statement items, te circumstances tat cause tem, and ow tese

risks inter-relate.

Key risks must be aggregated and quantiied to determine ow tey will likely impact inancial

projections. Only ten can eecutives begin to analyze te volatility tat risks may introduce

into an NOCs inancial statements, ranging rom its sort-term cas low to its annual earnings

to its long-term balance seet. Linking risk management to mid-term inancial planning also

allows a company to attain more transparency and precision in its inancial plans.

ExhIBIT 3: DETERMINING ACCEPTABLE RISK TAKING ThREShOLDS

CONSIDERATIONS Shareholder

and debt holder

perspectives should

be incorporated

Companys ability

and willingness to

take energy related

market risk

Risk policy and

expressed business

unit limits (i.e. capped

at $0.02/year)

Scenarios that

push the companybeyond acceptable

EPS thresholds

External

market driven

Internal

strategy drivenDEBTPAYMENTS

EARNINGS SHORTFALL IMPACT

DIVIDENDS SUSTAINED

CAPEX

(CURRENT)

CASH FLOW REDUCTION

$0.03

$0.06

$0.94

$0.10-0.50

Default

Dividend cut

(below target

of $1.36/year)

Credit rating

(Moodys) downgrade

(from Baa 3 to Ba 1)1

Miss analyst consensus EPSestimate (below $2.27/year)

Miss EPS estimate (below lowerbound of $2.24/year)

Expected EPS $2.30/year 2011

STRATEGIC

GROWTH

CAPEX

(NEW)


Armed wit tis inormation, eecutives can more clearly understand te potential impact

o various management actions suc as making new investments, managing te spend rateon eisting investments, or initiating mitigation actions. Tis enables management teams to

reine teir plans rater tan be orced to i a big problem once it as already occurred.



8/12

LINK RISKS TO STRATEGIC DECISION MAKING

Finally, NOC eecutives must consider tese risks in evaluating critical strategic decisions.

Weter an organization is deciding weter it sould epand into a new country, move into

downstream reining and marketing, or diversiy into renewables, its important to quantiy

te key risks involved in eac initiative and determine ow oten tey may, or may not, be

aligned wit te companys overall appetite or risk. Based on tat inormation, it becomes

very clear wat needs to materialize or te strategy to work.

Te igure below sows ow evolving rom a risk-only perspective, to a dynamic inancial

planning perspective tat takes into account bot risks and returns, to a perspective

tat includes te utilization o risk appetite, can alter te perspective o wat te best

investment may be.

ExhIBIT 4: EVOLVING PERSPECTIVE OF FOUR INVESTMENTS

RETURN

RISK AS A % OF RISK APPETITE

N

E

U

P

N is the best project.

RETURN

RISK

N

E

U

P

Is N still the best project? U looks to be farriskier that E for only a small incrementof return. P, while producing low returns,seems the safest.

N

E

U

P

It seems that projects N and U are themost consistent with the organization.N is just a better project that E and Pisnt really on strategy and is inferior to U.

RETURN

RETURN ONLY PERSPECTIVE RISK AND RETURN PERSPECTIVE RISK, RETURN AND

RISK APPETITE PERSPECTIVE

New refinery

Refinery expansion

Refinery upgrade

Add pet-chem train


Muc o te inormation and epertise required to weave togeter dynamic inancial

planning and strategic decision making is already available witin NOCs organizations. All

tat is missing is te connective tissue between disparate groups. Suc connections are

essential or eecutives to be able to understand and to evaluate te risk-return position o

current assets and new investment opportunities.



9/12

Developing tis risk-return culture isnt easy. Initially, organizations require a risk management

process and organization tat will continuously deliver a standard set o reports wit te inormation

necessary to support inancial decisions. Sometimes tis may involve armonizing data so tat

assumptions, suc as epected values or input or output prices, are consistent across te irm.

Eecutives must also take ownersip o deining teir organizations risk appetite and

engaging in dynamic inancial planning. Regardless o organizational structure, te process

must be directed by someone wo can commit and allocate te necessary resources. Tis

person must ave a olistic view o te organization. Oterwise, an NOC will likely duplicate

risk management eorts.

ExhIBIT 5: DYNAMIC FINANCIAL PLANNING ROAD MAP

Definerisk appetite

Refinerisk appetite

Develop and implementgroup risk model

Develop large projectrisk model

Develop business unitrisk model

Transform towards risk-reward culture

Restructure risk managementorganization

Link key planningprocessesG

ROUP

PILOT


Many eecutives may believe tat teir organization as already invested more in risk

management tan is reasonable. To tese skeptics, we suggest conducting a small diagnostic.

Assign some o your best inancial sta or a ew monts to identiy te most meaningul 10-15

inancial, operational, and strategic risks. Ten aggregate tese risks and quantiy ow tey

migt impact your inancial projections over a one-, two-, and ive-year time orizon.

Tis minimal, but wortwile, investment will likely surpass te bottom-line impact o past risk

management initiatives.



10/12

Questions eecutives sould ask to determine i tey ave te appropriate

dynamic inancial planning resources in place:

how can I ensure tat I ocus on te key risks tat impact decision-making (instead o

drowning in undreds o pages o risk reports)?

Wat is te risk-bearing capacity o my organization? how large o a deviation rom my

plan is acceptable beore I need to signiicantly cange course?

Wat is my risk appetite? how sould I spread my risk tolerance over various risks?

Wat risks are on-strategy and wat risks are o-strategy?

Wat are te ive critical risks to my business and ow can I mitigate tese risks?

Do I understand ow uncertainty in te market will aect my credit rating?

Is my plan or capital ependitures realistic under dierent economic and industry

scenarios? Or will it leave te company sort o capital?

how robust is my mid-term plan given te uncertainties in te market?

Under wat alternative views o te uture will I be unable to eecute my strategic plan?

how muc volatility do my top 5-10 risks introduce into earnings?



11/12

DRAFT


12/12

About Oliver Wyman

Wit oices in 50+ cities across 25 countries, Oliver Wyman is a leading global management consulting irm tat combines deep

industry knowledge wit specialized epertise in strategy, operations, risk management, organizational transormation, and leadersip

development. Te irms 3,000 proessionals elp clients optimize teir businesses, improve teir operations and risk proile, and

accelerate teir organizational perormance to seize te most attractive opportunities. Oliver Wyman is part o Mars & McLennan

Companies [NYSE: MMC]. For more inormation, visit www.oliverwyman.com

About the Global Risk & Trading Practice

Oliver Wymans Global Risk & Trading Practice enables te worlds top industrial corporations and commodity trading organizations to

gain competitive advantages by assisting tem wit managing risk across teir businesses more eectively. By working wit global leaders

in a broad range o industries, our practice as developed unique capabilities tat elp industrial corporations and commodity trading

organizations create value and maimize teir perormance by making risk-adjusted strategy, investment and capital allocation decisions.

About the author

MARK ROBSON

Partner, Global Risk & Trading, Oliver Wyman

+971.4.425.7085

[email protected]

Mark Robson is a Dubai-based Partner in Oliver Wymans Global Risk and Trading practice. he as over 20 years eperience consulting ina wide variety o industries spanning energy, cemicals, parmaceuticals, tecnology, and manuacturing. Mark specializes in designing

approaces tat use an organizations internal knowledge o its own operations and te competitive market place to create decision and

risk management rameworks. Tese decision making tools ave been applied to many contets suc as climate cange analysis, strategic

planning, capital budgeting, large project value optimization, corporate portolio design, and inancial edging.

Copyrigt 2012 Oliver Wyman All rigts reserved. Tis report may not be reproduced or redistributed,

in wole or in part, witout te written permission o Oliver Wyman and Oliver Wyman accepts no liability watsoever or te actions o

tird parties in tis respect.

Te inormation and opinions in tis report were prepared by Oliver Wyman.

Tis report is not a substitute or tailored proessional advice on ow a specic nancial institution sould eecute its strategy. Tis report

is not investment advice and sould not be relied on or suc advice or as a substitute or consultation wit proessional accountants, ta,

legal or nancial advisers. Oliver Wyman as made every efort to use reliable, up-to-date and compreensive inormation and analysis,

but all inormation is provided witout warranty o any kind, epress or implied. Oliver Wyman disclaims any responsibility to update te

inormation or conclusions in tis report. Oliver Wyman accepts no liability or any loss arising rom any action taken or rerained rom

as a result o inormation contained in tis report or any reports or sources o inormation reerred to erein, or or any consequential,

special or similar damages even i advised o te possibility o suc damages.

Tis report may not be sold witout te written consent o Oliver Wyman.

www.oliverwyman.com

national oil companies creating value under pressure

Documents