May 27, 2015
Any strategy refers to specific external factors. In the case of oil companies, macroeconomic variables can include crude oil prices, product margins and the price of the US dollar. As changes in these variables have a strong effect on financial flows, assumptions about their future values are an important element of all business strategies. Since numbers are always very specific and the future uncertain, one may say right away that the future will play out differently, and the assumptions will turn out to be incorrect. In other words, a different kind of scenario will materialise than originally assumed. It is true, but only if numbers regarding the future are treated in the same way as hard data – as concrete information. And there’s the rub. In numerical terms, an unfulfilled future is an unquantifiable set of possible scenarios of which only one will come true. Applying a geometrical definition, the probability that the predicted scenario will come true is zero (which is not to say it is impossible). If so, do companies which publish strategic assumptions put into a single prognosis make a mistake? No, provided they do not treat their projection as a specific scenario chosen from a set of possible ones, but rather as a yardstick for all potential scenarios. Most often, the yardstick is an arithmetic mean – a specific number describing the entire scenario set. The problem is that the mean – the medium scenario – says little about how it relates to the success of the strategy, which is what the investors are the most interested in after all. In practice, companies test their strategies against alternative scenarios selected to highlight the relevant opportunities and risks. However, for obvious reasons, they do not share this information so as not to aid their competition. To break the impasse, they only communicate to the investors that the strategy is both ‘robust’ to adverse developments and enables the company to gather momentum. This can be done by presenting the train of thought that has produced the strategy.
While current macroeconomic figures have a bearing on short-term decisions regarding production and the financial performance of companies in the oil sector, investment decisions and strategies are structured primarily around long-term predictions, whose horizon is noticeably longer than the average investment cycle in the sector and often encompasses long-term demand and supply conditions, where the price of oil fluctuates around (marginal) production costs (the most expensive 3-4 million barrels of oil a day).
Long-term forecasts, showing how a company perceives the future of the environment in which its strategy will be tested, are therefore of key importance to understanding and evaluating development strategies in the oil sector. Crucially, rather than foresee the future, which is always uncertain, such forecasts are meant to illustrate the links (how the elements are connected and what they affect) between various factors which shape the company’s environment. Thanks to such correlations, the factors do not change independently and tend to follow specific scenarios over time. If we properly recognise the processes shaping the environment and the key factors responsible for its changes, we will be able to review a wide variety of alternative scenarios and concentrate only on those which are important to the company’s strategy. The aim is to make the best use possible of emerging challenges while maintaining safe exposure to risk.
Business strategies and future drivers
Among the oil industry’s drivers there are unpredictable factors (new, game-changing technologies, conflicts, disasters, and other ‘shock’ events), which provoke lengthy adjustment procedures when materialised. While the shocks themselves cannot be anticipated, especially the time of their occurrence and scale, we know quite a bit about the oil industry’s and the economy’s reactions to past shocks, which were adjustments to lasting changes in the price of crude oil and refining products, involving both demand and supply. The knowledge of how the immediate environment of oil companies works is in fact an understanding of how the sector adapts to lasting changes in the price of oil, its products, the US dollar, and costs. With this kind of knowledge, we can predict how companies will react to price changes in the future, or in other words – how the environment in which they operate will change.
For instance, a steep decline in crude oil prices makes all companies involved in the upstream business review their investment projects. If the price slump is caused by excessive production potential, which is the current situation, low prices can be reasonably expected to last for a relatively long time, which should compel companies to scale down their investments in production. It can therefore be expected that the surplus potential will disappear over time, driving prices up. However, companies involved in already advanced investment projects can be reluctant to quit given the costs incurred and expectations that the prices will increase in the future. Such decisions are easier to make at the beginning of the investment cycle, when abandoning a project is the least expensive. A company launching a new upstream project may be unwilling to back down, concluding that the price of oil can rise again before the project is complete. In effect, it may well turn out that despite the price decline caused by surplus production capacities, the upstream sector will not reduce the planned increase of production potential on the expected scale and the price of oil will remain unchanged for a long period of time. Such as scenario is just as probable as the base one, which assumes that upstream companies would scale down their investment projects in anticipation of lower prices, thus driving the prices up in the near future.
Companies create their own strategies to plan how they are going to use their growth opportunities and increase their resistance to various threats, and such strategies transpire in the expected scenario of external developments. Whether such a strategy is original depends largely on subjective expectations on whether certain unforeseeable events occur which may drastically change the course of the relevant scenario and, among other things, increase the company’s exposure to risk. To refer to the previous example, it is possible that amid the currently ambiguous price signals the strategic plan of the majority of upstream companies is to ‘wait and see how other companies adapt’.