‘Embedded optionality’ is the way to go, says UH Bauer Finance Department Chair.

Despite an unfolding global financial crisis, quarterly earnings reports issued the last two weeks make it clear the major oil companies have the wherewithal to continue developing global petroleum resources. It’s a different story for small and midsize companies, for whom challenges related to the freeze in credit markets are wreaking greater havoc than is the depressed price of oil and gas.

Of course, the two — credit freeze and oil price — aren’t unrelated. Yet it may seem a bit unclear to many how “irrational exuberance” in the issuance of real-estate mortgages has not only curbed global demand for petroleum, but also threatens to bring the entire world economy to a screeching halt.

Dr. Praveen Kumar, chair, department of finance, C.T. Bauer College of Business, University of Houston, has spent time lately connecting the dots for oil industry executives. Even once the severe strains caused by the credit meltdown are past, Kumar believes, extreme oil price volatility will continue.

One reason is because the national oil companies (NOC), whose governments use oil revenues as a political tool, are likely to overreact on the supply side to any rise in demand, sending prices spiraling back down again. To succeed in such an environment, Kumar says oil companies will need to factor needs for “embedded optionality” into their planning and risk management processes.

Embedded optionality means having access to opportunities and technologies that will allow a quick response to any increase in demand that leads to rising prices. For example, in offshore production, said Kumar, “an embedded opportunity might be the specification of an oversized platform relative to the immediate opportunity.” Speed will be of the essence in increasing production in response to demand spikes, because the opportunity for increased profits at any given time may be short lived.

Anatomy of a crisis

“The securitization process by means of which banks, credit card companies, and other institutions were able to take loans off their books and pass them to intermediaries has shut down,” Kumar said. “For at least the last two decades this process was important in lowering the cost of financing risk, including for oil projects. And financing costs are likely to remain high for quite some time.”

The breakdown in credit markets also seriously dampened oil demand. “For a while we thought growth in developing countries such as China and India meant a permanent change in demand for oil. And longer term this in fact might be the case. But short-to-medium term we’ve seen growth in the rate of auto ownership in these economies drop from 20% per annum to 4% per annum. Growth will remain anemic because potential owners of automobiles can’t borrow, just as business managers can’t get funding for new projects.”

Further, in the US, not only are drivers being more conservative today when it comes to jumping into their cars and going for a spin, but it’s estimated that commuting to work is responsible for about one-third of total miles driven. Having so many people unemployed means fewer cars are on the road.

Yet if history were any guide, the banks eventually should work through their problems, and an economic recovery would start to take hold, leading inexorably to rising demand and a return to higher oil prices.

“History may be a poor guide to what will happen next,” Kumar said, despite trends that seem to argue for higher prices. “Let’s say that in six months the rate of demand decline begins to slow, but stays in the negative in relation to where we’ve been the last two years. Lack of financing will be a huge impediment to increasing supply to meet the incipient demand resurgence. Private E&P providers, at the least, won’t be able to ramp up production to meet the anticipated demand rise.”

Another factor that might suggest rising prices is that the aggressive production stance the NOCs have taken, “caused a huge crunch when it comes to availability of E&P equipment.” It’s been recently estimated that production costs today are twice as high as they were last time oil was $40 per barrel.

Yet despite specialized equipment and credit constraints, Kumar believes that because decision making by NOCs isn’t necessarily driven by profit optimization, but rather is based on considerations of political economy, the pricing environment will remain volatile.

“These are societies where political stability is being bought by means of a certain rate of economic growth and infusion of cash into the population,” Kumar said. “Given any signs of increasing demand, they will be aggressive in increasing production, even though demand growth will be spotty. That will bring prices back down.”

As for the cure

Kumar maintains that for the last year or so petroleum markets are already in a period of greater price volatility. And with prices rocketing to more than $140 a barrel and then plummeting to less than $40 a barrel who’s to doubt him? But what impact should knowing this have on petroleum company finance and project evaluation?

“To enhance shareholder value creation, you need to think about embedded optionality,” Kumar said. “These are the opportunities or technologies that can limit supply constraints and allow quick ramp-ups in the event of growing demand. The more options and opportunities you have the better, because those that respond more quickly to price spikes will be the companies that succeed.”

A second example of embedded optionality might be a plant that allows flexibility in terms of inputs so that the lowest cost input mix can be used at any given point of time.

“You have to think carefully about this and it has to be embedded in your models,” Kumar said. “You have to assign values to these options, and that may change the value you place on investments and projects.” Once petroleum companies begin to place greater value on quickened response it also should lead to increased reliance on and a more favorable view of systems and information technology in the industry.

One further impact following from the current global environment may be a changed industrial structure in the upstream sector. The big oil giants are coming off historic highs, with Exxon Mobil and other majors sitting on huge piles of cash.

In an interview with E&P at this month’s CERA Week in Houston, Patrick Pouyanné, senior vice president, strategy business development, R&D, Total Exploration & Production, said, “The majors won’t be cutting back on their investments because of the financial crisis. You can’t do development work as stop and go, stop and go. But the best way to react is by managing the contractor side of it. You want to invest in the low side of the cycle, with lowered costs. Then you’re producing when the cycle is back at higher levels.”