Developing and Applying a Portfolio Management Approach in an Oil Business - Thesis Example

Developing and Applying a Portfolio Management Approach in an Oil Business Chapter 1- Introduction 1.1 Background The industrial revolution of the nineteenth century and the communication and information revolutions of the twentieth century have changed the face of the world and are responsible for growth of energy needs. The increase of comforts for the people leads to the greater fuel and energy needs. The global energy demands are on the upswing and the major contributor towards meeting the demand is oil which is rightly termed as the black gold. From 64.7 million barrels per day in 1999, world production grew to 71.2 million barrels per day in 2004, coming from the Middle East, the Western Hemisphere, the former Soviet Union, Africa, Europe and the Asia-Pacific regions. Growth came from the countries of Mexico, Canada, Western Siberia, West Africa, and China.1 The economic liberalization, market economy reforms and western style corporatization management reorganizations in the last two decades have had their impacts on the oil and gas industries of major energy producing countries such as Russia, Norway, Canada and Malaysia. The gap between the high ranking of national oil companies’ resource holdings and the ranking of the world’s largest oil and gas production operating companies highlights a potential source of supply instability in world energy markets.2 How ever, the major national oil companies are in the process of re evaluating and changing business strategies, goals and priorities which would have an impact on the market supply stability and security. In addition to the demand supply equation which makes the oil business a complicated one, the oil industry is also subjected to risks and uncertainties in a number of ways. The world economy and the price of oil seem to be dependent on each other. The major events of the world like wars and political turnarounds have major effect on the oil business. The resulting price fluctuations in turn change the economic trends of major oil consuming countries. For example, Yom Kippur War between Israel and Syria led to the 1973 oil crisis3 and the breakup of the Soviet Union in 1991 that contributed to the heavy oil pollution in the Caspian Sea. The strategy for increasing the oil business and revenues by it is to construct new pipelines such as Baku-Tbilisi-Ceyhan oil export pipeline. The construction of these types of pipelines will involve the employment for labor and results in construction new surface transport infrastructure. This provides extra employment and even generates revenue for the companies involved in it. The construction will result in Trans Caspian pipelines. These pipelines as they are able to affect the fish migration routes the business and lives affected by that change must also to be taken into consideration. When the regeneration of the natural resources is difficult the revenues generated and the portfolios managed now will be difficult to be sustained in future.4 The spike in the prices in 2005 was not tolerable to the American companies. The price has rose by 52 percent in 2005. As no developed or developing country is showing a trend of decreasing oil consumption, from 2005 to till date, the oil companies can manage a portfolio of new investments. As almost every OPEC country is producing to its full capacity, the investment on the oil fields other than OPEC countries or, acquiring the oil fields in OPEC countries will be growth signal for the oil companies. The investment on the oil exploration also can be termed as a good decision towards managing the portfolio.5 Environmental Impacts Along with the risks and uncertainties, the oil companies also have to consider the damages caused in the natural environment due to the various operations involved in the oil business. Right from the drilling (effects caused due to the drilling liquids), transportation of oil (possibilities of leak and spillage, e.g. - The Exxon Valdez Oil Spill in 1989), the harmful by products and wastes resulting during the refining stage and finally to the burning of oil itself (increase in levels of carbon dioxide emissions leading to global warming, acid rain and infiltration of ozone into air), each operation poses a threat to the environment.(www.crudeoilbiz.com). The governments are in a compelling position to enforce strict rules and regulations to the oil companies in order to mitigate and control these potential hazards and to safeguard the eco system. Oil companies could lose more than six percent of their investments to comply with requirements to curb climate change and constraints to access of energy reserves to protect biodiversity, ecosystems and communities especially in environmentally sensitive areas (Duncan and Sauer, 2002). In this complex environment of commercial and technical risks, safety and environmental concerns and changing legislations, owning and operating assets in the oil industry requires considerable investments. In this scenario, companies must realize the importance of having adequate project controls with better risk managing ability and enough coordination between the different projects towards achieving the goals to gain market share and to improve profits. Forward oil market requires computer systems and specialized softwares that allow instantaneous on-line analysis on: what is happening in oil and other futures markets around the world; access to industry and market data; general news that influence oil prices and to what extent. According to the analysis of the Goldman Sachs, the spike in oil prices will result in reduce of energy consumption and creates a cushion in spare capacity. If this happens the oil companies have to maintain a demand for the oil and energy to optimize their profits. By following the Goldman Sachs survey, the hike in oil prices in this manner may affect the future profits of the oil companies. This may be a result of alternative sources or exploration of new oil resources in developing countries. To maintain the present financial performance and to keep the profit margin at a reasonable level, the prices must be decreased to a certain extent to keep the demand in a reasonable level by the oil companies. 6 A consistent and integrated set of planning and management principles in organizational structure is needed. This can bring the changes in the marketing strategy and keeps the demand and profit margins at a reasonable level. The portfolio management system helps to define the overall corporate strategy- in the case of oil companies, it helps to define an achievable set of goals which are consistent with each other, decide on sets of portfolio of projects that can lead to meeting the goals by evaluating them in terms of investments, risks, environmental concerns, regulations, performance, profits and finally picking up and putting in to place a best combination of projects that require optimum investment, better risk managing ability and maximum return while systematically achieving the goals.( Brimble,2001) 1.2 Aim and objectives This research is being proposed with the following aim and objectives. Aim The aim of this research is to analyze and prove that by adopting a portfolio management approach in oil business, the uncertainties that arise due to the risks involved in the operation and that are caused due to environmental concerns can be better assessed and managed. Managing such uncertainties and even the price spikes is a necessity for the oil companies to keep the demand at a reasonable level to maintain a better profit margin for a longer period. The investments in an oil business are huge and the risks are also more which involve lives (humans, plant and animal species) as well as money. Protection and better utilization of both are very crucial. The very nature of the oil industry (exploration, extraction, transport, refining and consumption) involves risks to human lives and to the eco system. The happenings in the world’s political arena pose a big uncertainty. Finally regulations imposed by the governments for the oil companies demand them to shell out more money. The oil business needs a system in place to effectively assess and minimize the risks in advance and manage them efficiently in order to sustain and grow healthily. This research proposes that by implementing a portfolio management system, how the risks and environmental concerns can be effectively managed with an improvement in the overall performance. Objectives Generally the top management of the oil company will set the corporate goals and strategies. A tem can be constructed with some senior members of the staff and the planning and implementation of actions that make the goals achievable can be assigned. The arrangement of portfolio management system will assess, prioritise and implement the potential projects. The risks involved in the strategies needed for maintaining the profit margins should be analyzed. The environmental concerns, the cost effectiveness of the projects that reduce the environmental pollution can be mooted. The overall investments and returns of the company can be recorded and monitored. This information will make the portfolio management approach to decide the portfolio of projects. This portfolio must use the financial and human resources of the company effectively. To attain above goals the company should make optimum use of the human and financial resources. The aim can be achieved through the following objectives Drawing up of a set of achievable goals and business plan for the short, medium and long term and determining the factors that go in to this process. Determining how the project portfolio is determined and the actions are chalked out to meet the business plan. Finding out the criteria that are used to select a particular project in terms of investments and return, the potential risks, environmental concerns and the costs involved in mitigating them. Identifying the systems (portfolio management system, computer softwares and insurance) in use to assess and manage the potential risks and uncertainties that may arise. Checking the degree of compliance to environmental rules and regulations and the costs involved. Testing how the company really reacts to situations caused by risks and environmental concerns with the available systems. If the portfolio management system is in use, checking out how it has enhanced the company’s capability to better manage the risks and environmental concerns and resulted in overall better performance compared to prior installation of the same. If a portfolio management system is not in use, then developing the same and employing it to check that uncertainties due to risks and environmental concerns can be better managed and the performance can be enhanced by it. Providing a set of guidelines for adopting a portfolio management approach. 2. Literature Review 2.1 Examining the portfolio management of an oil firm The majority of studies about diversification and portfolio management will study and examine the benefits of the method. Generally the costs involved in it will be ma in concern about adopting it. The benefits due to portfolio management should be increased with more pace than the costs. This can encourage oil companies to diversify the returns in the form of portfolio management approach. The firm that follows the portfolio management approach will develop an ability to internalize the market failures. This even can result in higher productivity of the firm.7 The sources that result in increase of costs for portfolio management should be identified first. The insufficient allocation for the diversification and portfolio management may result in reducing the value of an oil company. The problems regarding agencies may also result in generating the costs for portfolio management and diversification. Hence those should be addressed first. The method should be in a manner to get optimal incentives from the diversification and portfolio management to the agencies. If the oil business firm concentrates more on diversification rather than portfolio management, there is a chance of excess of value reduction. The diversification should be least if the oil business firm wants to concentrate on the portfolio management. The objective before deciding to adopt the portfolio management is to investigate the marginal effect of diversification on firm returns. This requires the resolving of econometric problems. The independent variables used in this process are market return, firm size, book value to market value. These control the effect of the market on firm’s portfolio management. It was found that the firms that adopt portfolio management have higher returns than those who didn’t. The measures for adopting portfolio management, methodologies and the organizational structure of the industry should be taken into account and the changes that are needful to be done. The firms that adopt portfolio management presume that they have done for good reasons. It will not be good if the costs of the adoption is not viable to the benefits of the approach. The decision of adopting the portfolio management approach should depend upon the firm value and firm returns. The original capabilities of the firm and the line of business should be taken into account while portfolio management approach is being adopted. The oil firm should allocate resources for portfolio management according to the relative efficiency of the divisions. When there are reasonable returns on the portfolio management, the firm should take care that the divisions that enabled the portfolio management should not suffer. The methodology and the structure of portfolio management should not be in a manner to incur losses to share holders of the firms, when the portfolio management is accruing profits. This may result in decrease in the probability of gathering capital from the public sources. To make this possible, the policy of the firm should allow the share of profits on portfolio management with the share holders. This is due to the fact that the firm is diverting the funds for portfolio management from the divisions funded by shareholders. To minimize the losses or to avoid them the monthly returns of the firms and the monthly market returns should be computed using data available. Regarding the portfolio management measures, the number of segments in a firm is defined as the number of segments that exceed 10 percent of the total accounts of the firm should be taken into account. 2.2 Research Methodology The research will be carried out as case study. A company in the oil business which has more than one operation (oil exploration, extraction of oil, transport of oil to the refineries either by tankers, ship or through pipelines, refining and distribution to wholesalers) in its projects portfolio will be chosen as the subject. The company may or may not belong to OPEC. The company selected will be identified by its name and a complete profile of the company will be presented. The case will contain the time of creation, time of modification and a complete audit trail of each origin and modification. The co-operation of the company will be sought to carry out the study across its various projects. The emphasis will be to collect information about the possible risks associated with that particular project operation, the regulations imposed by the country of operation due to environmental concerns and the systems in place to manage both. Details on the present portfolio management approach – stage gate process or the portfolio review based approach will be collected. If there is no portfolio management system in place, the reasons for the absence will be sought. If the portfolio management system is in use, the visible changes noted in the performance of risk and environmental concerns management before and after the installation of the system in regard to the projects and to the overall business will be noted. The tools used to collect information are questionnaires and personal interviews. All the personnel from management to support staff involved in each project will be covered. The range of questions in the questionnaire can be broadly grouped in to three categories. 1. General The organizational set up in each project The role of each personnel in the project The goals of the project Action plans in place to achieve the goals 2. Risk management Identification of potential risks in the project Criteria used to evaluate the risks (A risk matrix with likelihood of occurrence as rows (high, medium and low) and the seriousness as columns (high, medium and low) will be constructed. The placement of the risks in the cells of the matrix defines the action to be taken. For example, if the risk occupies the first cell it means the chances for it to happen are very high and the adverse effects produced by it will be also very high. This would demand an immediate and efficient action.) How they are managed Costs involved in managing the risks Computer softwares (e.g. @risk, project management, risk assessment and management)) that are in use to help the managers schedule and monitor operations in relation to their target goals at definite time intervals until the projects are satisfactorily completed Possible scenarios of risks like oil spills by tankers, pollution to land and water, government sanctions, taxes on environmental cleanups will be presented and how these are managed by the concerned people will be tested 3. Environmental concerns and compliance The environmental concerns, rules and regulations enforced in the countries of operation Compliance of the company Willingness to undergo risk assessment protocol in this area. Based on the above responses, a qualitative analysis will be carried out to prove the efficiency of portfolio management system (one will be developed if not in place already) in minimizing the risks and improving the safety in the environmental region. 1.4 Limitations of the research This research is carried out based on the operations of a single oil company and it discusses the type and the benefits of deploying portfolio management approach to manage the risks and environmental concerns in the oil business. The merits and demerits of having an alternative approach are not compared here. The analysis is qualitative and the findings are supported by analysis and logical outcomes. Only the operations and the countries in which the company has involved are under consideration and no work is done to determine the benefits of applying the portfolio management approach to other operations involved in the oil industry. The findings are not checked for other oil companies operating in either a bigger or lesser plane.k 1.5 Scope of Transfer Report Chapter 2 – State of Affairs of World Oil Industry This chapter discusses the current state of the world oil industry and also what is in store for the future. The dwindling of present oil reserves result in explorations of new reserves. The major stock holders and the major players behind it will be discussed. The alternatives for the oil companies regarding the portfolio management and diversification can be discussed. The effects of increasing concerns on environmental pollution and the growing demand to use alternative energy sources like solar energy and bio fuel on the oil industry will be explored. In case of environment pollution control acts, the measures should be taken to minimize it, so that the reduced costs on the management of environment pollution can be diverted to portfolio management. Chapter 3 – Risks and Environmental Concerns of the Oil Business From the exploration of oil to the point of distribution, the oil business involves many stages and each has many potential risks involved. Assessing the risks and managing them effectively requires special expertise. Similarly there is a rising concern about the effects of global warming on the world’s eco system. Oil by- products are major sources of contributors to global warming. The risks and the environmental concerns affecting the oil business will be discussed in detail in this chapter. Chapter 4 – Portfolio and Risk management as Applied to the Oil Business As mentioned earlier the risks and uncertainties involved in the oil industry are more and they need to be managed efficiently. Oil companies use different approaches and systems to assess and manage the risks and allot funds for portfolio management. A survey of the various portfolio and risk management approaches, the markets for the investment, the divisions in which the diversification needed, computer soft wares available for the purpose and the procedures adopted by the companies will be presented in this chapter. The actual benefits offered by the procedures involved in the portfolio management will be explored. Chapter 5 – Research Methodology This chapter deals with the method of research adopted. The basic set of criteria based on which the company under study is chosen will be defined. The kind of information required to understand the different strategies used by the company for risk assessment and management and to comply with the environmental regulations and laws are taken as the objectives and based on that a questionnaire will be prepared. The views of management, staff and the support personnel involved in the operations will be obtained through personal interviews and the questionnaire. Based on the results a qualitative analysis will be carried out. References Brimble, S. (2001). Portfolio management helps petroleum companies achieve consistent performance. Oil & Gas Network. [Internet] April, 2001 Available from http://www.slb.com/content/services/software/articles/article_04nn2001.asp?seg=petrel& [Cited 27 January 2007] Caspian Sea Region: Environmental Issues. [Internet] Available from http://www/eia.doe.gov/emeu/cabs/caspenv.html [Cited 28 January 2007] Duncan, A. and Sauer, A. 2002. Changing oil: emerging environmental risks and shareholder value in the oil and gas industry. [Internet] Available from http://pubs.wri.org/pubs_newsviews_text.cfm?cid=325 [Cited 27 January 2007] Greg Croft Inc. World Oil Supply Outlook. [Internet] Available from http://whttp://www.gregcroft.com/oilsupply.ivnu [Cited 27 January 2007] Hartshorn, J.J. (1993), Oil trade: Politics and Prospects. Cambridge Studies in Energy and the Environment. Cambridge [England], NY, USA Cambridge University Press. E-book ISBN: 0511002416. ISBN 0521331439 How the Use of Oil affects the environment, [Internet], Available from www.crudeoilbiz.com, [Cited 28 January 2007] James Young, Dan Palomino and Anthony Guevara, Programme and portfolio Management in the Oil and Gas Industry: Technology support for Best Practices [Internet], available from http://www.cpm.co.yu/materijali/OilGasStandardization.pdf [Cited 28 January 2007] Oswald, A. (July, 2004). Opinion: Dangers in the oil business. Accountancy. London: 134(1331): 21. The Changing Role of National Oil Companies in International Energy Markets, [Internet], Available from (http://www.rice.edu/energy/research/nationaloil/index.html). [Cited 27 January 2007] Wikipedia, 1973 oil crisis. [Internet]. Available from http://en.wikipedia.org/wiki/1973_energy_crisis [Cited 27 January 2007] Dr. Nimrod Raphaeli, 2005, The "Super Spike" in Oil Prices - Implications for the U.S. and Saudi Arabia, Free Muslims Coalition, ,electronic, 22-3-07, http://www.freemuslims.org/news/article.php?article=863 Diane Li et al, 2003, The effect of diversification on firm returns in chemical and oil industries, emerald, ,electronic, 22-3-07, http://www.emeraldinsight.com/Insight/ViewContentServlet?Filename=Published/EmeraldFullTextArticle/Articles/2850050102.html Read More