The APQC Blog

How Great Risk Management Will Help Oil and Gas Companies Survive $50 Oil

I, like many, have benefited from low oil prices in the last several months. Last week I filled up my car with gas in Dallas, Texas for $1.75 per gallon; I didn’t know whether to take these rates as a happy surprise or a sign of the apocalypse. I then wondered how oil and gas companies are coping with falling gas prices and whether any of them are using this confluence of realized risks—surplus supplies, political impasses, increasingly energy-efficient technologies, and geopolitical strategizing, to name a few—to further their business strategies.

Demand for energy is closely connected to economic activity.[1] If producers think the price of oil will remain high or increase, they invest—which, after some time, will boost supply. On the other side of the spectrum, falling prices tend to lead to an investment drought. This is what is happening now: In the wake of the sudden oil price slump, investors are dumping shares and bonds while energy companies in the North America are moving to cut costs by closing rigs and pulling out of projects.

When oil prices drop, production levels usually decline, which in turn helps to stabilize prices. This time, however, the reduction in oil rigs has yet to stop growth in U.S. oil production, which added 60,000 barrels a day at the beginning of this month.[2]

This year’s simultaneous fall of oil prices and rise of American oil output is unconventional. Could companies have seen this coming? How are companies navigating the current market, and what practices have they put in place to potentially make this situation strategically advantageous for themselves?

Oil Prices and Risk Management

It is important that oil production companies take strategic risks. Energy exploration and production (E&P) companies must employ new ways to find and extract reserves; otherwise, all of their revenue is generated from a product with a quantity that is finite and decreases over time. To stay afloat, E&P companies must grow their revenue bases by acquiring or finding new reserves. The most recent way of doing that has been via shale formations. In fact, the output of rigs in shale formations account for virtually all oil production growth in America.[3] This, of course, is part of the phenomenon known as “fracking”: extracting oil from underground rocks by blasting them with a mixture of sand, chemicals, and water.

Many of the E&P enterprises that invested in fracking were less stable than other companies. In 2013 more than a quarter of all shale investment was done by firms with debts of more than three times their gross operating profits. With a break-even point of $70 per barrel and current oil prices dipping below $50 per barrel, many of these operations will likely go bust.

Situations that should have been considered involve emerging risks (ones that could affect an organization’s financial strength, reputation, or competitiveness) have come to fruition in the last few months, including:

  • Political obstacles—Many citizens are vocally opposed to the practice of fracking along the Keystone pipeline for social, political, and environmental reasons. President Obama has said that even if legislation was passed to approve the pipeline, he would exercise his veto power to stop it.
  • Increased supplyFracking has boosted America’s oil output by two-thirds in four years; as a result, America is now the world’s largest oil producer.
  • Decreased demand—Technological advances in all industries require less and less energy (for example, household electronic are using approximately 12 percent less energy in 2013 than they did 2010, despite an increase in number of devices[4]); additionally, Americans producing more oil means we are importing less.
  • Power playersSaudi Arabia, which produces a third of OPEC's oil , wants to preserve its market share and hopes to drive out upstart shale companies, and as such will not ameliorate falling prices by halting production or exports.
  • Foreign policy—Countries that have both social policies antithetical to American foreign policy interests and a heavy economic reliance on oil exports, such as Iran and Russia, are being subjected to pressure by major oil-producing countries like the United States and Saudi Arabia in the hopes of influencing  those governments to adopt policies more aligned with U.S. policy goals.
  • Declines in output—Shale output declines by 60-70 percent within the first year of production, so within a couple of years its output is severely diminished.

Effective enterprise risk management (ERM) programs consist of tools for the top executives of the company to use to ensure they know what threats are out there and what those threats could mean in terms of shareholder value and market capitalization. As stated in APQC’s Enterprise Risk Management: Seven Imperatives for Process Excellence Best Practices Report, when a strategic risk is not properly identified and managed, no organization is immune to negative consequences. Even still, ERM remains a work in progress at most organizations.

Best-practice organizations have primary goals of ensuring sound risk planning by focusing senior management and boards on risks that are capable of affecting strategy; creating value for key stakeholders by ensuring effective execution of strategy; ensuring that risks are properly identified, assessed, monitored, and mitigated; and creating a risk-intelligent culture to keep decision makers engaged in the process.

Companies that have anticipated this oil boom and/or bust, or at least have put in place a stop-gap strategy to prevent worsening conditions, will likely bounce back faster than those who have not. Those who have considered new rounds of innovation in drilling, standardization, and techniques for fracking may be put in a better position once prices eventually rebound. They will be back up to speed much faster than the ones still recuperating from this wild ride.

[1] “The Economist Explains: Why the Oil Price is Falling.” The Economist, December 8, 2014.

[2] Lynn Doan. “Shale Is Losing to OPEC, to Judge by Mothballed Drilling Rigs.” Bloomberg News, January 16, 2015.

[3] “Shale Oil: In a Bind.” The Economist, December 6, 2014.

[4] Mike Orcutt. "Why Household Gadgets Are Using Less Power.” MIT Technology Review, July 28, 2014.