EY’s Portfolio management in oil and gas: building and preserving optionality identifies a variety of approaches to build and preserve options given the long-term planning cycle inherent to much of the sector’s activity.

“Over the last few months we’ve seen stakeholders demand even greater capital discipline amid ongoing oil price volatility and geopolitical concerns,” EY’s global oil and gas transaction advisory services leader Andy Brogan said.

“Companies have responded by divesting non-core assets and postponing riskier and uncertain investments. But active portfolio management alone can fail to improve returns.

“More than ever before, companies must marry portfolio management with flexible and adaptable operating and financial models.”

Improving return on capital depends on the speed with which companies can identify and respond to both opportunities and threats.

Oilers that establish a portfolio with built-in flexibility will be better positioned for success as adaptability enhances companies’ ability to manage risks and redeploy resources, he said.

It also enables companies to reconcile the sector’s long-term investment horizons, which are sometimes measured in decades, with sudden changes in the market.

“Moving forward, the world is going to be a more volatile and unpredictable place. Companies that have optionality can better manage their stakeholders’ requirements and deliver better returns,” Brogan added.

“The drop in oil price came quickly and took many in the sector by surprise. Companies have turned to portfolio management to withstand this period of uncertainty, but it’s those who look ahead and embed optionality into their business models that will come out on top.

“There will be winners and losers, and the ability to respond quickly to unexpected market changes is crucial. Companies can’t afford to be caught unprepared in today’s competitive marketplace.”

The report found that optionality allows oilers to quickly, effectively and efficiently shift focus from underperforming businesses, assets and projects to better-performing ones that fit with a renewed strategy and enhance the overall value of the portfolio.

Oil companies need to be able to quickly assess the impact of macroeconomics factors, demand, costs and pricing changes and then act to preserve or enhance value, EY said.

The best companies will have not only strong and flexible balance sheets and adaptable capital structures, but the right tools to examine all possible outcomes, such as joint venture optionality, geographic diversity and low leverage/high debt capacity.

They need balanced and transparent portfolios, flexible talent and strong alliances, while individual projects should have adaptable commercial and contractual structure, with decisions taken early in the project life cycle, before funds are committed, for maximum flexibility.

Common barriers to building and preserving optionality at the corporate level include cash traps, pre-emption rights and capital gains tax exposure, so it is important to regularly understand the medium-term cash position, dividend availability and debt capacity across the group; test to verify that acquisitions, disposals, investments and funding will not have material unintended consequences before committing capital and retain decision-making flexibility.

A sustainable upstream business generally requires a portfolio of production, development and exploration licenses supported by a targeted production level.

EY found that without producing assets, companies could be hindered by capital or resource constraints, a common complaint among junior oilers.

Anecdotally the consultancy found that lenders are being more lenient in their facility agreement negotiations with those clients with producing assets since the oil price has fallen.

Companies may need to divest development-phase assets and acquire producing assets and non-core assets may need to be identified for sale or farm out to reduce short-term capital demand.

At the other end of the spectrum, identification of late-life assets for divestment could help to mitigate decommissioning liabilities. The long timeframes can easily render a project uneconomic or sub-optimal.

Pricing assumptions may change as demonstrated by the recent drop in oil price, placing margins under increasing pressure, or there may be higher-return alternatives, made possible by advances in technology.

Add in the oil and gas industry’s poor track record for delivering projects on time and within approved budgets, and risk increases even more.

If companies move into the development and phase of capital projects, they face require significant investment and are challenging to manage, especially the big megaprojects now being chased by the majors and supermajors.

EY said that companies must aim for commercial and contractual structures that allow for adaptability when needed at the outset.

It believes more projects will be downsized or deferred in response to weakening oil prices and the global downturn, as happened between 2008 and 2011 in the aftermath of the global financial crisis.

Companies need the contractual and financial structures in place early to scale back or halt projects, with an effective performance management system and clear trigger points for intervention.

Scenario planning should take into account scope changes during development, including termination provisions.

Obviously the JV partners also need to be clear about the dissolution strategy and possible options from the outset.

Finally, active business and portfolio management is a critical link connecting corporate strategy, capital allocation, portfolio management and project implementation.

Frequent and effective reviews help companies identify possible symptoms of portfolio inertia early and correct them before they significantly hinder business performance, highlighting disconnected between capital allocation and an assets strategic value and an awareness of investment gaps and missed opportunities.

Companies also need to be able to avoid reactive approaches, which result in low-quality investment options and wasted effort in evaluating non-strategic options.

EY says boards and executive teams need to know their core business so they can make better decisions, but worryingly only 21% of the oil and gas executives that participated in EY's survey have redefined their core operations in the last 12 months, half include the executive board in setting the review agenda, and 22% of oil and gas companies say they need better analytics tools to improve portfolio reviews.

EY’s Portfolio management in oil and gas: building and preserving optionality was the third report in its capital projects series.

The first, Spotlight on oil and gas megaprojects reviewed the performance of 365 megaprojects and discovered that the oil and gas industry has a very poor track record for project delivery with 64% of the projects valued above $US1 billion facing cost overruns and 73% were behind schedule.

The second report, Navigating geopolitics in oil and gas, EY found that while geopolitics is one of the top risks facing the oil and gas sector, it can be viewed as a source of both risk and opportunity, and that when companies are unable to foresee emerging trends or react to rapid, unforeseeable geopolitical change, the potential impacts on corporate and capital project performance can be significant.