I recently overheard an oil and gas operations executive boasting to a group of finance people, “We make history, you guys record it.” The finance organization has been given a bad rap by their operational counterparts due to the traditional focus on recording and reporting history: accounting. However, many finance organizations have taken the opportunity to shift their focus from recording the past to predicting the future.
At the conclusion of "Back to the Future," Doc declares, “Where we are going, we don't need roads,” as his DeLorean flies off in the air. As organizations accelerate into the future, someone in the organization needs to focus on what the road looks like ahead, particularly the financials.
Furthermore, someone in the organization must be able to translate and compile operational, marketing, legal, tax, economic, and external information to provide an idea of what the future holds. No other executive is better positioned than the CFO to equip the organization with the discipline to understand where the organization is going and present the strategic options to the executive team. The understanding of where the organization is going is otherwise known as the planning process.
The planning process is predominately a Finance-led process that's often met with trepidation and skepticism, as the process contains many manual and iterative processes. This is even the case at companies that have planning systems in place but are not flexible enough to provide the key information needed for the strategic decision making process.
Industry challenges such as commodity price fluctuations, geo-political issues, and environmental issues come and go, and executives are continually looking at different ways to optimize their portfolio. Given the longer lifecycle of oil and gas projects, decisions that executives make have a more significant effect on a company’s financial future than in industries that have a shorter product lifecycle.
One could argue that getting the planning process and systems right at oil and gas companies is more critical than in many other industries.
Finance can excel at predicting the future by setting the right targets, integrating operational and financial planning, identifying the right drivers, and understanding sensitivities. These four components have an impact on the information needed to execute a company’s strategy and equip companies to look at the future in different ways.
Successful companies have assimilated a top-down with bottom-up planning process where the executive team provides guidance on what each top level metric should be for each division or department. The plan is then built bottom-up at an operational level to meet the targets set by the executive team. Setting targets enables communication of goals and should motivate individual performance to meet the goals of the company and the business unit.
Common questions often arise: How do I measure success? What metrics should I use?
Metrics should be identified and linked to the company’s core strategic competencies. Several example competencies for an E&P company include exploration, development, production, and safety. For each competency, there are a set of activities that can be measured.
For example, the exploration competency could have an activity of finding large, easy-to-produce reservoirs. Success can be measured by the reserve additions or the reserve replacement ratio metrics. From there, the company can identify what the target metrics are for each division or department.
Finance should help the organization define which metrics are important and which correlate with financial success. Ultimately, these targets can be used as metrics in the planning process.
In many organizations, the financial plans or forecasts do not tie to what operations consider truth or reality. Finance and operational peers spend most of their time digging for information and reconciling to the last budget version or forecast.
There are multiple causes for the difficulties associated with planning process: multiple sources of information, inconsistent data structures, broken mappings between systems, data integrity issues, errors in spreadsheets, and inconsistent planning processes across business units and departments.
We assisted an E&P client with integrating their economic and reservoir management systems in order to have better look-back capabilities and operational accountability for results. Although the reservoir management systems are not meant for planning, they have the necessary information to seed data at the beginning of the planning process. As economic systems are updated, the data extraction is automated into the planning system rather than downloaded into spreadsheets that cannot be refreshed easily with new information.
Tying operational systems in with the planning process helps an organization integrate what is recognized as operational reality with predicting the future. The finance organization has the purview to tie the operational systems with the overall planning process and provide a single view of the future.
Driver-based planning provides the ability to generate and update the plan based on business drivers given certain levels of business activity, basin production, or contractual arrangements in place.
First, selecting the right drivers can make a big difference in the planning process. For example, many companies are tempted to forecast headcount by employee and try to be as precise as possible on headcount planning. This seems relatively easy to do. However, it may not provide insight into predicting financial success when other variables have a more significant impact on profitability.
Selecting the right drivers does not mean the organization has to spend thousands of hours on financial forecasts every cycle. An oil and gas company can use the current production curve as the base volume and model the forecasted capital projects’ production decline curves. The model could include number of drilling rigs that can be run in an area, rig cost per day, number of days it takes to drill and complete a well, the average working interest, and the expected production curve for the given area. The driver-based method can save time compared to the level of effort required to set up each well prospect in the economic system.
Ultimately, the finance organization should be accountable for defining how the operational drivers impact profitability.
Historically, oil prices and gas prices tracked consistently with each other. For years, oil to gas price ratio ranged at about 5 to 10 times the price of gas. The advances in natural gas production have caused a natural gas glut and disrupted the balance between oil and gas price. In April 2012, when oil was at the high end of its 52-week range and gas was at the low end of its 52-week range, oil was running about 50 times the price of gas. The variability has caused companies to rethink how they manage their portfolio.
The organization’s challenge is to manage its portfolios in order to stay cash neutral while meeting the company’s goals and objectives. Price is the key lever on the level of cash available. In cash shortfall or periods with excess cash, companies have trouble determining what to do. Should we borrow or cut projects? Should we pay down debt or execute more projects? Which projects?
In today’s environment, executive teams have a greater need to review their business models, plan with more scrutiny, and perform what-if analyses. The planning process needs to tie together multiple pieces of information to clearly define the business strategy going forward. Commodity price, debt-to-equity ratio, project net present value, project internal rate of return, lease expiration, and reserve targets are some key metrics and drivers that must be choreographed to meet a given strategy. The finance department is in the right position to first educate operations on the definition of the metrics and sift through these metrics to determine the optimal capital structure to respond to the changes in price or costs.
The Finance department is in a unique position to change the perception of the role of Finance by driving the implementation of key planning practices. How a company is executing its business strategy will be more transparent to executives by integrating operation and financial planning, identifying the right drivers, and understanding sensitivities.
Trenegy is a non-traditional consulting firm based in Houston, Texas.