Blog Archive

Monday, January 24, 2011

Ian Fraser: Myopic Metrics and Blind Alleys for High Finance – and Big Oil, too

Myopic Metrics and Blind Alleys for High Finance – and Big Oil, too

by Ian Fraser, a financial journalist who blogs at his web site and at qfinance.
Hitching your wagon to flawed or “dozy” metrics is never a particularly good idea. We saw this in the build up to the global financial crisis. RBS’s obsession with earnings growth, whilst paying no attention to return on capital, is just one idiosyncratic example; spurious “credit ratings” of structured products are another, and pervasive. It was financial institutions’ blind faith in flawed metrics, and their penchant for burying risk, through the use of deceptive risk models such as Value At Risk, that, as much as anything else, encouraged a generation of bank CEOs to lead their institutions over a cliff.
Equally flawed metrics are now driving risky, and indeed sometimes even desperate, behavior in the oil and gas sector. Campaigners suggest that investors’ and analysts’ obsession with certain flawed indicators is driving international oil companies such as Shell BP, Total and ENI to take environmental, political and financial risks that are likely to blow up in investors’ faces – indeed in all of our faces (they already have in the case of BP’s disastrous Deepwater Horizon spill).
According to a report by Massachusetts-based Oil Change International, Platform, and Greenpeace, “Reserves Replacement Ratio (RRR)” – the rate at which production was replaced by new oil discoveries – is the most pernicious indicator of all.
RRR measures the volume of proven reserves that company adds to its reserve base in a given year, relative to the amount of oil and gas it produces over the same period. The yardstick is widely used by analysts and investors, to the extent that an oil company is deemed to be “successful” if it consistently keeps its RRR above 100% (i.e., it is replacing more oil and gas than it is producing), but a failure if its RRR is below 100% (i.e., it is failing to replace depleted reserves and will eventually run out of oil).
But RRR is a flawed metric because it is blind to risk. According to the Oil Platform International study, RRR’s failure to differentiate between cheap and expensive to produce resources distorts corporate behavior, driving IOCs to replenish their reserves from far more costly and risky sources, such as in the Canadian tar sands or ultra-deepwater oil fields. The OPI report suggests that if they had not accessed such sources, many of the leading IOCs would have had RRRs of below 100% in the past five years.
RRR is also opaque and fails to place any value on the discovery or acquisition of non-oil energy reserves (such as when an oil firm invests in a wind farm) or investment in pipelines and other infrastructure, further driving risky behaviors.
Here are six questions asked about RRR by Oil Change International in its report:
  • If reserve additions are made with oil that is costlier and riskier than the oil being replaced, does the RRR indicator adequately value the additions?
  • Is there enough transparency within reserves additions reporting to enable investors to judge risk?
  • Does RRR tell investors enough about the potential or otherwise of the additions made in that year?
  • Are companies taking excessive risks because of perceived pressure from investors to maintain RRR?
  • If such pressure exists, is it in the interests of investors to de-emphasise RRR and allow companies to adopt more flexible business models?
  • Would reducing emphasis on RRR render diversification into low carbon technologies more attractive?
Goaded by short-termist analysts and investors, oil firms generally believe they must keep their RRRs above 100%. They are frightened that any failure to achieve this will cause their shares to be marked down and their companies to fall out of favor with investors and analysts.
The report suggests that, among other things, RRR is driving oil firms to play fast and loose with the environment in ecologically vulnerable frontier regions like Alberta and the Arctic.
And it was investor obsession with RRR, together with the “resource nationalism” that is making cheap-to-drill oil less accessible to international oil companies, that drove BP into its controversial alliance with Russia’s Rosneft via a share swap. Ironically, Rosneft is the Russian state-owned company that was handed the bulk of assets of Yukos after these were expropriated by the Russian government.
However, the only way that oil firms can keep their RRRs above 100%, is by taking “unprecedented risks” as well as by accepting “escalating costs and tighter margins,” according to the 24-page report headlined "Reserves Replacement Ratio: Adequate Indicator or Subprime Statistic?
Invariably this means cutting corners – which in turn invariably leads to accidents. This much has been identified in the first chapter of the National Commission’s report into the Deepwater catastrophe. The report found that:
Decisionmaking processes at Macondo did not adequately ensure that personnel fully considered the risks created by time- and money-saving decisions. Whether purposeful or not, many of the decisions that BP, Halliburton, and Transocean made that increased the risk of the Macondo blowout clearly saved those companies significant time (and money).
The Oil Change International report states:
The bulk of the oil that remains freely accessible to IOCs is technically difficult and expensive to produce such as the Canadian tar sands, ultra-deepwater and the offshore Arctic…
We label these resources marginal oil as their high-cost and high-risk places them at the top end of the production cost curve and they are vulnerable to emerging trends towards efficiency and climate change regulation that may dampen demand growth and stabilize price…
To maintain Reserves Replacement Ratio (RRR) rates above 100%, IOCs have increasingly turned to tar sands and ultra-deepwater in the face of the continuing decline in their conventional oil fields…
Our research found that at least four of the top six IOCs have significantly relied on tar sands reserves additions to support RRR rates in the past five years. “As a percentage of total liquids additions, tar sands represents between 26% and 71% of reserves additions for these four companies.
In a blog post, Lorne Stockman, the report’s author and research director at Oil Change International, said that in the last five reporting years, four of the top six oil companies would not have achieved RRR levels above 100% had they not been active in Canadian tar sands.Stockman said:
The truth is that oil companies are running out of places to find more oil and the end game is not far off. A recent Deutsche Bank analyst report suggested that high oil prices over the next few years coupled with an accelerating decline in the cost of battery technologies for electric vehicles will precipitate a global peak in demand for oil by 2020.
Stockman cited research from the International Energy Agency suggesting that humanity must aggressively reduce its use of oil if it is to meet climate change goals. Meeting the climate objective means that demand for oil would have to peak by 2018, said Stockman.
So the question is: does replacing production with these risky and expensive forms of oil always make sense? While RRR is just one of many metrics used by analysts, it is one that demands strong performance in something other than simple profit generation or return on investment. It demands the constant reacquisition of a fast-disappearing commodity.
Surely the time has come for analysts and investors to adopt a saner yardstick? As Stockman says, the oil companies are determined to “stay the course”. Their belief that they can continue to keep their RRRs above 100% without harming the environment is not only delusional, it is also impeding the transition away from oil.
A version of this article was published in qfinance on January 18th, 2011.

No comments: