Ernst & Young: Political constrains and competition for proven reserves is #1 risk for O&G companies

Ernst & Young: Political constrains and competition for proven reserves is #1 risk for O&G companies

Summarized and edited by

Nihad Azizli, Assurance Senior, Ernst & Young and

Turgay Teymurov, Assurance Partner, Ernst & Young

Political constrains in North Africa and the Middle East and competition for proven reserves is #1 risk for O&G companies according to recent study published by Ernst & Young ("EY"). The ranking is based on the interviews with oil and gas commentators and EY's global multi-sector survey (which included 82 oil and gas executives in 15 countries).

This article covers the top 10 risks applicable to the industry:

1. Access to reserves (political constrains and competition for proven reserves)

Survey refers to a combination of political unrest in North Africa and the Middle East, high oil prices and the growth of new government-backed rivals as the reasons pushing this risk to the top of the list.

In many new market opportunities, companies faced with either very strong local content or ownership provisions (such as Brazil where companies must partner with a local organization), or the government does not allow companies to participate in the market on an equity basis, instead limiting participation, in effect, to service contracts.

The trend of increased competition from government-owned and government-backed companies also shows no sign of diminishing. High commodity prices encourage governments to establish or expand National Oil Companies ("NOCs"). Today, Chinese companies gain the headlines, but the oil and gas sector is also likely to see the internationalization of NOCs from other emerging economies including Brazil, Russia, India and Korea.

2. Uncertain energy policy

Uncertainty over the future energy policy of both consuming and producing countries remains a high-level risk for the oil and gas industry. Lack of progress on policy debates, including US energy policy, greenhouse gas reduction measures to replace the Kyoto protocol, deepwater drilling and environmental standards, creates a lot of concerns for the industry.

3. Cost containment

Companies are facing increasing pressure on their cost containment efforts as a result of a number of factors. Firstly, operating environments for oil and gas companies have become more complex, posing both physical challenges (resulting from, for instance, deepwater drilling or Arctic exploration and production) and political challenges. Secondly, increased and constantly changing safety and environmental reporting requirements are causing a substantial increase in compliance costs.

4. Worsening fiscal terms

The fiscal and contractual terms offered by host countries change over time and depend on a multitude of factors, including the size and complexity of the resource, current levels of investment, the degree of competition and national experience. However, governments tend to take a more assertive stance when prices rise. Under uncertain market conditions, governments tend to make regulatory changes to their benefit. This has previously been the case in the petroleum industry and is returning in some cases. Domestic supply obligations and changes to fiscal regimes are re-emerging, which will affect upstream investment.

5. Health, safety and environmental ("HSE") risks

HSE issues have risen on the oil and gas industry's agenda in recent years. This reflects both an increased focus of oil and gas companies on a more sustainable and robust operating model and the fact that the industry is facing more complex operational challenges than ever before.

A stronger emphasis on HSE issues may affect the ability of companies to explore and produce oil and gas in certain regions, particularly ecologically sensitive areas. Specifically, there are growing public and political concerns over the environmental impact of unconventional oil and gas exploitation (for example shale gas).

The developments following the Gulf of Mexico spill have shown that both the industry and the regulatory bodies are now evaluating the suitability of the different regulations and the effectiveness of safety management practices among operators and suppliers.

6. Human capital deficit

While the oil and gas sector is by no means in crisis in terms of a talent gap, a serious situation could arise if insufficient action is taken to develop the next generation of skilled workers. "An aging workforce and a shortage of new recruits will remain critical factors in an era where fossil fuels are seen by many as a 'dirty' or sunset industry," noted one industry expert surveyed.

Indeed, almost 45% of workers are currently above 45 years of age. A significant proportion of the industry's workforce will retire over the next 5 to 10 years and it appears there is no adequate replacement for this knowledge and expertise.

Another contributor to this risk is deteriorating brand image of the oil and gas industry which has long been a target for environmental activism and periodically suffers high-profile environmental incidents. This could amplify the loss of talent to more "fashionable" sectors, such as renewables.

7. New operational challenges, including, unfamiliar environments

There is a shared recognition in the industry that the time of "easy" oil and gas is over for most International Oil Companies ("IOCs"), and many NOCs. For this reason, the challenge of unfamiliar operational environments was included into the risk ranking.

Because oil and gas reserves are getting harder to access as supplies are consumed and political barriers rise, the industry is pushed toward the pursuit of less accessible sources. Companies face both physically challenging environments, such as ultradeepwater and the Arctic, and politically testing environments, such as insecure regions and those with unstable regimes.

Operating in new environments requires management of several challenges. These include technological developments; changes to the way companies can execute and operate across the value chain; the need for more and different skill sets from future employees; and the need for different organizational models between the host country, operator, partners and suppliers.

8. Climate change concerns

Despite the slow progress of international climate talks, oil and gas companies face pressure from many stakeholders to address climate change concerns. Though the Copenhagen summit of 2009 failed to achieve a breakthrough, pressure on companies can arise from other stakeholders. Given that intergovernmental negotiations over climate change has failed to produce a legislation with binding targets in order to replace the Kyoto Protocol that will expire in 2012, civil society groups may have to turn directly to companies to address the climate change issue. Oil and gas companies will increasingly be evaluated by public opinion on their policy regarding climate change.

9. Price volatility

Price volatility tends to be caused by geopolitical or macroeconomic shocks. While capital intensive oil and gas projects will benefit from sustained high oil prices, the global economy is likely to be impacted negatively, and the problems created may be persistent.

Small to mid-cap companies and large independents are particularly exposed to price volatility, while major IOCs or NOCs are at an advantage. As Marcela Donadio, Ernst & Young Americas Oil & Gas Leader, pointed out: "Companies cannot be in this business and ignore the volatility of pricing, because investment decisions are very long term and the volatility of the price curve is very extreme."

10. Competition from new technologies

The survey found that some 14% of oil and gas respondents reported difficulty in managing emerging technology risks. The most commonly reported driver of the risk is a failure to develop an innovation culture and processes.

In addition to new technologies for exploration and production, the sector is impacted by broader technological advancements. For instance, the cost of alternative power generation is expected to fall, which in the long term could threaten the market share of oil and gas companies that fail to adapt.

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