Valid and timely information is the foundation for any successful risk-management process.

Decisions are made based on an individual's assessment of the current and future situation using available information. "Gut feeling" is a combination of experience and information. However, how many times have our stomachs led us astray?

Like physicians treating the symptoms and not the disease, management often makes critical decisions based solely on indicators of an opportunity and not solid facts. Wildcatter "Dad" Joiner of Spindletop fame could live by his wits, but today's executives do not have that privilege. Truth be known, the legendary Joiner did not have that luxury either, as he died almost broke after a long string of failures.
Risk and the management of uncertainty always have been part of the energy scene. Over the last 150-plus years, successful producers have developed a core competency addressing economic, technical and geopolitical ambiguities. A key success factor of any risk-management process is the availability of timely, valid and reliable information.

Prelude

The year 2002 finds the global economy at an increased level of confusion. Political and economic uncertainty in key petroleum geographical areas is not limited to just the Middle East and post 9-11 issues, but manifests itself in South America and Southeast Asia, as well as other geopolitical landscapes that long have been known to present difficulties.

Well understood by politicians and sociologists, "knowledge is power," or rephrased, it is competitive advantage. Advantage also has an economic aspect. Its value is a function of its marginal cost, or the additional capital required to add another economic unit of information. Firms must make decisions when the marginal value of additional information is zero or even negative.

Organizational knowledge is the synergy of normalized data transformed by software applications into information, and interpreted by the core competency of the firm into competitive knowledge. This synergistic effect requires that value be derived from data being in the right format, at the right place and at the right time.

Addressing uncertainty, which manifests itself as a lack of understanding or the lack of information, reduces ambiguity to zero. In the real world, this Pareto optimal frontier can never be measured, (Heisenberg Uncertainty Principle) and even if economic equilibrium were realized, it would only be a moment before exogenous forces would disturb the balance.

Project uncertainty

The petroleum industry has developed substantial expertise in managing risk on a global scale. This industry is project driven, and each revenue-producing asset may have several ventures under way concurrently. Most projects have several components of exposure including geopolitical, economic and technology.

Petroleum producers have a set or portfolio of assets, each with a different risk silhouette. Successful organizations have developed a formal risk-management methodology using tools such as portfolio management to reach an expected (statistical) average level of risk, or profile the firm is willing to bear across its global asset mix.

Degrees of uncertainty

One approach towards defining uncertainty has been developed that models four different "levels of uncertainty" along with an appropriate set of tools necessary for the analyses of the opportunities presenting themselves. The decision-making process also changes depending on the degree of managerial confidence, availability of the required resources necessary to evaluate prospects and accessibility to cost-effective marginal information.

Uncertainty is a function of the decision-maker's knowledge base. The greater the understanding of the issue under consideration, the greater management's confidence level. This knowledge is often embodied in the organizational culture or sometimes only in the minds of a few individuals. The more internalized the knowledge base, the better prepared the firm will be to address an uncertain world.
Even experts can overlook opportunities, fail to appreciate the risk associated with entering a new area or ignore the opportunity cost associated with not capitalizing on the prospect. In 1977 Digital Equipment Corp. (DEC) passed on the idea of the individual desktop computer even though there was ample evidence, to industry insiders, that this could be an emerging market. This case of opportunity lost was perhaps one piece of ongoing culture that ultimately led to the sale of that once-great company to Compaq Computer Corp. several years ago.

Risk management

Risk management is one of the core competencies of any firm. Whether a petroleum producer, energy trader or energy service provider, policies should be developed and adhered to that insure the organization has developed an appropriate risk profile and stays within those bounds. Economic shareholder value is realized when the firm returns economic profit, defined as the surplus of revenue over all costs, including the opportunity costs of employing all inputs.

Economic profits cannot be realized if the firm does not develop a strategy that capitalizes on its core competency and generates earnings at an above-market return on capital employed (ROCE). To accomplish high ROCE, the firm must be willing to take calculated risks, defined as higher on the risk-reward curve as exceeding the return capital could earn as bank deposits.

However, risk taking without proper governance is a recipe for disaster. The following steps outline one approach for managing under uncertainty.

In 1990, Morgan et. al., Uncertainty: A Guide to Dealing with Uncertainty in Quantitative Risk and Policy Analysis established the following10 commandments for good policy analysis as one approach to combine quantitative analysis in conjunction with qualitative policy assessment.

1. Do your homework with literature, experts and users.
2. Let the problem drive the analysis.
3. Make the analysis as simple as possible, but no simpler.
4. Identify all significant assumptions.
5. Be explicit about decision criteria and policy strategies.
6. Be explicit about uncertainties.
7. Perform systematic sensitivity and uncertainty analysis.
8. Iteratively refine the problem statement and the analysis.
9. Document clearly and completely.
10. Expose the work to peer review.

This approach is an information-centric methodology that provides guideposts for developing risk policy. Quantitative information forms the basis of stochastic decision support models that integrate qualitative information to improve processes and build organizational knowledge.

This schema reduces uncertainty and allows management to make better-informed decisions. It provides a vehicle for ranking subjective managerial and technical opinions and observations.

The role of information

Traditionally, firms are identified with the goods and services they deliver in industry sectors. Tasks are optimized through the division of labor, economies of scale achieved and shareholder value created. Or are they?

Information flow. The economy and its actors can be viewed as a system of information flow. Firms acquire and utilize asymmetrical information to achieve competitive advantage.
Information is shared and managed across the extended enterprise, and this knowledge is communicated to the market in the form of price quotes for the organization's goods and services. Economists have developed a systematic understanding of the role of information within the firm and its supply chain as well as in the overall economy.

Information movement is the fundamental underpinning of the decision-making process within the supply chain. Better information leads to better competitive decisions, and lower quality information leads to less market-efficient choices.

Treating information as a revenue-generating or direct cost-saving asset changes the way firms treat the acquisition and management of information.
• information flow is the very essence of the firm and its extension into its supply chain, including both suppliers and customers;
• information interchange is the intermediation process across the supply chain; and
• information dynamics are the tangible asset of the exchange process.

Information economics. Firms seek asymmetrical information to secure advantage during negotiations or transactions. Game theory with its set of pay-off alternatives suggests that asymmetrical information can provide one market actor with advantage over his or her rival.

However, there is a cost associated with procuring and managing information. The deployment of a supply chain network and application infrastructure requires a level of investment. However, in the extended supply chain, this sunk cost may be spread across all firms if standards are adopted. Once this investment has been made, firms can begin reaping marginal cost-driven benefits.

According to mathematician and economist J.F. Nash, equally efficient firms supplying homogeneous energy products, all with constant marginal costs, must price products at the marginal cost. Once the information management infrastructure is in place, the firm can lower its marginal cost structure by reducing direct cost of operations as well as reducing process cycle times (reducing time to first oil, thus increasing net present value (NPV) of the project).

The chief executive officer (CEO) of a telecom firm once stated, "...we'll end up with a much lower marginal cost structure, and that will allow us to under-price our competitors." The same economics are at work in the commodity driven energy market place.

Risk mitigation. As an industry pioneer and leader, DEC Chief Executive Officer Ken Olson was uniquely positioned to capitalize on the emerging personal-computer industry. Indeed, DEC's minicomputer line previously made significant inroads into the mainframe installed base, ominously allowing individual divisions to drive their own computing needs without depending on corporate management of information services (MIS) departments. Ironically, DEC led the way for the desktop computer revolution.
Industry stature does not in and of itself confer wisdom. We are all bound by our legacy and often cannot see the forest as we are mired in our own trees. Rather, developing a corporate culture, processes and policies that reward creative, intelligent, synergistic thinking by the organization and its strategic suppliers better mitigates risk.

As an information-processing engine, the 21st- century firm, including its extended supply chain, is well positioned to capitalize on both quantitative and qualitative information to make better decisions under conditions of varying uncertainty. Moreover, valid, reliable and timely information can positively affect the marginal cost structure of the firm, thereby lowering the return on investment bar management and providing real options when managing capital assets throughout their life cycle.

Conclusions

The energy industry has evolved to a high level of expertise in risk management. It is a successful global industry that has long had to deal with a declining product price point in real economic terms. Surviving economic actors are very good at managing their risk-reward curves.

Risk management is typically driven by portfolio assessment techniques. As business complexity and security requirements increase, firms must deploy new granularity for dealing with an uncertain world. Valid and timely information is the foundation for making better decisions. It is also the foundation for new or enhanced processes that can lower the marginal cost to the firm and improve financial posture.

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