What is a rolling budget and how can it help oil and gas executives? In a rolling budget, the annual 24- or 36-month budget is re-forecast every month over the forecast periods as actuals are recorded. Therefore, the number of forecast periods decreases every month as the number of actual periods increase, resulting in a real-time outlook on the prompt year in its entirety, as well as updated outlooks for future years.

In a constantly changing world (technology, prices, plays, A&D), a rolling budget can therefore provide upstream executives with the tools and analyses needed to stay abreast of the short- and long-term outlooks for their operational and financial performance, as well as keep on top of goals and key performance metrics on a real-time basis.

For example, with a rolling budget, executives will have insight into how much the latest strip prices will increase or decrease this year’s cash flow; they can anticipate and mitigate the impact on production of an unplanned refinery shut-down this summer; they will know whether the latest accounting policy change will positively or negatively impact revenue or expenses; and the list goes on. This information can prepare executives for the next quarterly earnings call, for investor and board presentations, for calculating bank covenants and assessing liquidity.

The bottom-line benefit of a rolling budget to oil and gas executives is to minimize surprises, be proactive in addressing problems and thoroughly understand all the options.

Getting started

The starting point for the rolling budget is the annual budget, a 24- or 36-month outlook beginning in January. The annual budget process should be a coordinated, companywide effort involving the business units (BU), centralized functions (such as marketing, HR, legal, IT, records, land, treasury, etc.), accounting, and the financial planning and analysis (FP&A) group, which manages the budget process.

Responsibility for inputting data into a centralized budget system should be as follows:

• The BUs should input production/sales by product, lease operating expenses, major expense, and capital expenditures;

• The marketing group should input basis, price deducts, and transportation rates by product;

• The accounting group should input severance and ad valorem rates by product;

• The centralized functions and the BUs should input general and administrative expenses; and

• FP&A should input the price deck as determined by senior management.

Once all the data has been input into the budget system, it has to be downloaded into the financial statement models. However, a number of assumptions need to be input into the financial statement models by FP&A, including DD&A rates, interest expense and rates, a minimum cash balance assumption, G&A and interest capitalization rates, tax rates, and hedge settlements. FP&A needs to reach out to the accounting, treasury, tax and marketing departments for this data.

The next step is to combine the budget system data with the financial statement assumptions to generate a 24- or 36-month income statement, balance sheet and cash-flow statement (let’s assume 36 months going forward). Ideally, this final step would be done in January after the year-end close for the prior year. This timing ensures that the budget balance sheet will correctly reflect actual closing balances as of December 31 of the prior year. Note that bank debt is the plug on the balance sheet to balance retained earnings and capital expenditures. If retained earnings exceed capital expenditures, bank debt decreases, and if retained earnings are less than capital expenditures, bank debt increases.

With these financial statements in hand, any combination of operational and financial performance metrics can be calculated over the budget forecast horizon: revenue/boe, expenses/boe, margin/boe, net cash flow, debt/capitalization, debt/EBITDA, EBITDA/interest, liquidity, return on equity, return on invested capital, and even enterprise value/ EBITDA if management makes a stab at forecasting its stock price. Management can use these financial statements and metrics to set companywide and BU-specific goals for the coming year; to prepare for the first-quarter earnings release; to build investor and board presentations; and finally, to use as the starting point for the rolling budgets. However, there is one more step, and it has to do with prices.

Assuming this budget was run at a flat price deck, which is fairly typical in oil and gas firms, this budget should now be run at the current strip price deck, including any updates to price deducts that might change with prices. Therefore, the company now has a second version of the budget based on the strip as of a date in the second half of January. This “strip budget” and its associated strip financial statements are now the starting point for rolling budgets.

Building the process

There are a number of steps to creating a rolling budget (RB), even more steps than creating the annual budget, especially for the FP&A group. The first step is to create a new version of the strip budget financial statements which references the most recent actual month and the number of forecast months left in the prompt year.

For example, after the January books have closed in mid-February, the 1x11 RB financial statements (which at this point are a copy of the strip budget) will be updated with January actuals for the entire company and by BU. Therefore, January actuals will overwrite January strip budget for all the accounts in the income statement, balance sheet and cash-flow statement. Close attention has to be paid to ticking and tying the January actuals, specifically whether the sum of the BUs equals the bottom line on total company reports. For example, if the sum of the BUs’ revenue, expenses, capital expenditures and taxes, etc., does not equal the totals for the company, then digging has to be done into the accounting system to figure out and fix these discrepancies.

Next, the annual budget inputters in the BUs access the budget system to update the remaining 11 months of the prompt year, and the subsequent 24 months of the budget period, based on any new information they may have regarding wells, drilling schedules, refinery outages, A&D activity, marketing assumptions, pipeline constraints, etc. They should also take into account whether January was better or worse than predicted in the strip budget, and how that will affect the prompt year and possibly the next two years. Note that these updates should include production/sales by product, lease operating expenses, major expense and capital expenditures.

The FP&A group updates the budget system with the latest strip price deck, and inputs the resulting hedge settlements into the 1x11 RB financial statements. Also, perhaps every quarter, the FP&A group should reach out to the accounting, treasury and tax departments for any material updates to DD&A rates, interest expense and rates, minimum cash assumption, G&A and interest capitalization rates, and tax rates for inclusion in the forecast months of the RB financial statements.

The budget system data is then combined with the 1x11 RB financial statements to produce a new 36-month income statement, balance sheet and cash-flow statement, in which the first month equals January actuals and the remaining 35 months have been updated based on current conditions. These financial statements provide management with a real-time outlook for the full year as well as an advance look at the next 24 months. Every month, the RB is run again by making a copy of the prior month’s RB financial statements, with an additional actual month added and the number of forecast months which are updated decreasing one month at a time, resulting in the 2x10, the 3x9, and by mid-December the 11x1.

Using a rolling budget

The next steps revolve around variance analysis: comparing the current RB to the prior one, comparing the current RB to the budget, and comparing the current RB to the last earnings call.

RB to RB: The point of comparing RB to RB (for example, 10x2 vs 9x3 or 6x6 vs 5x7) is to identify and quantify early on any changes in business or operational conditions which might become trends. The FP&A group, with input from the BUs, should analyze why the full-year outlook for prompt year net cash flow has improved or deteriorated since last month, which is a combination of the last actual month’s variance and the forecast months’ variance: the WTI or HH forward strip have changed resulting in $A change in revenue; production for oil, gas, or NGLs has changed resulting in $B change in revenue; operating expenses have changed to the tune of $C; hedge settlements have changed to the tune of $D due to the new strip; G&A, interest expense, taxes have changed to the tune of $E due to other causes; capital expenditures have changed to the tune of $F; etc. The BUs should provide the “why” behind these changes: why their production, operating expenses and capital have changed versus last month.

Next, the FP&A group should calculate operational and financial performance metrics and analyze why they have improved or deteriorated since the last month: What is the cause of the increase/decrease in expenses/boe? How has the full-year outlook for debt and liquidity changed? What are the new debt/EBITDA, EBITDA/interest, debt/capitalization ratios? How will these changes impact bank covenants? Will these changes put the company’s S&P/Moody’s ratings at risk?

RB to budget: It is also useful to compare the latest RB to the budget because usually a company’s full-year goals are based on the budget. Therefore if there are production, expense, capital expenditures, or operational/financial performance metric goals for each BU, analyze why the BU might be coming up short or exceeding their goals by performing the same type of variance analysis as RB to RB (note, assuming the budget was run at a flat price deck, the latest RB will need to be price normalized to make the comparison apples-to-apples for price-related goals such as net cash flow, EBITDA, expenses if they include production taxes, etc.).

If a BU knows well ahead of time how it will perform versus its full-year goals, it can focus its resources and expertise during the year on how to mitigate any predicted shortfalls, or on how to re-deploy any predicted excess.

RB to earnings call: Assume the first earnings call of the year discusses prior-year results and includes guidance for upcoming quarter(s) and the full year based on the strip budget. During the earnings call in the spring, management will discuss Q1 actuals, and will be well-versed on why Q1 actuals might differ from the guidance they issued at the beginning of the year based on the cumulative variance analyses in the 1x11, the 2x10 and the 3x9.

By the time of the spring earnings call, management will also have the 3x9 RB done and ready to go to provide new guidance for the remaining quarters in the year and for full-year. Since the 3x9 is the latest and greatest outlook on the upcoming quarters in the prompt year, it should be a simple exercise for investor relations to use the 3x9 in the spring earnings call guidance. This same process is repeated for the summer and fall earnings calls.

Rolling budgets have many uses for oil and gas executives, ranging from managing internal goals to providing earnings call guidance to analysts and investors. Assuming the company has a robust annual budget process in place, in which a 24- or 36-month income statement, balance sheet and cash-flow statement are the end products, the next step is to build the process for rolling budgets. Building this process could take months, depending on the complexity of a company’s organizational structure and how much detail it wants to include in the rolling budgets. However, once that process is in place, and the FP&A group is successfully herding all the relevant cats every month, the benefits to management far outweigh the monthly resources devoted to rolling budgets.

Michelle Wolpert (michelle_wolpert@hotmail.com) is an energy finance professional with experience in financial modeling and budgeting.

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