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Planning for price swings in the age of "peak oil"

July 9, 2008

It was only January of this year when the price of oil first hit $100 per barrel. Who knew that those were the good old days?

The price of oil has more than doubled in the past year and higher fuel costs are affecting virtually every business and consumer.

For industries directly affected by fuel costs, like airlines, automobiles and trucking, the consequences have been severe.

Hoping for a price plateau?

With the price of crude oil setting new records almost weekly, it's tempting to believe that prices will continue to rise indefinitely. In fact, some think that the best we can hope for is a price plateau, perhaps somewhere near the $150 per barrel level.

Yet the reaction of oil companies to these historic price levels is one of caution. Far from anticipating an ever-upward trend in prices, The Economist recently observed that "[o]ilmen remain scarred by the rapid expansion of output in the late 1970s, in response to previous spikes in prices that led to a glut and so to a prolonged slump."¹

Following the first "energy crisis" of the 1970s, oil producers around the world responded by increasing production substantially. But energy consumers responded too.

Buildings, appliances, and vehicles became much more efficient. The first minivans, for example, got roughly double the gas mileage of the old family station wagon. As a result, the price of gas, in constant dollars, actually fell in subsequent decades.

So today, in spite of unprecedented price levels, "Exxon Mobil claims that it still assesses the profitability of potential investments using the same assumptions about the long-term oil price as it did at the beginning of the decade, for fear that prices might tumble again."²

And that fear is well founded. In fact, one energy economist at Lehman Brothers predicts a sharp fall in prices for the end of 2008, and an average price of $83 per barrel for 2009.³

"A structural change"

Consumers, businesses and the broader economy can be expected to adjust to high energy prices as they did in the past.

The laws of economics haven't changed since the 1970s. But the nature of the world's economy has. As Alan Mulally, the CEO of Ford Motor Company, said, "This is a structural change, not a cyclical one."⁴

Energy demand from China, India, and other developing countries has grown dramatically in the past decade and is still growing.

Output from oil producers such as Russia is at an all-time high.

But some believe that we've entered the era of "peak oil," in which nearly all the oil that can be found has been found, and production levels will only decline from now on.

And overshadowing all of this is the specter of global warming and the urgent need to reduce the burning of fossil fuels.

Conservation and innovation

In the long run, conservation and innovation have the potential to both meet our energy needs and leave us with a cleaner planet. Vehicle fleets will be replaced, and new energy sources will come online.

Investment in alternative energy sources, such as wind, solar and biofuels, is already growing at double-digit annual rates.

Wind power, for example, presently accounts for only 1% of the U.S. energy supply. But government and industry leaders "want to see that share hit 20% by 2030."⁵

Complementary technologies will also have a substantial impact.

One long-standing drawback to electric power from wind and solar has been the problem of storage. But increased storage capacity, in the form of batteries inside millions of electric cars could solve that problem.

Scenario planning for the here and now

In the short-term however, high energy prices – and their unpredictable fluctuations – are a painful fact of economic life.

Companies have been forced to adapt to higher costs for the transportation of goods, for petroleum-based materials, higher travel costs for employees, and a multitude of other changes that affect profitability.

In such a business climate, rigid annual budgets become a serious handicap. And powerful financial performance management solutions such as IBM Cognos 8 Planning and IBM Cognos TM1 become an invaluable ally.

IBM Cognos 8 Planning provides real-time visibility into resource requirements and likely operating performance.

It supports practices such as driver-based planning and rolling forecasts, which enable analysts in the office of finance to examine the consequences of oil at $150 per barrel, $83 per barrel, or anywhere in between.

IBM Cognos TM1 gives users the ability to view and edit enormous volumes of multidimensional data quickly and analyze profitability, factoring in a myriad of business variables.

It lets you modify business assumptions to perform flexible, "what-if" scenario modeling to provide senior management with sound options for any eventuality – such as a carbon tax.

A Performance Blueprint for Oil and Gas

Of course, no industry is more affected by the price of oil than the oil companies themselves. And no set of investment decisions within the oil and gas industry is more affected by the price of oil than those involving exploration, drilling and the operation of oil and gas wells.

For this segment of the industry, Cognos offers the IBM Cognos Upstream Oil and Gas Performance Blueprint.

A Performance Blueprint is simply a data, process, and policy model that is pre-customized for the specific needs of a given industry or organizational area.

The Upstream Oil and Gas Blueprint helps companies plan production, revenue, expenses and capital expenditures at the well, field or area level.

This Blueprint addresses numerous factors such as projected and historical volumes of production. It helps identify variances and trends in operating expenses, and forecast field expenses at gross and net levels.

It even incorporates currency exchange assumptions to produce forecasts in the appropriate local currency – a critical capability when central banks the world over are simultaneously fighting both inflation and recession.

Plan A, Plan B, Plan C

When the future cost of an essential commodity like oil is so unpredictable, the office of finance needs the ability to consider and prepare plans B, C, and D in case the organization's plan A becomes obsolete overnight.

No one can say for sure what the price of oil will be in a month or a year. But those businesses that can minimize the damage from current high prices, and position themselves for a more stable future, will be able to weather the storm.

Find Out More Cognos Performance 2008: Sign up now! Cognos solutions for Oil and Gas

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Sources

¹ Double, double, oil and trouble, The Economist, May 31-June 6, 2008.

² ibid.

³ Stanley Reed, Help from the House of Saud, BusinessWeek, June 9, 2008.

⁴ Peter Coy, Breaking Point, BusinessWeek, June 9, 2008

⁵ Steve Hamm, Wind: The Power and the Promise, BusinessWeek, July 7, 2008.