Oil and water do mix

The merger last October of Norway's Statoil with domestic rival Norsk Hydro's energy division created the largest offshore oil and gas company in the world, as well as the biggest revenue-producing business in the Nordic region. Petter Kapstad, StatoilHydro's chief risk officer, talks to Rob Davies about the company's approach to enterprise risk management

Fuelled by surging demand from the rapidly emerging Asian economic powers of China and India, as well as fears over supply constraints, the price of oil has almost doubled in the past year. The one-month futures price for Brent crude oil was $66.51 a barrel on May 14, 2007; on May 22, 2008, the price stood at $130.51. Furthermore, the likes of Goldman Sachs have predicted oil prices could touch $200 within the next two years.

StatoilHydro, the largest revenue-generating company in the Nordic region, is well positioned to take advantage of the global commodities boom. Based in Stavanger, Norway, the company was established in October 2007 as a result of a merger between Statoil and the oil and gas business of Norsk Hydro. At the end of 2007, the company employed 31,000 staff in 40 countries, with proven reserves of 6.3 billion barrels of oil equivalent (BOE) and daily production of 1.7 million BOE.

On May 13, 2008, StatoilHydro was valued at Nkr610 billion ($120.9 billion), and its recent earnings suggest any teething troubles that might have been expected as a result of the merger have been minimised. First-quarter net income rose 63% to Nkr16 billion from Nkr9.8 billion in the corresponding period last year, on the back of rising oil prices and increased production. This compares well with the performance of its main European peers, BP and Royal Dutch Shell, which reported first quarter growth of 63% and 25%, respectively.

Given that StatoilHydro forecasts its daily production output will increase to 2.2 million BOE by 2012, and assuming the current high price environment will persist for the foreseeable future, the near-term profit outlook for the company looks healthy.

Nonetheless, the oil and gas business has historically been subject to dramatic price movements, meaning the company has to keep a close eye on risk management.

Petter Kapstad, who leads the firm's risk management function in his capacity as chief risk officer, joined Statoil in 1994 and is fully aware of the fickle nature of the industry.

"When the levels are as high as we see now, it could be easy to make bad decisions, so there needs to be a lot of focus around risk management," he says. "We have a very strong financial situation, but it is not so long ago (in late 1998 and much of 1999) that we operated in a $10-13 per barrel environment. Back then, when we tried to do some scenario-based modelling in a $20 environment, it was looked upon as too optimistic."

While not predicting oil prices will plummet to the levels last seen a decade ago, Kapstad says the company cannot afford to get ahead of itself when deciding whether to proceed with new projects.

"Let's take, for example, a development where the breakeven price is $80, but the actual price of oil is $120. There would be pressure from some quarters for us to commit to such a project, but there has to be an element of caution, because it is not inconceivable the price could drop back to $60 in future. That is a tough discussion," explains Kapstad.

Even in the current market, StatoilHydro is aware that not everything goes to plan. In May 2008, the company was forced to shut down its Arctic Snohvit liquefied natural gas plant, located in Norwegian waters in the Barents Sea, for two months. The plant had been running below full capacity since production began in 2007 and was closed down for scheduled maintenance. The aim of the turnaround is to inspect the facilities and perform maintenance work and adjustments. This, the company says, will allow it to correct weaknesses discovered during the start-up of the plant.

Notwithstanding this, the merger does not appear to have had significant downsides. Although putting the deal together was challenging, Kapstad says the integration of risk management practices was relatively easy.

"We had actually done the analysis of synergies between the companies years ago, and worked out there was between 70% and 80% correlation in terms of the share prices. The energy division in Norsk Hydro was a good fit with Statoil: the two companies obviously came from the same country so there were limited cultural issues, and we were even working on many of the same projects," he adds.

In assessing his own role at StatoilHydro, Kapstad says his chief responsibility is ensuring the executive management get a good overview of the total risk picture. Central to achieving this is the enterprise-wide risk management approach he initiated in 1996.

According to Kapstad, enterprise-wide risk management helps the company know what to manage and, from a portfolio perspective, enables it to utilise correlations and avoid sub-optimisation. "The aim is to use foresight and identify opportunities and challenges, challenge accepted truths and enter unfamiliar territory," he explains.

The enterprise-wide risk management model consists of three modules: time series analysis, a company risk model and a debt optimisation model. Exposures are run through the system, which uses historical data to calculate correlations. These are then used to quantify probability distributions of net income, returns on average capital employed, and earnings before interest, taxes, depreciation and amortisation. The model also helps the company analyse the potential effects of changing its risk profile - for example, through acquisitions or employing different hedging strategies.

StatoilHydro applies its approach to every large transaction, with senior management made aware of the potential effects on the business. "We run strategic decisions through our model to see how it fits in with the company's risk profile and how this changes as a result of doing the deal. This involves analysing the upside and downside - the potential costs, risk capital required and profit and loss effects. But the corporate risk committee does not try to act as a super trader with any particular mandate: if I go to management and only outline the potential upside, I am no longer a risk manager," remarks Kapstad.

Enterprise-wide risk management as a concept is not new: it was central to the Committee of Sponsoring Organizations of the Treadway Commission's (Coso) concept of internal controls first introduced in 1985 and the Sarbanes Oxley Act of 2002 (Sox). However, Kapstad says the idea of enterprise-wide risk management in Coso and Sox bears little resemblance to StatoilHydro's version.

"They have very little to do with risk management and everything to do with risk control: they assess risk, attempt to find the downside, eliminate and mitigate as much as possible. What we do is real risk management, and that is completely different - we do not see ourselves as auditors or controllers," he insists.

StatoilHydro's core risk is defined as oil and natural gas price risk, together with production risk. "For our core risks, our risk policy is normally to keep the upside risk and to assess whether we should adjust the downside risk, depending on the financial robustness of the company."

Much of the work the corporate risk management committee does is based on scenario assessments - for instance, testing the company's robustness in different oil price environments. Kapstad says the company would normally run between three and five scenarios in its enterprise-wide risk management model. This, he adds, is especially beneficial prior to major investments as it allows the company to see whether any downside protection is needed.

The potential impact of catastrophic events on production is another issue that is constantly considered and revisited. "You have to factor in the possibility of extreme events - whether we can protect ourselves against them, and how our situation will look after tax and insurance costs are factored in," says Kapstad.

In the wake of Hurricane Katrina in 2005, which caused between $40 billion and $60 billion in insurance losses in the US, large corporates have found it increasingly difficult to get cover against larger catastrophic events. In response, a group of StatoilHydro's insurance staff and risk managers looked to see if there were any other means of protecting against income losses. In the event an accident caused production from an oilfield to be closed, they first asked whether the oil and gas would be lost forever. The reply from the engineers was that there would be, on average, a 90% probability of getting it back during the tail-end of the field's production life. However, there would be a different net-present-value in having the oil today versus getting it at the tail end.

Consequently, the company put all its fields together into one portfolio and modelled this difference, and went to the commercial insurance market with Lloyds of London to see whether this amount (as opposed to full production capacity) could be insured.

"Lloyds really liked the approach because it was so simple: it was easy to go out and get sufficient capacity for this insurance. In effect, what we are doing is only insuring what we are losing, whereas previously we actually had over-insurance by getting cover for total capacity," says Kapstad.

In terms of more general hedging strategies, senior management have what Kapstad describes as "mature discussions" over whether to put on hedges, but there is never any impetus to simply lock in a margin. "The question we ask ourselves is whether we have the equity to carry that financial risk from the very beginning. If we do, why should we pay a penny for hedging instruments," he says. "If the risk is not what we perceive as being threatening or something we especially want to get rid of, then we do not hedge."

Nevertheless, this is something the company constantly revisits when putting together its financial plans, adds Kapstad. To minimise commodity price volatility and match costs with revenues, StatoilHydro uses a combination of futures, options, forwards, swaps and contracts for difference in the crude oil, petroleum products, gas and electricity markets. The fair value of these hedges was a negative Nkr2.025 billion ($406.7 million) in 2007. The value of its financial derivatives book was Nkr6.2 billion.

In terms of the future, with North Sea reserves gradually being depleted, the company's bottom line will become ever more dependent on activity in countries such as Libya and Iran, and the Gulf of Mexico, bringing additional challenges.

"What a lot of people ignore when they look at the price of oil is that operating costs have gone up massively as well. We still have a few fields where production is cheap, but by and large those days are gone. We are a high-tech company drilling thousands of metres down to get oil out of places, and in the future this process will get tougher. Regimes in the countries where we operate might also take the view they do not want to give drilling rights to foreign companies - I expect we will see that happening more in future. We must be constantly aware of these kinds of eventualities," notes Kapstad.