Analysis: Uncertain Energy Policy Among Key Risk to Upstream O&G

Uncertain energy policy poses a key risk to upstream oil and gas companies worldwide, according to the Ernst & Young Business Risk Report 2010.

Uncertainty, which was ranked second in Ernst & Young's previous report in 2009, has grown as a risk as direction of energy policy have been prolonged, partly by the vague outcome of the Copenhagen climate conference in December 2009 and partly by the inability of the U.S. to adopt a clear energy policy. Policy decisions worldwide have further been complicated by the Gulf of Mexico oil spill.

"Broadly, speaking, the absence of clarity around regulatory and legislative changes will undoubtedly impact the industry in the future and create an uncertain framework for long-term investments," said Ernst & Young.

The Obama administration has proposed a number of regulatory changes and changes in tax laws that could discourage industry growth and drive up costs. To maintain margins and the ability to absorb unsuccessful exploration costs, upstream companies must continue to find ways to reduce operational costs, while maintaining safety and environmental standards.

Steps companies can take to respond to this risk by adopting an organized approach to educate and lobby political leaders and the general public about the need for a coherent and consistent energy policy, Ernst & Young said. Other solutions include understanding and anticipating the national energy policy of the country in which operations take place, which may include use of policy advisors on the ground, even for smaller companies.

Risks to Upstream Activity

Access to reserves, including political constraints and competition for proven reserves, poses a significant risk for companies. According to Ernst & Young, companies seeking new reserves face more difficult environments, such as Canadian oil sands, the Arctic or deepwater, which often increase the cost involved and the risk.

International oil companies (IOCs) also face the threat of supply disruptions from nationalization of assets and political unrest, particularly in regions with a history of resource nationalizations and sudden regime changes. Additionally, strong competition from national oil companies also increases uncertainty that IOCs can maintain access to reserves, much less the profitability of the project.

Companies can respond to this risk by investing in time and resources to fully understand the risk environment in which operations are conducted. Seeking a local partner to take advantage of existing opportunities can allow a company to completely grasp the political climate on the ground, Ernst & Young said.

"Upstream companies also must balance their oil to natural gas reserve ratio. Russia, the Middle East, North America, Africa and other regions possess huge gas reserves – enough to satisfy world demand for the next century or longer, according to some estimates. Additionally, natural gas is being viewed as a bridge to a low-carbon future, and could become the major fuel for multiple end uses, such as electricity, heating and transportation.

"The growing importance of natural gas will lead to a shift in investment priorities now involved only in oil-related areas have increased or most likely will increase their involvement in natural gas," said Ernst & Young.

Oil prices this year have been relatively stable due to modest consumption habits, and weak developed economies have eased demand pressures. However, any setbacks to the global economic recovery could put downward pressure on prices, which will affect revenues and reduce companies' capacities to finance projects off their balance sheets. Natural gas prices also remain at historically low levels, and threaten the economic viability of many natural gas fields.

Upstream oil and gas companies also must consider environmental issues, which have created not only increased regulations but also difficulties in predicting how these regulations will be implemented over time. In the U.S. controversy surrounds the environmental impact of oil and gas operations, including the use of hydraulic fracturing technology for enhance oil and gas recovery, an environmental, safety and health concerns have emerged and are being debated. This debate will continue to complicate the strategic decision-making of oil and gas companies across the industry.

Worsening fiscal terms seem almost inevitable for the upstream subsector in 2010 and beyond as many governments seek ways to increase revenues after seeing revenues decline during the recent recession. Large upstream companies provide a highly visible tax target, and many companies are re-evaluating their tax positions and developing new strategies to manage their tax supply chain management, Ernst & Young noted.

Upstream companies conducting exploration and production (E&P) activity in extreme environments such as the Arctic often need to develop or invest in new technologies. The added costs and difficulties or building, operating and maintaining infrastructures in these environments also increases risk; if commodity prices fall below a certain threshold, once-viable fields become uneconomical to produce. "As demand rises with limited reserves available, pursuing E&P in harsh or challenging environments may be the only way to significantly increased reserves, and therefore future revenues."


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