Sensitivity Analysis:

The crude oil exploration & production industry operates under high uncertainty.
Profits and earnings volatility is the way in which this uncertainty turn into risk for oil
companies. The main factors for this volatility for the given industry rely over a wide
spectrum of causalities. Within the most important, Oil & gas prices and success rate
for drilling operations are one of the most important for Unocal.

Unocal as a capital-intensive business has considerate financial obligations to

continue with their normal operations. This commitment requires operation of the
business to maintain returns and cash flows as high and constant to keep up with the
due payments. The main factor for maintaining this besides creditors’ payment
commitment is the volume of produced barrels of crude oil per day. Sometimes this
may vary due to external factors from 120,000 barrels to 180,000 barrels per day.
This is 30% of the volatility in the production. The cash outflows generated from due
payments generally come from the following sources:

Firstly, the industry uses heavy and costly machinery within their factories to obtain
crude oil. The cost of this process can reach a cost of $1 billion per whole drilled.
These investments are subject to many conditions in order to avoid incremental costs.
The additional risk includes accidental risk and mechanic risk. Also weather is a great
factor for the effectiveness of the machines.

Additionally, the factory requires replenishment of the installations at a constant and

short-term rate. The value of this replenishment process is very high due to the
specifications of the materials needed and the fact that the factories can’t suspend
operations by any chance. If this is the case, and the company needs to suspend
activities due to machinery issues, the effect on the factory’s production per day will
be heavily affected. Collateral consequences of this can be a fall in shares price and
profit loss to shareholders.

Finally, the uncertainty of finding or not petroleum is a constant high impact risk to
the company. Money paid for exploration and drilling is paid upfront. To minimize this
risk companies spend millions in research and investigation of the land before
starting any drilling. This cost is also paid upfront. The company can develop
continuous investigations of topography and characteristics of the land without any
success maintaining a cash outflow for a long period until it gets dry of money.
Insurance over this activities are available and also have to be paid upfront. John
Donohue, Spirit Energy 76’s president stated the following about risk in this industry:
“You've got to pay for the majority with the minority success ratio.”
Unocal Analysis:

For Unocal, as any other company within the oil, gas or any hydrocarbon industry, the
change in oil prices represents volatility to the company’s return and profitability. The
effects of these changes in oil and gas price can be measured in changes on pre-tax,
after-tax profit change and earnings per share change.

The table bellow illustrates the changes in pre-tax, after tax profit and earnings per
share for Unocal related to change in oil and gas price:

Change in pre-tax Change in after-tax Change in earnings

profit profit (Dollar per share)
(Million dollars) (Million dollars)
Prices
Oil Price per $47 $33 $0,14
$1 change
Lower-48 gas $28 $18 $0,07
per $1,1 change

Also, has been identified that the rate of success of drilling to find rich oil wholes
makes substantial price sensitivity. The reason to this is that the costs of research for
land with oil is very expensive and having a low success level will increase sunk cost
with no return to the company. Also insurances for this purpose are expensive and
paid upfront.

The table bellow illustrate the changes in pre-tax, after-tax profit and earnings per
share for Unocal related to change in success rate:

Change in pre-tax Change in after Change in

profit (Million tax-profit (Million earnings (dollar
dollars) dollars) per share)
Exploration drilling
10% Change in $44 $27 $0,11
overall success
rate.

Competitors Sensitivity Analysis:

BP Sensitive analysis reports 2012:

Unocal restricts its operations to just exploration and extraction, thus its sensitivity
analysis is narrowed to just two main factors. On the other hand competitors will be
focused on other main factors since their operations extend to refineries and
distribution. This structure is known as vertical integration and joins exploration and
production with refinery and distributors. In this way the Unocal competitors

In actual reports of BP to the market, they publish sensitivity analysis towards their
refinery margins as fllows:

Price sensitivity analysis for BP 2002:

BP’s annual report usually dedicates special space to deliver information about
sensitivity of the company to external factors such as oil and gas price changes. The
excerpt from the annual report is listed bellow:

“The adverse business conditions had the greatest impact on refining and
marketing. Worldwide refining margins were depressed for much of the year,
at nearly half the average level of 2001. They may remain under pressure,
although a colder winter after the unusually mild 2001-02 season could help
offset the impact of a subdued economic recovery, especially in the key US
market. Margins in chemicals were at levels similar to the bottom of previous
cycles.”

Sensitivity implications for BP in 2002 are the following:

Min Brent Price 2002 $18 per barrel

Max Brent Price 2002 $31 per barrel

Average oil Price 2001 $24,44 per barrel

Average oil price 2002 $25,03 per barrel

Increase in average gas price decrease of $0,6 per mmBtu

A High volatility was spotted towards the end of the year due to cold weather (natural
gas). The increment during this period was of $5 per mmBtu.

Result of BP’s performance linked to these two factors are announced to the overall
market as well in the annual report as follows:

“BP’s result for the year was $8,715 million, compared with $11,559 million in
2001. The result per share was 38.90 cents, a decrease of 24%. The
replacement cost operating result was $14,720 million (2001 $19,608 million).
 Replacement cost profit before exceptional items was $4,698 million (2001
$8,291 million). “

These changes are also affected by other factors such as significant operation risk.
Nevertheless linking BP’s losses during the 2002 to oil price volatility is very
straightforward and in this way BP presented the information to investors under the
subsection of ‘Financial, Business and Operations Review’.

Hedging against Sensitivity factors: Oil price volatility

Many companies within the oil industry tend to manage this exposure to oil prices by
doing several hedging strategies.

Risk Mitigation strategy through Vertical Integration:

Applied to competitors that incorporate refinery divisions within their operations can
have more certainty on their cash flow stability. Unocal as a company does not own a
refinery division within operations, but it was acquired by chevron that does have this
services. This business is more stable because is based on the usage of chemicals and
specialized tests and research. By delivering refinery services the companies can
mitigate cash flows volatility from their exploration and extraction divisions. There is
a constant in the world that the light oil is getting dry and heavier crude oil need to be
refined. For this, refineries need to invest resources on research and development to
continuously find low cost methods to treat this material for preparing the companies
to face this change in the future.

 When Price of Oil is High, the Exploration and Production will earn high
returns due to increment on prices from their main product (seller
perspective). On the other hand the Refineries have to buy the oil at a higher
price and there is a operational risk involved (Buyers’ perspective).
 When price of oil decreases, the Exploration and production will earn low
returns while the refineries will purchase crude at a lower price potentially
increasing their margins.

Risk Mitigation strategy through customer-end transfer pricing:

For refineries is much more easy to manage the risk for rising prices of oil in the
market. The companies transfer directly the direct cost of purchasing crude oil to
customers. This is why the operational risk in refineries tends to be less than
exploration and production divisions.

Risk Mitigation through Futures and Derivatives:

Oil companies risk management systems:

Companies are moving form an old paradigm of risk to a much more efficient one. The
efficiency is based on integrate the business as a whole and look at the big picture.
Also this risk perspective needs to be subject to continuous analysis and
improvements. A direct benefit for the company to deploy this strategy is that
employees of the company will have a risk-management mind-set to deal with day to
day and mayor decision-making. This is taking risk management from isolation to a
holistic manner.

The systems applied by the oil companies are build-up to create, enhance and protect
value generated by their operations. This can be through the reduction of earnings
volatility and getting new opportunities to finance business or transfer risk.

Unocal Risk Management system:

“I think sometimes when we say ‘risk’, we tend to segment risk as something different
than just running our business. To me, running a business is all about managing the
risk and managing returns, whether on the financial side or the balance sheet side, or
running a field operation”.
-Tim Ling, CFO Unocal-

Karl Primm became head of auditing of Unocal after being part of a ‘Big five’
accounting firm. He was the direct influence for the company to incorporate the
enterprise-wide risk management approach.

To apply this approach the first thing was to identify the risks both systematic and
unsystematic risk. (for the presentation: This was discussed by Winn in the risk
identification profile) The company was aware of these risks what took them to
deploy self-assessment over those risks. In the past they used to have a very
systematic way to answer to 800 questions that answer more to documentation than
actual risk probabilities. This process entertains management in risk strategies or
controls of low impact and relevance situations. The process of changing from the
previous system to the enterprise wide system showed resistance form the managers.
They replied that this was a burden on the management team but they where
convinced by the argument that they will be near heavy decision making in the
company and will carry out the process with top management.

Unocal established teams for analysing all risks within the company. The risk
assessment was driven by also a risk ranking component that allow the management
to focus on the most likely situations that have a large impact on the company’s
performance. In this way budget allocation can be delivered in a better way to planned
projects of the company.

Unocal distributes to their teams a risk document. Directly, the top management ask
the teams for improvement on the way risk is being managed. This is a question that is
asked to improve risk mitigation strategies and systems. Additionally the teams need
to take into consideration the different mitigation strategies and their probable
outcomes. Then they are asked to find new creative ways to solve the risk mitigation
and at the end decide which one will give the company a better outcome. On the
document, there was written a group of categories to divide the risks that might arise
during the analysis:

 External/Relations
 Customers
 Employees
 Operations
 Information
 Technology
 Corporate Infrastructure

After categorizing the risks, they have to allocate a concern level to each one of them.
With this process, an interview session with the manager will follow up to a better
understanding of high impact and concern risks. This will lead to a beter
understanding on the severity of the possible outcomes. A data base was maintained
in the company with the content of all relevant information for the assessments of
these risks. The database will deploy functions, and categorization to all risks is
released in for private usage of senior management as shown below:

In general Unocal risk management has remained within the audit department and
corporate Health, Environment and Safety Department. Their change from the past
systems to the more integrated one was possible due to the high interest of their CFO
and department leaders of auditing and HES over risk management.
ENI Risk Management system:

Company Overview:
Eni S.p.A is an Italian company owned partially by the governments of Italy and china.
The rest of the equity is traded in the market. This company is very active in the oil
and gas industry. This company has different business units such as exploration and
production, gas and power, engineering and construction, versalis and refining and
marketing.

As the global trend continuous, Eni is a company that has also implement an
enterprise-wide risk management system. They call it “Integrated Risk Management
Model”. This model work by having three levels of risk control: Fist line, Second Line
and Third Line.

First Line:
This level is where the people directly involve with the risk. By saying directly
involved with the risk we mean that they handle the risk in a day-to-day basis. For
instance a plant manager has to be sure to mitigate any safety risk for its employees,
so if a heavy storm is taking place and the safety of the workplace is compromise is his
decision to assess the risk in the best possible way.

Second Line:
This level relates the risk control functions with the risks the business faces. For
instance, headquarters can direct their business units a list of specific restrictions that
lead to a reduction of the allowed risk to be undertaken in projects of specific
characteristics. Also can work the other way around and headquarters may direct to
initiate drilling in high risk success areas for the exploration and production business
unit.

Third Level:
This level is based on auditing and certifications of planning and functioning of risk
management process for the different process. Third parties do the auditing and
certification process.

ENI on its reports also outstand their risk management process to be continuous and
dynamic. Their business risk management process is lead and followed closely by the
board of directors. They dictate the scope of risk management for a certain period.
Based on this the risk management assess the risk of their core business and their
subsidiaries. Afterwards, mitigation strategies are suggested to board of directors for
each one of the risks identified.

The board of directors and risk management committee gather all the information
from the levels and periodically run monitoring studies to check whether their
planning on management was successful or need to be restructured. Normally this is
done twice a year through interim IRM reporting and annual IRM reporting.
The reports usually include the company target, risk category, main risk event, risk
factors and uncertainty section, and also the treatment measure. Here is an example of
one report delivered for the year 2013: