Guest Post: Balancing Capital Reinvestment and Risk Management for Business Growth in Oil & Gas
Ron Armstrong is an accomplished oil and gas industry leader with over 40 years of experience in petroleum refinery operations, economics, and strategic planning. In this article, he and Cicely Striolo, Copperleaf’s Global Manager, Oil & Gas and Chemicals, examine the complexities downstream oil and gas companies face when determining how much sustaining capital to reinvest in a business. They outline the importance of striking a balance between reinvesting in asset renewal and growth, and ensuring shareholder returns.
Earmarking Capital for Operations Sustainment
Determining the amount of capital to reinvest in a business is one of the most important decisions company executives make. Deloitte recently surveyed business leaders across the globe and found despite the urgent need to instill greater capital discipline, many organizations admit they still lack a formal capital allocation framework. Organizations often have an investment approval process, but many lack a clear capital allocation framework to structure, prioritize, and guide deployment decisions in a way that’s grounded in the principles of long-term value creation and risk management.
As a part of their strategic objectives, many companies communicate future growth expectations and shareholder returns through dividends and share buybacks. A business directing all free cash flow to shareholders creates the metaphorical “cash cow” liquidating itself. On the other hand, directing all free cash flow to growth could disappoint shareholders and erode the earnings power of the existing business.
Honoring these strategic commitments around cash usage can constrain the amount of capital available to reinvest in sustaining the earnings capability of the current business, and grow the business (new geographies, new products, increased capacity, etc.). Fulfilling these promises to shareholders can be particularly difficult in a commodity-based business when companies have limited market influence, and the available gross profit is determined by the difference between raw material prices and finished product sale prices.
Ideally, the amount of capital allocated by the management team to sustain the existing business should be set to balance the amount of risk with the earnings from the current business.
The most effective use of sustaining capital ensures individual projects within the spend are aligned with significant, long-term strategic objectives, such as reducing greenhouse gas (GHG) emissions or preparing for future growth investment plans. The business risks to be considered for sustaining spend should include items such as health and safety, environmental impact, public perception, reputation with customers, and achieving corporate strategic goals, in addition to the normally quantified financial risk of equipment damage or unscheduled production outages.
Delivering Sustainment Capital: Decision Making Through the Good and the Challenging Years
From the broader corporate perspective, the capital allocation process may simply accept the facility manager’s subjective judgment of the amount of sustaining capital required to sustain the safe, reliable, and profitable operations of the existing business. In parallel, the corporate plan is developed for growth capital that enables the company to meet its commitments to shareholders.
This approach sets the sustaining capital budget based on the key premise that the individual projects being selected for funding are the ones that will reduce risk most cost-effectively, and that executing against a predefined plan results in better productivity and increased capital efficiency. However, taking this approach, founded in seasoned but subjective judgment, it’s possible to either over-invest in the sustaining arena and exceed the point of diminishing returns for risk reduction, or under-invest and generate more business risk than is desired.
During “good” years, when current business results are acceptable, “status quo bias” can lead to a sustaining budget amount that is the same (or similar) each year, regardless of whether the amount of risk being accepted by the business has changed. Allocating the sustaining budget to specific projects (and/or facilities) can result in funding the projects that attract the most emotion, or the most short-term urgency. Often, the alternatives are not very well-defined for these ‘must-have’ projects, leading to missed opportunities that are more capital-efficient.
Furthermore, the specific projects selected for funding may not be the ones that generate the most effective long-term risk reduction or strategic advancement. When companies operate facilities in multiple locations, it’s often difficult to ascertain if the level of risk being accepted in different facilities is consistent with the role that facility plays in the overall strategy of the company, and status quo bias can result in a similar approach (i.e., default to the same budget as last year).
Alternatively, during the “challenging” years when market conditions are unfavorable, or even when attractive new growth opportunities appear, there’s a temptation to reduce the sustaining capital as a lever to maintain the commitment to shareholders on cash returns. When reducing the sustaining capital budget, it’s difficult to know how much additional risk the company is accepting to balance its near-term cash needs.
At all times, if the sustaining capital budget is set too high, the amount of risk reduction may not be the economic optimum. Many people attempt to track these risks (such as Health, Safety and Environment) or progress towards strategic objectives (such as GHG reductions) using a plethora of spreadsheets, which are notoriously difficult to keep updated as specific projects are completed. The result is the total sustaining budget is set by judgment, often with incomplete or inaccurate measures on the amount of risk being accepted.
Finding the Balance
To address these challenges of balancing cash requirements with risk management, a rigorous and dynamic approach to quantifying risk reduction, whether safety, reliability, environmental impact, GHG emissions, perception, reputation, or financial costs and benefits is needed. Utilizing a more nimble methodology to quickly evaluate alternatives avoids defaulting to a suboptimal solution.
Moving beyond spreadsheets to a continuously refreshed view of project expenditures, status, and well-defined alternatives can lead to better optimization of sustaining capital spend in real-time.
Further, with consistent metrics in the primary risk areas a company chooses to monitor, the decision-making process will be even better-informed of the relative value of individual projects, and the risk reduction of the budget program. This lets management move towards a fact-based decision process, with less subjectivity. Ultimately, improved capital allocation decisions can achieve the same amount of risk reduction for lower total spend. Experience has shown these savings can vary between 5% and 20% of the entire sustaining capital budget.
Key Takeaways
- Risk-Cash Flow Equilibrium: Leaders must judiciously balance capital reinvestment to ensure investor returns and long-term business vitality. A consistent and fact-based approach can reduce the amount of individual subjectivity in the decision-making process.
- Sustaining Capital Strategy: Capital allocation should serve dual purposes: sustaining current business and fostering growth. It should align with long-term objectives and balance acceptable risk, with potential hazards in both over- and under-investment.
- Dynamic Risk Assessment Approach: Companies should adopt a robust and adaptable strategy to measure the value of risk reduction, moving beyond complex spreadsheets and embracing refined, user-friendly solutions. These solutions enable frequent updates in project valuations, empowering better-informed decision making.
By implementing this type of approach, companies can improve capital allocation and achieve comparable risk reduction with 5-20% less spend.
To learn more, download the full report by Ron Armstrong and Cicely Striolo on Optimizing Capital Allocation and Risk Management: A Strategic Approach for Downstream Oil & Gas Organizations.