Petro-Canada International Assistance Corporation and World Bank 1988 Conference on Petroleum Industry Management (Vol. 3 of 9) : Investment Planning

v. 3 PETRO-CANADA INTERNATIONAL ASSISTANCE CORPORATION AND THE WORLD BANK 1988 CHINA CONFERENCE Paper 7 INVESTMENT PLANNING By E. W. BEST FOSTER RESEARCH CALGARY, ALBERTA This paper has been funded by Petro-Canada International Assistance Corporation but its content is the responsibility of Foster Reearch.  Table of Contents Section Page A. INTRODUCTION - 1- 1. -Management's Perspective on Investment Planning - 3 - 2. Investment Planning Within a Broader Planning and Control Process - 4 - 3. Organization of this Paper - 5 - B. CONCEPTUAL FRAMEWORK FOR INVESTMENT PLANNING 6 - Requirement for an Effective Process - 6 - '1. Identifying Goals and Objectives - 7- 2. Assessing the Company's Current Position and the External Environment - 8 - 3. Developing Alternative Strategies and Investment Plans - 11 - Strategy Development - 12 - 4. Selecting the Best Strategy and Plan - 13 - 5. Plan Implementation and Monitoring - 15 - 6. Summary of Conceptual Framework - 17 - C. APPLICATION OF THE CONCEPTUAL FRAMEWORK -- SOME SPECIFIC CONSIDERATIONS IN EVALUATING INVESTMENTS - 18 - 1. Major Considerations in Formulating Strategies -- Application of Step 3 of the Conceptual Framework - 19 - (ii)  Section Paye (a) Corporate Strategy Guidelines - 20 - (b) Principal Characteristics of the Sector - 20 - (c) Assessment of Risks and Returns in the Sector - 23 - (d) Critical Success Factors - 25 - (e) Company's Current Strategy and Position in the Sector - 26 - (f) Strategic Objectives - 27 (g) Strategic Program - 28 - (h) Expected Results of the Program - 29 2. Major Considerations in Formulating Business Plans -- Application of Step 4 of the Conceptual Framework - 30 Contents of Business Plans - 31 - 3. Major Considerations in Formulating Operational Plans -- Application of Step 5 of the Conceptual Framework - 34 - Contents of Operational Plans - 34 D. PRINCIPLES UNDERLYING THE ASSESSMENTS OF SPECIFIC INVESTMENTS - 36 - 1. Quantitative Assessments - 37 (a) Project Evaluation and Discounted Cash Flow Principles - 37 - (iii))  Section a se (b) Dealing with Risk and Uncertainty - 40 - (c) Sensitivity Analysis - 50 - 2. The Role of Prices - 51- E. SUMMARY ON INVESTMENT PLANNING - 54 - 1. Making Investment Decisions - 54 - 2. Requirement for Both Process and Analysis - 56 - (iv)  List of Figures Figure I GENERAL FRAMEWORK OF INVESTMENT PLANNING - 59 - 2 LINKAGES BETWEEN COMPANY'S LONGER TERM STRATEGIC DIRECTION AND OPERATIONAL PLANS 60 3 TYPICAL VARIABLES IN EVALUATIONS OF CAPITAL PROJECTS - 61 - 4 OVERVIEW OF KEY ELEMENTS IN PETROLEUM ECONOMICS 62 5 STEPS IN THE ECONOMIC EVALUATION OF A CAPITAL INVESTMENT IN EXPLORATION AND PRODUCTION - 63 6 PRINCIPLES OF EXPECTED VALUE COMPUTATIONS - 64 = * ~~~~~~~(V)  INVESTMENT PLANNING A. INTRODUCTION The primary objective of oil and gas investments by the western petroleum industry is not merely to produce oil and gas, but normally to do so at optimal profit consistent with the risks, its financial restraints, and -the forecast political, social, and economic scenarios. Individual corporations may have other prime objectives such as growth, or corporate survival in times of economic turndown or specific circumstances. Optimizing profit over a short/medium or longer term, though, is normally the prime objective. The industry therefo-re carefully plans for its capital investments, since such investments: require substantial financial resources and specialized human resources; are inherently risky and uncertain reflecting, for example, political, economic, and geological factors; affect the corporation's financial performance over a long period of time; and are generally irreversible once commitments are made to joint- venture partners, governments, customers, etcetera. Investment planning in exploration and development is complicated by the fact that the primary determinants of a project's profitability are uncontrollable, notably, the world price of oil, royalties/taxes, and other external economic factors. In addition, the investments themselves are inherently risky but controllable to greater or lesser degrees. Before an investment decision is made, explorationists, engineers, economists, and planners conduct thorough integrative analyses of the key factors that impact on the economic attractiveness and therefore on the profitability of a project. These assessments deal with questions such as: - 1-*  Will geophysical/geological activities locate prospective anomalies on the acreage and how many? * What will be the costs and timing of exploration expenditures to success or completion of the program? If there are anomalies, what are the chances of finding hydrocarbons and what type and quality (sweet or sour gas, light or heavy oil, etcetera)? - Given a successful wildcat, what is the probability as to areal extent of accumulation, reservoir and production character- istics, development and production costs and timing of these expenditures? - . If developed, what are the market opportunities, what will be the transportation costs to market or the capital costs for transportation if undertaken by the company? What will be the selling prices of the product and the taxes, royalties and other economic factors? - If the delineation phase is successful, will full exploitation of the discovery generate enough financial return consistent with the profitability objectives of the corporation and with due regard to the risks and financial capability of the company? - At. the level of the producing field, what production method, number of wells, spacing of wells, type of equipment, etcetera will achieve optimal unit production costs relative to optimal recovery? These analyses, which are mainly conducted at the operational or subsidiary level of companies, involve geophysical, geological, reservoir and production engineering, economic and financial considerations. For decision making purposes, however, these analyses are factored into broader, more strategic considerations developed by the company's corporate or headquarters level management. These strategic considerations deal with issues such as the company's longer term goals and direction, its relationship with the specific country, its overall financial health, the riskiness and return of this investment relative to others, etcetera. The level at which the decisions are made (i.e., headquarters or subsidiary level) will depend on the scale of the investment, its strategic importance, and how closely it fits the corporate objectives and strategies. Because of the magnitude of and the risks associated with major capital investments in oil and gas (such investments can range in the billions -2-  of dollars), the complexity of the investment analyses, the size of many companies, and their specialization of functions at the corporate and subsidiary levels, companies have developed systematic processes and proce- dures to evaluate investments and to integrate these evaluations within a broader strategic planning framework for management decision making. 1. Management's Perspective on Investment Planning From the corporate or headquarters perspective of the typical company in the western oil and gas industry, one of management's principal goals is to optimize the company's present worth over a period of time. Investments are therefore directed to that portfolio of activities where the overall balance of risks and returns appears to be optimum by reference to this goal. The goal of investment planning is to provide a company's shareholders with a financial return which, over the long run, is no less than that which they could have obtained from similar investments in a business of comparable risk. A company may have other important objectives, such as growth, in which case it may be prepared to invest if the return is slightly greater than its cost of money; or it may have a risk aversion strategy for financial or philosophical reasons and concentrate on low risk investments such as the acquisition of reserves at a return only slightly above its cost of money; or it may wish to diversify and be prepared for entry and experience reasons to accept an initial lower return. There is no single criteria as they will depend on the company's strategy and objectives. The important element is that the corporation's strategies and objectives are well defined and utilized by the investment decision makers. Both the process and content of investment planning emphasize the achievement of its financial goal. The investment criteria, which are developed at the corporate level, are sufficiently flexible to deal with the diversity of the subsidiaries' business activities and of the returns and risks they produce. In addition, the economic forecasts for prices, inflation rates, currency exchange rates, etcetera to be used in the analyses are developed at the corporate level and adjusted by the operating unit for local -.3-  conditions. In line with the emphasis on economically attractive opportun- ities, certain general investment criteria might be identified: - Investments should demonstrate a return that at least covers the - company's incremental cost of capital. Where an investment proposal has a significant risk of failing to cover the cost of capital, it will be acceptable only if the expected return is correspondingly higher. No investments are made where there is any likelihood of losses in single projects or in combinations of projects, that could jeopardize the viability of the company as a whole. - Payout of capital may be required more quickly at a time of uncertainty or if the company has a high debt/equity ratio. 2. Investment Planning Within a Broader Planning and Control Process The application of the investment criteria and the procedures developed by the petroleum industry to screen capital investments are usually embodied in a broader, management planning and control process within each company. This process includes the evaluation of strategic, economic and financial factors. Although the nature of the process is specific to each company's needs, management philosophy, organizational structure, areas and types of operations, etcetera, certain generalizations can be made. Most of these planning processes are aimed at generating information useful for decision making in five principal areas, as shown in Figure 1. These areas are:  Step 1 Identifying and quantifying major objectives and strategic direction at the corporate and business (or subsidiary) levels; 2 Assessing the company's internal and external situations, through the development and analyses of relevant data (for example, technical, financial, economic) in order to provide inputs for the development of strategies and investment plans; 3 Developing and evaluating alternative strategies or courses of action, to meet the company's desired goals or objectives; 4 Identifying criteria for and selecting the "best" means or plans for the company to achieve its objectives (this plan includes both medium and shorter term investments); and 5 Implementing the plan, monitoring, and evaluating the results relative to the expected outcomes. An important element is to react and adjust the operations if required; that is, it is not just monitoring but utilizing the information to make adjustments. As illustrated in Figure 1, Step 4, and also in Figure 2, major investments within a company's operational plans are justified against a broader background of company goals, objectives, and strategies. In other words, before a major investment decision is made, management must understand the organization's targets and how to achieve these targets with full consideration of alternative opportunities and strategies. 3. Organization of this Paper This paper is organized as follows: The conceptual framework for investment planning in the oil and gas industry is outlined in the next Section 8. This section illustrates how investments are viewed within the broader framework of goals and strategies. It explains the underlying principles, key results expected, and responsibilities at each of the principal steps of the typical company's planning activities, as shown in Figure 1. -5  Following the conceptual framework, Section C then illustrates its application, by noting some of the-more specific planning considerations that are involved in selecting investments. It demonstrates the linkages between the investments included within a company's shorter term operational plans and its longer term investment and strategic plans -- as outlined in Figure 2. Finally, Section D outlines the underlying principles of the procedures used in the quantitative and qualitative evaluations of capital investments -- as illustrated in Figures 4 and 5. B. CONCEPTUAL FRAMEWORK FOR INVESTMENT PLANNING Requirement for an Effective Process For the diversified oil and gas company with operating subsidiaries in several geographic regions or separate businesses, the requirement for an effective management process within which to integrate investment evaluations by its subsidiaries is as important as the evaluations themselves. Companies spend considerable effort in streamlining processes which effectively meet their unique needs, without involving an excessive amount of bureaucracy. In establishing such a process, it is vital to have clear lines and levels of responsibility and effective communications upwards, downwards, and laterally -- since several levels of corporate and subsidiary management and personnel are involved in the investment evaluations. As outlined earlier, the management process is basically a planning and control process which is developed and managed by a central planning group at the headquarters level supported by planners in the subsidiaries. The process is a reiterative one between management at the corporate and sub- sidiary levels, where corporate objectives and business opportunities are continuously evaluated and mutually modified in the ongoing effort to balance the risks -and returns of alternative investment opportunities. The end objective is normally to seek those opportunities that increase the economic value of the company. The process is facilitated not only through the identification of clear roles and responsibilities, but also through the communication of -6-  l; planning guidelines and suitable timetables. It includes a hierarchy of planning activities as shown in Figure 1 -- commencing with broad corporate objectives and business environmental surveys and following through to corporate and business strategies and down to the operating or shorter term plans against which business activity is controlled and monitored. It is within these operational plans that specific investments are decided. Each of the five key elements of the investment planning process as outlined in Figure 1 will now be elaborated on, emphasizing the major results that are generated at each step, the rationale for the activities, and the key responsibilities for action. 1. Identifying Goals and Objectives Major investment opportunities are assessed by a company's executive management within a broader framework of that company's strategic direction -- and its mission, goals, and objectives. This direction is established and/or re-examined at the corporate or headquarters level by executive management at the initial phases of the process. It serves to provide guidelines to management at the subsidiary levels on the corporate priorities and therefore on corresponding objectives of the investment programs of the subsidiaries. The mission of the company defines the company's basic business and overall purpose. It is a long-term vision of what the company seeks to do and the company's purpose to its shareholders, employees, customers, and society. The mission states in what businesses it intends to engage and sometimes the type of organization it is and will be. This mission, developed at the senior level of the company, sets out the overall direction for the company. The next level of direction is that provided by the corporate objectives, which state specific targets within the framework of the corporate mission. In the oil and gas industry, these frequently include objectives for specific functional areas such as finance, human resources, marketing, and technology, in addition to economic/financial objectives such as growth rate, profitability, return on investment, cash flow, and interest coverage. -7-  The corporate objectives, as well as those that cut across several businesses, are established at the corporate level. For example, a corporate financial goal might to be achieve the highest quality debt rating over a five-year period or attain a certain debt/equity ratio within a defined period of time. Objectives that are specific to a particular business, such as exploration or a geographic area, are usually established at the subsidiary or business unit level, but subject to corporate approval. These objectives are usually established through a top-down, bottom-up process of discussions. The identification of objectives is central to an effective strategic and investment plan. Objectives should be specific, measurable, concise, understandable, achievable, clearly prioritized, internally consistent, and communicated to all those at the corporate and subsidiary levels who will have a part in achieving them. They are the corporate standards against which the company and responsible parts of the company are measured. Although the corporate objectives are normally established before strategic assessment and plans, the process is reiterative and may lead to changed corporate objectives and particularly to changes in functional or geographic objectives. In some instances, subsidiary objectives may not be established until corporate strategic plans are established. The strategic planning horizon is usually a five to ten-year time frame, with the long-term plan more likely for a five-year period. There will frequently be generalized financial data prepared for the ten-year period. 2. Assessing the Company's Current Position and the External Environment Within the broader framework of investment planning, once the company's objectives are established, the next step in the process is to determine the company's position relative to its objectives -- in other words, where the company is relative to where it wants to go (see Figure 1, Step 2). This is a critical step in investment planning, since it is this gap that the proposed investment should fill. -8  Key members of both corporate or headquarters management and operating or subsidiary management are involved in obtaining certain key results at this step: - - A sound competitive and strategic understanding of the company's businesses, or of a specific business in which an investment is contemplated, such as heavy oil. - A sound understanding of the key factors in the external business environment that impact on the economic viability of the company, on a specific business .activity and on attaining its corporate objectives; together with a good grasp of alternative scenarios for the future course of events (these factors are quantifiable, such as world oil prices, but also include political, technical, social factors, etcetera). - A sound understanding of the most important issues, risks, and opportunities facing the company, and which might impact on its longer term or strategic direction (for example, internally a declining reserve base of conventional oil or externally a declining supply of condensate for heavy oil pipelining or declining energy prices). The company's internal assessment is aimed at defining its principal strengths and weaknesses, and what could be done to ameliorate weaknesses, and its current operational. and financial performance relative to its planned targets. For example, the company may have a strong technical capability on heavy oil, but has marketing problems; or it may have a low financial capacity to undertake major capital investments in heavy oil. Information for the internal assessment is collected, and the assessments themselves are usually conducted at the business or subsidiary levels for issues peculiar to a particular business activity (for example, advanced technology experience for heavy oil). The corporate level usually is responsible for identifying issues that impact across the company, such as a deteriorating financial capacity to support major new investments. The external assessment is aimed at monitoring and evaluating trends, events, and the demands of the company's various constituencies which impact on the company's operations and profitability. Some key factors include macro-economic variables such as world oil prices, inflation rates, exchange -9g-  rates, and interest rates; together with relevant government activity in a subsidiary's particular geographical region such as legislative or regulatory initiatives; relevant public opinion and life style factors such as an increasing concern for environmental pollution and decreasing energy intensity of industrial production processes. In addition, assessments are made of the position. of the industry within the economy and the competitive position of the company within the industry. The results of the external environmental assessment are usually embodied within alternative business environment scenarios which are used for planning purposes throughout the company. The judicious use of scenarios is an effective tool for stimulating strategic thinking and also at the operational level on different ways of running the business or on different businesses to be involved in, depending on internal capabilities and goals of the company. The scenarios are developed at the corporate or headquarters level with substantial inputs from the subsidiaries, who are much closer and more aware of problems or opportunities in their markets. Central to the activities at this stage of the process is the availability of a timely and reliable information base, which relates to both internal factors within the company and external factors that impact on the company. The collection, organization, and communication of information which is relevant to the issues facing the company, are major tasks by themselves. It is important to maintain effective communications between the corporate and subsidiary levels and within each subsidiary, and this is facilitated through various mechanisms such as the establishment of appro- priate planning co-ordination committees; the circulation of key planning assumptions (for example, guidelines on the opportunity cost of capital, guidelines on alternative methods for assessing risks in different business, exchange rate assumptions, etcetera); and the identification of a key central group to manage the planning process. By the completion of this stage of the process, management at both the corporate and subsidiary levels would have developed a good understanding - 10 -  of the company's strategic direction and its current situation relative to its objectives. 3. Developing Alternative Strategies and Investment Plans Once corporate management has agreed on the company's longer term direction and current position, and has identified the key issues, risks, and opportunities faced in its various businesses, the next step is to clarify the alternative means or strategies by which the company could achieve its objectives. It is important to-understand clearly management's alternative strategies since one of the most important criteria in the selection of an investment is its "strategic fit" with the strategy of that particular subsidiary and with the overall corporate strategy of the company. The key results expected at this stage of the process for developing alternative strategies are: -. A good understanding of the company's corporate strategies and the strategic direction they imply. - The development, by operational managers at the business or subsidiary level, of a small number of significantly different alternative strategies -- aimed at dealing with the most significant issues identified earlier in the process. - The integration of the various business- or subsidiaries' strategies (for example, one for gas, one for conventional oil, one for heavy oil, etcetera) into alternative corporate-wide strategies and their associated financial impacts. It is important to understand the current strategic direction implied not only by the existing operations but also by the committed investments. If the current direction differs significantly from the planned direction, changes to existing strategies or operations are required. Each of the company's subsidiaries will have its business strategy and associated investment plan based on its component investments. The integration of these strategies and investments aggregates to an overall corporate strategy with its associated financial impacts. -11  Strategy Development The development of alternative strategies is an art rather than a science, and requires a balance of creativity and objective analyses. At least three guidelines can be suggested. First, corporate or company-wide strategies must build upon the strengths of the individual subsidiaries or businesses. Second, formulating business strategies is most effectively done by people who know the business best, at the subsidiary level, with proper guidance from the corporate level and within an organizational structure that promotes a certain degree of risk-taking. Third, it should be a reiterative process between subsidiaries and corporate headquarters. An important result of strategy development is the developing of strategic thinking, the consid- eration of alternatives, and the consideration of "what if this happens, what if that happens." At this stage of developing alternative strategies, the role of corporate management is -to provide the overall corporate-wide direction, to establish guidelines and assumptions for developing strategies, to review and integrate the strategies developed by the businesses, and to assist in selecting the "best" strategy and investment plan for the company as a whole. The intensity of guidance from the corporate level on strategy development depends on the culture and business diversity of the particular company. It is important that both the corporate and business or subsidiary perspectives be brought to the investment planning process and reconciled during the subsequent stage of selecting the "best" strategy and investment plan. The business perspective ensures that the expertise is utilized in developing alternative strategies and that a high level of commitment and understanding will be generated in implementing the "best" strategy. Active corporate level direction ensures the use of consistent planning assumptions and macro-environmental scenarios, helps to clarify individual roles and responsibilities, and assures integration of the various business strategies. Nevertheless, for a company with diversified businesses (such as conventional oil, heavy oil and gas, and in various geographic areas), the integration of the various business strategies into "corporate" strategies is a complex task, - 12  The alternative strategies and investment plans for a particular business, represent selected sets of functional strategies. Each of these strategies (for example, a strategy to maximize joint-venture participation in selected heavy oil areas) seeks to take advantage of the company's internal strengths (such as technological expertise) and the external opportunities (such as the acreage owned by other companies) and to minimize threats and weaknesses in the most likely future scenario. The emphasis at the subsidiary level is on optimally positioning each major investment within its current and projected investment areas, considering corporate-directed resource allocation constraints. At the corporate or headquarters level, the planning is more portfolio than functional in nature. It involves the evaluation of the best overall positioning of the company in terms of key strategic factors (for example, growth and positioning for potential gas markets) and of key financial factors (for example, level. of capital expenditures, cash flow, debt capacity, etcetera). The strategic positions considered for the company include alternatives beyond the scope of current operations in the businesses or subsidiaries. These include alternatives for growth in new geographic or business areas. At the same time growth in new areas are being examined, broad alternative approaches to current business operations are usually addressed. This may include liquidation of selected marginal, low growth or non-core businesses, running lower cost operations through reductions in administrative expenses, and examining the relative advantages of concentrat- ing on fewer investment areas. 4. Selecting the Best Strategy and Plan It is the responsibility of corporate or headquarters management to choose the "best" of the alternative strategies and plans in order to optimize overall corporate objectives (see Figure 1, Step 4). This selection process includes the allocation of financial, human, and technical resources to the various subsidiaries or businesses taking account of their expected contribu- tions to existing operations or to new opportunity areas. 13 -  The process of selecting an overall "best" strategy and investment plan usually involves intensive negotiations between dperating and corporate executives. The aggregation of the individual business plans is assessed relative to key company performance criteria in terms, say, of strategic and financial factors -- for example, finding and development costs, risks, return on capital employed, or longer term impact. It is this performance gap which corporate management seeks to fill by means of the best possible strategic and investment plan. In the negotiating process, there is essentially a dialogue between operating management, equipped with highly-detailed knowledge of respective areas of their businesses, from which their plans are generated, and corporate management equipped with their broader understanding of the portfolio of strategies for the current businesses and potential investment opportuni- ties. The dialogue attempts to generate the most creative approaches to corporate issues, and might involve application of the following criteria for the "best" strategy and plan: - Is it consistent with overall corporate mission, goals, and objectives and the long-term positioning strategy of the company? - Does the strategy and associated investment plan reflect appropriate considerations of broader business environmental scenarios? Which strategies and associated investments are compatible with the corporate objectives under the various business scenarios? - Does it adequately recognize threats and opportunities and make the greatest improvement to the company's positioning in current and future markets? - Does it capitalize to the greatest extent on corporate and business-level strengths including technology, human resource skills, and financial resources? - Does it reduce corporate-wide weaknesses by allocating effort and/or resources to correct problems identified in the internal assessment? - What are the major risks associated with the strategy and plan, both quantitatively and qualitatively (for example, political risks, price risks, financial risks)? - 14 -  Are the risk levels acceptable given the expected returns and financial condition of the company? Is there internal consistency among the functional strategies that constitute the best corporate strategy? - Does the company have now or will have in the future, adequate resources, knowledge, and other requirements to implement the strategy? Are there adequate controls and procedures in place or which can be effectively developed in order to ensure proper implementa- tion of the strategy? As an outcome of the dialogue during this step of the planning process, a management decision is made as to the strategic direction that the company will take in the planning period. The comprehensive set of strategies and investment plans which emerges serves to link the corporate and subsidiary levels into an agreed-upon long-term direction. In some companies, strategic planning has fallen into disrepute. In part, this is because its purpose, to set out how the company is to achieve its objectives under various possible environments, is neglected. Secondly, the equally important implementation of strategy is difficult. 5. Plan Implementation and Monitoring The final step of the investment planning process is that of implementing the selected strategy and investment plan and monitoring actual performance relative to planned targets (see Figure 1, Step 5). The challenge here is to properly integrate the longer term or strategic planning with the shorter-term operational plans. The key results expected at this step are: - the development of integrated short-term plans, including specific objectives; - clear organizational authorities and responsibilities for results expected from the shorter term plans; and - 15 -  the development of a process for monitoring and assessing actual performance and modifying the shorter-term plans where appro- priate (this usually includes developing contingency plans to account for unforeseen events). The shorter term operational plan is essentially a further specifica- tion of the initial phase of the longer term strategy and investment plan, and usually extends for one year. The corporation will also have a three and/or a five-year plan developed in less detail which will include capital expendi- tures, expenses, revenues, etcetera. The business level management quantifies measurable short-term objectives not only for financial performance but also for exploration, production, marketing, human resources, and other functional areas. Objectives and operational tactics are translated into specific programs and action plans. Projects are identified with programs for each of the company's businesses for the following year(s) and the action plans are the step-by-step means for achieving the desired results from each program. For the successful implementation of a plan, adequate delegation of authority and responsibility to the subsidiaries is essential but, at the same time, ensuring that each subsidiary operates according to strategy and to the investment plans approved by corporate or headquarters management. The delegation of authority and responsibility is generally an evolutionary process that is not changed radically as part of the planning process unless there are significant changes in the company's strategy or in the business environment. For instance, if a company's financial position has deteriorated, or if energy prices have declined significantly, subsidiary or business authorities may be lowered to give more centralized control. Under the same circumstances, other companies will not decrease authorities, but impose more stringent guidelines on investment criteria, on reduction of operating and administrative expenses, and on human resource numbers and expenses. Through the years, the company will have developed detailed corporate policies and procedures to guide and control the company and its businesses as to how it will carry out and administer its strategy and plans (i.e., the 16 -  rules, procedures and practices). The plan lays out what is to be done while the policies and procedures lay out how they are to be done within the company's organizational framework. These policies and procedures will range from broad statements at the corporate level, such as the company will optimize the use of local goods and services, to detailed policies and procedures at and within the subsidiary and business level, as for instance, hours of work. Effective control of performance at the corporate level is maintained through the implementation of a company-wide performance monitoring system, as shown in Figure 2. It is this linkage between the planning and control system that permits managers at the subsidiary level to enjoy the necessary operating freedom within the framework of the agreed strategy and plan. This monitoring and control occurs not only from the corporate level, but is mirrored also in each of the subsidiaries. It is essentially an extension of the planning process into the current year and immediate short- term, and has five key elements: - an operational plan with associated targets; - a system for monitoring performance against this plan; - a forum where performance is critically examined; - an independent group that services this forum; and - unambiguous lines of authority that enable action to be taken but with the monitoring process. The development of this monitoring system is well established in the western oil and gas companies, and is the subject of another paper at this Conference. 6. Summary of Conceptual Framework As outlined above, in the western oil and gas industry, the typical company assesses a major capital investment, first, by reference to its broader corporate strategy. The corporate strategy sets out how the company - 17 -  is to achieve its objectives in broad terms. The individual strategies adopted by each of the subsidiaries are developed in the light of the broader agreed-on business environment scenarios and the more specific conditions peculiar to each subsidiary (such as political conditions, availability of technical expertise, etcetera). These are the strategies that are judged by corporate management to be the most robust with respect to their risk/return profile and other key factors, when tested against the alternative scenarios. In addition to strategic fit, the proposed investment must satisfy management's investment criteria in order to qualify for inclusion in the investment program associated with the selected "best" corporate strategy. Because of the specialization of functions at the corporate and subsidiary levels of the typical diversified oil and gas company, and the breadth of the issues to be considered in evaluating capital investments, companies have developed systematic processes and procedures to facilitate the selection of investments. Central to the effectiveness of such processes (illustrated in the five steps in Figure 1) is adequate communications between corporate and subsidiary levels, the clear identification of responsibilities for results within the selected shorter term operational plan, and a workable performance monitoring and control process. C. APPLICATION OF THE CONCEPTUAL FRAMEWORK -- SOME SPECIFIC CONSIDERATIONS IN EVALUATING INVESTMENTS Following the conceptual framework for investment planning in the previous section, this section illustrates the application of the final three steps to this framework -- the development of the strategic plan, the investment plan, and the operational plan (i.e., Steps 3, 4, and 5 respective- ly of Figure 1). The application is demonstrated by pointing out some of the more important planning considerations that are involved in each of these steps. In other words, the emphasis in the previous Section B was on "what was expected" or the key results at each of the major steps of the investment planning process; the emphasis in this section is on "how to achieve these results" at each of the steps. - 18 -  The practical application of these steps in the typical company is reflected in the linkage between its longer term strategic plan (five to ten years), its medium-term investment plan (three to five years), and its shorter term operational plan (one and sometimes three years) -- as illustrated in Figure 2. Because of the importance of a company's strategy as the initial basis for evaluating investment proposals, relatively more attention is given to the considerations surrounding strategic development (i.e., Step 3 of the conceptual framework in Figure 1). 1. Major Considerations in Formulating Strategies - Application of Step 3 of the Conceptual Framework Since investments in major projects are not approved unless there is an agreed strategy against which they may be assessed, it is important to understand -the primary factors which the oil and gas companies consider in formulating their strategies. Given the lead. times on planning, between exploration and production, and on the environmental changes typical of the oil and gas industry, the time horizon for strategies is normally of the range between five to ten or more years. Strategies therefore represent qualitative and directional rather than quantitative and precise thinking. Key factors considered by companies in developing their strategies include: - relevant corporate strategy guidelines -- as well as its mission and objectives in strategic and financial terms, as appropriate; - principal characteristics of the business sector (for example, heavy oil, conventional oil, gas, etcetera) that shape the risks and returns attached to projects in that sector; - assessment of risks and returns in the sector; - critical success factors for profitable operations in the sector; - company's position in the sector (technical, human resources, land holdings, etcetera); - competitors' positions in the sector and their strengths and weaknesses; - 19 _  company's sector-specific strategic and longer term objectives; strategic program and set of projects designed to achieve the objectives; and results expected from the strategic program, in terms of indicators that can be monitored. Each of these factors will now be briefly elaborated. (a) Corporate Strategy Guidelines As outlined in the previous section (Section B.1), the corporate strategy guidelines (in terms of variables such as objectives, strategic positioning, product/market mix, competitive mix, overall financial targets, etcetera) are generated at the corporate or headquarters level and provide direction to the subsidiaries. These guidelines recognize that: - the company is made up of several businesses; - the businesses often operate across national boundaries; certain supporting services (such as financing) are provided internationally; and the activities of the subsidiaries must be adjusted, in line with corporate guidelines, to the particular economic conditions under which they operate. (b) Principal Characteristics of the Sector The assessment of the principal characteristics of the sector is an important starting point for the development of strategy at the subsidiary level. The objective here is to identify those aspects of the technological, economic, competitive, political, and social environment which are likely to be most important in determining the nature and extent of the risks and returns associated with business activity in the sector. The nature of these factors and their relative importance vary greatly from sector to sector and from one geographic region to another. No - 20 -  simple guides to their selection can be provided. Their determination is essentially an act of business analysis and judgement, but the key factors can usually be identified by considerations in the context of supply and demand, and the extent to which they are impacted by forces such as: - technological factors; - economic and financial factors; - competitive forces; - political forces, and social/environmental forces. These forces impact on the supply and demand for the particular hydrocarbon in various ways, and this differential impact provides a basis for the assessment of risks and returns on specific project activities in that sector. Some of the elements of demand and supply which are investigated include: Demand The volume and structure of demand by type and location of consumer under a set of alternative scenarios. For example, in the industrial market in the western economy, efficiency considerations have largely dictated the selection of less energy-intensive production processes, leading to reduced rates of demand growth for oil and gas in this sector. The elasticity of demand for that hydrocarbon. This requires consideration of factors such as price elastici- ties (i.e., the sensitivity of changes in demand to changes in price); patterns of consumer demand; and the possibi- lities and probabilities of substitution (for example, gas for oil). Political forces that affect demand, such as government regulations on conservation. 21 -  Supply - The volume and structure of supply by supplier and location, and the relative competitive position of suppliers. For example, since oil and gas are commodities, the natural resource markets are dependent on supply and demand, and since the products of one company are virtually identical to another, companies have pursued different strategies to asssure stable supply. Some companies have pursued strategies of geographic diversification, to utilize government incentives or to minimize political risk. Other companies have attempted to mitigate the impact of cyclical price fluctuations by securing long-term contracts or a mix of long to spot supply. The nature of technology impacts on both supply and demand for a particular hydrocarbon, and also on the company's ability to produce the hydrocarbon. For example, the development of alternative fuels and sources of supply impacts the economic potential of petroleum, both as a local and world commodity. Alternatively, the technolo- gical demands imposed by some operations under certain circumstances (such as offshore and Arctic activities or oil sands development) are more strenuous than the demands imposed by conventional oil and gas activities -- both directly in terms of technology and indirectly, for example, in terms of their financial and human resource requirements. The viability of a company's exploration and production strategies and also its research and development initiatives are influenced by the technologies it employs. - The elasticity of supply for that hydrocarbon. This includes factors such as the price elasticity (i.e., sensitivity of changes in supply to changes in price); the costs of entry into the sector (e.g., the resources in cash, technology or management required to enter into thermal in situ oil projects; the costs of exit from the sector (e.g., the ability to sell fixed assets and recover original costs, the political and social costs of reducing employment, etcetera). - Institutional characteristics of the industry in that sector. This includes factors such as organization, ownership, control, etcetera. - Political considerations. This includes factors such as strategic interest on the part of the government, fiscal concessions or penalties by the government, environmental control regulations, etcetera. Social considerations that might impact on supply. This includes factors such as nationalization sentiments, emphasis on renewable sources, etcetera. - 22 -  The assessment of the factors identified under the demand and supply characteristics usually includes the manner in which they are likely to change over the time period covered by the strategy, and how they are influenced by the behaviour of competitors. The ultimate objective is not only volumetric estimates of supply and demand for the specific commodity, but also costs of supply and market price. (c) Assessment of Risks and Returns in the Sector The characteristics of supply and demand in the sector, when matched against each other, provide the base for assessing the expected returns in the sector and for relating these to the risks involved. The primary concern for most companies, in dealing with risk, is to identify and quantify those factors which have a significant positive or negative impact on the expected financial returns. Although many of the supply and demand factors can be described in detail, the assessment of risks and returns, like the choice of the factors themselves, is a matter of business judgement. The risks can be categorized and many can be quantitatively described. Some major categories of risks include: - Price risks -- the financial impact to the company and project due to price changes. - Cost risks -- the financial impact due to changes in capital, operating and administrative cost. - Technological risks -- these can range from the strategic and financial exposure of the company to technological changes that reduce the demand for a commodity, to the technical assessment of the reserves, to technology failure of a process (enhanced oil recovery, production platforms, etcetera). - Political risks -- such as the risks associated with government changes in fiscal policies or in product pricing policies. - 23 -  Socio-environmental risks -- such as those associated with shifts in patterns of consumption or requirements to decrease H2S emissions. Financial risks -- such as those related to foreign currency changes, interest rates, or impact of the project financing on the company's financial health. Risks are not easily quantified, but must be assessed and estimated in a rational manner. The returns likely to be achieved in any sector are also not easy to quantify. Reference to past experience or to results achieved by competitors (that is, the use of analogies) are used, but the financial aspects will also be built up primarily by building blocks, particularly for large investments, These appraisals are primarily in financial terms, such as finding and development costs or return on capital employed. As outlined previously, the identification of an appropriate risk/return profile for a particular sector is largely a matter of business judgement and will depend on individual companies' financial position and strategy. Market forces will usually ensure that high prospective rewards are associated with high risks of f-ailure and relatively low risks with low prospective rewards. Where returns are high, political forces tend to depress returns in relation to risk. For example, the combination with low prospec- tive return might be associated with: Demand Factors demand stagnant, - demand elastic, - technological factors acting to depress demand. Supply Factors - existing capacity above potential demand, - large number of competitors, widely distributed, - low costs of entry, 24 -  high costs of exit, no major supply constraints. Several combinations of risks and returns are possible and must be carefully assessed -- generalizations are misleading. For example, economies of scale may raise the cost of entry but encourage the generation of surplus capacity by firms who enter the sector. Also, government project subsidies may encourage overcapacity but may still make the business profit- able for those who receive the government benefits. In the final analysis, although it is largely a business judgement based on an assessment of both quantitative and qualitative factors, the determination of the risks relative to the returns from activities in a particular sector is most critical to strategy development and to the selection of the most economically attractive project investments. (d) Critical Success Factors After the principal characteristics of the sector have been identified, including the risk/return potential, the next phase is to clarify the most important factors or -criteria for investment and operations which determine the successful implementation of a strategy. Essentially, the effort is directed at locating those factors, largely derived from the risk/return assessment, which are necessary to secure full realization of the sector's potential and to help ensure the viability of the proposed activities. In oil and gas exploration and production, these key success factors are usually in the following areas: - land position, - risk sharing or risk reduction, - technical information, knowledge, and skills, - financing, - 25 -  finding, development and operating costs, political (concession terms, royalties and taxes, etcetera). The description of these factors might be in terms of: - Market (pricing, demand/supply, transportation) Investment timing, location, size, need to distribute risk by farm-outs, joint ventures, government participation, etcetera. = Management and Organization data and information systems, * technical capability and support (research and development requirements), * skilled personnel and availability. = Political Factors government regulations, concession terms, taxes and royalties, specific project support or hostility, * consistency with national policies, etcetera. (e) Company's Current Strategy and Position in the Sector Once the sector's characteristics and the criteria for success- ful exploitation have been assessed, as described above, it is then important to review the company's current strategy and its position in the sector. This review process, which was outlined in the previous Sections B.2 and B.3, is aimed at clarifying the nature of the risks and opportunities peculiar to the company's strategy and position in the sector, and what is required and can be done to improve the viability analyzing its competitive position. 26 -  A thorough understanding of the company's and competitors' strengths and weaknesses is an important part of the assessment of the company's relative position in a business sector. An objective analysis of competitors can give useful insights into the criteria for success in the business. It also enables the competitiveness of the company to be judged in as realistic a manner as possible. This information is valuable in that it suggests activities that should be included in the company's strategic program in order to improve its competitive position. Assessment of a company's position in the exploration and production business will include particular attention to: - the current and projected production base of the company, - the quality and potential of its land holdings, - factors affecting the marketability of its current or projected reserves, the financial resources of the firm relative to its project commitments, the quality of its technical expertise and data base, special relationships that might promote or impede strategic flexibility, such as long-term delivery con- tracts, joint venture arrangements, etcetera, organizational structure of the company and the extent to which this promotes or impedes effective and efficient operations. The focus here is on identifying the manner in which tasks are -grouped into special sub-units, the level of authority delegated to these sub-units, and the -formal or informal provisions or systems for integrating the work of the sub-units. Generally, the larger the organization, the greater the tendency for the specialization of tasks and therefore the greater the need for systems of integra- tion. (f) Strategic Objectives The analyses carried out to this stage (sub-sections (a) to (e) above) provide a thorough appraisal of the sector's strategic and financial potential for the company. The extent to which this potential might be - 27 -  exploited is determined mainly by reference to the company's strategic goals and objectives for this sector -- as outlined earlier in Section B.1. These objectives usually include the priority, nature and scale of the activities to be pursued, the relative strategic position in the sector which is desired, appropriate financial targets, and the internal organiza- tional requirements to attain these objectives. The objectives are stated in terms that are robust to business environment changes of the order that can be expected over the period covered by the strategy unless the company has specific strategic positioning objectives. (g) Strategic Program In addition to an elaboration of its qualitative strategies based on the factors described above, the two principal outputs of the company's strategic plan include: the strategic options and program, and - expected results of this program. The strategic program is based on the assessments completed and is essentially a set of projects, satisfying the criteria for successful operations in the sector, designed to achieve the strategic objectives. The program includes: the set of projects or investments for. that sector with some priorizing and possible alternatives, timing of the program and sequential relationship of the projects, - any required changes in policies with respect to management and organization to attain the expected results, - the requirements for technology, personnel, information systems, research and development, etcetera, and - quantitative estimates of the resources required, for- example in terms of financial and human resources. - 28 -  It is important that the program include an account of the relative importance of the various projects to the success of the strategy and the key elements that could impact on its attaining its goal. This indicates to senior management at staff and line levels the flexibility in the strategic program, or how it can be adjusted to deal with unforeseen events -- such as emerging expansion opportunities faster than anticipated, or financing capability problems, change in government terms, and new technologies. (h) Expected Results of the Program The final element of the strategic plan is the identification of the expected results of the proposed program in the planned period. These results are described in both financial and non-financial terms which can be monitored within the company's control procedures. Since the timeframe of the strategic plan is between five and ten years, the quantitative estimates are sometimes directional rather than precise. Financial results could be priorized and specified in terms of: - capital expenditures, - operating and administrative expenses, - asset values, - cash flows, - operating revenues, - net income, - profitability measurements such as return on investments or on capital employed, - debt to equity level, and - cash flow or net income to interest coverage. Non-financial results could be priorized and specified in terms of: 29  projects completed on schedule, production rates, finding and development costs, market shares, proven, probable, and potential reserves found or estimated yet to be found, manpower indicators, safety targets, and state of technology development. 2. Major Considerations in Formulating Business Plans Application of Step 4 of the Conceptual Framework The company's strategies provide the framework against which specific projects and activities contained in the short-term operational plan or budget (timeframe usually one year) are developed -- in other words, the operational plan provides the means of short-term control of the strategic progress. The linkage between the longer strategic plan term (five to ten years) and the specific operating activities of the one-year budget is usually provided by an intermediate plan of three to five. years -- described as the company's business plan in Figure 2. This business investment plan is developed against the longest time horizon for which plans can usefully be formulated in quantitative terms. In the oil and gas industry, this period is usually three to five years, depending on the scale and timing of the projects involved. The investment plan therefore indicates how, in the light of the medium-term business environment scenarios, the company will progress towards its strategic goals in the subsequent three to five years. The base for the plan will be a three or five-year financial forecast of revenues, expenses, capital expenditures, royalties, taxes, cash flow, and net income as well as debt, etcetera. More than one forecast, based on different defined assumptions may be made.