Scenario analysis and stress testing for the energy industry

Scenario analysis and stress testing for the energy industry Pre-Conference Workshop Stress testing calculating your limits Value of diverse scenarios Karen Sund Founder/ Partner Sund Energy London 8 February 2012

Full-picture perspective Sund Energy helps navigate into the energy future Energy Economics Environment Learning between countries, industries, energies, technologies and more Oslo Tbilisi Helsinki Copenhagen San Francisco by understanding the full picture of stakeholders Page 2

With you today: Karen Sund Experience from gas & electricity in more than 20 countries Consulting to energy companies, governments, investors, buyers Analysis/ input for 25 years Structure/ policies/ trading for 10 years Strategy/ management/ organisation for more than 5 years Right answer observer noting great differences! Greatest uncovered risk? Recently on several company boards Oil companies Norway, Iraq/ Kurdistan, Yemen, USA, Ukraine Electricity portfolio manager Nordic RM support to major international energy player Adapting risk management to asset light by awareness + reorganisation Page 3

Introduction / Agenda Introduction to risk management Risk management what is it? Reverse stress testing From banking to energy and beyond? What can you not afford to loose? Strategy and business models Not only to minimise risk, but maximise upside! Making them and using them involving management How not to kick yourself (or get kicked) in 20 years from now Two scenario examples: European energy EU27 energy towards 2020, what will the role of gas be? Infrastructure options for Barents Sea gas from Norway/ Russia Page 4

Risk management what is it? The identification, analysis, assessment, control, and avoidance, minimization or elimination of unacceptable risks. Relevance Credit Banking Increased volatility in several markets Concern for bank and business failure Energy and CO2 prices Page 5

Managing risks at several levels Trading Short term, policies, stop-loss etc Strategy Future investments more agile? Organisation/ mind set: Open to new right answers? Less bias with diverse teams? Less cocky/ self assured? Operational risk openness and responsibility? Political at home, too, not only in difficult countries Page 6

Risk categories many! Operational Strategic Financial Safety Hazard Reputation/ public image Political/ economic Compliance Competence Page 7

Risk management process dynamic? Objectives / strategy Identification Assessment / measurement Risk response Adjustment & learning often forgotten! Control / mitigate Reporting / monitoring Page 8

Tools for identification and analysis vary Stress/ sensitivity analysis Analysis of the impact on a defined change in a key input parameter One-way Scenario analysis Analysis of the impact of multiple stresses occurring simultaneously One-way Reverse stress testing The process and results surrounding the identification of those scenarios that could give rise to business failure, i.e. what would it take to break the business? What makes an unviable business model? Page 9

Reverse stress testing - the FSA definition Reverse stress-tests are stress tests that require a firm to assess scenarios and circumstances that would render its business model unviable, thereby identifying potential business vulnerabilities Reverse stress-testing starts from an outcome of business failure and identifies circumstances where this might occur This is different to general stress and scenario testing, which tests for outcomes arising from changes in circumstances Page 10

Decision trees are much used What is plan B? Optionality increasingly important! Decisions Events KNOWN OUTCOMES Business model unviable As is Business model unviable Growth & profitability Both events and decisions will influence outcomes As is What about decisions of peers/ politicians/ customers? Page 11

Reverse stress testing things to consider Business failures are a product of a combination of events and decisions OR bad luck what about unknown (unpredictable) outcomes? Bias in expectations (biological & cultural) How good is decision support for small vs. very large financial decisions? Much can happen from decision time until assets are operating Change in assumptions opportunity or loss? Page 12

Reverse stress testing important input to learning! Multiple scenarios multiplicity è mathematical challenging Still important but qualitative thinking is important, too! Objective is to plan for future possible action when identified circumstances occur Selection of undesirable scenarios honestly! Detect hidden vulnerabilities of the business model Need to go beyond simple sensitivity Are mechanical scenarios good enough? Page 13

Reverse stress testing how and what? To test an idea on future situations, it is important to be open minded That means not only changing one of the assumptions (such as price), but seeing the full picture: What will the market do if we develop our idea customers, competitors, regulators and how will that impact profitability and exposure? Base case, worst case and best case in a realistic fashion without too much bias How can idea, strategy, investment, business model be adapted to manage the uncertainty optionality, procedures, etc Horizon: Short term, medium term and long term Trading (daily), strategy (5-20 years), infrastructure (20-40 years)? Page 14

Example: Integrated business model Situation Integrated power company (production, sale, network) Stretched balance after a major acquisition Power balance: Sales 3 x production Regulatory limits on how prices can change to end-user Not seen quickly enough when introduced Events Sharp increase in interest rate Impacting ability to be exposed to customers Cold winter and very high electricity prices Very high exposure Outcome Significantly higher need for working capital in a high interest rate environment Extremely high need for liquidity - Working capital stretched Page 15

Stress testing from banking to energy Regulators are often inspired by other sectors Sarbanes-Oxley was used in banking and trading, also energy Enron and others brought high focus on this After the financial crisis, more ideas migrate Insider trading regulations on commodities REMIT etc Some energy markets, such as NordPool, already have this discipline Energy companies used to secrecy especially gas do not More transparency can give opportunities, too! Lately, criticism of economic models Rational behaviour, or lack of it opaqueness of complexity Will this migrate to energy markets, too? Page 16

How could it fit with your business model? Need to consider: Integrated or specialised? Counterparty risk many levels Supply-chain exposure fuel, hardware etc. Contract portfolio (sourcing & sales contracts) What is your net risk exposure & what are you comfortable with? Optionality in business model and strategy what is it worth? Transparency Many companies rely on having more information than the market This is often coupled with a culture for need-to-know sharing How to adapt to a more transparent world? Pro-active embracing of new requirements could be better General trend in most markets with globalisation and IT solutions Page 17

Agenda Introduction to risk management Risk management what is it? Reverse stress testing From banking to energy and beyond? What can you not afford to loose? Strategy and business models Not only to minimise risk, but maximise upside! Making them and using them involving management How not to kick yourself (or get kicked) in 20 years from now Two scenario examples: European energy EU27 energy towards 2020, what will the role of gas be? Infrastructure options for Barents Sea gas from Norway/ Russia Page 18

Expect the unexpected! How can we avoid bias in viewing the future? Technology, policy/ preferences, energy mix All impact profitability of new investments! Base load less common and variable/ uncertain load more common More spot, less contracts how to plan and mange risks? Not only black swans that are overlooked many other factors Lack of maintenance, lax regulation, cultural changes Fukushima? Page 19

Who knows best and who can we trust? Does anyone have the full picture? Markets/ traders? Overreacting, near sighted? Regulators/ policy makers? Consumers/ voters? Academics? NGOs?? Others? Detailed analysis vs.. gut feeling both used Easier to measure the easy numbers more detail on small decisions? Uncertainty could leave full decision to management intuition Often shaped by historical/ personal experience and own risk comfort Entering a corrupt regime for oil vs.. trading spot gas in the UK Page 20

Taking out bias difficult, but good risk management! Many view own skills (and rationality) as better than most Country, industry, company, project, Leading to overly optimistic views Easy to select information to support own views Important to consider skills of others, too Different energy forms Wind, gas, solar all think they are best Relative developments High growth could be from low starting point (or up from decline/ recession) Relative attractiveness Great differences in time and by country Page 21

It starts with understanding the other side better Respecting the other side as equally intelligent is a good start Different views are often the result of cultural differences all think they are right Negotiations Vital to understand perceived value and risk comfort Could get much better deals with parking risk rightly Stakeholders Owners, government, employees, partners, customers All can change over time: Preferences and views/outlook CSR: Good deeds or risk management (or both)? Opposition Government/regulators, NGOs, competitors, etc Page 22

but there are other challenges, too Uniform thinking comfortable, but Consensus could lead to dangerous surprises Example: NordPool, where most players use the same rational model What is corruption? Important when entering new markets not just direct payments! What is a good model for sharing benefits with host country? What to do when assumptions change over time? Expectations vs. reality how to adjust terms? Proactive dialogue could give better solutions: Wind, oil production, etc Alternative could be knee-jerk reactions Page 23

Understanding hindsight? What will shock or impress the next generation? People tend to judge surprises from the past with glasses from today What was OK in the 1970s could look shocking now What will look shocking in 2030 and what will be commended? Less reliance on rationality going forward? Behaviour and preferences depend on many things some unknown Supply cost curves designed for monopolies with obligation to supply Better to look at demand curves now? Page 24

Supply costs curves don t always work Assumed merit order for UK gas supplies LNG Expected Unit cost Continent (oil link contracts) Norway Observed: Other UK gas Must-run UK gas LNG and Norway competing at low prices, crowding out some own production and maxing exports to Continent Volume Gas is more difficult to balance than some expect Many oil companies are not prepared to turn down production increasing oversupply On the other hand, if there is little gas available, extremely high prices may not be enough! Page 25

and demand curves could be worth looking at Assumed demand curve Gas to ships LNG to HDVs Unit Price Gas to balance wind? Gas to cars / CNG to LDVs Gas to Distribution / Industry Gas to spot / electricity Volume Page 26

Globalisation embrace it! With the world more connected, opportunities and risk grow Take tested models to new markets Common mistake to copy own solutions and talk to (rather than with) locals Use local offices actively to understand culture, preferences and risk Valuable learning to be had, even in more backward countries! As we get closer to the new markets, assumptions need updating Old enemies become friends new governments change policies Example: Russia very different when we grew up, then Yeltsin, now Putin Unfortunately, not always straight forward risk or opportunity? There is less black and white, but very many shades of grey Some understand this better than others and manage accordingly Page 27

Agenda Introduction to risk management Risk management what is it? Reverse stress testing From banking to energy and beyond? What can you not afford to loose? Strategy and business models Not only to minimise risk, but maximise upside! Making them and using them involving management How not to kick yourself (or get kicked) in 20 years from now Two scenario examples: European energy EU27 energy towards 2020, what will the role of gas be? Infrastructure options for Barents Sea gas from Norway/ Russia Page 28

Scenarios how to improve and use them better? We have developed two cases for discussion Gas demand in Europe 2020 Overall energy need Environmental focus degree and solutions Prices of gas and its alternatives what will suppliers do? Annual demand, load factors, need for imports and contracts Transporting gas from the Barents Sea to markets Destinations, optionality, prices and netbacks Pipeline, LNG, both or none of the above? Risk, investors, decisions, preferences Page 29

We have developed two alternatives to the EU view The EU has used the PRIMES model to calculate future energy Assumes high prices for gas and oil, more renewables and less growth We have two alternatives to this Affordable and available gas: Better image and economics Managed gas prices for higher prices: Producers holding back, less use Methodology: Both bottom-up and top-down + dynamic Different price assumptions impact demand, production (esp. shale), and thereby import needs Managed high prices of both oil and gas are expected to give higher energy prices all round and dampen economic growth This will again impact life of current plant, investment in new capacity Each country considered, then top-down assessment to ensure overall consistency with logic What will the market do to adapt to new realities? Considered second and third order reactions by producers, policy makers, consumers Page 30

Political right answers change over time Illustration: Sund Energy Top of mind and story now: Fuel poverty/ recession Ensure households are warm Support businesses Impact: Gas may be OK, after all Especially if produced locally: Large shale potential in UK, Poland, France, Norway (!), and more Top of mind and story 2007: 20-20-20 Reduce demand with efficiency Reduce imports with renewables Reduce climate emissions by 20%, financed by less imports Impact: Less use of gas, especially imports What happened? Gas became cheaper and abundant Nuclear less acceptable Wind a bit difficult Page 31

Is there indeed a new ice age coming? or Climate policies Energy demand Commodity prices Economic growth Everything, really Note: A Frost Fair on the Thames at Temple Stairs by Abraham Danielsz Hondius (Abraham de Hondt), circa 1684. This fair, one of several built on the frozen Thames in London during severe winters, was exceptional in that it lasted from December 1683 until 4th February 1684 Source: The Guardian, September 2011 Far fetched? What would it mean for your business? Page 32

Expectations for the evolution of the energy mix PRIMES Less fossil fuels for thermal generation Gas demand even lower, with more used for peak load to balance RES Volatility in flow and prices need for balancing will they still like it? Nuclear plans before Fukushima, with constant output but falling share Germany closing down without life extensions Some build up in Eastern Europe, France, Finland Considerable growth in onshore and offshore wind, solar and biomass 80% of investment in generation capacity to RES from 2015 to 2020 CO2 prices remain too low to influence investment decisions CCS is not profitable and only EU demonstration projects are in place in 2020 Page 33

1 Affordable and available gas what does it take? Continued over supply until new balancing price is found This will be discovered over time with more liquid markets Balancing by buyers mainly electricity Taking care to avoid extreme prices Price-elastic buyers especially electricity Revised policies on energy and environment Energy security better at abundance Some may be provided at home see section on unconventional Strong effort now to develop redundancy in transmission Many ways to reduce emissions gas could be part of answer Trade balances will continue to be important impacting oil more? New areas of demand develop Transport, more direct use and continued use in electricity Could take time, especially where new investments are needed Page 34

2 A balanced market, with prices similar to oil again? This has been the objective of Gas Exporting Countries forum The producers would need to reduce gas production significantly May be difficult for some Tested already in 2009, when demand fell due to recession Algeria, Russia, Netherlands, UK and Qatar all reduced exports Purpose was that this fall in income would avoid extreme low spot prices Not all played the same game, so spot markets delinked What is willingness to do this again? A significant reduction in production would be needed soon Bringing gas to oil levels again will reduce demand significantly Requiring further production cuts especially if new gas is developed Net earnings may be better at lower prices Some forecast high demand and a return to sellers market This would help too, if realistic Sellers active in balancing the market (price elasticity and spare cap) Page 35

Future gas demand in EU 27 is uncertain 750 Scenario 1: Affordable and available 650 More base load (than EU plans) More use in transportation (trucks, ships and cars) Much more imports needed bcm We have developed two scenarios to compare with EU projections Scenario 1 700 Scenario 2 Reference 600 550 500 450 400 Scenario 2: Managed supplies EU27 - Scenarios for natural gas use 2000 Higher prices and lower volume Mainly peak load in electricity More investments in renewables More domestic shale gas Less imports needed 2005 2010 2015 2020 EU27 - Gas (net) import need 600 Scenario 1 500 Scenario 2 Reference bcm 400 Risk for Barents Sea: Scenario 1: Too low netback? Scenario 2: Too low volume? 300 200 100 0 2000 2005 2010 2015 2020 Data: PRIMES; Sund Energy Page 36

There are many challenges for Barents Sea gas There are large resources of gas in the Barents Sea All are far away from the markets we normally aim for Transportation costs could reduce profits Markets are more uncertain than before Demand for gas could be higher or lower than today Price, emission balance, cost of alternatives Supply could be plentiful and from new sources US becoming exporter instead of importer much loose LNG Advent of unconventional gas in Europe will impact use of gas and trade Prices are uncertain and could be a dilemma High price regime will reduce the demand and have less need for Arctic gas Low price regime could increase demand but give less netback to Arctic Gas is generic/commodity, more like oil in the future Less separation between suppliers/countries, more focus on price Less payability for Norwegian gas in a Norwegian pipeline than before Page 37

and some opportunities that should not be dismissed Local markets could develop Arctic region expecting growth in industry, minerals, energy Shipping in the Arctic could well wanting LNG as fuel Much better for the environment (climate, pollutants to air, no oil spills) Higher payability for gas as LNG better than pipeline gas to spot markets Rather than parallel, competing solutions, cooperation could win Sharing joint solutions give more choices to all Could allow for pipeline, LNG, local industry and LNG to ships Lower costs for all and much higher upside for all Economies of scale + hedge if one of options is less attractive So, being stuck with a single option could be scary Especially if it turns out to be less attractive than expected Let s avoid regretting decisions in the future based on the past! Page 38

The arctic opens new opportunities for infrastructure Skrugard Norvarg Shtokman Snøhvit LNG 550 km 400 km Teriberka >1000 km 1000 km 1300 km Illustration: Sund Energy Page 39

Many new developments synergy or competition? Gas developments are growing in the Arctic, and several as LNG: Aiming for Asian markets: North Slope, Alaska: Long delayed decision on pipeline now LNG is possible and preferred solution Sakhalin and Vladivostok: Expanding LNG Even the unexpected: Australia is growing LNG exports rapidly, partly from unconventional US could export profitably, even from East coast via Panama, to Asia This will compete with other sources, such as Middle East, that may choose European markets So, what will large, global players do? Total, Statoil, Gazprom, ExxonMobil, ConocoPhillips etc Different views, alternatives and logic in markets! Some more comfortable to adapt, others more stiff Best answer for Barents Sea gas will partly depend on the field developers Page 40

Time to take off blinkers and enter the future? Traditional assumptions that many still use: Gas markets will grow steadily with much new capacity in power Norway, Algeria, Russia compete for gas markets in the EU Long term sales contracts are needed for infrastructure Exporters should produce and transport at base load Local sales in Norway are not attractive When a pipeline is built it will be used This could easily result in the following scenario Little or no focus on domestic sales or LNG to ships Shtokman builds a pipeline to Nord Stream in 5 years Norway waits for resources then builds a pipeline in >10 years Competing pipelines result in lower prices and lower netbacks Less use of gas in the region, less income to gas, more emissions Page 41

LNG to ships is growing quickly Norway early mover: Primarily motivated by NOx reductions Technology Fuelling Now global: China US Europe Increasingly motivated by economics Emissions Control Area - ECA Estimated volumes 2030; 65 MT LNG Source: dnv.com Page 42

How to make robust solutions under uncertainty? Producers: Having more than one choice often helps Alternative infrastructure, alternative markets, different prices Easier to develop fields for producers with more than one option This may also include option to produce less flat Infrastructure: Stepwise, or low CAPEX vs. OPEX is easier Large economies of scale, but risky to build too large Booking of capacity can secure investments Market: Capacity easier (and cheaper) to book than the gas itself Ensures more options/ competition, securing supplies + lower price Could be valuable even if gas never flows in that capacity! Page 43

We are happy to discuss further! Selected recent work by Sund Energy that may be of interest Scenarios for European gas 2020 prices and flows Impact of Japan on global LNG prices Gas for transportation (road + sea) Security of supply values We also offer strategic and commercial advice partner selection Producers, TSOs, traders, large buyers, governments Gas, electricity, CCS and more Karen Sund, CEO, Sund Energy AS, Oslo, Norway Karen@sundenergy.com, +47 917 86 928 Page 44