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Quantitative Risk Management Methods, Techniques and Tools TONY MILSOM Specialist Risk Engineering KPC w w w. k u w a i t e r m. c o m
KPC ERM Objectives: Three key objectives of KPC s risk journey Achieve high certainty that the oil sector will meet the expectations of the State Ensure the availability of adequate funding to support oil sector capital expenditure Enable the oil sector to make a more fact-based and quantitative assessment of risk vs. return trade-offs in its activities and projects SOURCE: Team analysis 6
The top ten risks for KPC were identified and mapped to each of the K-Cos Risk modeled and have effect Risk 1 Domestic political influence 2 Regional instability 3 Project execution 4 Hydrocarbon market disruption 5a Crude price volatility 5b Gas price volatility 5c Interest rate volatility 5d Charter rates 6a FX volatility 6b Refining margin volatility 6c Petrochemical price volatility 6d Retail margin volatility 6e Counter-party credit risk 7a HR and HSSE - Manpower 7b HR and HSSE Labor disruptions 8a Operational - Production 8b Operational - Sabotage 9 New technologies 10 Unexpected drop in reserves KCo1 KCo2 KCo3 KCo4 KCo5 KCo6 KCo7 KCo8 KCo9 1400 risks from risk registers were considered KPC SOURCE: Team Analysis 9
Risk modeling aims to increase transparency and improve decision making KPC s strategic directives (not exhaustive) KPMs help measure success of these directives. Upstream Increase crude production to 4.0 mmbpd by 2020 Increase non-assoc. gas prod. capacities to 2.1 BSCF/d by 2020 Profitability Costs Profit margin ROACE Cost of risk R&T spend vs. plan Downstream Grow domestic refining capacity to 1.4 mmbpd (new built) and subsequent 1,6 mmbpd (enhancement of facilities) Increase refining complexity Production/ capacity HSEE Free gas production Proven reserves Fatal cases Environmental incidents Midstream and others Human Capital attraction and retention Kuwaitization and stakeholders Percentage of Kuwaitis in KPC Share of Capex spent locally Ability to attain targets on KPMs are influenced by multiple risks Strategic project risk Political/regulatory Operational/technical Portfolio/business risk Financial risks (counterparty, liquidity, market) 12
Working Draft - Last Modified 11/24/2006 4:22:00 AM Model top risk effects via quantitative risk model Risk assessment Price $55 Forward Curve 120 80 40 0 $35 Technical Capex Production disruption Political Tax changes Nationalization Cash flow at risk model Company portfolio Company-bycompany profiles Production Capex Opex Quantitative risk model Project valuation model LOX-ZZV233-20061123-MHDC Industry has a limited set of project growth options. We characterised these with 28 projects covering 75% of industry growth potential Growth projects/strategic initiatives NA Arctic gas Norway oil U.K. oil Canada oil sand U.K. gas Russia non-psc Risk return portfolio model NA Steam flood US onshore gas GoM DW Mexico DW NOC redevelopment Nigeria DW Angola DW Mid East LNG Mid East GTL NOC bonusbuyback Oman oil Central Africa Oil Malaysia DW OECD Frontier Exploration Non-OECD Frontier Exploration Estimated 75% of future hydrocarbon resource types modelled Source: USGS; McKinsey 13 SOURCE: McKinsey Risk Practice 13 13
The impact of risks is assessed by five key measures in line with the business KPM s Risk measures Probability distribution variable Risk measures chosen on the basis of KPC and K- Companies KPMs Financial risk measures Cash flow for KPC and Subsidiaries Stakeholder and KPC cash flow Annual cash flow for next year(s) (operating cash flow) Annual cash flow to both Kuwaiti government and KPC (remaining cash flow share) For financial KPMs (e.g., ROACE), cash flow identified as main driver of uncertainty For non-financial KPMs, production and capacity levels identified as most impactful factors Nonfinancial risk measures Crude capacity Gas production Annual crude capacity Annual associated and nonassociated gas production Refining capacity Annual refining capacity 14
Risk Modeling 15
Each K Company has it s own risk model; output measures risks modelled both in deterministic and stochastic cases Relevant risk factors Financial models Model output War/political scenario Project delays Oil price KPI KNPC KOC Financial Non-financial All relevant risks modelled for all K Companies Focused risks modelled in detail for K Companies Deviation from base case due to each of these risks modelled separately All 9 K companies deterministic financial cash flows is modelled For each of these deterministic, the impact of all relevant risks modelled separately for output Cash flow distribution (by each risk type for each K Company) 1 Varies by K company For KGOC and KOC Oil capacity Gas production For KNPC Refining capacity 1 While we calculate cumulative cash flows, we will use discount rate as follows 0% for next 5 years, 10% for remaining 15 years/there after SOURCE: Team analysis; expert interviews; k-company working teams 17
Probability Cash flow Model provides cash flow from operation over time and as a cumulative distribution Mn KD Cumulative operating five year cash flow (20XX-20YY) Yearly cash flow from operations (20XX-20YY) Illustrative 5th Mean Baseline 95th 95th 5th Baseline Mean x y z Cash flow Model can also calculate deviation from baseline for production volumes 20XX +1 +2 +3 20YY SOURCE: K-Company CFAR model illustrative example. Team analysis 18
Rank risks based on contribution to total cash flow at risk, and quantifies diversification effect 5 year cash flows (20XX-YY) Illustrative Risks Global crude/gas price volatility External influence on key decisions Large project execution risks New technologies risks Refining/petrochemical prices Operational risks HSSE and HR risks Diversification Total Cash Flow @ Risk = Baseline 5 th Percentile Remarks Baseline refers to currently projected cash flows from the 5 Year plan Diversification results from low or negative correlation of various individual risks leading to total risk lower than sum of individual risks SOURCE: K-Company CFAR model illustrative example. Team analysis 19
Risk Modeling Strategic Projects 20
Current project appraisal approach with a probabilistic risk view From deterministic to probabilistic Frequency of occurrence in simulation 1 High case 2 Base Case 3 Low case 3 2 1 Future value Discrete scenarios with no associated understanding of probability of occurrence Scenarios based on intuitive assessment bias likely in selection Fat tail risks often ignored Fact based assessment of full range of outcomes with associated probabilities Removes bias towards most likely scenario Quantify potential downsides and upsides at appropriate probability 21
The risk-return quantification methodology adds probabilistic metrics on top of the current appraisal and strategic metrics Value metrics Metrics currently used for program appraisal 1 NPV Additional risk-adjusted metrics introduced by the methodology Expected NPV Return metrics IRR Profitability index Expected IRR RAROC (Risk adjusted return on capital) Time metrics Payback period Expected payback period Sensitivity/ Scenarios Sensitivity of NPV to CAPEX overrun Oil price Project delay Scenarios NPV at risk (NPVaR) Probabilities To breakeven To meet baseline Stress-test expected economic performance of the project Prioritize and assess magnitude of key risks to focus mitigation actions Estimate likelihood of project success and the underlying value to the organization 1 Using base case assumptions SOURCE: Team analysis 23
and informs decision making at portfolio level ILLUSTRATIVE Technology Site Expected NPV KD million Old Prioritization NPV/investment (%) New Prioritization NPV/(Inv+NPVatRisk) (%) A B 75 158 15 31 5 9 8 22 2 9! C 85 19 8 12 8 D E 30 53 23 48 2 6 17 17 6 5! F 55 37 3 22 3 G H 50 145 33 97 4 1 20 54 4 1 I 35 19 7 13 7 N Ranking SOURCE: McKinsey Risk Practice 26
Overview of risk-based economics for project NPV distribution, KD 5 th percentile (P5) Breakeven point Probability to breakeven 70% 0 Expected NPV E1 NPVaR = B1-P5 Baseline Probability to meet baseline 24% B1 NPV, KD Key metrics Commissioning date Peak production, tpa Capex, KD Illustrative Numbers Baseline metrics 20AA CCC2 BIG Expected metrics 20BB.CCCX BIGGER Min Required NPV, KD B1 E1 IRR, % 10 13 10% Payback period, year 9 10 tbd Profitability index 1.8 1.88 >1 Return on NPV/I, % 80% 85% >0 capital RAROC, % 10% >0 NPVaR, KD B1-P5 Prob. to breakeven, % 70% tbd Prob. to meet baseline, % 24% tbd Key risks Observations Key risks Crude price Capex overrun Refining margins Feedstock availability Execution delay -R5 NPVaR, KD R3 R4 R2 R1 Contribution, Percent 69 59 20 4-1 Difference between baseline NPV and expected NPV, mainly driven by crude price, results in a lower probability to meet the baseline Probability to breakeven implying that the project is likely to be profitable Large NPVaR brings down expected return on capital after risk adjustment SOURCE: Economic model, team analysis 28
Risk Modeling Strategic Options 30
Risk could be integrated in both capital allocation and project appraisal processes in a consistent way Risk based capital allocation Risk based project appraisal Project selection RAROC % Project 1 2 3 4 5 Budget limit Capex KD mm Prerequisites KPC strategy identifies a set of strategic initiatives to guide future investments Pipeline of projects by strategic initiative, with project economic model and parameters Understanding of project risks Pipeline of projects for a strategic initiative, with risk based economic assessment Budget allocated to initiative Process 1 Assess strategic initiatives on a stand-alone basis 2 Assess impact of combinations of strategic initiatives on KPC portfolio Assess project economics for each strategic initiative Integrate risks in the economic appraisal and generate risk based metrics Rank projects based on RAROC Prioritize and select projects given budget constraint Outcome Allocated budget for each strategic initiative and/or K- company Risk based project economic metrics including RAROC Suggested list of projects for approval within a strategic initiative SOURCE: team analysis 31
Taking the Stakeholder perspective can significantly change the risk-return profile of strategic options Value creation of strategic options on portfolio Illustrative KPC view Stakeholder view Value (NPV), KD Less risky strategy More risky strategy RAROC Value (NPV), KD Less risky strategy More risky strategy RAROC Alternative option preferable Preferred option depends on risk appetite Alternative option preferable Preferred option depends on risk appetite Option 4 Option 6 Option 5 Option 4 Option 3 Option 5 Option 2 Option 3 Option 1a Option 1 (Current plan) Option 1a Option 1 (Current plan) Option 2 Option 6 Preferred option depends on risk appetite Current FYP preferable Preferred option depends on risk appetite Current FYP preferable 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 9 10 Risk (NPVaR), KDmm Risk (NPVaR), KDmm SOURCE: Strategic Planning model, team analysis 33
3 interlinked ERM quantitative processes CFaR model Objectives Provide a risk perspective on the FYP by introducing major risk factors Identify key risks for KPC and the State Monitor evolution of risk exposures over time and against tolerance limits Example output Programlevel riskreturn quantification Portfoliolevel riskreturn quantification Provide a risk perspective on Program economics (including RAROC, Expected NPV, probability to break even) Identify key risks on a program Quantify impact of mitigation actions and support creation of action plans Assess the risk return profile of different strategic options for the portfolio Support selection and definition of strategic directions Estimate the impact of strategic decisions on the portfolio 34
By the end of the ERM journey KPC will be a much more effective organisation Effective management tools to support better decision making A much deeper understanding of major risks and how they affect the businesses and Oil sector's ability to implement the 2030 strategy Concrete materials with quantification of the risks improving ability to engage the stakeholders in an informed manner Attention drawn towards the extreme tail risks facing the oil sector Suitable leading risk indicators and a good understanding how to quantify and assess the impact of range of mitigation options Ability to evaluate the investment portfolio from a risk adjusted point of view to create increased organizational value both at a KPC level and individual K-co level 35