Risk Management Techniques in the Oil and Gas Sector: A Focus on the Risk of Oil Price Volatility

ABSTRACT: The oil and gas industry is arguably the industry with the highest risk factor
given its complex nature. Over the years, oil companies have had to deal with the fluctuating
global oil price and its recent plunge has dealt a major blow to these companies. However, the
risk that companies in the oil and gas sector face is not limited to price volatility. The study
primarily focuses on the instruments of risk management in the oil and gas sector with respect to
price volatility, but it is not limited to that aspect. The research starts by discussing risk and risk
management in general, and then narrows the scope down to risk within the oil and gas sector.
Besides discussing the techniques that could be used to mitigate price risk, the study also gives
some insight into the techniques that can be used to manage the other forms of risks encountered
within the oil and gas sector.
Contents
CHAPTER 1................................................................................................................................................5
INTRODUCTION...................................................................................................................................5
1.0 Background of Study.....................................................................................................................5
1.1 Brief History of Risk Management................................................................................................5
1.2 Defining Risk.................................................................................................................................7
1.3 Statement of the Problem...............................................................................................................8
1.4 Objective of Study.........................................................................................................................8
1.5 Research Question.........................................................................................................................9
1.5 Significance of Study.....................................................................................................................9
1.6 Scope and Limitations of the Study...............................................................................................9
1.7 Organization of the Study............................................................................................................10
CHAPTER 2..............................................................................................................................................11
REVIEW OF RELATED LITERATURE.............................................................................................11
2.0 Conceptual Overview..................................................................................................................11
2.1 Overview.....................................................................................................................................11
2.2 Modern Concept of Risk Management........................................................................................14
2.3 Risk Management Techniques.....................................................................................................14
2.4 Understanding Risk in the Oil and Gas Sector and its Uniqueness relative to Other Sectors.......18
CHAPTER 3..............................................................................................................................................24
ANALYSIS AND DISCUSSION..........................................................................................................24
3.0 Introduction.................................................................................................................................24
3.1 Hedging as a Risk Mitigation Technique in the Oil and Gas Sector............................................24
3.2 System Safety Engineering as a Risk Mitigation Technique........................................................27
CHAPTER 4..............................................................................................................................................28
CONCLUSION.....................................................................................................................................28
4.0 Summary and Conclusion............................................................................................................28
CHAPTER 5..............................................................................................................................................29
RECOMMENDATION.........................................................................................................................29
5.0 Recommendation.........................................................................................................................29
References.................................................................................................................................................30
List of Abbreviations

AFA – American Finance Association

RIMS – Risk and Insurance Management Society

CAPM – Capital Asset Pricing Model

OTC – Over the Counter

CBOE – Chicago Board Options Exchange

OOIP – Original Oil in Place

EOR – Enhanced Oil Recovery

SIMEX – Singapore International Monetary Exchange

NYMEX – New York Mercantile Exchange

IPE – International Petroleum Exchange

 CHAPTER 1
INTRODUCTION

1.0 Background of Study

Risk is an inevitable aspect of everyday living. The mere fact that an individual is alive ensures
that some form of risk would be encountered by this individual. Activities as regular as taking a
morning shower to driving or taking a bus, and decision making come with certain levels of risk.
As a result of this, human beings consciously or unconsciously set out to mitigate these risks or
entirely eradicate them through several precautionary measures.
The oil and gas sector is faced with several forms of risk at different stages in the business. The
risks this sector is exposed to in the developed and developing country are quite similar.
However, there are some forms of risks that are unique to the oil and gas sector in developing
countries such as political risk and security risk.
The price volatility experienced by the global oil market is the primary reason for this study and
as such, more attention would be given to the technique used in mitigating this risk. However,
the study is not limited to the risk of price volatility but covers other risks that plague the oil and
gas sector and the techniques that can be applied to mitigate these risks.

1.1 Brief History of Risk Management

The first record of risk management studies is dated back to the post World War II era
(Harrington and Niehaus, 2004). After the World War II, it was observed that books or articles
on risk management didn’t exist and courses on the subject were not being taught in educational
institutions. However, humans were informally involved in risk management practices in their
daily activities long before the World War eras. The risk management practices include but are
not limited to the following; conscious effort to live healthy (i.e. exercising, dieting), profit-
oriented business decisions by business owners, healthy financial practices for the rainy day (i.e.
saving, investing) and physical security measures (Crockford, 1982). The first two academic
books on risk management were published in 1963 and 1964 by Mehr and Hedges, and Williams
and Hems respectively. The main scope of these books were however limited to pure risk
management. In the later years, engineers developed the technological risk management models
and subsequently broadened their scope to operational risk (Dionne, 2013). Harrington and
Neihaus (2004) argue that risk management has for a long time been structured around the use of
market insurance for the protection of individuals and companies from various losses associated
with accidents.
The mid 1950s saw the emergence of new forms of pure risk management which served as
alternatives to the different costly and incomplete insurance packages that were common during
that period. Several businesses found it expensive or impossible to insure risks related to their
operations (Dionne, 2013).
The 70s saw the introduction of derivatives as tools to manage insurable and uninsurable risks.
This developed very quickly during the 1980s (Bank for International Settlement, 2005). In the
80s time period, companies began to give consideration to financial management or risk
portfolios. This time period also saw financial institutions such as banks and insurance
companies intensify their market and credit risk management activities. Operational liquidity risk
management was introduced in the 1990s (Dionne, 2013).
Another development that occurred in the 90s was the international regulation of risk. Several
financial institutions created risk management models for use within the institution where they
were created, and capital calculation formulas to shield themselves from risks that were not
anticipated and reduce regulatory capital. This further resulted in the introduction of integrated
risk management, giving room for the creation of the first risk manager position (Dionne, 2013).
Risk management cuts across every form of business, from the very simple business set-ups to
the complex ones. However, the level of risk varies across business set-ups with the capital-
intensive businesses facing a higher level of risk while the less capital-intensive ones tend to
experience lower risk levels.
Despite the birth of the concept of risk management in the post-World War II era, the concept
was not applied in the oil and gas sector until the 60s due to the fact that the concept was
restricted to academia in its early days. During its introduction to the oil and gas sector, the
objective of risk management was, as it is today, to provide a strategy to minimize the exposure
of petroleum projects to risk and uncertainty in petroleum exploration activities. Since then, the
concept has become an important aspect of business strategy within the oil and gas industry
(Suslick and Schiozer, 2004).
1.2 Defining Risk
According to the Business Dictionary, risk in general is defined as “A probability or threat of
damage, injury, liability, loss, or any other negative occurrence that is caused by external or
internal vulnerabilities, and that may be avoided through preemptive action.” For the purpose of
this paper however, the focus would be on financial risk as it deals with investment. The
Business Dictionary defines financial risk as “the probability that an actual return on an
investment will be lower than the expected return.”
In general, there are several types of financial risk but this paper would be focusing on the
following;
I. Liquidity Risk: Liquidity risk is defined as the risk whereby the inability of a given
security or asset to be traded quickly in the market to prevent a loss exits. Liquidity risk
can be categorized into market liquidity and funding liquidity. Liquidity risk arises from
situations whereby an entity that is willing to trade an asset cannot do so due to the
absence of entities that are interested in trading for that asset (Pedersen and
Brunnermeier, 2009).
II. Default Risk: According to Vassalou and Xing (2010), “default risk is the chance that
the bond issuer will not make the required coupon payments or principal repayment to its
bondholders.” A firm defaults when it fails to service its debt obligations due to factors
such as insufficient cash reserve or negative cash flow. In this manner, default risk
actuates lenders to require from borrowers a spread over the risk free rate of interest
(Vassalou and Xing, 2010).
III. Market Risk: Market risk can be defined as the risk that comes with the decline in value
of an investment due to certain market actions such as change in price. The market risk
factors have been grouped into four categories namely; equity risk, interest rate risk,
currency risk, and commodity risk (Bank for International Settlements, 2003).
IV. Operational Risk: This is the risk of a change in value that occurs due to the fact that
real losses acquired for inadequate failed internal processes, people and systems, or from
external dealings, differ from the expected losses (CEA, 2007). Operational risks can also
include other categories of risk such as fraud, privacy protection, legal risk, security,
physical (i.e. infrastructure shutdown) and environmental risks. Unlike other categories
 of risk, operational risks are usually not intentionally incurred or revenue driven. Also,
this form of risk is not diversifiable and cannot be totally eradicated due to the
imperfection that exists in humans, systems and processes (Power, 2005).
V. Pure Risk: Business Dictionary (2014) defines pure risk as “a situation where there is a
chance of either loss or no loss, but no chance of gain.” For example, the destruction of a
building in the event of a natural disaster. Such risk is classified as pure risk to the owner
of the building because there isn’t any potential benefit to this risk. The most common
measure used to mitigate pure risk is the purchase of an insurance policy. Other examples
of pure risk include premature death, career-threatening disabilities and identity theft
(Rhodes, 2013).
Financial risk however is not limited to the categories mentioned above. Other categories exist
but are not discussed in this paper.

1.3 Statement of the Problem

The importance of risk management/mitigation in business organizations cannot be
overemphasized. As stated above, the higher the capital required for a business set-up, the higher
the risk and vice versa.
The oil and gas sector is faced with uncertainties at different levels, starting from the geological
survey down to the lifting and production level. It is also a capital intensive business to venture
into. Given the aforementioned reasons, coupled with the complex nature of the oil and gas
business, it is arguably the most risk plagued industry and therefore requires a significant number
of risk mitigation techniques to protect the investors within this sector.

1.4 Objective of Study

The main objective of this study is to determine the technique that could be used to mitigate the
risk of price volatility faced by investors in the oil and gas sector in order to protect their
investment. However, other specific objectives of this research study are;
I. To analyze the risks common to all sectors of the economy.
II. To examine the general risk mitigation techniques that are applicable to economic
sectors.
III. To determine the risks that are unique to the oil and gas sector.
IV. To determine the risk mitigation techniques which are applicable to the oil and gas sector.

1.5 Research Question

In light of the stated problems and the objective of study, certain questions that should be
answered at the end of this study arise. They are;
I. What are the risks faced by investors in the oil and gas sector?
II. What techniques can be used to mitigate these risks in the oil and gas sector?

1.5 Significance of Study

From the background of this study as well as the discussion held in the objective of the study, it
is important that there is enough support to warrant a study that seeks to recommend financial
instruments for risk management within the oil and gas sector.
This study stands to be significant to stakeholders within the oil and gas sector. Private investors,
executives, as well as government regulatory bodies stand to benefit from this study as it would
help increase revenue by guiding the private stakeholders on investment decision within the
sector and increased revenue for private investors would result in increased revenue for the
government.
On the other hand, the study will also serve to inform both present and future researchers to the
effectiveness of the relevant instruments of risk management within the oil and gas sectors.

1.6 Scope and Limitations of the Study

The scope of the study is within the period of the first oil shock (1973) to current events in the
global oil market. Research materials for this study were obtained from previous literature in
journals, presentations, websites and books. It is believed that the extension of the study to cover
a period of over forty years will ensure that the conclusion is devoid of sudden occurrence.
The primary limitation of this study has to do with the financial constraint of the researcher
which creates boundaries to the research. Also the researcher is constrained by insufficient time.
1.7 Organization of the Study
This research project is made-up of five chapters. Chapter one shall review the scope of this
study; see the background of the study, its problems, objectives and significance. Chapter two
looks at the literature review, instruments for risk management, effectiveness of the risk
management instruments and the risks which are unique to the oil and gas sector. Chapter three
will focus on the techniques for risk mitigation in the oil and gas sector; an analysis on the
effectiveness of these instruments will be made in this chapter. Chapter four will be a summary
of the whole research paper and conclusion. Finally, chapter five will give possible
recommendations on how these instruments can be utilized or improved to fulfill the objectives
for which they were developed.
 CHAPTER 2
REVIEW OF RELATED LITERATURE

2.0 Conceptual Overview

The conceptual review will attempt to thoroughly examine the idea of risk mitigation in the oil
and gas sector by discussing risk management in general and then focusing on risk within the oil
and gas sector; it will aim at explaining the techniques for risk mitigation as well as the
effectiveness of these methods and the risks that are unique to the oil and gas sector.

2.1 Overview
According to Hallikas et al., risk management can be defined as “the process of identification,
analysis and either acceptance or mitigation of uncertainty in investment decision-making.” Risk
management is normally carried out prior to investment decisions. The investor or fund manager
investigates and measures the potential for losses in a venture and afterward makes the suitable
move (or inaction) depending on their investment objectives and level of risk tolerance (Hallikas
et al., 2004). Inappropriate risk management actions can result in severe consequences for
organizations as well as individuals. An example was the 2008 recession that occurred in the
United States of America that came about as a result of loose credit risk management by
financial firms (The Economist, 2013).
Risk management has evolved over the years since its conception. Certain economic, political
and geographical activities can be attributed to the evolution that has occurred in risk
management (Dionne, 2013).
It is argued that the seminal work of Louis Bachelier in the 1990s, which gave birth to the
financial theory, was the first step towards financial risk management. This theory was later
modified in the 1930s by the American Finance Association (AFA). In 1932, the American Risk
and Insurance Association was created, and went on to publish the first Journal of Insurance that
same year. Other related journals such as Risk Management by the Risk and Insurance
Management Society (RIMS) which was founded in 1950, and the Geneva Papers for Risk and
Insurance by the Geneva Association, were published between 1950 and 1976 (Weiss and Qiu,
2008).
Although the 50s and the 60s saw researchers undertake important studies of financial decisions
that led to what is now known as the modern theory of portfolio choice based on the Capital
Asset Pricing Model (CAPM), it wasn’t until the 70s that the foremost financial risk
management products came into existence and the premier theoretical models for modern risk
coverage were published (Dionne, 2013).
The premier proposition of an explicit formula for the pricing of a derivative (an option) was
contained in the model developed by Black and Scholes and published by the Journal of Political
Economy in 1973. This led to the rapid expansion of risk coverage derivatives, spawning
currency and interest rate swaps, and over the counter options (OTC). The increasing popularity
of personal computers and mathematical finance played a part in the increased use of derivatives.
The 1980s and the 90s saw the growth of the options market enhanced after the Chicago Board
Options Exchange (CBOE) standardized contracts and established secondary markets required to
generate sufficient liquid assets for market efficiency (Smith, Smithson and Wakeman, 1988).
In subsequent years, other statistical tools such as the credit scoring were developed and utilized
in financial institutions to aid with clientele selection and manage credit risk. The credit scoring
tool facilitated the assessment of default/credit risk and risk pricing. The Basel Accord of 1988
enforced a new regulatory vision of risk (Dionne, 2013).
Several other milestones occurred over the years that led to more modifications of risk
management and the creation of new statistical tools for risk management. The table below gives
a summary of the milestones that occurred in the history of risk management from 1730 to 2010.

Table 1: Milestones in the History of Risk Management

Time Milestones
1946 First Issue of the Journal of Finance
1952 Publication of Markowitz’s article “Portfolio
Selection”
1961-1966 Treynor, Sharpe, Lintner and Mossin develop
the CAPM
1963 Arrow introduces optimal insurance, moral
hazard and adverse selection
1972 Futures contract on currencies at the Chicago
Mercantile Exchange
1973 Option valuation formulas by Black and
 Scholes, and Merton
1974 Merton’s default risk model
1977 Interest rate models by Vasicek and Cox,
Ingersoll and Ross (1985)
1979-1982 First OTC contract in the form of swaps:
currency and interest rate swaps
1980-1990 Exotic options, swaptions and stock derivatives
1985 Creation of Swap Dealers Association, which
established the OTC exchange standards
1987 First risk management department in a bank
(Merrill Lynch)
1988 Basel I
Late 1980s Value at Risk (VaR) and calculation of optimal
capital
1992 Article by Heath, Jarrow and Morton on the
Forward rate curve; Integrated Risk
Management and RiskMetrics
1994-1995 First bankruptcies associated with misuse (or
speculation) of derivatives: Procter and
Gamble (manufacturer, rates derivatives,
1994), Orange County (management funds,
derivatives on financial securities, 1994) and
Barings (futures, 1995)
1997-1998 CreditMetrics: Asian and Russian crisis and
LTCM collapse
2001 Enron bankruptcy
2002 New governance rules by Sarbanes-Oxley and
NYSE
2004 Basel II
2007 Beginning of financial crisis
2009 Solvency II ( to be implemented after March
2013)
2010 Basel III
Source: Interuniversity Research Center on Enterprise Networks, Logistics and Transportation,
2013
These milestones played significant roles in defining risk management as it is known today.
Several risk management instruments were developed and modified within the cause of these
milestones to evolve into the various risk management instruments known to us in modern times.

2.2 Modern Concept of Risk Management

Risk management is primarily aimed at developing a reference framework that will enable
companies to deal with the issues of risk and uncertainty. Firms are faced with the presence of
risk in any financial or economic activity they undertake. This has led to the introduction of the
risk identification, assessment and management process as part of the strategic development of
organizations. The process has to be designed and planned at the top echelon (board of directors)
to effectively function. According to Ong (2006), “a well-designed management process should
evaluate, control and monitor all risks and their dependences to which the company is exposed.”
The primary risk management activities are diversification and risk hedging through the
implementation of various instruments such as derivatives and structured products, market
insurance, self-insurance and self-protection (Dionne, 2013).

2.3 Risk Management Techniques

There are different types of instruments for risk management depending on the sector it was
created for or what the instrument was designed to achieve. However, due to the nature of the
research, this section examines the financial instruments for risk management that are commonly
used in the international financial markets. They are as follows;

I. Forward-Forward: Forward-Forward can be defined as an agreement between two

parties to participate in a credit exchange in the future. In this type of contract, the lender
consents to give the borrower finances on a predefined future date. The borrower consents
to reimburse the advance, in addition to a premium, at a date past the credit issue date.
Forward-Forward permits to an entity which needs to get an advance or to understand a
position to a further date (given time period) to assess the credit cost or the placement
output (Bessis, 2010).
 The Forward-Forward of contracting a loan differs from the concept of Forward-Forward
placement. In the case of the former, the bank or credit facility agrees to grant credit to an
enterprise of a certain size, in a given time period at a previously fixed interest rate.

Figure 1: Illustration of the Forward-Forward of Contracting a Loan

Ensured
The Bank The Credit
Interest

The Forward-Forward placement frame on the other hand is a situation where an investor
is bound by contract to make a placement to a bank or credit institution of a certain size,
at a given time period and to an interest rate prior fixed.

Figure 2: Illustration of the Forward-Forward Placement Frame

Ensured
Investor Placement
Interest

The rate to the Forward-Forward operation is dependent on the loan interest, loan
duration, placement interest, placement duration and the operation duration.

Mathematically;

( Li × Ld )−( Pi × Pd)
Rf=
Pi+ Pd
O d ×(1+ )
B ×100

Where;

Li = Loan Interest
Ld = Loan Duration
Pi = Placement Interest
Pd = Placement Duration
Od = Operation Duration
B = Day count basis applicable to money market transactions in the currency of the loan
This instrument is used for hedging or speculation with respect to interest risk
management financial operation (Hagiu, 2008).
II. Forward Rate Agreement (FRA): This is an over-the-counter contract between entities
that decides the rate of interest, or the exchange rate of currency, to be obtained on a
 commitment beginning at a future start date. It is also known as the future rate of
agreement. The agreement will focus the rates to be used alongside the end date and
notional worth. The only payment that is made in this type of agreement is the differential
that is paid on the notional amount of the agreement (Teasdale, 2004). In this contract, the
buyer’s aim is to be shielded from increasing interest rates while the seller protects itself
from diminishing interest rate.

Figure 3: Illustration of the FRA

Contract

FRA Buyer FRA Seller

Protection against the Protection against the

Interest Rate Increase Interest Rate Diminish

Source: The Financial Instruments for Risk Management on the International Financial
Markets, 2008

In this instrument, the difference in interest is dependent on the nominal value of the
operation, ensured interest rate, market interest rate and number of days.

Mathematically;

C ×(rg−rp)× T
D=
r m × T + B ×100
Where;
D = Difference in Interest
C = Nominal Value of Operation
rg = Ensured Interest Rate
rp = Market Interest Rate
T = Number of Days
B = Day count basis applicable to money market transactions in the currency of the loan

The FRA can be used in covering risk operation by fixing the interest rate for a future credit.
It can also be used to reduce the loan cost or enhance the output of a money placement for a
given time period (Dufloux and Margulici, 1997).
 Finally, FRA can be practiced between an organization and a bank or on an inter-bank basis
(Hagiu, 2008).
III. The Swap: Swap can be defined as an exchange of financial assets between concerned
parties at a predetermined time, as indicated in the contract. Swaps are not exchange
oriented and are traded over the counter (OTC) rather, normally arranged through banks.
They can be used to hedge risks of different types such as interest rate risk and currency
risk. The two most common kinds of swaps traded in the market are currency swaps and
interest rates swaps (The Economic Times, 2015). Other types of swap include commodity
swaps and subordinated risk swaps.
IV. Interest Rate Option: An interest rate option can be defined as a specific financial
derivative contract with a payoff that is dependent on the future level of interest rates
(UniCreditBank, 2014). Here, the buyer uses cap to secure an upper interest rate limit
(strike price) on future borrowings for himself. With respect to speculative trading, the
value of cap experiences increase as the interest rate increases. The sale of cap is used as a
speculative instrument only. The seller obtains a premium and is obligated to compensate
the buyer for any difference in interest rates.
Floor depicts a contract where the buyer secures the lowest possible interest rate on a
future investment. The value of floor increases as the rates decline in speculative training
(Hagiu, 2008).
Other financial instruments for risk management include straddle, strangle etc. It should be noted
however, that the financial instruments are not limited to the ones mentioned above.

2.4 Understanding Risk in the Oil and Gas Sector and its Uniqueness relative to Other
Sectors
The complex nature of the oil and gas sector makes it vulnerable to certain risks that are unique
to the sector alone. Besides the general risk associated with the oil and gas sector globally, some
risks appear to be location specific. This simply means that oil companies within a certain
geographical location are exposed to risks that can only be found in that area because they are
caused by the geographical composition/layout of that area. Also, there are risks that are unique
to developing economies. Oil companies in developed economies are not vulnerable to these
types of risks.
This section seeks to examine the types of risks faced in the oil and gas sector on a global scale
and explain why they are different from other sectors.
Before examining the types of risks faced in the oil and gas sector, it is important that we discuss
the activities involved in the production of oil in order to gain a better understanding of the risks.
The activities involved in production for oil and gas can be divided into three stages;
Exploration, Development and Production.
I. Exploration: Like many other natural resources, oil and gas deposits are concealed
beneath the earth’s surface. The deposit is usually made-up of gas, oil and water
contained within porous rocks to enable their movement. The oil and gas deposit
experience pressure which is contained by an impermeable “cap rock”. The diagram
below is an illustration of the exploration process.

Figure 4: Diagram of the Exploration Process

Wild-Cat Dry Wild-Cat
Well Well

GAS

Oil

WATER

Source: Petroleum Policy and Economics Lecture Note, 2013.

As shown in the diagram above, the oil is concealed beneath the earth’s surface. This
implies that certain steps have to be employed in order for the oil to be found. These steps
include geological and geophysical surveys; the surveys need to be carried out in order to
determine the underground geology. These steps are used to determine the possible
 location of the oil and gas deposit. The technology used for geological and geophysical
surveys has experienced improvement over the years and this has helped to further reduce
the probability of drilling a dry wild-cat (a well that does not contain any oil and gas
deposit). However, the only guaranteed way of establishing the presence of oil or gas is
by drilling.
II. Development: Upon the discovery of oil, the next stage involves taking a decision on
whether to develop the deposit or not. This aspect is more of an investment decision
which depends on several factors, primarily on the amount of deposit that was
discovered.
The development phase entails creating the capacity to produce oil. This involves drilling
development wells and regulating their flow with a device called the “Christmas Tree”.
The function of the wells is to boost production and determine the limits of the field
(Appraisal Drilling). The oil emerges from the well as a mixture of oil and gas. This
mixture is collected and sent to the gas-oil separator plant for the gas to be removed. The
crude oil is sent to the market while the extracted gas may be flared, used to maintain
pressure by re-injecting it into the oil field, used as a fuel or petrochemical feedstock,
depending on the oil company’s mode of operation.
III. Production: After the exploration and development stages, the next stage in the process
is the production stage although the previous stages involve the production of
hydrocarbons. In the production stage, certain recovery methods are applied in order to
get the most out of the oil deposit beneath the earth’s surface. These recovery methods
can be classified under three categories; the primary, secondary and tertiary recovery
methods. The primary recovery involves utilizing the natural pressure in the reservoir to
extract oil out of the well without any extra assistance. The primary recovery method can
recover approximately 20 per cent of the original oil-in-place (OOIP). The secondary
recovery method is used to maintain reservoir pressure and displace oil to the wellbore.
This is achieved by injecting gas or water through injection wells, in order to avoid a
rapid decline in production. A successful combination of both primary and secondary
methods would result in a total recovery of about 25-40 per cent of the OOIP. Despite the
application of primary and secondary recovery methods, production would eventually
decline except the tertiary recovery method is introduced. This method entails improving
 the flow of oil by washing it out with chemicals, raising its temperature by in situ burning
or using steam hoses. Tertiary recovery boosts the recovery factor by an extra 5-15 per
cent. The primary and secondary recovery methods are known as conventional recovery,
while the tertiary recovery method is known as enhanced oil recovery (EOR).
Economically, for production on any field to be maintained, the costs experience
continuous increase. In other words, each production phase requires more investment.
This rising cost has been managed by the technological advancement over the years.
(Mu, 2013).

These three phases are significant to investors given the depletable nature of oil. The depletable
nature of oil simply means that barrels produced today are lost forever. The figure below
illustrates the time profile of a reservoir.

Figure 5: Time Profile of a Typical Oil Field

Source: Petroleum Policy and Economics Lecture Note, 2013.

The diagram above shows the three phases of production. At the initial stage (development
phase), the output increases due to the successful drilling and utilization of more development
wells. Production then reaches its peak level and may maintain that level for a few years (plateau
phase). Afterwards, production then reaches the decline phase due to the dropping pressure of the
reservoir; it is at this stage that the tertiary recovery is applied. Finally, when the production
value is unable to cover the operating cost, the field is abandoned (Mu, 2013).
Having discussed the activities involved in crude oil production, this section would now look at
the types of risks faced in the oil and gas sector, at the different activity levels. The three main
types of risks in the oil and gas sector include;
 I. Prospect Risk: The prospect risk has to do with the possibility of failure of the well to
find hydrocarbons in commercial quantities. In other words, the wild-cat would be a dry
hole. As the years go by and technology improves, the risk of a dry hole keeps reducing.
For example, there is a one in two chance of finding commercial quantities of
hydrocarbons in the UK North Sea today. Prospect risk matters to investors because of
the high cost of drilling.
The presence of prospect risk has resulted in the alteration of agreements that form the
basis by which oil companies engage in exploration and production activities. In most
cases, the changes are aimed at placing the burden of the prospect risk on the oil
company. This implies that in the event of failure to find oil in commercial quantity, the
loss falls entirely on the oil company without the government of the host nation losing
anything.
II. Contract Risk: In most countries, with the exception of the United States of America,
every mineral resource beneath the ground is the property of the state. This implies that if
an oil company intends to explore for the oil and gas within a country, an agreement must
be signed between the government of the host nation and the company, usually based on
the fiscal regime of the country. This agreement includes the profit sharing formula of
both parties (the fiscal terms of the agreement). Companies face the challenge of not
knowing how much of the oil or gas is recoverable from the reserve when going into the
agreement. Once oil is discovered and production commences, the government has the
upper-hand in relation to bargaining power. There have been cases where the
governments of host nations try to strong-arm oil companies for more favorable terms
once they find oil and start producing.
III. Commercial Risk: The commercial risk involved in oil exploration can be classified into
two categories. The first category has to do with the geology. Geological and geophysical
surveys give information about the estimated quantity of oil that is underground;
however, this information may be misleading as it is not 100 per cent accurate. The
geology may be much more fractured or the quantity of the oil deposit may be far less
than the estimation given in the survey.
Secondly, the market conditions have to be taken into consideration. The price of oil has
been characterized by fluctuations over the years. Due to the lengthy time frame required
 to bring an oil field online for production, the oil price may be lower than expected when
production commences. On the other hand, the costs could be higher than expected due to
inflation in engineering and procurement of raw materials and equipment.
(Mu, 2013)
The risks mentioned above are the three main types of risks that are experienced in the oil and
gas sector. However, there are order types of risks that are faced in the oil and gas sector but they
are not unique to the sector. These risks include;
I. Operational Hazards: According to Newman, operational hazard is “anything on or
around a work site which may compromise worker safety or health if appropriate control
measures are not implemented.” Operational hazards are common in every sector of an
economy but differ according to the sectors. In the oil and gas sector, operational hazards
include explosion and oil spillage in offshore facilities (Newman, 2014).
II. Political Risk: This could come in from regulations or nationalization, however, political
risk is not restricted to these two forms. In the oil and gas sector, a company’s exploration
activity is managed by regulations set by the government of the host nation. These
regulations could sometimes be unfavorable to the oil companies (Beattie, 2011).
Oil companies became conscious of the issue of political instability during the first oil
shock of the 70s. The middle-east, which was the dominant oil producing region, was
rocked with a series of uprising that led to the nationalization of foreign oil companies
within the region and this led to massive loss of investment. These days, oil companies
are careful to engage in politically stable countries in order to protect their investment
(Bielecki, 2002).
III. Security Risk: The importance of security in the oil and gas sector, just like every other
economic sector, cannot be overemphasized. For economic activities to go on smoothly,
the operating environment of business organizations has to be safe. In the oil and gas
sector, poor security could result in dire consequences for oil companies. For example,
during the Niger delta uprising of the early 2000s, shell, a foreign oil company in Nigeria,
evacuated 235 non-essential personnel from two oil fields, cutting oil production by
30,000 bpd (Human Rights Watch, 2005). The unrest in the Niger delta resulted in
significant loss to oil companies that operated within the region, causing the country to
cede her position as the foremost oil exporter in Africa to Angola (Paki, 2011).
 Another aspect of security risk has to do with the issue of oil theft. Using Nigeria as an
example, it was estimated that in the first quarter of 2013, an average of 100,000 bpd was
stolen from facilities on land, swamps and shallow waters due to the poor security in the
Niger delta region (Katsouris and Sayne, 2013).
Although these types of risks affect the oil and gas sector, they also have impact on other
economic sector. Investors in the oil and gas sector should take these risks into consideration
when making business decisions.
The next chapter focuses on the instruments or techniques that could be used to mitigate the
above mentioned risks in the oil and gas sector.

CHAPTER 3
ANALYSIS AND DISCUSSION
3.0 Introduction
Despite all the risks that are encountered in the oil and gas sector, the global demand for energy
remains high, and oil and gas occupies a significant share in the global energy demand. The
numerous risks in the oil and gas sector do not make it less lucrative. Investors can still make
enough profit, as long as they are aware of the risks involved and take the necessary steps to
mitigate these risks. This chapter seeks to analyze and discuss the risk mitigation techniques
within the oil and gas sector.

3.1 Hedging as a Risk Mitigation Technique in the Oil and Gas Sector
The oil and gas sector, just like every other economic sector, has employs certain techniques to
mitigate the risks faced by investors in the oil and gas industry.
Hedging can be defined as the process of making an investment to mitigate the risk of adverse
price movements in an asset. This instrument is used in all economic sectors given the fact that
every sector experiences price volatility at different magnitudes. The magnitude of price
volatility in the oil sector makes global oil price the single biggest variable in forecasting
earnings before interest and tax (EBIT) for non-integrated independent exploration and
production companies. This tool is especially crucial for upstream companies (Price, 2014).
In the oil and gas sector, hedging can be carried out with the use of derivatives. Using
commodity derivatives can mitigate or eradicate price uncertainty in the oil and gas sector
(ABSConsulting, 2014). According to the Economic Times, “A derivative is a contract between
two parties which derives its value/price from an underlying asset.” Types of derivatives include:
I. Forward Contract: In relation to oil, a forward contract is a private agreement between
a buyer and a seller, giving the buyer an obligation to purchase oil (and the seller an
obligation to sell oil) at a set price which is equal to the forward price at the time the
contract is entered into, at a future set date. Like other economic sectors, the forward
contracts in the oil and gas industry are conducted OTC. Each participating party bears
the risk of default on future commitments by the other party (Edwards, 1998).
II. Futures Contract: A futures contract is a forward contract that incorporates the rules of
exchange. The fact that futures contract is traded in exchanges, where a clearing house
represents the buyer and seller, differentiates the futures contract from the forward
contract. The clearing house primary purpose is to mitigate the risk of default between
 the buyers and sellers as seen with the forwards and ensure the quality and quantity of the
products delivered. The three main futures exchanges include the Singapore International
Monetary Exchange (SIMEX), the New York Mercantile Exchange (NYMEX) and the
International Petroleum Exchange (IPE) (Hull and Hull, 2006). Given the fact that the
clearing house takes the risk away from the parties involved, the futures contract is
favored over the forwards in the oil and gas industry.
An illustration of hedging as an instrument for risk mitigation in the oil and gas can be
seen in the example of an oil producer. The global price is volatile in nature with
occasional large moves in either direction. Based on current prices and forecast levels at
the time the field is brought online for production, the producer might decide that
upstream activities would commence at a given time period, but the price of oil might
experience change as time goes on. Once upstream activities commence, the producer is
committed to it for an entire production cycle. If the actual price of oil rises significantly
between the period of exploration and when the oil is lifted from the ground and taken to
the market, the producer stands to make more profit than he anticipated, but if the actual
price drops by the time the oil is lifted and taken to the market, he is going to lose a
significant portion of the invested money. If during the exploration period the producer
sells a certain amount of oil futures contracts equivalent to his anticipated output, he
effectively locks in the price of oil at that time: the contract is an agreement to supply a
certain quantity of oil to a given location on a set future date for a certain fixed price. The
producer has hedged his exposure to the volatile oil price; he is no longer affected by the
price changes because the contract guarantees the producer an agreed upon price. He no
longer needs to worry about a decline in price when it is time for him to take his oil to the
market, but he also gives up the possibility of making extra profit from high oil price at
the time of lifting.
III. Swap: The concept of swap as a hedging instrument of risk mitigation can be applied to
the oil and gas sector. As stated in chapter two of this paper, a swap can be defined as an
exchange of financial assets between concerned parties at a predetermined time, as
indicated in the contract. It is usually arranged through banks or other financial
institutions. Just like the forward and futures contracts, oil swaps are used to mitigate the
risk of price volatility. Swaps transfer the risk of price volatility from the oil producer to
 the lender. This transaction guarantees the oil producer a firm price for a calculated
volume of crude oil through a physical contract. In the event of a fall in crude oil price
below the fixed price, the lender or financial intermediary is obligated to pay the
producer the fixed price that was agreed upon in the contract, thereby bearing the loss;
and in the event of a price increase, the lender enjoys the whole benefit. This financial
instrument was given the name swap because a fixed price (crude oil producer) is traded
or swapped for a floating price (lender). A similar example can be seen in the North
American model. One feature that distinguishes the North American model from other
models is the presence of the volumetric production payment (VPP) feature in the US
market. The VPP has similar workings to a conventional loan, but unlike a conventional
loan, the holder of the instrument provides the producer with an upfront cash payment in
return for receiving a certain amount of oil or gas from selected fields, over a given time
period. The producer does not pay back the loan with cash plus interest as seen with
conventional loans, thereby transferring the price risk exposure to the lender (Price,
2014).
IV. Options: This derivative gives a buyer the right, but not the obligation to buy or sell a
given asset at an agreed price and a specified date. The option holder has the right not
obligation to buy or sell oil while the option writer is obligated to sell or buy the oil if the
holder of the option exercises the right. When both parties come together, they agree on a
value for the option which is called the option price or option value. The ability of both
parties to agree on the price eradicates the risk of oil price volatility (The Economic
Times, 2014).

The hedging risk mitigation technique is primarily used to tackle the commercial risk aspect of
the oil and gas sector. Despite the benefits that come with this technique, it should be noted that
hedging also has a flip-side. If hedging is implemented without a proper understanding and
consideration for the relationship that exists between the derivative products, the underlying
reserve, production, timing and fiscal risks, there is a high possibility that it can multiply losses
in the case of reservoir-related production (Price, 2014).
With regards to the contract risks, the risk mitigation techniques have to do with company
policies which are designed to make the best out of the fiscal regime of the country where the
company intends to invest. Also, mitigation of prospect risk is tied to technology. Technological
breakthroughs in geological and geophysical surveys would help reduce the prospect of a dry
wildcat for companies.

3.2 System Safety Engineering as a Risk Mitigation Technique

This technique has to do with mitigating the risk of the occurrence of an operational hazard. The
technique has been in existence as an aspect of system engineering for over 50 years. System
safety engineering is the process of operating safer systems and managing safety risks
successfully. It has proven to be successful over the years in industries such as commercial
aviation, nuclear power and defense systems. Recent accidents in the oil and gas sector such as
explosions and oil spillage show that oil companies need to integrate this technique into
operational decision making in order to mitigate the aforementioned risks, especially in upstream
activities (Leveson, 2014).

As stated in the first chapter of this study, the primary reason behind this research is the issue of
price volatility in the oil and gas sector. However, the scope covered other types of risks faced by
investors in the oil and gas sector. Besides the risk mitigation techniques mentioned above, other
techniques include;
I. Careful study of the political scene in the country of interest by investors to determine if
the country is safe for investment and
II. Knowledge of the security situation of the host communities to determine the safety of
lives and property of the oil company.
 CHAPTER 4
CONCLUSION

4.0 Summary and Conclusion

This study has shown the risks investors face in the oil and gas sector and has provided
techniques that could be used to mitigate some of these risks. As stated in the first chapter of the
study, the primary reason for this research is the price volatility in the oil market and therefore
much detail was put into the risk mitigation technique that tackles this aspect. The study talked
about risk, the history of risk management and its transition into the oil and gas sector. It also
gave an insight on the instruments used for risk management in general.
Also, the study was able to show why the risks in the oil and gas sector are different from the
risks in other economic sectors. However, the study also showed that just like in other sectors,
hedging can be used as a risk mitigation technique in the oil and gas sector. The research also
argues that the mitigation of prospect and contract risks is tied to technological breakthrough and
company policies respectively. Finally, other techniques were suggested to mitigate the risk of
operational hazards, political and security risks respectively.
In conclusion, the study shows that as long as the concept of hedging through derivatives is
applied effectively as well as the other risk mitigation techniques discussed in the previous
chapter, oil companies can reduce their level of exposure to the risks faced in the oil and gas
sector.
 CHAPTER 5
RECOMMENDATION

5.0 Recommendation
In order for investors in the oil and gas industry to reduce their level of exposure to the risks in
that plague the sector, the risk mitigation techniques have to be understood and implemented
appropriately or there would be dire consequences. Given the effect the recent plunge in global
oil price has on oil companies across the world, some argue that the use of derivatives is not an
effective enough tool. However, the present woes of the oil companies can be attributed to
ineffective use or the implementation of the wrong mitigation techniques to absolve them from
the price volatility risk.
Also, oil companies should avoid investing in politically unstable countries. The experience of
international oil companies in the Middle-East during the first oil shock should serve as a lesson
to investors looking to invest in politically unstable regions.
Finally oil companies should ensure that they are up to date with the technological trend as this
can help mitigate the prospect risk and minimize the possibility of operational hazards. The
researcher also suggests that further research needs to be carried out to determine the appropriate
risk management techniques to be applied to the prospect and contract risks.
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