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(originally published by Booz & Company)


Taking a Chance on Oil

Currently, unrest in the Middle East, the diplomatic standoff between the U.S. and Iran, doubts about the intentions of President Hugo Chavez in Venezuela, and Russian supply disruptions lead traders to try to protect themselves by locking in oil prices, an activity that inevitably increases the price of oil. The high degree of uncertainty also has an economic component, as local and regional inflation, fluctuating currency exchange rates (not least, the declining value of the U.S. dollar), and the potential for rapid increases and declines in national economic growth rates influence the behavior of market players.

Using the Gold Standard
The conclusion, then, is that greater geopolitical and financial uncertainty translates into wilder fluctuations in oil prices. Armed with this information, companies can make better assumptions about the future price of oil when their planning initiatives call for them to do so. Although the uncertainty buffeting the price of oil is unavoidable, executives can recognize the risk involving the market trajectory of oil and determine their companies’ appetite for it by taking into account the uncertainty factor in the circumstances affecting investment decisions. For example, when an oil company decides how much to invest in upstream efforts such as exploration, it typically sets a future price for oil, the “hurdle” price, above which its investment will produce positive returns. The risk in such a decision rests in the probability that the price of oil will dip below the hurdle price, thus destroying the profitability of the investment. As the uncertainty of oil prices increases, planners must recognize that this uncertainty forces them into the position of taking on greater risk.

Taking uncertainty into account in decision making applies not only to oil exploration; the decision to build a new nuclear plant or a wind farm, for instance, should be driven by the same considerations — how likely is it that the price of oil will drop to the point where alternative energy sources are less competitive? Alternative energy players may well be willing to make investments in new technologies, betting that oil prices will go up and they will reap the rewards. At the same time, however, they are braving the possibility that prices may go down. The key is that they must be well aware of the dangers and plan their contingency scenarios accordingly.

The relative level of uncertainty in the price of oil also has consequences for downstream companies: The greater the uncertainty, the more important it is for these companies to optimize the supply chain in order to have product available when the price is high.

Similar considerations hold true for every company whose future profitability depends to some degree on the price of oil, from airlines to plastics. An auto company contemplating major investments in alternative technologies should tread carefully when the oil market is uncertain, because the risk is much greater that the price at the pump may drop to the point where the auto-buying public will decide that those new technologies aren’t worth the extra cost. When the price of oil is uncertain, any investment in fixed assets designed to reduce variable costs will have a bigger risk.

Making long-term investments based on the price of oil is, right now, very risky. Yet all companies must make such bets — and a better understanding of the role of uncertainty in determining oil prices, aided by an understanding of the correlation between oil and gold prices, can help them to do so. What’s critical, therefore, is to make sure that risks are calculated as carefully as possible given that such investments are probably more chancy than they have been in the past. In light of the ever-shifting circumstances in the world’s political and financial environments, every company needs to determine how much risk it is willing to take on.

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  1. Michael M. Hutchison, “Aggregate Demand, Uncertainty and Oil Prices: The 1990 Oil Shock in Comparative Perspective”  (PDF), Bank for International Settlements, Economic Paper No. 31, August 1991: A traditional analysis of the role of uncertainty in the price of oil.
  2. Oil Market Uncertainty Hampers Investment,” Pipeline magazine, August 20, 2007: An oil industry view of how uncertainty affects the future demand for oil.
  3. Crude Oil: Uncertainty about Future Oil Supply Makes It Important to Develop a Strategy for Addressing a Peak and Decline in Oil Production” (PDF), United States Government Accountability Office, Report No. GAO-07-283, February 2007: An effort by the federal government to predict when oil production will peak, given a wholly uncertain supply-and-demand future.
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