Enterprise DFA™
Application of Dynamic Financial
Analysis in the Oil Industry
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Discussion Outline
Background
Oil Company Imperatives
Problem Diagnosis
The Application of DFA
The Opportunities for Actuaries
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Background
Stochastic Financial Modeling Not New
Significant Academic Interest
Standard in 1970’s Finance Texts
Promoted Heavily by IBM et a
Did Not Gain Wide Acceptance in Practice
Miscast as Predictive Tool
Difficult and Expensive to Implement
Measuring / Understanding Risk Not
Valued
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Background
Considered Evidence that Long Term
Forecasting Was Not Practical
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Time
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Background
New Focus in Investment Management
Earnings Growth Was Theme
Results Now Handicapped on Risk
New Pressure From the Market
Earnings Predictability
Managing Analysts’ Expectations
Managements Search for Tools to
Understand / Manage Earnings Volatility
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Oil Company Imperatives
Large Oil Company’s Stock Under
Performing
Management Believed It Undervalued
Earnings “Surprises” Had Hurt Values
Perceived as High Risk Company
Board Losing Confidence in Management
Huge Bets on High Risk Projects
Unsure How Risks Managed
“We Going to Lose the Ranch?”
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Oil Company Imperatives
Project Undertaken to Evaluate Earnings
and Business Risks.
Objectives Included:
Understand Earnings Forecast Failures
Communicate Risks to Board
Change Market’s Perception of Company
Risk
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Problem Diagnosis - Forecast Failures
EPS Forecasts Only Compiled by
Corporate
No True Enterprise Model
Roll Up Of Divisional Forecasts
Tied to Business Planning / Challenge
Process
Significantly Different Risk Levels / Drivers
Each Used its Own Economic Assumptions
Forecasts were Deterministic Point
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Problem Diagnosis - Board
Investment Project vs. Enterprise Focused
Analyses - Complex Issues
High Detail - Low Information
Lack of Context and Comparability
No Enterprise Level Conclusions
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Problem Diagnosis - Market
Market Perceived Company High Risk v.
Competitors
Reinforced by Earnings “Surprises”
Low Appreciation for Risk Hedging
Programs
Resulted in Lower than Market P/E
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Application of DFA
Project to Address Issues Using DFA Type
Analysis
Enterprise Level Financial Model
Developed - Tied to Corporate Plans
High Impact Variables Identified
Assumption Variability from Key Executives
Disaggregation Analysis
Competitive Analysis
Board Presentations
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DFA Methodology
Enterprise Model
Common Environmental Assumptions
Economic - Common for All SBU’s
Non Management Controlled Issues
Corporate Financial Leverage
Strategy Based Management Assumptions
Business Unit Based
Probability of Strategy Implementation
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Enterprise Model Structure
DFA - Methodology
Exploration /
Production
Economic Environment
- Weather
- Economic Growth
- Supply Constraints
- Spot Market Prices
Refining /
Marketing
Management
Interventions
Chemicals
Coal / Power
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Common Environmental Assumptions
DFA - Methodology
Economic - Non Management Controlled
Energy Price / Demand Drivers
» Weather
» Economic Growth
» Supply Conditions
Capital Markets Conditions
Corporate Financial Structures
Financial Leverage
Hedging / Market Risk Control
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Business Strategies
DFA - Methodology
Exploration / Production
Profitability of Existing Production
Success of Exploration Opportunities
Project Selection / New Market Growth
Refining & Marketing
Sales Growth in High Value Fuels
Expansion in High Growth Markets
Shut Refining in Low Growth Markets
Reduce Unit Expenses
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Business Strategies
DFA - Methodology
Chemicals
Reduce Unit Costs
Redesign Major Processes
Commercialize New Technologies
Coal, Minerals & Power
Increase Facility Utilization
Mine Expansions
Expand Electric Power Business
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Earnings Forecast Failures
DFA Results
x
Earnings per Share
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Consolidated
Forecast
Earnings Forecast Failures
DFA Results
Capital Requirement
Aggressive vs. Most Likely Assumptions Used in Forecasts
Expected Value
x
x
Consolidated
Forecast
95% Confidence Level
0
100
Earnings Per- 18Share
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Communicate Risks to Board
DFA Results
Financial Leverage Added High Risk and Small Earnings Gain
Expected Value
x x
With Leverage
Without Leverage
Earnings per
Share
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Communicate Risks to Board
DFA Results
Businesses Differ in Risk - Exploration Forecasts Aggressive
Refining /
Marketing
x
x
Coal
x
Exploration/
Production
0
Earnings per- 20Share
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x
Chemicals
Communicate Risks to Board
DFA Results
Energy Market Price Greatest Risk Source
Base Strategy
x
x
0
Earnings per- 21Share
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Hedge All Price Risk
Communicate Risks to Board
DFA Results
Strategies to Lower Costs Had Small Impact on Risk
x
0
Earnings per- 22Share
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Market Perception of Risk
DFA Results
Client Had Lower Risk than Most Competitors
Comp. C
Competitor B
Competitor A
Client
0
Earnings % of
Revenue
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Opportunities for Actuaries
Risk Analyses are Central to Industrial
Managers
DFA Type Analysis is High Value Added
Actuaries Must Expand beyond
Technicians to become Strategists
If Actuaries Don’t - Others Will
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Preliminary DFA Results
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