"Economic Capital Optimization" (ECO) provides a comprehensive methodology to improve a firm’s expected long-term growth while reducing its risk. This framework adapts and extends proven economic capital methodologies developed in the financial services industry to address both the similar and unique financial issues facing oil companies.

Economic capital is the capital a firm must maintain to sustain long-term growth by covering short-term and long-term needs or losses. For sustainable growth, a firm must have the capital to support the operations that create economic value, despite anticipated and unforeseen shortfalls in cash flow or changes in business cycles. Insufficient economic capital can disrupt a firm’s operations, destroying value and eventually leading to potential default. Overcapitalization or poor allocation of economic capital can lead to corporate returns and growth that fail to meet investors’ expectations.

Optimizing economic capital requires properly aligning a firm’s capital structure, strategies, capital allocation process and risk management practices to maximize long-term growth. ECO provides a practical framework for examining the interdependencies among these components and for understanding how each impacts the long-term success of the organization.

This paper discusses the concepts behind ECO and its practical application in the oil industry. This paper also will demonstrate how an oil company can improve its expected long-term growth by applying the ECO framework to more effectively allocate economic capital among business units or projects, to adjust its economic capital to meet long-term strategic needs, and to better manage its risks.

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