"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.
All companies are in the business of managing risk. Those that excel at it survive and prosper; those that manage risk poorly fail. Successful organizations must actively manage risk to create a competitive advantage over those that manage risk passively.
Over the last decade, a new generation of risk management practices has revolutionized the financial industry, enabling companies to control and manage risk while maximizing shareholder value. This new methodology was developed in response to the financial disasters of the 1990's and increased volatility in the financial markets. At the heart of this revolution is the practice of economic capital analysis. In a recent survey of over 200 financial institutions by the Economist Intelligence Unit and PricewaterhouseCoopers, almost 75% of respondents either had adopted economic capital analysis or planned to introduce it. The survey also indicates that a large number of companies outside the financial industry are beginning to adopt this methodology.
Economic capital is the lifeblood of an organization. If a company begins to deplete its economic capital, it suffers financially. Financial distress destroys shareholder value, forcing a company to meet its liquidity demands by monetizing assets or raising capital at a disadvantageous time, borrowing at higher interest rates, and/or discontinuing the execution of its strategy. If a firm exhausts its economic capital, the firm becomes insolvent and eventually dies.
A company can have a superior strategy, but if it has insufficient economic capital, a setback or down cycle eventually will force the firm to delay or discontinue execution of that strategy, and the expected value creation will be lost. Over the last few decades, many oil companies have started aggressive strategies during rising oil prices, only to curtail or exit them when prices fell. Their actions are tantamount to buying at high prices and selling at low prices, a practice that decimates shareholder value.