A comparison of the business prospects of two energy companies facing similar risks
by Jeffry Ocay
Every business endeavour always demands preparedness in managing certain risks. The term risks in business refers to factors causing a company to lose revenue or cease its operation (Chapman & Ward, 2003). But in 2009, the International Organization for Standardization (ISO) adopted a standardized definition of risk, which means the ‘effect of uncertainty on objectives’ (Lark, 2015). This implies that perceived risks have the potential of a positive and/or negative impact on business, depending greatly on how these are managed. For example, innovation is one of the most common business objectives. However, some thriving companies might have not felt the need to act on this objective when the market place was yet comfortable with traditional processes. But as we propel into the age of technology, competitors that use cutting-edge nanotechnologies in the oil and gas industry for instance, are emerging. While this competition risk has the potential to crash unprepared companies, it becomes an impetus of action to those that have management strategies in place (Filippov, 2011). Hence, risk management strategies in business operations that conform to set standards are an essential determinant of a company’s success toward a long-term enterprise viability, profitability, and growth.
This essay intends to examine how companies develop their risk management strategies as outlined by the ISO, and how the utilization of these processes are impacting their business prospects. As a starting point, this essay briefly discusses the basic concepts of risk management, which includes its key principles and processes. Then, this proceeds with an introduction of two petroleum companies, which are the biggest players in the oil and gas industry in Russia, namely, Rosneft and Lukoil. Their similarities in profile, such as resources data, recent performance, and market activities are discussed. Then the essay continues with a comparative analysis of their risk management strategies. Finally, the essay draws a conclusion as to which company adopts a better, reasonable, and more comprehensive strategy that is aligned to the core concept of risk management: maximizing opportunities and minimizing potential losses for a business to thrive.
An overview of risk management
Risk management is not at all new concept. In fact, Nocco and Stulz (2006) clearly described how risk management processes have evolved over the past two decades. Back then, risk management in the business platform only focused on financial implications, inasmuch as business enterprises turn to insurance companies as safety net from hedging effects. Due to its limited scope, the risk manager was once viewed as a bottom-rank position in the corporate world. But things have greatly changed recently. The risk management functions are now spearheaded by a corporate senior executive with the position of Chief Risk Officer (CRO). Obviously, this is because risk management in business has now become an umbrella of interrelated factors, which include but not limited to the management of strategic risks, operational risks, and legal risks. In one way or the other, management of these risks have direct and indirect impact on the enterprise’s financial standing.
Management of risks is imperative for all companies, whether small-medium (SMEs) or large-scale enterprises. From birth and all throughout the existence, operations of businesses always involved risks. Enterprises in any industry, which face risks in a consistent and effective way, have the edge of being more productive, becoming more stable and profitable (Chapman & Ward, 2003; Lark, 2015).
Anchoring back to the standard definition of risks, uncertainty about everything that matters in the operation of business is the focal point in any risk management strategy. Thus, despite the element of a ‘lack of certainty’ of events and its consequences to business prospects, companies have the capability to predict risks (Lark, 2015; Knight, 1921), as they have to determine the risk domains that are relevant to the nature of the business. Should the perceived risks occur, the effects can be controlled through great and effective risk management.
There are two different strategies that companies can utilize in managing risks. The first uses a classified and regionalized method in addressing risks one at a time. The second one utilizes a method that collates all potential risks of the business enterprise and approaches these risks in a coordinated and strategic process. This strategy is called an ‘enterprise risk management (ERM)’ that when developed effectively, yields long-term advantage to companies (Nocco & Stulz, 2006; Sottilotta, 2017).
The key principles of a risk management strategy
According to Lark (2015), the ISO provides a set of 11 guiding principles in developing a strategic risk management process, which can be condensed as follows:
- It is adopted as an integral component of an organization that plays an important part in a decision-making process by addressing areas of areas of uncertainties and assumptions.
- It is structured systematically with transparency and inclusiveness based on the best information available.
- It considers the welfare of the people.
- It is dynamic, iterative, and responsive to change for improvement, based on the findings from periodic re-assessment.
- Expenditures to mitigate risks must be lesser than the financial consequence of not doing any action.
The risk management process
As outlined by the ISO, creating and implementing a risk management strategy typically involves three fundamental stages that follows the virtuous circle of ‘Plan-Act-Evaluate’ concepts (Ephraim & Marois, 1996). The planning stage involves three processes. First, the company establishes the contexts of the risk management strategy to be developed. Context simply refers to the perceived risk domains or areas that the company determines to focus on based on its varying needs.
Second, the company identifies specific potential risk factors in each domain. For example, in the operational risk domain, the company identifies specifically a risk related to failure to meet market demands due to potential shortage of resources or manpower. The specific risks are clearly defined and described, in the lines of questioning as to what, how, and why circumstances can be a threat, or an opportunity of the company. Prioritization shall follow, by assessing and analysing all identified risk factors as to the degree of their effects and their probability of occurrence.
Finally, the most important step in the planning stage is outlining a set of actionable plans. The plan of actions is categorized into four: avoidance, retention, reduction, and sharing of risks. Avoidance of risk simply means not doing something that entails a risk. For example, a company is expanding and is contemplating on the need to purchase a parcel of land for that purpose. This action poses potential financial risks due to a very high value of land. When such company finally decides not to proceed with land purchase, it’s a typical example of avoidance of risks. On the contrary, if the purchase is pushed through, the company is applying retention of risks management. It accepts the financial loss at the start and proceeds with tightening the budget and expenditures to recuperate. On the other hand, reduction of risks is observed when a company involved in hazardous materials strictly implements safety standards. The financial implication or severity of loss is reduced through prevention of untoward accidents. Outsourcing and purchasing insurances are an example of sharing of risks.
The second and most important stage in a risk management strategy is implementation of action plans, should the perceived risks actually occur. This is precisely the reason why a risk management strategy has to be considered as a part of the decision-making process, so that when risks surface, an organization can easily decide to implement an appropriate plan of action.
The third stage involves steps of monitoring and evaluating the implemented actions. Perfecting a company’s risk management strategy necessitates the plan to be applied and tested in an actual risk situation so the action plans are evaluated for effectiveness, and areas of improvement are determined.
Now that the fundamental concepts of risk management have been tackled, I will now proceed with relating these concepts into practice by exploring the risk management strategies of two oil and gas companies in Russia, namely, Rosneft and Lukoil. Both companies have identified their risk domains. In each domain, several specific risk factors are identified. However, for the purpose of doing comparative assessment as to how these companies manage the same risks, the essay discusses the same areas that are given attention by both companies.
Rosneft has been operating successfully for over two decades now. This company is majority-owned by the Government of Russia. It is recognized as one of the biggest and top players in the oil and gas industry in Russia and worldwide. Although the headquarter is located in Moscow, Rosneft is expanding business operations in approximately 60 regions in Russia, and in more than 30 neighbouring countries, offering not just quality product and services, but also great opportunities for employment (Wardany, Bierman & Stanley, 2017). As of 2014, Rosneft has more than 260,000 people (Rosneft, 2017).
In terms of resources, Rosneft has extensive hydrocarbon reserves. As shown in Figure 1, while many companies are declining, Rosneft’s hydrocarbon production continues to grow over the past 10 years (Rosneft Annual Report, 2015). In fact, based on the audit and estimates conducted by DeGolyer & MacNaughton, Rosneft’s hydrocarbon reserve is sufficient to support production for approximately 20 years.
Additionally, Rosneft displayed a very striking financial performance, especially in 2015, when Russia was in a state of recession as a result of the collapse in oil and gas prices (Bloomberg, 2017; Chakraborty, 2017; Ambrose, 2016;). The net income of several petroleum companies dropped, but Rosneft managed to increase its income from the previous year (see Figure 2). Although part of its success was attributable to the fall of the U.S. currency, the increase in income of Rosneft amid the crisis is a clear indication of the company’s financial stability.
Moreover, just as any large company is expected to execute, Rosneft has put in place systematic plans and implements strategic activities that are essential to improve their business performance in the market and ensure long-term profitability. Most importantly, Rosneft recognizes the inevitability of risks in any of its business prospects and acknowledges the role of risk management.
Rosneft’s risk management program
Rosneft precisely applied the ISO risk management guidelines. As discussed in the following sections, the risks are clearly established, identified, assessed and analysed. Rosneft also ensures that each identified risk has corresponding plan of actions (Rosneft Annual Report, 2015). Rosneft also has focused on four risk domains, namely, industry-wide risks, financial risks, country and regional risks, and legal risks.
One of the risks identified is related to access to monopolized petroleum transport. In Russia, the transport of petroleum products is only made possible through the state-owned transportation and railway service companies, mainly JSC Transneft and Gazprom. Periodically, these companies increase their tariff, which is beyond the control of petroleum companies. Also, there is the risk that the operations of these transport systems are limited during uncontrollable circumstances. These factors may cause disruption in the normal export activities of Rosneft, thereby posing a risk to its financial status and the overall business performance. Recognizing the potential negative effect, Rosneft is making changes to its transport flows and maintains flexibility to adjust schedules in transporting products and supplies depending on market demands.
Another aspect the company looks into is related to its own resource reserves. Rosneft understands that the quantity of its reserves is determined based only on estimates done by their oil technology consultant. So this poses the risk of failing to achieve optimum production and sales as the estimation is really not an accurate. Although Rosneft has an extensive resource reserves that can be utilized in the event of shortage, the company is not neglecting this risk. Thus, it ensures that quality information is made available to consultants to minimize the discrepancy in estimation. Moreover, it continues in exploring for potential additional reserves.
Additionally, although Rosneft is a global leader in oil and gas industry, it still considers the risk of competition. The oil and gas industry is one of the businesses that has the strongest competition in Russia. When a number of companies are emerging, the risk of limited access of some companies to new hydrocarbon sources arises. To prevent this from happening, Rosneft continues to do geographical diversification of the distribution of products. The company believes this is the most effective strategy in minimizing the financial loss due to competition risk. At the same time, it maximizes potential gains in other regions and countries that might have lesser competitors. Also, the company enhances its refineries and redefines the processes to meet the market demands. Moreover, the company develops strategies for ease of access to filling stations though electronic cards. This is the trend now, and Rosneft has made quick adaptation to capture more clients (Trickett, 2017; Kramer, 2016).
The risks that Rosneft identifies as having direct impact on the company’s financial standing includes volatility petroleum products prices, fluctuation of international currencies, changes in interest rates, and inflation. In general, these risks are obvious risks that the company is exposed to due to the fact that the business operates globally. Thus, changes in the global market can directly affect the company. In this connection, Rosneft continually observes trends in foreign exchanges to be able to act timely. The company can apply natural hedging effect should the issues arise. Additionally, to mitigate the effects of inflation for one, the company has prepared alternative sources of materials, equipment suppliers, and contractors.
Country and regional risks
Because Rosneft operates globally, the company is predisposed to risks involving foreign policies. Should issues arise, Rosneft’s course of action is dependent on the actual situation. Definitely, the company will continue to work closely with executive authorities to resolve issues while maintaining its operations and controlling financial losses.
Several legal standards are in place to control the operations of petroleum businesses, especially that this involves international relations that may trigger conflicts among countries. Moreover, the nature of business involves handling of chemicals that can be detrimental to the people’s health and the environment. Hence, Rosneft acknowledges that these laws may threaten the company’s operations. In order to respond to this risk, Rosneft established a team of specialists who actively partake in the development and any amendment of laws. This team interacts with lawmakers so that the company’s standpoints shall be taken into consideration. Moreover, the company ensures compliance with the laws on industrial and environmental safety to avoid repercussions.
Lukoil is another leading petroleum company based in Moscow, Russia. It has a close similarity with Rosneft in the terms of location and geographical activities, company size, resources, recent performance in the industry, and market activities. Lukoil has over two decades of success in business. It is managed by independent, private investors, as opposed to Rosneft. Like Rosneft, Lukoil operates globally, employing over 110,000 people (Lukoil, 2017; Overview of Lukoil, 2017).
Although the quantity of its hydrocarbon reserves is quite lower than Rosneft, it is important to note that it is still greater compare to other competing companies. Lukoil’s reserves still has an estimated span of 20 years in production. Also, Lukoil was the sole company that performed similarly with Rosneft during the oil slump in Russia in 2015 (Lukoil, 2017; Johnson, 2011).
Like Rosneft, Lukoil envisions to preserve the status quo and strengthen its position in the market. Thus, it continues to innovate toward seamless operations through state-of-the-art technologies (Alexandra, Konstantinovna & Isaakovich, 2015). It also strives to maintain financial stability by developing more upstream projects, endless prospecting, exploration, and production of more resources, and enhancing product marketing strategies domestically and internationally.
In what follows, I will present some important points of Lukoil’s risk management strategies to address the same risks identified by Rosneft. Since the same risks are already described in detail in the previous sections, the essay discussions directly focus on the specific risk management actions that Lukoil has identified.
Lukoil establishes a very detailed action plan to manage risks related to transportation of petroleum products. The plan includes the following: ending those long-term transhipment agreements so the company can proceed with diversification of export lines as the need arises; increasing product supply volumes to the company’s terminals; using alternative transport system, such as through rivers, to cut costs of railway transport; and maintain close partnership with monopolies to potentially increase transfer output.
To minimize any negative effect of changes in product prices, Lukoil is setting up systems specific to a certain issue. For example, it uses a commodity supply management system in order to respond quickly to changes in the market. One unique risk management that Lukoil has in place is the liquidity management system, which includes an ‘automated system of concentration and re-distribution of funds, corporate dealing, and cash flow rolling forecasts.’ These are being monitored regularly to ensure that responses to any changes can be done quickly.
Lukoil’s action plan when facing country-related conflicts is also aimed at maintaining operations and limiting loss. However, in the event that the situation worsen, Lukoil has outlined a ‘crisis response’ initiative which includes ‘cost saving, optimization of the investment program based on the new conditions, equity drawdown, and invite partners to share project risks’ (Liuhto & Majuri, 2014).
To be effective in addressing legal risks, Lukoil ensures that they do constant monitoring for any changes in customs policy, and law amendments, and assesses the potential effects of any change to its business operations. It also ensures that the company is well-represented in legislative discussions. Moreover, the company also give importance on the health and welfare of its people by complying with health and safety standards (Lukoil, 2015).
Risk of terrorist attacks, wrongful acts by third parties
This part of Lukoil’s risk management program is unique and impressive. Because the number of terrorist attacks are increasing worldwide, the company considers the risk that these actions impact on its business operation. As a result, Lukoil established set of actions to manage this risks, such as, active participation in events initiated by the National Anti-terrorism Committee of Russia, the RF Federal Security Service, the RF Ministry of Internal Affairs to help suppress terrorism; identifies individuals who might be inflicting harm to the company’s assets intentionally; implements the Information Security Program and carry out activities to enhance information security, such as acquiring licenses to use encryption-based information security tools (Bierman, 2016).
This essay examined how companies develop their risk management strategies as outlined by the ISO, and how the utilization of these processes impact their business prospects. It began with a brief discussion on the basic concepts of risk management and then proceeded with an introduction of two petroleum companies, which are the biggest players in the oil and gas industry in Russia, namely, Rosneft and Lukoil. This is followed by a comparative analysis between these companies in terms of their profile and risks management program.
The essay has found out that Lukoil is better than Rosneft in terms of risk management program, inasmuch as Lukoil has a detailed and specific action plan. In addition, Lukoil’s risk management program appears to be unique in the sense that it considered other risks that cannot be found in Rosneft’s risk management program. The essay also found out that Lukoil has a liquidity system which is not considered by Rosneft.
However, both Lukoil and Rosneft’s risk management programs have complied with the standards set by ISO. Lastly, both Lukoil and Rosneft considered similar risks, except the ones just mentioned.
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