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Top risk for oil and gas industry

Easily-recoverable oil reserves are a thing of the past, and oil and gas companies have little choice but to turn to unconventional sources of fuel such as shale oil and ‘fracked’ gas; and to look in places where a few decades ago oilmen would never have contemplated.

The majors are now drilling for oil at incredible depths and in extremely difficult physical environments such as the Arctic, hoping to make the next big find, making use of the latest advances in engineering and no little cunning. But the search for hidden treasure comes with a litany of risks.

The main reason there isn’t more deep-water drilling right now is not risk-averseness but the economic barrier that comes with lower oil prices.

In April 2010, an explosion on the deep water drilling rig Deepwater Horizon precipitated the largest oil spill in the history of the industry at the Macondo field, just off the U.S. Gulf Coast. The ensuing oil spill was the largest in history, and led many countries to tighten regulation on deep water drilling.

Memories of the Macondo spill still loom large over C-Suite executives. When we polled top executives from across the energy sector earlier this year on the risks they see defining the coming decade, business leaders from the oil and gas industry overwhelmingly pointed in the direction of operating in difficult physical environments.

In time, the Macondo spill will likely come to be seen as an unfortunate accident and an important learning experience for the industry. And, in fact, the main reason why there isn’t more deep-water drilling happening right now is not risk-averseness but the economic barrier that comes with lower oil prices. The cost of drilling and building permanent infrastructure at huge depths, and the cost of transporting hydrocarbons from remote locations, means that a sub-$50 barrel of oil makes deep water projects difficult to justify, especially given the current regulatory environment in many countries.

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With a higher oil price, deep water drilling is likely to become more attractive, even in incredibly difficult environments such as the Arctic. In doing so, they are going to have to be incredibly careful, especially given that many oil majors often self-insure a proportion of their projects. That means the focus will be on risk mitigation, as well as risk transfer.

There is good reason to be optimistic about the future of deep-water drilling and exploration, in places like the Arctic. The industry has learned from Macondo with some firms even deploying two rigs at a time in tricky deep water plays.

Oil and gas firms are also incredibly innovative. The industry’s ability to overcome problems and work in new environments never ceases to amaze. A decade ago, deep-water drilling meant working in 1,000 meters of water. Today, it means drilling subsurfaces at a depth of 3,000 meters. In another decade, that’s likely to be commonplace.

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The Continuing Rise of Alternative Investments

Rising interest in alternative assets has been a prevailing trend over the last five years. Many now see student accommodation as a mainstream asset class – with nearly £6bn of investment last year. Meanwhile, the emerging build-to-rent sector will also receive its first tenants this year as schemes by Essential Living, Westrock and HUB open to the public.

Service stations, data centres and other such assets blur the lines between property and infrastructure. And what’s clear is that as investors continue to diversify from retail, office and industrial property, more opportunities will arise.

Since 2003, investment in alternatives has increased from 4.2% to 11.3% of investors’ property allocations.

In its 2015 report, ‘What Constitutes Real Estate for Investment Purposes? A Review of Alternative Assets’, the Investment Property Forum (IPF) said that since 2003, investment in alternatives had increased from 4.2% to 11.3% of investors’ property allocations. Many funds, such as L&G, have predicted this will rise to 20%.

The Risks of Diversification

Most investors agree that diversification is increasingly important for success. This is one of the main drivers of the increasing appetite for alternatives. But it isn’t without risk.

Although the office sector historically displays far more volatility than sectors more dependent on demographics and social factors, such as student housing, as an asset class, it is well understood. The lot sizes are also huge which makes them attractive for institutions who see little benefit in smaller scale transactions. This lack of stock has been one of the key barriers in establishing the Build to Rent sector, for example.

Unlike niche assets – such as marinas – the market for prime office or retail is also relatively liquid. That said, one of the biggest portfolios of marina changed hands last May when the Wellcome Trust acquired Premier Marinas from BlackRock for an undisclosed sum.

Irrespective of whether it’s a hotel, housing block or leisure park, operational risk is a much higher consideration across alternatives.

The IPF’s report said it was “a major distinguishing feature of alternative real estate assets” and indeed, it stands to reason that an office block rented in its entirety as a single bank will be simpler in many respects than a student housing block with 300 beds. Indeed, the skill sets for managing operational risk are entirely different from traditional asset management. This is why many investors – such as Round Hill and M3 Capital Partners – partner with premium operators who specialise in managing the company at the end of the chain.

The boundaries between operators and their investors routinely crossover. Yet the skill sets and management structures employed have a crucial role to play in defining just how much risk is acceptable.

Protecting Against the Risks

From an insurance perspective, there is an increasingly sophisticated market for protecting both the operational risk and the development or construction risk of alternatives.

Looking at insurable risks from a property owner’s perspective, insurers are generally comfortable with alternative asset classes as long as there is a clear dividing line between the operator’s and owner’s exposures.  For example, faced with student accommodation, insurers operating in the specialist real estate arena would expect any risks associated with the provision of pastoral care, leisure facilities and anything similar to be catered for under an operator’s policy.

Clearly, a high level of due diligence, focused research and market benchmarking is essential before entering new territory. But as demand drives up investment in new areas, the knowledge-base and familiarity we have will only grow. It’s worth remembering for instance, that retail parks never existed before the 1980s. Could there be a more familiar experience for many than a Sunday-morning drive to a local DIY emporium?