- 1 -

OMP 1

Enterprise DFA™

Application of Dynamic Financial

Analysis in the Oil Industry

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OMP 2

Discussion Outline

Background

Oil Company Imperatives

Problem Diagnosis

The Application of DFA

The Opportunities for Actuaries

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OMP 3

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 PracticeMiscast as Predictive ToolDifficult and Expensive to ImplementMeasuring / Understanding Risk Not Valued

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OMP 4

Background

Considered Evidence that Long Term Forecasting Was Not Practical

Time

Res

ults

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OMP 5

Background

New Focus in Investment ManagementEarnings Growth Was ThemeResults Now Handicapped on Risk

New Pressure From the MarketEarnings Predictability Managing Analysts’ Expectations

Managements Search for Tools to Understand / Manage Earnings Volatility

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OMP 6

Oil Company Imperatives

Large Oil Company’s Stock Under PerformingManagement Believed It UndervaluedEarnings “Surprises” Had Hurt ValuesPerceived as High Risk Company

Board Losing Confidence in ManagementHuge Bets on High Risk ProjectsUnsure How Risks Managed“We Going to Lose the Ranch?”

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OMP 7

Oil Company Imperatives

Project Undertaken to Evaluate Earnings

and Business Risks.

Objectives Included:Understand Earnings Forecast FailuresCommunicate Risks to BoardChange Market’s Perception of Company

Risk

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OMP 8

Problem Diagnosis - Forecast Failures

EPS Forecasts Only Compiled by CorporateNo True Enterprise Model Roll Up Of Divisional ForecastsTied to Business Planning / Challenge

ProcessSignificantly Different Risk Levels / DriversEach Used its Own Economic AssumptionsForecasts were Deterministic Point Estimates

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OMP 9

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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OMP 10

Problem Diagnosis - Market

Market Perceived Company High Risk v. Competitors

Reinforced by Earnings “Surprises”Low Appreciation for Risk Hedging

ProgramsResulted in Lower than Market P/E

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OMP 11

Application of DFA

Project to Address Issues Using DFA Type AnalysisEnterprise Level Financial Model

Developed - Tied to Corporate PlansHigh Impact Variables IdentifiedAssumption Variability from Key ExecutivesDisaggregation Analysis Competitive Analysis Board Presentations

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OMP 12

DFA Methodology

Enterprise Model

Common Environmental AssumptionsEconomic - Common for All SBU’s Non Management Controlled IssuesCorporate Financial Leverage

Strategy Based Management AssumptionsBusiness Unit BasedProbability of Strategy Implementation

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OMP 13

DFA - Methodology

Exploration /Production

Coal / Power

Refining / Marketing

Chemicals

Economic Environment- Weather- Economic Growth- Supply Constraints- Spot Market Prices

Management Interventions

Enterprise Model Structure

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OMP 14

DFA - Methodology

Economic - Non Management ControlledEnergy Price / Demand Drivers

» Weather» Economic Growth» Supply Conditions

Capital Markets Conditions

Corporate Financial StructuresFinancial LeverageHedging / Market Risk Control

Common Environmental Assumptions

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OMP 15

DFA - Methodology

Exploration / ProductionProfitability of Existing ProductionSuccess of Exploration OpportunitiesProject Selection / New Market Growth

Refining & MarketingSales Growth in High Value FuelsExpansion in High Growth MarketsShut Refining in Low Growth MarketsReduce Unit Expenses

Business Strategies

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OMP 16

DFA - Methodology

ChemicalsReduce Unit CostsRedesign Major ProcessesCommercialize New Technologies

Coal, Minerals & PowerIncrease Facility UtilizationMine ExpansionsExpand Electric Power Business

Business Strategies

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OMP 17

DFA ResultsR

even

ues

Earnings per Share

x Consolidated Forecast

Earnings Forecast Failures

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OMP 18

DFA ResultsR

even

ues

Earnings Per Share

x Consolidated Forecast

0

}

Capital Requirement

100

Earnings Forecast Failures

95% Confidence Level

x

Expected Value

Aggressive vs. Most Likely Assumptions Used in Forecasts

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OMP 19

DFA ResultsR

even

ues

Earnings per Share

Expected Value

xWith Leverage

Without Leverage

x

Communicate Risks to Board

Financial Leverage Added High Risk and Small Earnings Gain

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OMP 20

DFA ResultsR

even

ues

Earnings per Share

xx

x

Refining /Marketing

Chemicals

Exploration/Production

0

Communicate Risks to Board

x

Coal

Businesses Differ in Risk - Exploration Forecasts Aggressive

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OMP 21

DFA ResultsR

even

ues

net

of

Hed

ge

Earnings per Share

xBase Strategy

x Hedge All Price Risk

0

Communicate Risks to Board

Energy Market Price Greatest Risk Source

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OMP 22

DFA ResultsU

nit

Op

erat

ing

Cos

ts

Earnings per Share

x

0

Communicate Risks to Board

Strategies to Lower Costs Had Small Impact on Risk

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OMP 23

DFA ResultsR

even

ues

Earnings % of Revenue0

Market Perception of Risk

Client Had Lower Risk than Most Competitors

Client

Comp. C

Competitor A

Competitor B

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OMP 24

Opportunities for Actuaries

Risk Analyses are Central to Industrial Managers

DFA Type Analysis is High Value AddedActuaries Must Expand beyond

Technicians to become StrategistsIf Actuaries Don’t - Others Will

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OMP 25

Preliminary DFA Results