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Energy Supply Forecasting: a Commercial Perspective
presented by GP Saha and TG Montague, Ernst & Young, PO Box 490, Wellington, New Zealand,
at the 1998 New Zealand Petroleum Conference
The Energy Supplier in an Uncertain Environment
Oil and Gas Supply Perceptions
Implications for Energy Suppliers
Abstract
This paper discusses key issues and challenges that energy suppliers face in the deregulated energy markets. The approach taken in this paper takes the perspective of an energy supply firm. First, a discussion on the asset risks faced by energy suppliers in more uncertain deregulated energy markets is presented. Second, an examination of some of the reasons why available capacities tend to be underestimated in many supply forecasts. Finally, some of the implications of uncertainties in supply forecasts on the firm's strategy are evaluated.
The key conclusions of our research presented in this paper are:
- Financial risks associated with energy supply assets have increased in the recent past with the deregulation of energy markets and the resulting commoditisation of energy products.
- The difficulty in estimating the extent of oil and gas resources has less to do with forecasting methods than assumptions based on incomplete and less reliable information. The tendency to underestimate oil and gas supplies results more from the difficulty in assessing existing capacity than new greenfield capacities.
- While electric power systems are different from oil and gas fields, power supply forecasts seem to have similar difficulties in estimating future supply capacity as in oil and gas. As in oil and gas, a number of power supply forecasts have predicted capacity shortages based on the assumed relationships between current prices and the cost of adding future capacity. Experience shows that such assumptions are unreliable because of the declining cost of incremental capacity over time.
- Firms cannot predict the market future but can help shape it. The ability to react to changing supply conditions is a critical competitive advantage. International experiences in managing energy supply firms show that the ability to react depends on implementing business systems, information processing, commercial risk management and management structures that facilitate timely decision-making.
Introduction
Energy investments within New Zealand are largely driven by perceptions regarding energy supply and prices, be they gas reserves or power plants. Both public and proprietary forecasts are highly influential in creating these expectations.
This address examines the historical tendency for forecasters to underestimate supply capacity in both the fossil fuel and electricity industries and discusses the implications for energy suppliers operating in New Zealand.
Approach
Our approach emphasises the perspective of the firm. First we will discuss the asset risks faced by energy suppliers in an uncertain world. Second, we will examine possible reasons why available capacities tend to be underestimated in many supply forecasts. Lastly we will consider the implications of forecast uncertainty on the firm's strategy.
The intent is to provide an overview. Given the time constraints, our analysis cannot consider all the factors convergent on a supply forecast. We will refrain from detailed discussions about forecasting methodologies. The aim is issues not mechanics.
For the purposes of our discussion, "supply" means sustainable annual supply as opposed to daily or seasonal peaks. While short term shortages due to random events can influence the cash market (and forecasters) for a year or more, they soon become apparent as temporary phenomena.
The Energy Supplier in an Uncertain Environment
Holding energy supply assets such as gas fields or power plants carries a substantial risk. On the balance sheet, the value of reserves and/or capacity can fluctuate due to either market or technical factors. This risk has increased substantially in recent years with the commoditisation of energy products (such as natural gas and electricity) and resulting oscillations in prices. Reserve and capacity estimates are also subject to revisions due to natural variations in resource grade or equipment degradation.
On the cash flow side, holding energy supply assets also exposes the firm to value erosion, either from newer and lower cost capacity or from lower cost substitutes. This results in reduced operating margins, cash flow, and returns.
In response to this increased risk, firms strive to make better decisions through more timely and ongoing update of relevant information. Economic forecasters and business analysts have been under increasing pressures to "pick winners." However, history shows that it is extremely difficult to predict supply or price with a large degree of accuracy.
Oil and Gas Supply Perceptions
Oil and gas supply has proven an enduring enigma. However, it is fair to conclude that forecasts have underestimated the extent of oil and gas supplies. As an example, Figure 1 shows the estimates for the ultimate recoverable gas reserves for the Alberta portion of the Western Canadian Basin over the past 30 years. Note that the projections have doubled during this period, despite record annual production levels over the last decade. In New Zealand, an example would be the Kapuni Field where the ultimate recovery has increased from 250 BCF in 1960 to 1.2 TCF in 1997.
Our analysis suggests that the difficulty in estimating the extent of oil and gas resources has less to do with methods than assumptions based on incomplete and less reliable information. The forecast distortions generally result not from factual errors but from drawing the wrong conclusions from valid observations.
For example, many oil analysts have noted that the number of new giant fields has declined significantly since the 1960s (Figure 2). Analysts also note that oil production per well has declined in the USA as well as in OPEC countries such as Iran and Indonesia.
While these observations are accurate, the implications are often deceptive. For instance, the decline in oil production per well would logically suggest an increase in production costs per barrel. However, the statistics show that oil lifting costs have decreased even in mature production areas like the USA (Figure 3). Similarly, the dearth of new giant oil fields has not resulted in a decline in oil reserves (Figure 4). Even more surprising, oil reserves increased the fastest during a period of falling real prices!
Figure 2. Source: The Economist, BP.
Based on the explanations accompanying many forecasts, the tendency to underestimate oil and gas supplies results from the difficulty in assessing existing capacity rather than new greenfield capacity.
First there is latent capacity. This represents the reserves hidden from official statistics in technical details such as recovery factors or due to commercial sensitivity. According to Stratoil, recovery rates from existing fields on the Norwegian shelf have increased from 34% to 41% over the last decade. Recovery rates are forecast to improve to 50% by 2005. So the initial reserve estimates contained a sizeable portion (almost 50%) of latent capacity awaiting exploitation.
Another factor is capacity creep. This represents the tendency for existing reserves/capacity to increase due to incremental investments in new capacity. A typical example is the Maui Field, which has increased its oil reserves and production through developing deeper reservoirs (D and F Sands) from the Maui B platform. Such incremental additions are commonly far more economical than new field developments. In the case of certain LNG facilities, the US Department of Energy cites the costs of incremental liquefaction capacity (US$0.50 per million Btu) that are orders of magnitude lower than for new greenfield facilities (US$250/million Btu).
Figure 3. Sources: Independent Petroleum Association of America (IPAA), Texaco Annual Report, Exxon Annual Report.
Figure 4. Source: BP.
Thus, reserves and capacity are commonly more fluid than official figures suggest. The difficulty in assessing the impact of market behaviour and new technology make supply projections inherently difficult.
Power Supply Perceptions
The power generation industry has traditionally operated under a regulated regime quite different to oil and gas. With deregulation, power is now becoming a commodity like other energy products. This new competitive environment has increased the hazards of forecasting generation capacity.
Power systems are different. While there is effectively no inventory to consider, systems have largely been designed to meet the maximum peak demand. Planners and forecasters must consider auxiliary factors contributing to system stability such as spinning reserve and unique weather factors and its impact on hydro availability.
Regardless of these differences, power supply forecasts seem to have the similar difficulties in estimating supply capacity as in oil and gas. The market pull of new technology and push of competition make capacity far more dynamic in the medium term than under the old regulatory regime.
Power plants have displayed similar tendencies for latent capacity and capacity creep. Figure 5 illustrates the dynamics of power supply in the MAPP region of North America. In this figure the number of power plants (and units) is constant, but increased plant utilisation (resulting from new maintenance procedures) and the renegotiation of old coal contracts significantly increases capacity and lowers marginal costs.
Similar trends are evident in New Zealand. Electricity Corporation of New Zealand (ECNZ) reports their cash generation costs have fallen 14% over the past five years through dam refurbishments (effectively increasing the output per volume of water), thermal plant upgrades and process re-engineering.
As in oil and gas, a number of power forecasts have predicted capacity shortages based on the assumed relationships between current prices and the full cost of adding capacity. Experience suggests that such assumptions are unreliable because of the declining cost of incremental capacity over time.
Figure 6 shows the historical increase in thermal efficiencies of gas turbine combined cycle (GTCC) systems and a corresponding decrease in the installed cost (Electric Power Company contract cost) per kW. While Figure 6 is simplified (both the efficiency and unit cost depend on the size of the turbine units), it illustrates that technology has reduced the cost of capacity by 15% in only nine years. This means that new plants can significantly undercut the value of plants constructed only five years previously.
Efficiency gains are not always gradual. Historical trends show that introducing new generation technologies can lift capacity efficiency, thereby lowering costs. We note also that improvements in specific technologies tend to decline with time.
Figure 7 shows the improvements in performance of different power systems. There is no reason to assume such improvements will not continue.
Figure 5. Source: Hill and Associates.
Figure 6. Sources: ABB and Ernst and Young.
Figure 7. Sources: Shell, Ernst and Young.
Implications for Energy Suppliers
The future holds excellent opportunities for energy suppliers. The difficulties in forecasting supply illuminates several strategic issues.
Firstly, firms cannot predict the future but can help shape it. The ability to react to changing supply conditions is a critical competitive advantage. International experience in managing energy supply firms show that the ability to react depends on implementing business systems (intelligence, communication and data), information processing, commercial risk management, and management structures that facilitate timely decisions.
Secondly, investments in new capacity should focus on cost and technology changes. This, in turn, should stimulate engineering innovations. The risks of investing in relatively high cost reserves or capacity are simply too large to trust to future price rises.
Thirdly, better decisions result from eliminating bad ideas and myths. Firms should consider some periodic external review to question old dogmas.
There are opportunities for profitable new energy supply projects; the challenge is to make them work.
Authors
Dr Govind Saha is a Partner in Ernst & Young, Wellington, New Zealand. Dr Saha is the Director of the Strategy Consulting Division and also the head of the energy consulting group. Dr Saha specialises in providing energy consulting assistance to firms in the electricity and oil and gas sectors while undergoing significant changes in their market structures and regulatory environments. Dr Saha has a PhD in Engineering from the University of Auckland and an MBA from the Victoria University of Wellington.
Ted Montague is a Senior Manager in Ernst & Young's energy consulting group. Mr Montague specialises in energy consulting assistance to clients in the electricity and oil and gas sectors in the areas of pricing, regulatory strategies and cost analysis. Mr Montague has a Masters degree in Geology from the University of Canterbury and a Masters degree in Mineral Economics from the University of Colorado.