4 Common Pitfalls in Oil & Gas Financial Modeling and How to Avoid Them
With the financial distress that has plagued the oil and gas space over the past few years, it has become crucial to ensure that financial projections are as accurate as possible in order to have a thorough understanding of a company’s financial condition. The following points detail some of the common mistakes that are made in oil and gas financial modeling and the impacts these can have on a company’s projections.
1. Lack of risking of production volumes.Financial projections are typically based upon production forecasts which come directly from a company’s reserve report. Frequently, the projections will fail to adjust for unexpected downtime due to maintenance, weather, fires or other natural disasters. As a result, financial projections will tend to overstate projected production volumes. Although the actual impact can vary widely, unexpected downtime will usually result in actual production which is in the range of 5% lower than projected volumes.
2. Inaccurate forecasting of fixed vs. variable operating costs.Companies may forecast operating expenses as 100% fixed or variable without separating and forecasting the fixed and variable components independently. This will typically lead to forecasting issues when sensitives are run on production volumes and can result in overstating or understating operating expenses depending on how these have been modeled. The best approach is to look at historical operating expenses in the Lease Operating Statements and separate the fixed and variable components then model these independently on a per well or per unit of production basis.
3. Excluding the impact of minimum volume commitments.These are production volumes that E&P companies are contractually obligated to deliver. If the volumes do not meet the contractual threshold, a company will be required to make a cash payment for the difference. Ensure financial models are properly set up to account for contractual payments that will be required if volumes are below the required threshold. Pay special attention to scenarios where declining production volumes can trigger payments on minimum volume commitments in future years.
4. Inaccurate forecasting of ad-valorem taxes.Ad-valorem taxes are paid based on the value of oil and gas reserves; however, these are frequently forecasted on a percentage of revenue basis. These taxes should be relatively fixed in nature and should not vary based on increases or decreases in revenues due to changes in factors such as pricing. Forecasting ad-valorem taxes based on a percentage of revenue can lead to understating projected costs when downside sensitivities are run on pricing.
Although it might be a little more time consuming, it is important to take the time to model each of the items above accurately. An error in modeling one of these areas may result in financial projections that materially misrepresent the profitability and financial health of the company in question.