RISK APPETITE: A HUNGER FOR THE UNKNOWN OR STRANGLEHOLD ON GROWTH?

Abstract

The recent extreme volatility in the petroleum markets has introduced a level of volatile earnings for exploration and production companies (E&P) that has not been seen since the Gulf war in 1990–91. Many companies have reduced their hedging activity to increase exposure to rising oil prices and have consequently benefitted considerably. Rapid increases in oil prices historically have been followed by just as rapid decreases. Although oil prices are a key value driver for E&P companies so is exploration and development success, production variability, operational management, and, for companies who do not report in $US, foreign exchange rates. All these value drivers contribute to top line revenues and earnings so hedging oil price in isolation from other value drivers can have adverse financial consequences. The quarterly focus by investors of listed companies on meeting earnings targets/guidance creates the pressure for the board of directors of E&P companies to focus on the degree of earnings stability that is acceptable to the market. This is reflected by a company’s aversion to risk, or risk appetite. The collective management of the value drivers as a portfolio of risks allows companies to understand the potential for earnings variance, or earnings at risk during reporting periods. This, in turn, can provide companies with a degree of confidence in meeting earnings targets and the opportunity for companies to increase their transparency in terms of disclosure/communication of how effectively it is managing core value drivers of the business.