Roy Endré Dahl, Sindre Lorentzen, Atle Oglend, Petter Osmundsen Can oil price developments explain cost overruns in petroleum projects? Roy Endré Dahl, Sindre Lorentzen, Atle Oglend, Petter Osmundsen 11/26/2018

Introduction Development projects in the oil industry often have cost overruns The success rate in the petroleum industry is ~25% (Merrow (2011, 2012)) Projects undertaken on the Norwegian continental shelf perform worse than comparable projects undertaken in the Gulf of Mexico (Mishra (2014) ). Cost overruns lead to reduced profitability and sub-optimal resource allocation Poorly implemented projects require higher capital reserves and consequently increase the cost of capital

Causes of cost overruns? Optimism bias and strategic misrepresentation (Flyvbjerg et al. (2003)) Overoptimistic projects are chosen due to their underestimated costs and overestimated revenues (documented for public projects) Underestimating uncertainty and unrealistic ambitions create too optimistic estimates for project cost and progress (Norwegian Petroleum Directorate (2013) in a report on NCS investments) High turnover in project leadership (Merrow (2012)) What about “external” business cycle effects?

Research Question Can energy prices capture a common factor for cost overruns in petroleum projects linked to the business cycle? In periods of favourable energy prices, lack of capacity and expertise in a tight supplier market yield cost inflation and difficulties in managing projects Unrealistic ambitions and too optimistic estimates are likely correlated with the current business climate We study the quantitative effect of energy prices (oil and natural gas) on cost overruns in petroleum investments on the Norwegian Continental Shelf (NCS)

Data Data collected from the Norwegian Ministry of Oil and Energy based on approval of plans for development and operation (PDOs) and special permits for installation and operation (PIOs) The study considers 80 projects during the interval 2000-2013 Projects have estimates over several years, allowing us to compare cost estimates over time All cost estimates are inflation adjusted to year 2000 NOK values using the Norwegian index on inflation Cost overrun is the percentage difference between initial estimates and updated cost estimates during the project implementation

Average cost (thousand MNOK) Data 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 # megaprojects 2 3 4 5 7 8 6 11 13 16 # other projects 15 14 17 10 Total projects 18 20 19 22 24 27   Average cost (thousand MNOK) 6.5 4.1 4.5 4.2 8.5 7.3 8.3 10.6 10.8 10.5 13.0 14.0 16.1 20.0 Megaprojects >= 10 000 MNOK (1.2 Billion USD)

Decscriptive Statistics: Empirical Distribution

Decscriptive Statistics Mean/Median and Std. of cost overruns Conditional on % project completion All 0-25% 25%-50% 50%-75% 75%-100% 100% Mean 20.8 % 2.6 % 12.5 % 21.3 % 32.0 % 26.9 % Median 9.1 % 0.0 % 3.3 % 12.2 % 17.5 % 15.4 % Std. 43.4 % 8.2 % 41.4 % 54.2 % 49.5 %

Regression analysis Dependent variable: percentage difference between initial estimates and updated cost estimates Independent variables Percentage completion of project Megaproject (dummy variable) Annual average oil price and oil price surprise (defined as the percentage change in the oil price from start to end of project implementation) Random effects estimator with robust standard errors

Regression analysis: Results Estimation results, Cost Overruns and Oil price   Variable Coefficient t-value p-value Intercept -0.197 -2.170 0.030 Oil Price 0.001 0.980 0.329 Oil Price Surprise 0.167 1.980 0.048 Completion 0.352 3.370  Megaproject 0.096 1.000 0.316 R2 (overall) 0.1071

Discussion The price surprise variable has a (weakly) significant positive effect on cost overruns, while the oil price level itself has no significant effect Cost overruns depend more on the development of the oil prices during the project development, than the given price level any year of implementation Percentage completion of project is associated with higher cost overruns Cost overruns tend to accumulate and overruns are larger near completion than closer to start.

Discussion The R2 of the model is 0.107. Including only the oil price variables, the R2 of the model is 0.093. There is substantial heterogeneity across projects in terms of cost overruns, which a common factor such as the oil price cannot explain. How does the oil price influence cost overruns? Correlations between key investment cost variables   Oil price Rig rates Investments Wages Employees 1 0.9498 0.8963 0.9318 0.8804 0.9101 0.9789 0.9003 0.9321 0.9701 0.9946

Conclusion We find some evidence that cost overruns are higher, in relative terms, when oil prices increase during project implementation The industry may be pro-cyclical Both rig rates and wages are highly correlated with oil prices when total investments are increasing Consistency in budgets and investment analysis is crucial for the companies – expected oil and gas prices must be consistent with the expected cost level There is substantial heterogeneity in cost overruns Oil price explains about 10% of the variation in cost overruns