1. 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

2. 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

3. 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?

4. 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)

5. 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
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

6. 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 >= MNOK (1.2 Billion USD)

7. Decscriptive Statistics: Empirical Distribution

8. 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 %

9. 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

10. 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

11. 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.

12. Discussion
The R2 of the model is Including only the oil price variables, the R2 of the model is
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

13. 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