Please note that this article was written before the onset of COVID-19.
It is not uncommon for risk managers to talk in round numbers about the cost of their facility. A typical energy company employs engineers, project managers and accountants that work together to finance new projects, to continually manage the maintenance and refurbishment of the facility and to report the facility value for accounting and various other purposes. As such, the company holds a significant amount of background data on the facility that can help with any risk management related services and assist the risk manager to benchmark the overall value for insurance purposes. From a valuation perspective, this data can help to reduce consultants’ time onsite, allow them to prepopulate our cost model database prior to the site visit so that we can check, review, update and record any missing asset information. But should this data be relied upon in isolation, in the same way as a firm of accountants might complete a valuation for accounting purposes? Furthermore, does this methodology lend itself to deriving accurate replacement values for insurance purposes? The simple answer is no. As noted above, existing data is useful; however, it is very common for assets to be incorrectly recorded, missing from the data or simply that the data itself is just not representative of what is physically at the facility. These factors are often overlooked by risk managers.
The output from an insurance valuation can include a single figure, a schedule of values per process area or a complete plant register. Each output has a different time implication for the valuer and therefore carries a different consultancy fee. In recent times there has been a growing trend for values to be allocated to appropriate site areas, thereby facilitating the risk management process by identifying the target risk and minimising any PML/EML exposure. A detailed approach, including a full site inspection, offers a wide-ranging look at the company’s operations. It can greatly assist in arriving at a comprehensive assessment of the company’s risk profile with a higher level of accuracy. It is almost impossible to allocate this value to the individual facility areas by relying on internally-provided data which has only been analysed from a desk. Generally, values are allocated to appropriate plot areas, which normally are clearly defined at an oil and gas facility; however, the arrangement of individual physical facilities can vary from site to site. The location of interconnecting pipelines, pipe bridges, plant utilities and substations can materially affect the value of the individual plant areas and its EML exposure. An on-site survey minimises the risk exposure, identifying areas of concern and applying appropriate values to certain areas.
We are often asked to report valuations in local currencies, but generally we would also report in US dollars as well as the local currency. Local currency fluctuations do seem to impact replacement values from a labour perspective; however, most plant is purchased from China, the US and the EU using an internationally traded and stable currency. Reporting in one common value, across multiple countries, allows the values to be easily updated from the desk. However, it is not uncommon for clients to ask for values to be specifically reported in local currency. This can have a significant impact on valuation outcomes and should be carefully considered, especially when values are updated over time. This is obvious for less stable currencies but also applies to traditional currencies which have weakened in comparison to the US dollar. Figure 1 left illustrates the changes in value when applying local trends such as the Consumer Price Index (CPI) and comparing those to US dollar currency exchange rate movements between 2015 and 2020.
Case Study Rushton was appointed to undertake a revaluation of a major oil and gas asset in Canada. One of the major issues during the exercise was the sudden depreciation of the Canadian dollar, which had decreased considerably reducing the purchasing power of the currency and impacting on all aspects of the valuation. It was argued by the client that the local currency fluctuations would have little impact on the values, considering that the majority of the assets were manufactured locally and would utilise non-foreign construction labour. It was also argued that construction rates should not be benchmarked against US dollar amounts, which would increase the valuation dramatically in Canadian dollar terms. Evidence was produced of a newly constructed project that was plagued by construction issues and cost overruns which saw the project completed off schedule and over budget. It was discovered that the project was susceptible to increased costs, due to currency fluctuations whereby escalation rates were underestimated; this led to increased costs relating to all aspects of the project, including labour, bulk materials, engineered equipment and project in-directs. It was clear that higher domestic prices had increased import costs and had also negatively impacted labour rates, due to the inverse relationship between the value of the dollar and its effect on the local currency.
The world economic situation saw a dramatic shift in 2015, with crude oil prices collapsing to their lowest levels in many years. As a result, all base metals (including steel prices) had corrected in tandem with the fall in crude oil prices. The crash in crude was largely caused by oversupply and the continued growth in US shale production which is still evident today. At the close of 2019, prices in the oil and gas industry had steadied, reflecting the uncertainty over lower oil prices and international trade tensions, with an overall average increase of only 0.4% recorded since January 2019. This compares to an increase of 8-10% since 2015. A broad analysis of recent valuations in Figure 2 overleaf shows the “rule of thumb” estimates for various oil and gas facilities. Steel prices have remained volatile, due in large part to an unexpected rise in demand in China compared to the rest of the world, which saw demand decrease or slow in comparison to 2019. Prices have varied from 3,300 yuan to 4,400 yuan per tonne over a twelve-month period. The increase since 2015 has been more pronounced, with the market increasing since the correction in 2014. With regard to the financial markets, all major currencies have weakened compared to the US dollar. The dollar has strengthened on average of 5% since 2018 impacting and increasing values for assets, especially those insured on a local currency basis.
In the computer science world “garbage in, garbage out (GIGO)” coins the concept that flawed or nonsense input data produces nonsense output. A variation on the term “garbage in, gospel out” refers to a tendency to put unwarranted faith in the accuracy of computer-generated data or relying on data in isolation. While we are not saying that all the data is garbage, we would suggest that relying on data in isolation can lead to inaccurate valuations. The valuation output is just one part of a business’s risk management process and is used by third parties for EML studies. Both the valuation and the EML impact on the insurance buying strategy; however, the allocation of the valuation, together with the accuracy, impacts on the EML. There is always a quick and dirty way to complete a task so that it is cheaper or easier for the business to facilitate; however, consideration needs to be given as to whether the task is fit for the purpose for which it is being used.
Sue Davies is Managing Director of Rushton International.
