How to identify and mitigate the oil risk to your business

The IMF recently published a working paper predicting the real price of oil will double over the next ten years.

With interruptions to supply also likely to rise, it makes sense to assess and mitigate now the likely risks to your business.

Here is a simple process for doing so:

First, obtain a copy of your management accounts — the P&L you use to run your business. You will want enough detail to identify detailed areas within your business; a maximum level of around 80-100 line items. Use figures for 12 months, to include any seasonality. Make sure also that revenue is broken out where possible to identify income by customer group, by product or service type, or by the ‘channel’ by which the product/services is delivered to the customer. Five to ten categories should be adequate for a first pass here.

To these accounts, add two columns. The first is ‘Financial Impact’. The second is ‘Operational Impact’.

In the first column, write an estimate of what the change in revenue or expense figure will be, when (not if, when) the oil price reaches double what it is now in real terms. (For the moment, assume that oil is still in plentiful supply.)

Salaries, for example, are generally unlikely to be directly affected by a change in the price of oil; costs of travel, logistics, some raw materials, and direct energy* are likely to be affected an intermediate percentage, since the price of oil does not make up the full cost of these items; and revenues might be unchanged, or significantly shifted downwards, or upwards, depending on how a higher oil price would affect your customers’ available budget/disposable income and spending priorities.

(*If you expect that a higher market price for oil would lead to higher market prices for other forms of energy, you will want to factor that in as well.)

Completing this step, and totalling the figures, gives you a rapid assessment of how a doubling of the oil price would likely impact the profitability of your business.

It also identifies the key P&L line items that would most impact your business. This enables you to take action to mitigate those impacts.


In the second column, ‘Operational Impact’, rank the degree to which this line item would likely to be affected if supplies of oil were interrupted. You could rank this as 3/2/1 for high/medium/low. Or you could use a scale of 1-10. We recommend using a simple method you feel comfortable with to begin with, and then adding detail later if necessary. A good starting point might be to rate ‘1’ for ‘little or no impact’, 2 for ‘slight impact’, 3 for ‘significant impact’ and 4 for ‘very significant impact’.

Notice that the operational impact is completely unrelated to the P&L impact to your business. An oil-based raw material might form a tiny part of your cost structure, and yet be absolutely essential to your operations. Or the supply of an inexpensive raw material could be heavily impacted by an interruption to the flow of oil.

Notice also that significant impacts could come from items that do not appear on your P&L, or are outside your control. Could employees get to work if there was a petrol shortage? Would customers switch from out of town shopping to the high street or the Internet?

EXAMPLE:
The National Trust owns a selection of properties across Britain. In the past much of its revenues have typically come from visitors travelling from other parts of the UK or from outside the UK. As the cost of oil rises, those visits are likely to become more expensive and so the National Trust can expect revenue from these sources to decline. The organisation has therefore implemented a new strategy, with an increasingly local focus. You can read it about here and here, especially on pages 10-13.


Having assessed the operational impact you can now combine it with the financial impact. In a third column, multiply together the figures in the first and second columns to give the Weighted Operational/Financial Impact.


Priorities

By now you will have identified several ways in which the price and availability of oil might affect your business over the next decade.

You will need to apply management discretion to decide which items to focus on :

  • the items that would have the highest absolute P&L impact
  • the items that would have the the highest percentage change in P&L impact (compared to current figures)
  • the items that would have the highest operational impact
  • the items that have the highest combined/weighted scores (third column)

 


Fourth Column — Timing and Likelihood

The tightening of oil supplies will not affect all areas equally or at the same time.

In the fourth column add some more detail to the Operational Impact: add your assessment of when the events in column two are likely to happen, and how likely they are.

You now have sufficient information to produce a chart like this, of the top risks your business faces from oil:

 

Each circle represents a line item you have identified.

The size of the circle represents its financial impact. The vertical position represents the degree of operational impact.

The horizontal position indicates the date when this risk is expected to happen. And the colour of the circle represents its likelihood (green is ‘possible’, red is ‘very likely’).

The same line item (revenue or expense) might appear with different probabilities and different impacts in different years. Each of these scenarios might require a different action plan.


Fifth Column — Action Plans for Mitigation

Having identified the likely priority areas for your business, the most important thing is to come up with an action plan to address each one.

If you have a standard risk management methodology, use that.

If you want an quick and dirty approach, try this.

For each line item:

  • Be clear about the size and nature of the potential risk (financial, operational, or both)
  • Be clear about how the risk arises — identify ways to reduce the likelihood that the risk will happen, and/or to reduce the impact if it does
  • Identify ‘disaster recovery’ plans, if appropriate
  • Be clear about the role that each line items plays in your business model — identify ways to achieve the same ends by different means
  • ‘Disaster Recovery’: Identify ways to recover

It is difficult to to be specific about what these might mean in practice. But in general they are likely to involve three possible options.

First is to gain control of resources in order to be able to continue with the oil-based business model. This works in the short term, but increases the risk to the business, since it becomes increasingly reliant on scarcer resources. It also leaves the business facing the same or larger need for change, once those resources run out.

The second option is to continue with the current business model but become more efficient, in order to reduce the amount of oil-based materials used. This buys breathing space and may work for some businesses. The key question is whether efficiencies can be achieved faster than the tightening of oil.

And the third is to finding alternative ways to achieve the same ends, without using oil. This route offers the greatest potential — both for resilience and for growth — since the whole world economy will be experiencing the same change.

A post next week will examine how to look for opportunities.

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