Oil Prices: The Eisenhower Principle

Plans are worthless, but planning is everything.

That is how United States President Dwight Eisenhower explained his management philosophy as the Supreme Commander of the Allied Expeditionary Force in Europe during the Second World War. He proceeded to elaborate:

When you are planning for an emergency you must start with this one thing: the very definition of “emergency” is that it is unexpected, therefore it is not going to happen the way you are planning.So, the first thing you do is to take all the plans off the top shelf and throw them out the window and start once more. But if you haven’t been planning you can’t start to work, intelligently at least. That is the reason it is so important to plan, to keep yourselves steeped in the character of the problem that you may one day be called upon to solve–or to help to solve.

Remarks at the National Defense Executive Reserve Conference, November 14, 1957 Published at http://www.presidency.ucsb.edu/ws/?pid=10951 on January 3, 2015

Isn’t it ironic that Eisenhower acknowledged that he would inevitably “take all the plans off the top shelf and throw them out the window” whenever emergencies occur? His point, of course, is that the process of planning is far more valuable than the resultant plan itself.

Eisenhower’s principle is an important one to keep in mind when we consider the recent collapse of the price of oil. In his November 4, 2014 blog post entitled Oil, Money, and Pemex, Dr. David Donohue predicted that unconventional energy producers in the United States would continue to maximize output with prices as low as $65 per barrel, disagreeing with an expert who predicted supply cutbacks when prices declined below $85 per barrel.

So who was ultimately proven to be correct? By the end of 2014, prices fell well below $60 per barrel while unconventional producers continued to maximize output. So Dr. Donohue was indeed proven correct, although even he might express some surprise at the current state of the market. The price has now dropped below $50 per barrel. What are the producers doing now?

Some industry professionals might make the mistake of concluding that, in such an unpredictable economic environment, it is futile to make plans about the future. Eisenhower, however, would undoubtedly respond that the planning process becomes more valuable than ever during times of great uncertainty.

Consider, for instance, a chart entitled Sensitivity Analysis that appears in an IHRDC slide set entitled Probability Theory & Quantitative Analysis. The slide and its application is utilized at workshops and other financial modeling training sessions presented by the firm.

IHRDC, Oil Prices, sensitivity analysis, Eisenhower Principle, oil and gas

According to the chart, at the “most likely” levels of price, production quantity, capital expenditures, and royalty payment levels, the valuation of the project (which is quantified at the intersection of the four lines) is slightly less than $1 million. But according to the chart’s purple line, an oil price that is 20% greater than anticipated would increase the valuation to $6 million, while a price that is 20% less than anticipated would create a negative valuation (i.e. a loss) in excess of $4 million. The recent drop in oil price has been much greater than 20%, well below the low estimate.

In recent years, as the oil price rose well above $100 per barrel, we learned that, when analyzing projects, the majors set the oil price at a very conservative $60 per barrel.  Many thought that this was much too conservative.  Those in the industry in 1985-86 knew why it was set at that low level and those in the industry today will be more conservative in the future. Setting the price at this low level is a recognition that one large exporting country with large reserves and a very low cost of production can upset the market in short order and with ease. Time now to plan again but for what range of oil price?IHRDC, Oil Prices, sensitivity analysis, Eisenhower Principle, oil and gas

Some professionals might question the usefulness of the planning process that produced the first chart, noting that the recent decline in oil prices has more than doubled the +/- 20% range of the analysis. However, Eisenhower would likely note that this chart provides a baseline that can be extended to address the current situation.

Regrettably, such an extension would not simply involve a lengthening of the purple line to encompass a greater percentage variation. It is quite possible, for instance, that the organization would implement significant changes in operations when the price of oil declines more than 20%. Such changes would affect the slope or shape of the purple line below the point of implementation.

Thus, on one hand, as Eisenhower noted, the organization would indeed throw away this baseline version of its sensitivity analysis in order to address the contemporary price environment. On the other hand, before it does so, the organization would utilize this baseline version to develop a revised chart to analyze the current scenario.

The “bottom line” is that, during times of significant uncertainty, the planning process indeed becomes more important than ever, and the same management principle that was utilized to deliver victory in a great World War can be employed to ensure prosperity in an evolving energy industry.

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