Missed targets, the fallout from a drip feed of downward revisions, an unrelenting atmosphere of crisis, bonuses scrapped, poor morale. Not a universal affliction but for many leaders in recent years, a familiar story. When confronted with this scenario significant focus rightly zooms in on operational performance. But how much effort goes into making the forecasts and are we making targets that we have little chance of meeting? How do we deal with the unknown and can we use uncertainty to our advantage?
People have a notoriously difficult time in dealing with uncertainty but the simple fact is the world we live in and the businesses we manage have a great deal of it. There are countless studies* that demonstrate we underestimate variability. We imagine the world to be more benign than it actually is and we often think we know more about some things than it’s possible for us to know. All this can lead to an optimistic overconfidence in our forecasts. We also struggle with ranges and who hasn’t had to deal with the demand “just show me a single number”. We crave certainty.
Some parts of the E&P business woke up to this a while ago. A good example is exploration. Best practice here uses probabilistic techniques along with systematic analysis to capture the full range of uncertainty in the parameters that feed into an estimate. We also see probabilistic cost and schedule estimates increasingly becoming the norm for large scale capital projects. But in our ongoing operations, all too often we still live in the world of a single number, perhaps with an arbitrary ± percentage around it and sometimes getting it wrong can have wider impacts than we imagine**.
If you are someone who recognises the first paragraph, what can you do about it?
The first step is to get people to recognise that there really is a lot of uncertainty and that ranges on estimates are OK. This may sound trite but there can be significant cultural challenges to overcome amongst some key stakeholders when you offer a range because people are conditioned to think that you can’t know your business very well if you can’t give them one number. Sometimes only a single number will do but if you have a better handle on the range that lies around it you will be in a better position to supply the right “one number” and manage expectations along with it.
So, how to get a decent handle on the range?
In the perfect world, a statistically coherent probabilistic analysis would be ideal but this isn’t usually practicable for ongoing operational items such as production or operating expenditure. A more pragmatic approach can be developed using the key building blocks of the estimate. With these listed, the events that could cause them to be better or worse than assumed and by how much can be identified. This together with an estimate of the likelihood of these events happening can be combined using readily available software tools to provide a range on the base case estimate. It won’t be statistically pure but it will be far better than a single number and you can sense check it against the individual events.
The identification of the deviating events and their likelihood is best done by a small group of people who know the assets so that different perspectives are brought to bear and that there can be some challenge and discussion. It should be facilitated in such a way that “out of norm” items are also considered. It does not have to be a long meeting.
The other benefit of this approach is that it is identifying the risks and opportunities inherent in the next period of your operation. This enables people to be tasked and held accountable for mitigating the risks and capturing the opportunities and provides a format for follow-up and performance management. Focusing on these items and taking pre-emptive action is a better way to manage the business and improve outcomes. Being able to communicate around these items and what the business is actually doing about them can be a powerful tool to engage the people executing the work. Such transparency can also benefit your stakeholder relationships enabling expectations to be managed in a way that keeps the focus on value adding activities rather than aftermath accounting exercises.
The real world is uncertain and although our brains find uncertainty difficult to grapple with ignoring it won’t make it any less so. Forecasting operational items such as production or operating expenditure are an important part of managing our business and deserves attention. We can make significant improvements to our forecasts by a systematic process that identifies the events that can impact them. There are simple ways to do this short of using a full blown probabilistic approach and if you can embed them into your normal ways of working then the flow on benefits into the actual execution and the outcomes of your business will follow naturally.
* Here is not the place to go into those studies but there is a great read – “Thinking Fast and Slow” by Daniel Kahneman that covers a lot of this and why our brains are wired this way.
** The recent poor performance of UK based firms in making North Sea production forecasts was well known to the statisticians who prepare reports for the UK government. Their hard won experience of using industry numbers led them to apply their own discount factors but even then they often found outcomes lower than expectation and these gaps even became a contentious issue in recent politics.