The Deal Mapper: Scenario Analysis as a Critical yet Undervalued Tool for complex LNG agreements
In 1965, Shell started an activity it called “Long Range Studies”, which became famous as the “Shell Scenarios” when the company successfully anticipated the 1973 oil crisis*. Scenario analysis subsequently became very popular - yet it remains mired in controversy, as the recent IEA Net Zero Scenarios have shown. (see e.g. “IEA comes under pressure from former oil market chief to cut energy transition focus”.
Yet scenario analysis is one of the most powerful tools to prepare for commercial negotiations, and controversies most often stem from misunderstandings and misapplications.
Anyone who has ever negotiated a larger commercial agreement knows that price is often one of the simpler aspects to resolve, with other terms and conditions presenting far larger challenges. And those other T&Cs rarely fit into tried-and-tested templates in complex contracts, such as large LNG Netback or Joint Venture Agreements. Identifying and understanding the scenarios for which an agreement needs to cater is essential to not get caught out later when an unanticipated scenario materializes.
Let’s explore the key advantages of scenario analysis, why and where things often go wrong, and a few general recommendations for successful scenario analysis.
If you are interested in this line of thinking, check out our Deal Mapper workshops, which provide our clients with the structure and systematic approach for effective and efficient scenario and negotiation planning. Please Contact Us if you would like to learn more.
[This article is not financial or investment advice, but provided for general information purposes only. All information is subject to change and should not be relied upon for any decision making. See Webpage Terms of Use.]
The hallmarks of successful scenario analysis
At the start of this article we mentioned that Shell had successfully anticipated the 1973 oil crisis. Note the word “anticipated”, not “predicted” - the crisis was one of multiple scenarios. But the company took the scenario seriously, as it apparently had prepared some contingency plans in case it would materialize.
The real art and science of scenario analysis is in selecting the right type and number of scenarios. Too few, and gaps are likely too large. Too many, and the analysis likely becomes superficial and each scenario “diluted”. Stochastic simulations (Monte Carlo analysis) can be extremely helpful, but by themselves tend to inadequately reflect extreme outcomes.
Good scenario analysis focuses on both the most likely and the most extreme (yet still realistic) scenarios.
Why and Where things go wrong
First, scenario analysis and forecasting are often confused. Case in point - the IEA’s Net Zero scenarios, which were often misrepresented as forecasts instead of “what would need to happen to reach net zero by 2050” analysis.
And even if interpreted correctly, often the “bookends” are not set correctly. Most scenarios include at least a base case, an upper bookend and a lower bookend. It is worthwhile looking back at those scenarios when the actual outcome is known to see whether it is somewhere in the range of outlined scenarios. If not, then it is a good indication that the scenario analysis missed some major factors. We did such a review for past IEA scenarios in our article “Predictions are Hard, Particularly about the Future” - and noted that some of the world’s most knowledgeable experts had been (very) far off especially on oil prices, solar PV and EV sales. Yet more extreme scenarios may not have appeared to be credible at the time - it is always a true dilemma.
But the biggest issue is usually wishful thinking - scenarios being omitted as they might be seen as negating a company’s strategy. And as a result, the company ends up not preparing even basic contingency plans, instead rolling the dice. The LNG shipping industry went through a major capacity expansion that was very publicly discussed, yet the recent crash of spot charter rates seems to have caught many industry players by surprise. With the coming major liquefaction expansion, every player exposed to the spot market better have a contingency plan for (very) low prices - of course geopolitical events could avoid the scenario, but preparation is better than playing roulette. And preparation for downside scenarios enables capturing upsides far more effectively.
A few general recommendations
Successful scenario analysis is both an art and a science, but a few guidelines hold true in most settings:
Identification trumps details - time and budgets are often tight. When choosing between identifying more scenarios or defining identified ones in more detail, err on the side of identification. It’s a practical case of the 80/20 rule - 20% of the definition work usually results in 80% of the value, but if a scenario has not been identified at all it becomes a dangerous blind spot.
If in doubt, go more extreme - human tendency is to underestimate variance.
Seek input from independent experts - in other words, a fresh pair of eyes from industry experts. This does not need to be in the form of detailed, expensive consulting reports - a little tends to go a long way.
And to reduce the very normal tendency towards too much optimism in the base case, a good question to ask is “What scenario would materially improve the base case?” Difficulty in identifying such a scenario is a good indication that the base case is not truly the base case, but the best case scenario.
Scenario Analysis for LNG agreements
Even “small” LNG-related contracts - whether Joint Venture Agreements, Sale and Purchase Agreements, Gas Sales Agreements, Tolling Agreements, … - often have headline sizes in the hundreds of millions, if not billions of dollars. Thus even “small” tweaks to these agreements can improve their value by millions of dollars. Which scenarios one should focus on very much depends on the type of deal and venture, but as a starting point, here are three areas that can often unlock a lot of value and mitigate substantial risks:
Start of Commercial Operations
Feedgas supply interruptions / contaminations
LNG Lifting delays
As indicated at the beginning, our Deal Mapper workshops provide a time- and cost-effective structure for scenario-based deal planning. Please Contact Us if you would like to learn more.
* For a more detailed summary of how Shell’s scenario analysis started, see this insightful article by Politechnique Insights: