Back when oil prices were well over $100 per barrel, a friend approached me with a prospectus to invest in a portfolio of unconventional oil drilling projects. The opportunity seemed compelling, as many projects like it had already led to outstanding returns. But success depended on certain assumptions remaining true–including oil prices remaining high enough to warrant new projects with expensive extraction methods.
Every organization operates under a shared set of beliefs, including assumptions not only about pricing but also customer behavior, competition, and the regulatory environment. If your company is like most, you have at least one or two major assumptions that are lurking in the background-yet seldom discussed or questioned. What if one of those widely held beliefs that are taken for granted turns out to be plain wrong? And what if being wrong could fundamentally change the outlook for the business?
I call this the risk of the “outcome-determining assumption.” To be “outcome-determining,” an assumption needs to be important enough to make a meaningful difference in the success of a strategy, investment, business, or company. Your future could rest on the process of finding, exposing and challenging this flaw–and acting before it ends up causing damage or, in the worst-case scenario, before it proves to be fatal.
In the past, many companies have been harmed by these kinds of faulty assumptions-ranging from believing that a big merger will pass regulatory approval, to believing that Medicare reimbursement rates will remain stable, to ignoring a disruptive new technology or business model because it doesn’t appeal to your current customers.
Dealing with unexpected change
We’ve just witnessed a 60% drop in oil prices over the past six months. Prior to the plunge, virtually no energy forecast had highlighted this as a real possibility. Yet some companies in the energy sector will withstand the shock while others find themselves in real distress.
For instance, the super-major oil companies (such as ExxonMobil and Chevron) have all developed strategies in which supply and demand fluctuation is built-in as a critical risk factor in their planning. Their business models are equipped to handle high volatility, because they’ve seen prices rise and fall dramatically over decades.
But Barron’s recently highlighted five lesser-known oil and gas companies (such as Ultra Petroleum and Halcon Resources) with high debt-to-capital ratios whose businesses will “prove problematic if oil prices stay low.” The Financial Times says some of the same U.S. shale producers with high break-even points are now struggling to survive.
Indeed, many energy analysts interpret OPEC’s decision not to cut production as a deliberate strategy to drive U.S. shale producers out of business. Bloomberg has reported that shale oil production became unprofitable for dozens of companies when oil dropped below $80 per barrel.
Eighty dollars was a “plausible downside” in many business cases when oil was at $100. But what happens at $50 per barrel? Many of these companies are discovering that their business models (and supporting capital structures) simply lack sufficient resilience to the inherent volatility in oil prices.
The sudden change in oil prices shows why it’s critical to find and articulate your own business assumptions and explicitly build uncertainty into your strategy. For most large enterprises, there are often many kinds of assumptions–market, technological, regulatory and competitive, to start.
Building uncertainty into strategy
Of course, it’s easy enough to shine a light on assumptions that have already been overturned. But for all fossil fuel companies, there could be a different belief built into their business models that could still yet be a factor: that the United States and other major governments are unlikely to tax carbon emissions anytime soon.
Many experts say we’ve been in a “carbon bubble,” in which oil, coal and gas reserves have been overvalued. And in fact, the Intergovernmental Panel on Climate Change estimates that if governments got serious about cutting carbon emissions and started imposing higher carbon taxes, approximately two-thirds of the known and expected carbon-based deposits in the ground would be stranded. For companies operating on the assumption that this is unlikely to happen, the consequences could be dire if it does.
Many major oil companies are managing this uncertainty by putting sophisticated strategies in place that account for a world in which a price, tax or a “cap-and-trade” system will be placed on carbon. ExxonMobil and other super-majors have been applying a “proxy price” to carbon for years–even though it’s mainly just an internal strategy tool. The proxy price simulates a carbon tax, and it fluctuates according to how much economists and policy experts believe the tax will be in the future.
Even companies outside the energy sector have also have a similar proxy price in place to help guide decisions. According to a list published by the Carbon Disclosure Project, those companies include Google, Delta Airlines, Dow Chemical, Goldman Sachs, and Bank of America.
By building uncertainty into their business models, these companies won’t be caught off guard and their strategy won’t be made obsolete if the regulatory climate shifts.
Applying the assumption lesson to your strategy
My work with senior executives has yielded a method for continually exposing, ranking, testing, and re-evaluating your assumptions. In the oil price example and in many other cases, there is often one over-riding assumption that is so big and matters so much that if it’s proven wrong, the outcome could be dire.
In order to learn from cases like these and find your own organization’s outcome-determining assumptions, I recommend a five-step challenge approach:
Make a list of the core beliefs that your organization operates under.
Don’t try to judge them as you list them. Just write down as many of them as you can.
Rate the importance of each assumption to your business:
How important is this belief to the business? Does the assumption affect our existential viability, our future growth, or our current profitability?
Rate the strength of conviction for each of the assumptions.
Is it so axiomatic that it’s a “religious-level” belief? One level down would be “clinically confident.” And then the lowest level of strength would be a “trending belief.”
Develop an assumptions barometer:
Ask whether each assumption is more solid or fragile today than 5-10 years ago, and why. In doing so, consider key trends affecting your customers, your industry, the world.
Envision and act on alternate scenarios:
What are the potential scenarios in which your most strongly held, most consequential assumptions could turn out to be wrong? What would we do differently today if we knew the scenario were true?
This last step is all about building a margin of safety into your strategy. That leads not just to the right discussions about managing strategic and financial risk but also to a portfolio of innovation programs in which can you can help create new, more flexible business models.
Finding your potentially fatal flaw is often tough and difficult work for any leader. And rear-view mirror hindsight shouldn’t give anyone the confidence that they could have done any better than companies that have been done in by faulty assumptions in the past. But that’s the point. The object isn’t to create a sense of certainty, but rather to expose and embrace uncertainty.
Patrick Viguerie is President of Innosight and a Director Emeritus of McKinsey & Company.