Category: Scenario Analysis

During the past fifteen years, technological advancements in extracting crude oil from shale rock have propelled the United States into the unfamiliar role of the world’s top oil producer. Recently, though, representatives at several leading fossil fuel companies predicted that American oil production is peaking and will soon decline.

The causal factors that they cited for their “peak and decline” prediction are all foreseeable ones. There is a limited amount of crude oil reserves in American territory that can be extracted in an affordable manner, and much of it has already been processed by oil companies. Furthermore, the market sales price of crude oil is very low by historical standards, and thus there is limited revenue to pay for the costs of production. Finally, the costs of production are increasing for various inflationary reasons, further reducing potential profits.

Business planners and data modelers throughout many industry sectors may need to factor “peak shale” into their forecasts and projections. As domestic crude is replaced by imported substitutes, the increased costs of raw materials will “flow through” into higher costs of finished goods. Other production materials that are transported by fossil fueled cargo ships, airplanes, and freight trucks will also generate cost increases. And government tariffs on imported products will further increase costs.

Supply chains may also become more unstable. Domestic oil production is less vulnerable to many types of disruptions, such as weather events, political crises, and social protests. Product shortages may thus become more common throughout the American economy.

None of these potential impacts is necessarily new to U.S. industry sectors, though. During the 1970s, for instance, the Arab oil embargo caused severe shortages and price inflation in the gasoline and other energy markets. For a brief period of time, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) both mandated special financial reporting requirements involving “changing prices.”

Thus, planners and modelers do have historical examples that can be consulted for guidance. Although the American economy has not experienced these phenomena recently, it may be reassuring to keep in mind that they are not black swan events.

United Airlines is drawing attention over its recent decision to release two different sets of investor guidance. Some commentators are correctly noting that two sets of guidance is a “novel” occurrence.

Usually, companies release one set of guidance that reflects its assumptions about the economy’s probable future path. Alternatively, on rare occasions, companies may decline to release any guidance at all, asserting that the economy (at that moment) is so unpredictable that any information would be too speculative to be useful.

So why two? And why now? According to United’s economic forecasters, we will either experience an economic recession in the near future, or we will not. If we do, the future will feature one set of economic conditions. If we don’t, it will feature a very different set.

That’s a classic case of circumstances that warrants an approach called Scenario Analysis. It’s different than Sensitivity Analysis, an approach that is employed when future conditions are relatively predictable, but when specific quantitative assumptions (such as sales volume or the cost of labor) may vary by a few percentage points in either direction. 

In Scenario Analysis, one can define two or more (very different) potential future paths. One can also define the economic conditions that would exist for each potential path. However, one cannot be certain (and, instead, one is very uncertain) which specific future path is more likely to become our future reality. 

That’s the situation in which United finds itself today. It may be novel from a historical perspective, but it isn’t worrisome at all, given the extremely volatile state of our contemporary global economy. Thus, it would not be surprising if other companies adopt United’s approach and decide to issue multiple sets of guidance for their own investors.