McKinsey on Creating Value

In a world where Cash-for-Clunkers and QE II are considered solutions to what ails our economy. It is refreshing to see this presentation by McKinsey Consulting. This presentation is talking about the ways that value is created and destroyed in firms. Although the video at times seems to stumble, it is only in the presentation of difficult material that makes it appear that way. What is being discussed are advanced concepts that need to be adopted by innovative oil and gas producers.

McKinsey identifies four of the mechanisms that generate and destroy value in business. In the Preliminary Research Report it was noted that focusing on growth as a strategy may not generate the value that a producer firm needs. That innovation is a strategy to optimize the value of the producer firm is the focus of People, Ideas & Objects.

In a related paper, McKinsey relates the difficulty for firms to focus on value generation.

It’s one thing for a CFO to understand the technical methods of valuation—and for members of the finance organization to apply them to help line managers monitor and improve company performance. But it’s still more powerful when CEOs, board members, and other non-financial executives internalize the principles of value creation. Doing so allows them to make independent, courageous, and even unpopular business decisions in the face of myths and misconceptions about what creates value.

The Draft Specification provides two modules that make these calculations and enable these decisions to be made, the Performance Evaluation, and Analytics & Statistics modules. These two modules functionality are very similar. The key difference is that the Performance Evaluation module deals with the producer firm and the Analytics & Statistics module views data from the Joint Operating Committee perspective.

For the industry to successfully provide for the consumers energy demands, it’s necessary to build the systems that identify and support the Joint Operating Committee. Building the Preliminary Specification is the focus of People, Ideas & Objects. Producers are encouraged to contact me in order to support our Revenue Model and begin their participation in these communities. Those individuals that are interested in joining People, Ideas & Objects can join me here and begin building the software necessary for the successful and innovative oil and gas industry.

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S + B, Big Oil and the Natural Gas Bonanza

Booz & Co’s periodical Strategy + Business have published a paper that asks the question;

The oil majors hope to make major money in natural gas, but can they learn to operate two distinct types of businesses under one roof?

Noting that unconventional gas requires a different business model that may not be served by the conventional methods of the industry.

The unexpected revival of natural gas is quietly precipitating a fundamental shift in the oil and gas industry — a shift that few companies were prepared for but that may determine the industry’s overall future makeup. It pits the major oil companies against the independents, which have plied the unconventional reservoirs doggedly over the last seven to 10 years. And it raises questions about whether the oil giants can become big players in this new unconventional gas business. To do so, they will have to develop dual operating models under one roof — one, a traditional high-risk, corporate-led exploration model, and the other, a nimble, efficient, and decentralized operation. In other industries (notably airlines), such two-headed strategies have generally failed.

Change is certainly in the air. Oil and gas prices are probably one of the best measures of the level of change in the oil and gas industry. It is pleasant to see Strategy + Business’ analysis providing confirmation to many of the things that we have stated here. This critique is to ensure the innovative producers remain successful.

In order to compete in unconventional assets, oil majors will have to embrace a dual operating model — in essence, pairing traditional operations with separate and more agile business units modeled after the independent gas firms, with flatter organizations, simpler governance structures, and an emphasis on efficiency and innovation. These attributes are necessary to reduce operating costs, as well as to allow the firms to quickly adapt new well designs, source local contractors and materials, and secure labor as needed.

What concerns me is the nature of the oil and gas industry towards new ideas. There is a culture of how management will not support new ideas, which includes this software development project. I have attributed this to the 1980’s and 1990’s survival strategies that were a necessity in oil and gas. Times have changed and its time for the management to realize they have to act. S + B note.

Above all, management will need to ensure that existing processes and structures do not discount these fresh ideas because of a “not invented here” bias. If a joint venture is part of this approach, the company will need to develop a plan that allows it to learn from the arrangement, by creating formal and informal governance mechanisms to promote the transfer and dissemination of knowledge.

I am under no illusions at the scope of change that we are introducing in this project. Using the Joint Operating Committee as the key organizational construct of the innovative producer will be necessary at some point in the very near future. An idea that resonates with those in the business as something we should have been doing all along. By delaying this project, one in which we have many years of work ahead of us, I believe is dangerous.

If designed and managed appropriately, either strategy could be successful, but history suggests that most of the oil giants will struggle to make dual operating models coexist. Though it may not seem obvious today, many of these companies are likely to find that the technical hurdles of unconventional reserves are relatively minor. Far tougher — and ultimately out of reach for some — will be the challenge of changing behavior and culture. 

For the industry to successfully provide for the consumers energy demands, it’s necessary to build the systems that identify and support the Joint Operating Committee. Building the Preliminary Specification is the focus of People, Ideas & Objects. Producers are encouraged to contact me in order to support our Revenue Model and begin their participation in these communities. Those individuals that are interested in joining People, Ideas & Objects can join me here and begin building the software necessary for the successful and innovative oil and gas industry.

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Oracle - Adopting a Successful IT Strategy

A quick break from our review of the Preliminary Research Report, the Draft Specification and subsequent research to pick up an interesting point of view on technology. Oracle Vice-President and Fellow Frank Buytendijk talks about the application of technology to the organization.

In my own professional development, I’ve gone full circle. Twenty years ago, I started out being an MIS developer, but in the last number of years I have spent a lot of time on the soft side, looking into subjects such as impact of behaviors, values and culture. 

I have come to the conclusion that in order to successfully adopt such a strategy paradigm, you need to have a solid enterprise architecture. So I have gone from IT to business and back to IT. In the end that is only logical. Since the dawn of mankind, the key to progress has been in technology. A spear is technology, and it changed the way we hunted, the types of animals we could hunt, and the productivity of our hunting. We need to adapt to technology instead of the other way around in order to be successful. When the circular saw was invented, it became better to bring the wood to the saw instead of the other way around.

An interesting development in the thinking involved in ERP systems. One that I think summarizes the position of People, Ideas & Objects in building the Preliminary Specification. Taking the advanced Information Technologies and applying them in new ways to the Joint Operating Committee.

The moment we think technology should adapt to the organization, things start to go wrong. We will try to apply the circular saw to the wood. Unhandy, not to mention dangerous. Translated to modern IT, it leads to costly, inflexible solutions that don’t do what you want — and we’ve all seen our share of those.

Basically, we have forgotten that the way organizations look today is based on the constraints of yesterday. They are as technology-dependent as we’d like to prevent today. The moment we apply modern IT and adapt it to the organization, we are doing two things wrong. We are not improving the organization, and we are using unfit technology (the old technology had a much better fit).

Essentially stating that new technology needs to address new organizational constructs. So when People, Ideas & Objects use Cloud Computing to solve the networked effect of participants in the Joint Operating Committee, we are applying new technology to new organizations. Or when we use Oracle’s new Fusion Applications, which will be announced later this month, to identify and support the Joint Operating Committee, we are applying new technology to new organizations. We have chosen to let IT take a leading role in supporting the successful and innovative oil and gas producer.

The role of IT in your strategy is a choice. If you choose IT to have a leading role, you should let yourself be led by IT.

For the industry to successfully provide for the consumers energy demands, it’s necessary to build the systems that identify and support the Joint Operating Committee. Building the Preliminary Specification is the focus of People, Ideas & Objects. Producers are encouraged to contact me in order to support our Revenue Model and begin their participation in these communities. Those individuals that are interested in joining People, Ideas & Objects can join me here and begin building the software necessary for the successful and innovative oil and gas industry.

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Some Advantages of the JOC

Last week we began a comprehensive review of People, Ideas & Objects research and systems development. This review is focused around using the Joint Operating Committee (JOC) as the key organizational construct of the innovative oil and gas producer. It also appears, based on this blog’s analytics, that many of our readers may have been on vacation. I think this review provides substantial value to all our readers, and particularly for those that may have joined us in the past few years. To aggregate the posts that make up this review, please select the Review label on this blog. Last week we were able to summarize the four research questions that were answered in the Preliminary Research Report. Today’s post deals with the advantages of using the JOC.

The JOC is very much involved in the day to day activities of an oil and gas producer. What is surprising is that the ERP systems that are in use in oil and gas do not recognize the JOC. Not until such time as we develop the Draft Specification will we have the systems that align to the legal, financial, operational decision making, cultural and communication frameworks. All of the current ERP systems have been developed during the pre-Internet era. None of these vendors have approached the oil and gas industry from the point of view of the partnerships represented in the JOC, they only recognize the hierarchy of the individual producer. This prompted our assertion that SAP is the bureaucracy. The Preliminary Research Report noted the advantages of using the JOC are as follows.

• All participants are motivated equally. Financial opportunity drives consensus.

Attaining a consensus when everyone is motivated on the basis of financial incentives is the optimal situation. It is for this reason alone that the JOC provides such strong support for building the systems defined in the Draft Specification. Developing the systems to recognize the decision rights within the JOC will enable the decisions to be made more efficiently and effectively.

Subsequent to the publication of the Draft Specification, and around the time that the iPad was introduced. People, Ideas & Objects asserted that we could use the iPad or other device to have the JOC representatives video conference the meetings. Each representative being in attendance irrespective of when and where they may be. With the software development capability which is a fundamental element of the People, Ideas & Objects offering, these meetings would be supported with automated software that implements the processes and procedures that are decided on by the committee. When the decision was made to re-enter a well to complete another zone, the AFE’s would then be automatically issued and become effective within the system. Fast, high quality decision-making with full implementation of the necessary processes will be the result of producers funding People, Ideas & Objects software developments and Community of Independent Service Providers.

• The JOC is the legal, financial, operational decision making, cultural and communication foundation of the oil and gas industry. All the internal processes tacitly support this fact.

Moving the compliance and governance frameworks from the hierarchy to be in line with the JOC puts all the frameworks of both the producer and the committee into alignment. As decisions are made by the JOC they are implemented in accordance with the strategy, compliance and governance needs of each individual producer. Each producer employs their own strategy based on the unique makeup of their assets. Just because the producer voted for the recompletion of the other zone, does not impute any element of their corporate strategy or financial metrics to any of the other participating producers.

• The participants in the JOC hold significant technical and managerial capabilities.

The people that represent the producer firm in the JOC are usually of broad business experience and educational background. Usually sourced from the earth science and engineering disciplines, their focus is developing the oil and gas assets held within the JOC. In many of the smaller producers it is frequently the president that represents the producer. Building the software that identifies and supports these key individuals is the beginning of making the producer more innovative.

For the industry to successfully provide for the consumers energy demands, it’s necessary to build the systems that identify and support the Joint Operating Committee. Building the Preliminary Specification is the focus of People, Ideas & Objects. Producers are encouraged to contact me in order to support our Revenue Model and begin their participation in these communities. Those individuals that are interested in joining People, Ideas & Objects can join me here and begin building the software necessary for the successful and innovative oil and gas industry.

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McKinsey on Global Rebalancing

McKinsey have published an article that I think provides a good understanding of how our economy will be functioning in the near term. Entitled “Globalizations Critical Imbalances” it talks about the necessary adjustments in world trade and their implications. Coming from the point of view of the energy industry, I think this document shows the demand for energy will continue to increase substantially in the near term. Prices will be the means of allocating these finite energy resources and therefore the rewards to the innovative oil and gas producer will be substantial. McKinsey notes.

To some extent, the rebalancing of global economic activity from developed to emerging markets simply reflects economic laws of gravity. In a world where ideas can flow freely and countries are at different stages in adopting modern modes of production, communication, and distribution, less developed nations should grow more rapidly than their counterparts in the West as they catch up.

China, India, Brazil and others are providing substantial increases in the quality of life for their citizens. This naturally imputes greater volumes of energy will be consumed by these countries. Competition for energy resources will be extreme. How much of an increase in consumption and energy pricing is reflected in this next quotation.

The structural issue facing developed-world nations is that the amount of high-quality, high-productivity labor that will be mobilized over the next decade in Brazil, China, and India (not to mention Mexico, the Philippines, and Thailand) is likely to be measured in the hundreds of millions of people. By comparison, the entire US labor force comprises 150 million people. This is a wonderful trend for humankind and would be a boon for everyone in the world if emerging-market employment were directed largely toward production for domestic consumption. The challenge for developed-world governments and citizens seeking jobs, however, is that a significant fraction of this emerging-world labor displaces jobs that would otherwise be created in Europe, Japan, and the United States. This may be the underlying reason why unemployment in Europe, Japan, and the United States is becoming more structural rather than cyclical and may get worse over time no matter how much public stimulus is provided. Certainly, the job losses of the Great Recession look quite different from those of past recessions.

We are clearly not out of the woods in terms of the Great Recession. One of the best indicators of the world economies health has been the Baltic Dry Index. The costs to ship dry goods has fluctuated wildly during the last few years. Although the index has stabilized over the past few quarters, it remains substantially below the highs recorded prior to the beginning of the recession. (Note the recent decline in the index has been substantial.) McKinsey notes the difficult situation these global imbalances will cause various governments.

It is very difficult to say how these issues will play out. The global rebalancing that is needed is obvious: developed-world countries need to save more, consume less, become more fiscally disciplined, and run current-account surpluses (or at least be neutral). Emerging-world countries need to let their currencies rise until PPP rates are closer to financial-exchange rates. They need to consume more, save less, run current-account deficits (or at least be neutral), and continue investing, with some of the capital provided by outsiders. If major national governments work proactively together to rebalance and coordinate their fiscal, monetary, trade, and foreign-exchange policies, the adjustment process could be gradual.

The implications of this “rebalancing” may appear dire to those in the developed economies. I think the opportunities will be substantial and the challenges significant. Those that are able to innovate, and particularly the oil and gas producers, will realize many benefits. Realization that we are no longer in the “low cost” era of the energy industries past. Changing from this past mindset to one that can profit from these types of economic forces requires the changes that are contemplated in the Draft Specification.

The underlying global economic processes under way are very powerful, and the profit opportunities will be enormous as four billion people in emerging markets triple or quadruple their incomes and wealth over the next 20 years.

McKinsey are specific on how companies should position themselves for these changes. Oil and gas firms need to adopt these and other recommendations. It is foolhardy to think that these economic challenges and opportunities can be handled by the existing bureaucracies. Innovative oil and gas producers need to begin the process of addressing these opportunities by acquiring the software development capability of People, Ideas & Objects and begin the development of these software applications.

These suggestions represent specific applications of the more dynamic management approach I have urged companies to adopt in the past. The hallmarks of that approach—heightened awareness, greater resilience, more flexibility, and the timely alignment of leadership around needed adjustments—will be invaluable for companies as they navigate the choppy waters of global economic rebalancing. This process will continue and perhaps even accelerate in the years ahead, not despite, but because of the structural adjustments that are needed to put the global economy on a more sustainable trajectory.

Society is put in peril when world oil production declines. There is evidence that the world's oil production has declined. Therefore the world needs to have the energy industry expand its production. To do so requires that we reorganize to enhance the division of labor and specialization within the industry. As has been proven, this reorganization could achieve far greater oil and gas production. Management of the industry is conflicted in expanding the output of the industry. The less they do, the higher the oil and gas prices and the better they appear to perform. This managerial conflict must be addressed and the performance of the industry unleashed. To do so requires the current management of the industry to fund People, Ideas & Objects and build the systems as defined in the Draft Specification. Please join me here.

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Approaching regulatory issues

Many of the ways that problems are solved in the Draft Specification might lead to issues with the current regulatory frameworks. This should be expected. We are building a system that is designed and intended for the 21st century. Retrofitting 20th century regulatory frameworks into these systems is going to create some friction. Where conflict and contradiction exist, creative and innovative solutions can begin.

We have a variety of ways to deal with these issues, if and when they arise. We can take the literal interpretation and implement the compliance feature in much the same way they would be implemented today. We can design new and innovative ways in which compliance can be achieved and alternatively we can influence and change the compliance framework itself.

Of these three different approaches we should aspire to attain better compliance and governance of the producer and market firms. This clean slate approach is one of the advantages that we acquire, we should optimize it. Sounds like a job for the Community of Independent Service Providers.

Society is put in peril when world oil production declines. There is evidence that the worlds oil production has declined. Therefore the world needs to have the energy industry expand its production. To do so requires that we reorganize to enhance the division of labor and specialization within the industry. As has been proven, this reorganization could achieve far greater oil and gas production. Management of the industry are conflicted in expanding the output of the industry. The less they do, the higher the oil and gas prices and the better they appear to perform. This managerial conflict must be addressed and the performance of the industry unleashed. To do so requires the current management of the industry to fund People, Ideas & Objects and build the systems as defined in the Draft Specification. Please join me here.

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We are an Oracle Customer

Cloud computing is a paradigm shift. The consequences of moving to that new platform are substantial for all concerned. As software developers, we are not immune to these changes. Viewing cloud computing, as developers, from the same perspective as that used in the past would eliminate many of the benefits of this new dynamic. This post seeks to highlight how People, Ideas & Objects, as cloud computing software providers to the oil and gas industry, approach the use of Oracle technologies and services.

The overall strategy that I have used with respect to Oracle is that we are perceived as a customer. In today's environment, Oracle's business is based on selling technology directly to the oil and gas firms. People, Ideas & Objects now represents the oil and gas firms interest by providing the cloud computing services, and therefore we are Oracle's customer.

Usually, as developers, we would be classified within Oracle's developer network. Providing People, Ideas & Objects with a discount on all of their products. As a result of being a "customer" as opposed to the traditional "developer", People, Ideas & Objects will have to pay the full list price for Oracle's technology. This premium being paid entitles us to perceive Oracle as we noted in the second paragraph of this post. This is also wholly consistent with how the innovative oil and gas producer is focused on their key competitive advantages of their asset base, and earth science & engineering capabilities.

Many of Oracle's technologies are the preferred choice in most markets. That is to say that we will use Oracle technology and services at every opportunity. Hardware, operating systems, database, middleware, applications, consulting and services. The only area of conflict in our policies is regarding the Community of Independent Service Providers (CISP). If a member of the CISP and Oracle are providing similar services, we will defer to, and support the CISP.

People, Ideas & Objects as providers of a software development capability and cloud computing provider. Are in partnership with Oracle in bringing this technology to the innovative oil and gas producer. One thing that can be said about Oracle's technology, is that it is the best. When we look at the difficulties in increasing the market supply of oil and gas to the global economy. It is challenges such as these that Oracle is prepared for.

Society is put in peril when world oil production declines. There is evidence that the worlds oil production has declined. Therefore the world needs to have the energy industry expand its production. To do so requires that we reorganize to enhance the division of labor and specialization within the industry. As has been proven, this reorganization could achieve far greater oil and gas production. Management of the industry are conflicted in expanding the output of the industry. The less they do, the higher the oil and gas prices and the better they appear to perform. This managerial conflict must be addressed and the performance of the industry unleashed. To do so requires the current management of the industry to fund People, Ideas & Objects and build the systems as defined in the Draft Specification. Please join me here.

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McKinsey on Valuing Value

Today we have a short article from McKinsey on valuing value. Entitled "Why value value? -- defending against crisis: Companies, investors and governments must relearn the guiding principles of value creation if they are to defend against future economic crisis." The crisis in the economy is now called a debt crisis and no longer the financial crisis. The financial crisis was a liquidity driven issue and our current debt crisis is a solvency issue. Liquidity can be resolved relatively easily by governments providing cash to the markets, debt crisis' can only be solved with difficult choices and significant hardship one way or another.

An interesting perspective on the current economic situation is provided in this weeks EconTalk podcast by Professor Russ Roberts. Here Professor Roberts breaks down how things became unhinged from an investment point of view. I find the discussion around housing as an investment, Collateral Debt Obligations (CDO's), Synthetics and most of what Wall Street has been involved in as gambling. Nothing is generated out of all these machinations. No new products or services, nothing tangible or worthwhile. It seems to me that Wall Street management have provided leadership to the energy industries management. Leadership in terms of losing sight of what is real.

Discussion of the current economic situation is of importance to the development of People, Ideas & Objects. We can only institute the levels of cultural change within the oil and gas industry through an economic transition that causes the existing bureaucracies to atrophy, and the alternative, as represented in the Draft Specification, is built and grows to replace it. The debt crisis is this mechanism, and we are focused on building value throughout the oil and gas industry.

What I expect will continue to happen is the existing bureaucratic firms will have difficulty in earning "real" income from their operations. Commodity prices are high, and the expectation that they will stay high is supported through the increase in global energy demand and the difficulties in increasing reserves and production. Costs of operations will continue to escalate due to the inability of the bureaucratic culture to build the necessary scientific and engineering capabilities in the time they are required. Throwing more money at the problem will continue to be the only solution that management can provide. The point of making the changes as suggested in People, Ideas & Objects Draft Specification, is to enable the oil and gas producer to focus on generating value. It is the point of generating value that is discussed in this McKinsey paper.

In response to the economic crisis that began in 2007, several serious thinkers have argued that our ideas about market economies must change fundamentally if we are to avoid similar crises in the future. Questioning previously accepted financial theory, they promote a new model, with more explicit regulation governing what companies and investors do, as well as new economic theories. p. 1

One continuous theme that we are finding in our review of Professor Richard Langlois' papers is that markets need "market-supporting" institutions. Leaving the future to unfold as it "should" is consistent with the Lassiez Fairre form of capitalism that brought us here. Now, as represented in the Gulf of Mexico, it could be argued that the inability of BP to shut in the well is a market failure. I would argue that it is a failure of establishing the appropriate market-supporting institutions. I have also argued that software plays a key role in establishing these market-supporting institutions. Software is an enabler or inhibitor to innovation. The current bureaucracies use of SAP has cemented the hierarchies ways and means permanently.

In this next quotation the author intimates that crisis' are created as a result of a miss allocation of capital. This is accurate in the sense that the low costs of money over the past few years has created a lack of discipline in making the right investments. Do we save for the future or buy a bigger house? These types of decisions have been made by consumers and businesses and have led to the situation where everyone is now carrying large debts supported by poorly performing assets. What is the investment capital discipline in the oil and gas industry?

My view, however, is that neither regulation nor new theories will prevent future bubbles or crises. This is because past ones have occurred largely when companies, investors, and governments have forgotten how investments create value, how to measure value properly, or both. The result has been a misunderstanding about which investments are creating real value—a misunderstanding that persists until value-destroying investments have triggered a crisis. p. 1

and

The guiding principle of value creation is that companies create value by using capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). The faster companies can increase their revenues and deploy more capital at attractive rates of return, the more value they create. p. 1

Oil and gas firms have been profitable, many have had record profits. And that would denote they have generated value. However, what about the long term. These record profits have been generated as a result of increased multiples of the commodity prices. These profits have not been effectively invested in expanding reserves or productive capacity. Now that costs are escalating systemically and culturally, as I argue in the review of Professor Langlois, how much longer will value as defined by McKinsey continue to build?

In the Draft Specification, strategy is set by the producer at the Joint Operating Committee level. The producers competitive advantages are structured around their unique asset base and the scientific and engineering capabilities that are made available to them. With these tools the producer firm is able to focus on increasing their reserves and deliverability. Determining the best manufacturing methods to build drill bits do not provide value, and I have suggested that their involvement in owning and operating field level innovations be limited to defining and funding these types of industry capabilities.

Companies can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage. This is how competitive advantage, the core concept of business strategy, links to the guiding principle of value creation. p. 2

The oil and gas industry stands at a unique time and place. We recently learned through our review of Professor Alfred D. Chandler that bureaucracies essentially failed during the great depression. We see hierarchies in the global banking system have also failed. Do we need to wait until it is evident to everyone that the energy industries management are failing? High commodity prices have made these companies look like they are functioning properly. However, the excess cash flow has not increased their reserves or production? Knowing what we know about the duration of the commodity price spike, and the logarithmic decline curve, what is the future deliverability of these companies. Understanding the role that energy plays in our lives we need to act before the failures become too obvious.

These principles have stood the test of time. Economist Alfred Marshall spoke about the return on capital relative to the cost of capital in 1890. When managers, boards of directors, and investors have forgotten these simple truths, the consequences have been disastrous. The rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States during the 1980s, the collapse of Japan’s bubble economy in the 1990s, the Southeast Asian crisis in 1998, the dot-com bubble in the early 2000s, and the economic crisis starting in 2007 can all, to some extent, be traced to a misunderstanding or misapplication of these principles. Using them to create value requires an understanding of both the economics of value creation (for instance, how competitive advantage enables some companies to earn higher ROIC than others) and the process of measuring value (for example, how to calculate ROIC from a company’s accounting statements). p. 2

Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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Perez, Crisis and Innovation Part II

People, Ideas & Objects is about developing software that identifies and supports the energy industries standard Joint Operating Committee (JOC). The purpose in developing this software is to create the ways and means for the oil and gas producer to facilitate innovation in the expanding earth science and engineering disciplines. We are not about the latest version of Oracle's impressive database or some other technology. That is Oracle's business and we will implement these technologies in our software offering in innovative ways. The technology is not the critical element. We don't see significant levels of innovation being generated in the technology itself, they are mature and are not critical to the producers innovation. The innovation we are seeking is in the organizational methods that identify and support iterative development of the earth science and engineering capabilities of the producer firms and markets.

Installation and Deployment: different drivers of innovation

This difference between innovating on the Information Technologies and innovation in the producer firms is an important clarification of what we are doing. What I had not fully realized until reading Professor Carlota Perez' February 2010 paper is the clear distinction between the two types of innovation in the Information Technology & Communications Revolution (ICTR). With the two major phases of each "great surge of development" the "Installation Period" and the "Deployment Period", bring about two distinct types of innovation in the marketplace. Professor Perez notes;

Distinguishing between innovation in the core new industries themselves and in the industries or activities that apply the new technologies to innovate is important for understanding the main differences between Installation and Deployment as regards the rhythm and direction of technical change. p. 8

That we are innovating in "the industries or activities that apply the new technologies to innovate" is proof that we are in the deployment phase. This deployment phase is what Professor Perez compares to other golden ages and calls the "Sustainable global knowledge-society". A time when IT applied to traditional industries brings about the value creating activities that will sustain the globalized economy. Professor Perez contrasts the two periods.

The high and growing valuations of telecom and Internet-related companies during the NASDAQ bubble facilitated the completion of a global fibre optic network that has become the foundation of the globalisation process. p. 8

and

The deployment period is the time when the modernised companies across all sectors innovate using the power of the technologies of the revolution and of the new –by then, established– paradigm. It is a time of expansion, extension and multiplication of possibilities in the whole spectrum; it is also a time for social innovation in order to spread more widely across society the benefits of the vast wealth creating potential. p. 9

We have always considered, since the Preliminary Research Report, that high energy prices are the reallocation of the financial resources towards innovation. The investments in innovation by the oil and gas producers are not to be made through debt or equity or earnings but through the allocation of revenues to the appropriate areas. This reflects the high costs of innovation and the need to build capabilities within the producer firm and marketplace. Of note People, Ideas & Objects have developed a new classification of oil and gas workers that we call the Community of Independent Service Providers (CISP). These people are the critical resources that provide People, Ideas & Objects with the direction of our software developments. They are the ones that anticipate the needs of the producer firms they represent, and work with our developers to build the tools needed to support the user communities involved in oil and gas. It is the revenues of the producers that will go toward development of the capabilities within the producer firms, markets, the CISP and these software developments.

In sum, there is a changing of the innovation guard with the Turning Point. During Installation the innovation drivers are the new technological entrepreneurs and the financiers while the State has a service and facilitating role with a laissez faire attitude. During Deployment, the State comes back actively and serves as innovation driver together with production capital, which takes the helm of investment while financial capital serves as support. p. 9

I read "production capital" as the reallocation of the oil and gas revenues to the service industries to support the producers innovations. These are predominately service based businesses that provide a supporting role to the producers. "Production capital" denotes somewhat of an investment, whereas I see a long term relationship between the producers, their markets and communities. This restructuring of the oil and gas industry does not provide those, producers or otherwise, that may have invested "production capital" with any return. The continued expectation that the oil and gas industry will become innovative by the service industries investments and developments of technologies is fool-hardy. It may be debated whether that expectation is fool-hardy or not, but I can assure you that it is ridiculous when it is considered the oil and gas producers generate the entire revenue base of the producers, markets, service industry, CISP and People, Ideas & Objects. Continually squeezing the service industries for more has as much to do with the failure of the bureaucracies that control these financial flows, as the need for real reform in this area. I see the producers themselves spending this "production capital" on these markets and communities to support their own capabilities. Professor Perez has much more to say on this point later in this paper. We will revisit this point at that time.

The other process typical of the aftermath of technology bubbles that was already taking place during the second boom is the restructuring of one industry after another and the definition of new boundaries through mergers and acquisitions. p. 11

These changes in the industry structure underlay the revised focus on the demand for energy.

As will be discussed below, though, the hyper-segmentation of markets and the flexibility of ICT is likely to change the way of defining industries and the markets in which they compete, in order to focus on the demand sectors rather than on the supply ones. p. 11

If we are looking at this deployment period lasting another thirty years, re-structuring of the industry in some fashion to deal with these issues is necessary. And as I have noted in each of these posts, we will work with the producers and communities to determine which methods are the right ones and build the software on that basis. Professor Perez notes that these are consistent with the history she has studied.

Such sectoral redefinitions have occurred with every paradigm shift and the trace is kept –with delay– in the changes of statistical categories across history. Since such changes take time and occur as a result of trial and error strategies and competition, they can only be recognized in the statistics when they have already become the norm in practice. But being alert to these processes is crucial both for companies and for governments, because they provide important signals for innovation and growth paths. p. 11

and

But with Deployment comes a fundamental shift of focus. Rather than looking at the potential of technologies, the focus switches to the opportunities defined by markets and by growth possibilities. p. 11

Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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Encana's Form of Corporate Socialism

This past week we saw a number of 2009 annual reports being published. The majority of them reflecting the difficulty in the oil and gas business during the "great recession". One particular company, Encana Corporation caught my attention. There are a family of 800 pound Gorilla's in their report, one issue stands above the rest, which ties into a paper that I recently read. The paper is written by Professor David Bardolet of Bocconi University, Professor Dan Lovallo of the University of Sydney, and Professor Richard Rummelt of UCLA. The paper is entitled "The Hand of Corporate Management in Capital Allocations: patterns of investment in multi- and single- business firms." This is another paper from the April 2010 edition of the Oxford Journal of Industrial and Corporate Change .

So why does Encana get singled out for this special treatment? Simply this issue needs to be addressed, and they did everything they could to avoid addressing it. Looking at the report their is no discussion of this issue in the message from the CEO. There is no discussion of the issue in the Management Discussion and Analysis. Only in the notes to the financial statements will the issue be brought up, and none of the press releases reflect the point.

The issue is that for U.S. Generally Accepted Accounting Principles (GAAP) their is a $14.6 billion write down of the assets. This creates a $5.5 billion loss for all of 2009. However, as a Canadian company they have the option to report under Canadian GAAP rules and these show a profit of $1.862 billion. Just a small variance. Those that understand accounting for oil and gas will appreciate the ceiling test under Full Cost accounting. Both countries apply the same general principles for the ceiling test, the U.S. system has fewer exceptions and that is the cause of the $14.6 billion difference. What the management don't seem to realize is they will need to be explaining this anomaly in their reporting until such time as the timing differences in the Canadian reporting system expire. That could be as little as one year, or as much as the natural life of the firm, who knows, apparently not the management.

Reviewing the other Canadian firms that may report similar differences in the timing of their ceiling test write downs. I found no other material anomalies between Canada and U.S. reporting. So why has Encana been affected so materially whereas their peers have no such effect? Is it because they are "un-conventional" gas producers? Is there something inherently different in that classification that would cause these write-downs? We'll never know. As the management, led by the CEO, have taken the opportunity to be completely silent as to the anomaly. Why not take this as a teaching moment to inform and educate your investors as to why their assets have been impaired? Management doesn't think that way. They prefer to cower in the corner hoping that no one notices.

Encana defines it's strategy as a "low cost, margin maximizing natural gas producer". Whatever that means. The point of this post, and the branding of Encana as a form of corporate socialism, is based on the one size fits all strategy of this large bureaucracy. I will assert that the write down of $14.6 billion of its assets is a major hit to the firm. One that places them in the position of having to seriously address their asset base. An asset base where  its natural gas production declined by 3%. If "non-conventional" gas is such a lucrative and valuable business model, why are the reserve valuations and production in such decline. From the paper.

One possibility is that our study of “averages” misses the blockbusters. That is, multi-business firms might subsidize CNU businesses because, once in a while, one of them really takes off. We cannot completely discount this possibility or measure precisely the extent of this phenomenon. However, our study of the dynamics of these segments in Section VI suggests that multi-business firms are really not that successful in finding and nurturing these blockbusters. p. 19

By using the Joint Operating Committee as the key organizational construct, strategy can be set at the asset level. If the "low cost, margin maximizing natural gas producer" strategy doesn't fit the asset, a more appropriate one can be set for that asset. This assumes that we build the Draft Specification for the innovative oil and gas producer. Enabling them to manage their assets in that fashion. The use of generic global strategies is what firms did in the twentieth century, not today.

Our results are roughly consistent with the account of “corporate socialism” developed in the corporate finance literature. Some of the work in this line (e.g. Wulf, 1999; Rajan et al., 2000; Scharfstein and Stein, 2000) stresses the agency conflict between division managers and corporate headquarters. Division managers are portrayed as rent-seeking agents that try to obtain additional compensation (in the form of extra capital allocations, among others) from corporate headquarters. They try to do so by overstating their divisions’ prospects or by engaging in direct lobbying. In turn, corporate headquarters might decide that avoiding this inefficiency in resource allocation is not worth the cost of increased monitoring or low morale and thus accede to their demands. In particular, Scharfstein and Stein (2000) make the point that managers from weaker divisions have a stronger incentive to engage in firm politics given that their demands for capital investment cannot be argued so effectively solely on the base of a prospect’s quality. Therefore, those managers end up receiving more investment capital than they should and that creates the comparative difference with their stand-alone peers in the same industry.

The corporate socialism argument rests on a complex set of relationships among various agents within the corporation. A simpler theory is offered by the literature on cognitive biases. In particular, the allocations observed in this study can be explained as a consequence of behaviors called “naive diversification” and “partition dependence”. Naive diversification (Benartzi and Thaler, 2001)—also known as the “1/n heuristic”—is the tendency for individuals to be biased toward even allocations. p. 19

Just to be clear the authors point out that this applies to oil and gas as much as it does any other business.

Partition dependence is a consequence of naive diversification when the decision-maker faces a particular partition of the set of choices. In the case of capital allocations, this partition of choices would be the organization of the business units within the company. p. 19

And here the authors make it abundantly clear how these decisions are made.

Naive diversification and partition dependence are well-observed phenomena in other fields of human decision-making. For example, Benartzi and Thaler (2001) found a similar effect in both laboratory and field data studies of investment in 401(k) plans. When asked to choose between investing in a stock or bond fund, many individuals choose to invest 50% in each. When asked to choose between two stock funds and a bond fund, many individuals choose to spread allocations equally among the three funds, which creates an aggregate investment that is more heavily weighted (2/3) to stocks. Bardolet et al. (2009) found strong naive diversification and partition dependence effects in managers facing hypothetical capital allocation tasks. The naive diversification account applied to internal capital markets would predict a tendency toward equal allocation among all the business units in a firm, thus underweighting factors that would demand more uneven allocations (such as growth rates, profitability, etc). The experimental character of Bardolet, Fox and Lovallo’s study shows that even in situations where social and political factors are not in play (i.e. a laboratory environment) those two biases are enough to cause a tendency toward even capital allocations among all business units, thus corporate socialism is a sufficient but not necessary explanation of inefficient allocations. pp. 19 - 20

What I am asserting is that the capital allocations at Encana fall within the corporate socialism phenomenon. This has led to bad capital allocation decisions being made across the organization. Either too much capital was used in the development of the reserves, or the capital spent did not develop enough reserves to support the costs. Now those chickens have come home to roost in that the capital costs are too high to support the reserves held, forcing the write down. Those familiar with the nuances of the Full Cost ceiling test will realize the material nature of Encana's problem.

Further research on the anomalies we have identified seems warranted. In particular, it seems worthwhile to try to identify the relative importance of incentives, inertia, and biases towards even allocations in driving this result. One step in this direction would be a study which included data on corporate incentive mechanisms and changes in administration. p. 20

If they wanted to study Encana, one should also study the cognitive bias towards promoting pretty young blonde's to executive vice-president positions. Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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Putting Strategy into Practice

Strategy + Business have published "Putting Strategy into Practice" which is a summary of an article published by Harvard Business Review (HBR). The value in this post is that Booz & Company are sponsoring the free distribution of a series of articles entitled "HBR's Must Reads on Strategy". This 143 page .pdf is a collection of 10 articles from Professor Micheal Porter and others that have been published in HBR in the past two decades. A valuable resource to add to your virtual library.

I only want to highlight only the Strategy + Business article today, I'll be reviewing the other articles for content in the near future. The reason that I want to highlight the article is contained within this quote.

Of all the false distinctions that dog business thinking — leadership versus management, profitability versus growth, short term versus long term — the most pernicious is the separation of strategy (where the company should go) from execution (getting there). Strategy without execution is daydreaming. What good is a blue ocean to one who cannot swim? Execution without strategy is pointless, even dangerous. What profit is there in doing the wrong things well?

People, Ideas & Objects has taken the position that the innovative oil and gas producer's strategy should focus on their unique asset base and their inherent capabilities in terms of the earth sciences and engineering disciplines. This is further extended by expanding the role and capabilities of the marketplace of service providers. Capabilities in essence are the means in which to execute strategy.

But the article is also worth celebrating more generally — because it is a harbinger of the closing of that false gap between strategy and execution, and of a new understanding of the role of capabilities in driving strategy.

In our recent review of Professor William Lazonick's paper on Chandler we reviewed his "Social Conditions of Innovative Enterprise" contained within his framework of the "Theory of Innovative Enterprise". Recall the framework provides for analyzing the roles of strategy, organization and finance. The social conditions which include decision rights, organizational integration, and financial commitment resonate with the ideas in this HBR article.

The gathering of this data began in 2002, with a question: How does a company design its organization to generate results and successfully adapt when circumstances change? Neilson and his coauthors articulated four “building blocks” that mattered most in the execution of any kind of strategy: decision rights, information flow (including metrics), motivators, and of course the “lines and boxes” structure of an organization chart.

The Draft Specification proposes the innovative producer need this type of integration. Here we have substantial documentation supporting the changes necessary to move to the Joint Operating Committee, the legal, financial, operational decision making, cultural and communication frameworks of the oil and gas industry. In the preparation of this HBR article the authors, who work at Booz & Company, set up a website to capture this information from their clients. Eventually they documented 125,000 profiles within their database.

Here’s what the data showed, when combined with in-depth studies of 31 client companies: Decision rights and information flows had twice as much impact on the success of a strategy as did changes in structure or motivators. Not only that: Executives introducing strategic change should address the questions of decision rights and information flow first. Once a company makes the structural change and fills the boxes of the org chart with names, the opportunity to make changes in the more critical areas vanishes. Any plans to “get to that later” evaporate. Says Gary Neilson, “We have not seen any exceptions to this pattern in our client work.”

Decision rights and information flows are the domain of the Joint Operating Committee. It is therefore the place in which we need to start. Structure and motivators are important as well and need to recognize, define and support the Joint Operating Committee.

Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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Lazonick on Chandler Part IIIb

This is our third post from Lazonick's paper "The Chandlerian Corporation and the theory of innovative enterprise." In our past two blog posts we have learned some interesting things that are directly relevant to People, Ideas & Objects. In the first post we noted the three generic activities that require alignment; strategy, organization and finance. How the Draft Specification provides for these three activities. And the differences between two corporate strategies defined as "optimizers" and "innovators". Noting that Lazonick defines optimizers as non-innovators. In the second post we determined that the business of the oil and gas business required substantial investment to attain the necessary innovative strategic footing. How today the current bureaucracies are unwilling and incapable of making these investments. And that the investors / shareholders in oil and gas have the opportunity to form their own new and revised organizational ways and means around using the Joint Operating Committee as the key organizational construct, and the People, Ideas & Objects software development capability.

In the Preliminary Research Report it is noted that the higher commodity prices are a reallocation of the financial resources to support innovation. It is the product revenues from oil and gas sales that fuel the innovations. Financing of innovation through debt, equity or profits would be too costly and would generally be inadequate in terms of affecting the performance of the industry. A much larger source of funding is required to fuel the type of innovation that the oil and gas needs. Innovation is a profit generating activity. This fact becomes clearer in today's review of Lazonicks paper.

2. The theory of innovative enterprise cont

In the first quarter of 2010 People, Ideas & Objects attempted to fund its budget needs for the calendar year. As we are aware, the total sum of these activities generated $0.00. This in direct contrast to the 30 compelling reasons supporting why we should be funded. I have pointed to this funding failure as a fact that proves the bureaucracy will never fund these developments. The point is that this environment needs to be created and supported. As Schumpeter noted "innovation drives economic development."

The optimizing firm may calculate, on the basis of prior experience, the risk of a deterioration of current market conditions, but it has no way of contemplating, let alone calculating, the uncertainty of returns for conditions of supply and demand that, because innovation is involved, have yet to be created. The fact, moreover, that the optimizing firm will only finance investments for which an adequate return already exists creates an opportunity for the innovating firm to make innovative investments that, if successful, can enable it to out compete optimizing firms. Indeed, in the future optimizing firms may find that the cause of the “poor market conditions” that they face is not the result of an exogenous shift in the industry demand curve but rather the result of competition from innovating firms that have gained competitive advantage while their own managers happily optimized (as indeed the economics textbooks instructed them to do) subject given technological and market constraints. p. 9

Therefore I see the existence of two fundamentally different oil and gas industries for the next 10 years. Those that are optimizing and atrophying, and those that are innovating and growing. A key difference is the use of the People, Ideas & Objects software that supports and defines the innovative oil and gas producer. The critical role of the Community of Independent Service Providers (CISP) in enabling oil and gas innovation. And the direct investments in innovation that are needed.

An innovative strategy, with its fixed costs, results from the assessment by the firm’s strategic decision-makers of the quality and quantity of productive resources in which the firm must invest to develop higher quality processes and products than those previously available or that may be developed by competitors. It is this development of productive resources internal to the enterprise that creates the potential for an enterprise that pursues an innovative strategy to gain a sustained advantage over its competitors and emerge as dominant in its industry. p. 10

Lets be clear, the costs of these software developments are minuscule to the costs of developing the innovative oil and gas industry. The global oil and gas industry is currently a $3.8 trillion / year industry. I see a significant portion of those annual revenues being dedicated to the processes of innovation. A critical enabling resource within the industry will be the Community of Independent Service Providers, they are the ones that will have the skills and resources necessary to support the innovative oil and gas producer. They are how the energy industry evolves and matches or supports the innovations made at the producer level. Achieving the CISP's overall objective of providing their producer clients with the most profitable means of oil and gas operations. What is needed for both the software and communities to develop is to have access to these financial resources.

Such development of productive resources, when successful, becomes embodied in products, processes, and people with superior productive capabilities than those that had previously existed. But the high fixed costs that such investments entail mean that in and of themselves these investments place the firm at a competitive disadvantage until such time that, by developing and utilizing these investments, it can transform the technologies and access the markets that can generate returns. An innovative strategy that can eventually enable the firm to develop superior productive capabilities may place that firm at a cost disadvantage because such strategies tend to entail higher fixed costs than the fixed costs incurred by rivals that choose to optimize subject to given constraints. p. 10

I can not for the life of me see the energy industry as it exists today changing to the one described in the previous quote. It isn't in their organizational DNA. The process of creative destruction, or as I have detailed the two oil and gas industries, one optimizing the other innovating, is the only means that change of this scale can take place. As the optimizing firms atrophy and their earnings decline, assets will be sold to the innovators, creating a substantial opportunity for the innovative producer through this process of renewal.

If the size of investments in physical capital tends to increase the fixed costs of an innovative strategy, so too does the duration of the investment required for an organization of people to engage in the collective and cumulative—or organizational—learning that is the central characteristic of the innovation process. p. 10

and

The revenues (and not just the profits) that the innovating firm generates can be critical to maintaining its organization intact. When the innovating firm generates revenues, it has financial resources that can be allocated in a number of ways. If the gains from innovation are sufficient, the firm’s revenues create the possibility for self-financing....For the innovating firm, financial resources not only fund new investment but also enable the firm to keep its “learning” organization intact. The innovating firm can use the gains of innovative enterprise to reward its employees for their application of skill and effort to transforming technology (unbending the cost curve) and accessing markets (shifting out the demand curve). p. 13

We have commented on this blog many times before about the mechanical leverage that man has achieved over the past century. 18,000 man hours of labor is contained within each barrel of oil. To convert this factor into the number of man years of physical effort that is offset each year for each American, that number is 385. That is; each American receives the equivalent benefit of 385 man years of physical effort per year. Truly surprising and something that has to be maintained by ensuring that the oil and gas is available to continue to provide the offset. The point in raising this is to ask the question, at what point in time do we achieve an equivalent level of leverage in terms of intellectual thought? And as importantly, how do we get there? I know the first two steps are to gain a software development capability and secondly begin the development of the Community of Independent Service Providers.

The innovation process, that is, can potentially overcome the “constrained-optimization” trade-offs between consumption and production in the allocation of resources as well as between capital and labor, and even between enterprise and society, in the allocation of returns. It is for this reason that innovation can form the foundation for equitable and stable economic growth, or what I have called “sustainable prosperity” (Lazonick and O’Sullivan, 2002; Lazonick, 2009a). p. 14

Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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Lazonick on Chandler Part III

In the first post on Professor Lazonick's paper we discussed the differences between optimization and innovation in terms of corporate culture. How in oil and gas we need to move from optimization to an innovation footing. To do so requires a substantial investment for the oil and gas producers. An investment that begins with the development of the software defined in the vision of the Draft Specification. An investment that up until today, the oil and gas industry has been unwilling to make. What I think Lazonick makes clear in this second part of our review of this paper is that the means to which to make the changes are within our grasp. All that is missing is the willingness to make the necessary investments. That willingness is a product of the innovative firms corporate culture.

2. The theory of innovative enterprise cont

Professor Lazonick begins with a comparison between what he calls the neoclassical firm and the innovative enterprise. The role of the entrepreneur and the assumptions supporting each. In oil and gas I see the bureaucracy believing theirs is a management discipline that deals with all aspects of the industry. That their management capabilities are the critical resource to the profitability of the industry.Lazonick notes;

There are two assumptions of the neoclassical theory of the firm that limit its ability to understand innovative enterprise. First, the neoclassical theory assumes that the entrepreneur plays no role in creating the disequilibrium condition that triggers the reallocation of resources from one industry to another. In the theory of the innovating firm, by contrast, entrepreneurs create new profitable opportunities, and thereby disrupt equilibrium conditions. Second, the neoclassical theory assumes that the entrepreneur requires no special expertise to compete in one industry rather than another. All that is required of the entrepreneur is that he follows the principle of profit maximization in the choice of industry in which to compete. In the theory of the innovating firm, in contrast, the entrepreneur’s specialized knowledge of the industry in which he chooses to compete is of utmost importance for his firm’s ability to be innovative in that industry. p. 6

My experience in dealing with management of the oil and gas industry is accurately captured in Lazonicks text. What management has learned is they too can control the disruptive nature of the entrepreneur, by not allocating any resources towards it, and hence avoid the disequilibrium that is created. Or so they believe. This behaviour has become systemic and has the companies actively avoiding the necessary investments in the business of the oil and gas business. Optimization is the word that everyone marches to and any producer that makes the necessary investments ininnovativeness is deemed risky.

The limiting assumption here is that the entrepreneur does not choose the firm’s level of fixed costs and the particular productive capabilities embodied in them as part of his firm’s investment strategy. In the theory of the innovating firm, the level of fixed costs manifests strategic decisions to make investments that are intended to endow the firm with distinctive productive capabilities compared with its competitors in the industry. p. 7

I referenced this article from the Calgary Herald the other day. It suggests the National Energy Board has determined that Alberta Natural Gas production will decline to 8.5BCF / day in 2012 from 12.7 today. Are we as an industry unaware of the consequences of inaction in the investments necessary for innovation? AsLazonick notes the costs of optimization eventually turn to eliminate the profit elements. The oil and gas industry in Alberta is experiencing these increased costs, of which they attribute to greedy suppliers, and the declining production values. Why, in discussing this with Canadian management, it clearly is not their fault. Imputing they are only a small part of the market.Lazonick discusses this U-shaped cost curve of the optimizers.

The assumption is that the addition of variable factors of production to the firm’s fixed factors of production results in a declining average productivity of these combined factors (i.e., the firm’s technology, which is also the industry’s technology). In deriving the U-shaped cost curve, neoclassical theorists give two quite plausible reasons why productivity declines as output expands. Both reasons assume that the key variable factor is labor. One reason is that as more variable factors are added to the fixed factors, increasingly crowded factory conditions reduce the productivity of each variable factor as, for example, workers continuously bump into one other. The other reason is that as more workers are added to the production process, the entrepreneur, as the fixed factor whose role it is to organize productive activities, experiences a “control loss” because of the increasing number of workers that he has to supervise and monitor. p. 7

It is reasonable to assume that by 2012 the Canadian producers lack of investment in innovation, and the increased costs associated with the U-shaped nature of the optimizers fixed and variable costs, will eliminate them from the marketplace. As I have indicated here on this blog before, Canada, and that is all of Canada, represents a negligible 2 percent of the readership of this blog. I can say with almost 100% assurance, when the scope of the Preliminary Specification is determined by the users, that Canada will not be represented in the functionality of the People, Ideas & Objects application. Conversely, the U.S. makes up 88% of the total users represented here. Anyone want to guess where the innovative, or profitable, elements of the oil and gas industry will be located?

Hence organization—in this case the relation between the entrepreneur as manager and the work force that he employs—becomes central to the neoclassical theory of the firm. Within the theory of the optimizing firm, the constraining assumption is that the entrepreneur passively accepts this condition of increasing costs, and optimizes subject to it as a constraint. In sharp contrast, in the theory of the innovating firm, the experience of increasing costs, as shown on the left-hand side of Figure 2, provides the firm’s strategic decision-makers with an understanding of the limits of the initial investment strategy, and with that information they make additional new investments for the strategic purpose of taking control of the variable factor that was the source of increasing costs [for an elaboration of this argument, seeLazonick (1991: ch. 3, 1993)]. An innovating firm would not take a condition of overcrowding or control loss that results in increasing costs as a “given constraint,” but rather would make investments in organization and technology to change that condition. In effect, for the sake of improving its capability to develop and utilize productive resources, the innovating firm makes strategic investments that transform variable costs into fixed costs, which the firm, in order to innovate successfully, must now endeavor to transform into low unit costs. pp. 7 - 8

Therefore investment in the productive capacity of the oil and gas industry starts here. Development of the innovative organization is deemed a necessity due to the demands of the marketplace and the increased complexity in the underlying earth science and engineering disciplines. Today we live in a sophisticated marketplace that demands the changes to organizational structure be contemplated and built within the software first. This is only the beginning of the investments that are necessary. These investments are a significant undertaking for the industry, and they are past due.

An innovative investment strategy is inherently uncertain, and investments in innovation must be made despite the existence of uncertainties concerning prospective returns. Any strategic manager who allocates resources to an innovative strategy faces three types of uncertainty: technological, market, and competitive. Technological uncertainty exists because the firm may be incapable of developing the higher quality processes and products envisaged in its innovative investment strategy; if one already knew how to generate a new product or process at the outset of the investment, it would not be innovation. p. 9

In Part III of this paper we will begin to look at the risks associated with an innovative strategy. Our appeal should be based on these eight "Focused on" priorities and values of how better the oil and gas industry and its operations could be handled. They may not initially be the right way to go, but we are committed to working with the various communities to discover and ensure the right ones are. If your an enlightened producer, an oil and gas director, investor or shareholder, who would be interested in funding these software developments and communities, please follow our Funding Policies & Procedures, and our Hardware Policies & Procedures. If your a government that collects royalties from oil and gas producers, and are concerned about the accuracy of your royalty income, please review our Royalty Policies & Procedures and email me. And if your a potential user of this software, and possibly as a member of the Community of Independent Service Providers, please join us here.

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