Transaction Cost Economics in Real Time

Professor Richard N. Langlois, The University of Connecticut.
Industrial and Corporate Change Volume 1 Number 1
© Oxford University Press, 1992

I have a series of papers that were presented by Professor Langlois at the European School on New Institutional Economics (ESNIE) 2006 conference. These are the documents that were selected by Professor Langlois for his ESNIE presentation. A presentation that is entitled "Dynamic Transaction Costs". This will consist of the next four posts and will summarize the talk and apply it to the oil and gas industry through the perspective of the Joint Operating Committee (JOC). The last post will summarize Langlois' presentation slides which appear to be a summary version of his Economics 486 course slides.

Dynamic transaction costs are a new (new to this blog) concept that Langlois introduces in this first post. Written in 1992 and published by Oxford I am unaware of how the copyright applies in this case. In reviewing Langlois material I am finding the scope of his writings accurately mirrors the scope of defining the organization for oil and gas. A quick review of the postings that have been categorized with the label "capabilities" will aid in the understanding of where some of these concepts are headed. It is also recommended that a copy of the table and module design components be available for review throughout for reference.

First up is Langlois' definition of "Dynamic Transaction Costs".

"Over time, capabilities change as firms and markets learn, which implies a kind of information or knowledge cost - the cost of transferring the firm's capabilities to the market or vice-verse. These "dynamic" governance costs are the costs of persuading, negotiating and coordinating with, and teaching others. They arise in the face of change, notably technological and organizational innovation. In effect, they are the costs of not having the capabilities you need when you need them." p. 99

and

"Indeed, in cases in which systemic coordination is not the issue, the market may turn out to be the superior institution of coordination. In general, the capabilities view of the firm suggests that we look at firm and market as alternative and sometimes overlapping institutions of learning." p. 99

1. Transaction costs in the long run and the short.

Placing the energy industry into a long run vs short run time frame is difficult for a number of reasons. First the capital nature of the industry demands the long lead times necessary for the discovery, production and exploitation of the assets. Yet the industry operates in a competitive market that evaluates the energy industry on the same criteria as all other industries. And whether that is right or wrong is an argument that finds no definitive solution. What the energy industry does know is that the invisible hand demands that they compete in both environments. Placing transaction costs and there relevance into this debate is interesting from the point of view of the thinking that develops. First Langlois notes;

"Since Coase (1937), economists have begun to explain observed patterns of ownership and contract by their ability to minimize the sum of production costs and transaction costs. If my corollary is right, however, this modern - shall I call it neoclassical? - theory of the boundaries of the firm is necessarily a short run theory. Transaction costs are essentially short-run phenomena. This does not by any means make such costs unimportant." p. 100

Therefore if we look at transaction costs from the long term point of view. The nature of the business demands that most of the work done on the plants, wells, gathering and processing facilities are operated at arm's length by a variety of contractors engaged with the company to implement the producers plans. To have all the field people necessary for the producers needs is of course not possible. This applies to both the capital expenditure end as well as on operational expenditures. This denotes that the "contract" is the source of transaction costs and the means to achieve anything productive in the industry. And that would apply, in my opinion, to both ends of the time perspective.

"First of all, the standard concept of the runs is - almost paradoxically - a timeless notion. That is, the time that passes between the short run and the long run is what Mark Blaug (1987, p. 371) calls 'operational time' rather than real time." pp. 100 - 101

Operational time in the energy industry appears to me the time necessary from initial thought in the geologists mind to the shutting down of the field. It is alleged that only 3% of all geologist ever find any commercial oil and gas. Most are involved in the many facets of the science. And this is the reason that we see most of the industry operated by geologists. The lead times necessary to even present the geologists idea to management for funding could be 2 - 5 years. Yes it takes that much effort. And that is for any and all geologists, some are naturally employed in what I would consider a pure research area that reflect the basins in which they operate, such as production management, reserves evaluation etc. This entire process is a scientific approach that will develop the science known within the firm. such that firm will be known to specialize in certain regions, zones or other criteria.

It was in my thesis that I noted that certain constraints will challenge the geologists. With the increase in the knowledge of the science expanding as it is today, how will they keep up, and most importantly how will they innovate on that expanding knowledge base. I am including a link to the Peoples Daily Online on some of the new approaches the Chinese have developed in their industry. I question, that if this theory is valid (and I don't understand geology) why did this new theory not originate from Houston?

"It is, Marshall says, a"

"general rule, to which there are not very many exceptions, that the development of the organism, whether social or physical, involves an increasing subdivision of function between its separate parts on the one hand, and on the other, a more intimate connection between them. Each part gets to be less and less self sufficient, to depend for its well being more and more on other parts... This increased subdivision of functions, or "differentiation," as it is called, manifests itself with regard to industry in such forms as the division of labour, and the development of specialized skill, knowledge and machinery: while "integration," that is, a growing intimacy and firmness of the connections between the separate parts of the industrial organism, shows itself in such forms as the increase of security of commercial credit, and of the means and habits of communication be sea and road, by railway and telegraph, by post and printing press. (Marshall, 1961, IV.viii.1 p.241)."

"Economic progress, then, is for Marshall a matter of improvements in knowledge and organization as much as a matter of scale economies in the neoclassical sense. We can see this clearly in his 'law of increasing return,' which is distinctly not a law of increasing returns to scale: 'An increase of labour and capital leads generally to improved organization, which increases the efficiency of the work of labour and capital' (Marshall, 1961, IV. xiii,2 p. 318) p. 101"

This last comment reflecting on Adam Smiths division of labour. It is important to recall that Smith's example of the pin shop produced spectacular performance increases in the workers at the factory. As each task was broken down to a single task for each worker the pin shop's production increased 240 times. These externalities are what make economies grow. If the expanding base of geological and engineering knowledge is going to be expanded within the firm, then the need to have a greater division of labor will be required for any economy to increase its performance. I challenge anyone to argue that the hierarchy will be the organizational method that makes this happen. It is my opinion that the Joint Operating Committee (JOC) provides the ability for the producers to pool their geological and engineering talent directly on the subject at hand. And in so doing, increase the focus on the science project that is the JOC. (A fascinating and brilliant article that has Adam Smith introduced to the Symmetric Multi Processor is located here.)

"To say that a movement to the long run involves progressive changes in organization and knowledge is really to suggest an interpretation quite different from the standard neoclassical conception, in which substitution is supposed to take place with knowledge held constant. Adopting this learning and organization view, I argue, implies a shift to a real-time conception of the long run. In some sense, the long run is the period over which enough learning has taken place that adjustments are small and come only in response to foreseeable changes in exogenous conditions." p. 102

This long run perspective is not the development or result of any grand scheme. Hayek developed the idea of spontaneous order in which the actions of people are separated from human design. To design the next iteration of the division of labor, industry needs to organize themselves in a manner to achieve the division. The natural form of organization of the industry is the JOC. I have proven the validity of using the JOC through my thesis. I have also noted, and maybe this is a diversion away from Hayek's spontaneous order, that software defines the organization. Therefore in order to define a new organizational construct requires the JOC to be explicitly recognized and supported in the software. And that would involve a large portion of the transaction costs be moved from the hierarchy to the JOC, and hence, incur Langlois' Dynamic Transaction Costs. With regard to having Hayek's theory of spontaneous order coming to an end, that I will leave to the academic community to figure out. The opportunity to have the software spontaneously exist is something that runs against reality.

Langlois has helped us categorize the industry from the perspective of the long run as being the most valid for oil and gas. This has also helped in identifying that contracting between firms is the key determinant of where transaction costs should be incurred. (Recall the two choices are the contract or ownership.) And this is through the JOC that provides a further division of labor through the pooling of corporate resources. Or what I consider is an industry or cluster capability as opposed to a corporate capability. Langlois has also helped us realize that his "Dynamic Transaction Costs" occur as a result of changes between markets and firms. How I see the debate for oil and gas is the JOC has been developed to accommodate the needs of the marketplace. The hierarchies pursuit of compliance and governance issues associated with Tax, SEC, and others, brings about the conflict in which the JOC is summarily ignored by the major software vendors. Providing short term compliance to the regulations is not the business of an oil and gas company. Irrespective of how good the SAP's and Oracle's are, they are not supporting the JOC in any form or fashion and therefore will continue to be a poor choice for oil and gas systems.

I will update the ideas that have formed here and represent them in the table that defines the boundaries of the firm and the market. The following changes are to show the direction in which the "Dynamic Transaction Costs" are derived from.

Construct Market Dynamic Transaction Costs Firm

Transaction Costs (Current) s <------------ P Transaction Costs (Future) P s Assets s ------------> P
Contracts P <----------- s s = secondary P = Primary

"F.A. Hayek (1945, p. 523) once wrote that 'economic problems arise always and only in consequence of change.' My argument is the flip-side: as change diminishes, economic problems recede. Specifically, as learning takes place within a stable environment, transaction costs diminish. As Carl Dahlman (1979) points out, all transaction costs are at base information costs. And, with time and learning, contracting parties gain information about one another's behavior. More importantly, the transacting parties will with time develop or hit upon institutional arrangements that mitigate the sources of transaction costs." p. 104

2. Organization and Capabilities

If we take the points in the previous section as valid, and the oil and gas industry is organized around companies that maintain financial interests in a variety of JOC's. Then the view from the JOC is having at some point in time the need of every field service and product offering. If we take the global view that the industry is sourced on a contractual basis through these JOC's and the management of the companies are involved in three critical areas. These three are the science and engineering capabilities necessary to operate in their chosen areas and on their corporate strategies. Secondly the compliance and governance of their assets. And lastly actively participating in the JOC's of which they have an interest in, and are responsible for guiding their development. Is this not the manner in which the industry should operate? And although this may be considered different then today, the reality is that this is far closer to the way that the industry has been formed. The corporate hierarchy was a solution to the large number of assets owned and operated by growing large companies. In almost all industries the hierarchy is now considered the last choice of how to run a company.

"Although one can find versions of the idea in Smith, Marshall, and elsewhere, the modern discussion of the capabilities of organization probably begins with Edith Penrose (1959), who suggested viewing the firm as a 'pool of resources'. Among the writers who have used and developed this idea are G.B. Richardson (1972), Richard Nelson and Sidney Winter (1982), and David Teece (1980, 1982). To all these authors, the firm is a pool not of tangible but of intangible resources. Capabilities, in the end, are a matter of knowledge. Because of the nature of specialization and the limits to cognition, organizations as well as individuals are limited in what they know how to do effectively. Put the other way, organizations possess a pool of more-or-less embodied 'how to' knowledge useful for particular classes of activities." pp. 105 - 106.

And in a firm, the company consists of a pool of interests in various JOC's. One in which the science and engineering necessary to find, produce and optimize the reserves that are owned by the various JOC's. It is the legal title to the land that establishes whom it is that owns the reserves. The capabilities necessary to run a firm in a confidential manner, that no others will be entitled to know what others may know is a impediment to the future development of the industry. Until we can take a more global view of what resources are available and employ those resources in an optimum manner, the industry will be unable to transition to a higher performance. I realize I am suggesting something that is considered very secretive. But the act of publishing the ideas is what is necessary to earn the copyright. What I can't understand is the number of geologists and engineers that are educated in collaborative environment cease to collaborate while with a firm. If a firm has good quality research that is information of value then copyright it, patent it or trademark it. Hiding the information or knowledge from critical review, is not the way of the future of the industry. The open source movement, and Sun Microsystems, have proven releasing there most valuable intellectual property has generated significant benefits to them and everyone who use it. This is considered open innovation and approaches the difficult problems that companies face today. Companies in the energy industry need to cooperate in an area of science that is too large and fast moving for one company to attempt to handle alone. This is the reason that the JOC needs to be front and centre in the corporations software. The JOC is the way that business is done and indeed is the business of the oil and gas producer. I refer you to an excellent .pdf written by Charles Duke, Vice President and Senior Research Fellow, Xerox Corporation and Ken Dill, Professor of Biophysics, University of California entitled "The Next Technological Revolution: Will the US Lead, or Fall Behind". For a lucid clarification of the issue.

Turning now to the capabilities of the firm Lanlgois notes a few items that define what the skills of a corporation are.

"'Routines,' write Nelson and Winter (1982, p. 124), 'are the skills of an organization.'" p. 106

and

"Such tacit knowledge is fundamentally empirical: it is gained through imitation and repetition not through conscious analysis or explicit instruction. This certainly does not mean that humans are incapable of innovation; but it does mean that there are limits to what conscious attention can accomplish. It is only because much of life is a matter of tacit knowledge and unconscious rules that conscious attention can produce as much as it does." p. 106

and

"In a metaphoric sense, at least, the capabilities or the organization are more than the sum (whatever that means) of the 'skill' of the firms physical capital, there is also the matter of organization. How the firm is organized - how the routines of the humans and machines are linked together - is also part of a firm's capabilities. Indeed, 'skills, organization, and technology are intimately intertwined in a functioning routine, and it is difficult to say exactly where one aspect ends and another begins' (Nelson and Winter, 1982, p. 104)." p. 106

In reading these three quotations I am able to see clearly the boundaries of the oil and gas firm. On the one hand there are JOC's that operate the industry. On the other hand corporations involved in compliance, governance and research areas. Providing me with a tacit understanding of the division and what goes where and with whom. The tacit knowledge of the industry has been gained not "through conscious analysis or explicit instruction". Invoking Hayek's theory of spontaneous law, we see that most of the knowledge of how the industry operates is tacitly held by the JOC. What this software development proposal is attempting to do is move corporations roles and responsibilities more in line with the tacit understanding that makes up the industry. And as Langlois notes in the next quotations, this is consistent throughout industries.

"Ultimately, a firm will be restricted to activities that are fundamentally similar along one or another dimension." p. 107

and

"What gives this observation its salience, however, is that what is similar need not be what is complementary. That is, the various activities in the chain of production may - or may not - each require skills that are quite distinct." p. 107

3. Capabilities and governance costs.

This proposed reorganization of the energy industry is controversial for many reasons. Moving to a collaborative environment from a secretive mindset as I see it, and move to the JOC which is the tacit manner the industry has developed is one rather radical change. One that accurately mirrors the changes in energy supply and demand. Other industries have faced similar challenges, what organizational and business model changes did they incorporate? If we look to Detroit and see how the competition from the global auto industry has forced a transition to new business models. I am not intimately familiar with the car industry but would ask, is Detroit now reorganized on completely different means? For example are GM and Ford essentially filling the role of product design, brand management, finance and marketing of cars? We know that most of the parts are provided by tier 1 suppliers, and assembly is done less and less by the big three. What are the "capabilities and governance costs" of Ford, and what can we learn that may be applicable to the work proposed here.

"But often - and especially when innovation is involved - the links among firms are of a more complex sort, involving everything from informal swaps of information (von Hippel, 1989) to joint ventures and other formal collaborative arrangements (Mowery, 1989). All firms must rely on the capabilities owned by others, especially to the extent those capabilities are dissimilar to those the firm possesses." p. 108

With the industry being organized around the various JOC's there is a definitive need to have the industry perceived and operational on the basis of a "cluster" or "industry" of resources. Competition is not eliminated, only enhanced levels of cooperation and collaboration are added to enhance the performance of the people, the companies, and the industry. Some might argue that we are already doing that in the industry, and to an extent we are. But I am thinking of an industry with two specific organizational groups. All things associated with operations would be handled by the JOC's that have the legal, financial, cultural and operational decision making frameworks firmly in place. The other organization is a scaled down version of the corporation. One that is focused on compliance, governance, research and strategy. Within these two distinct organizational constructs are the entire industries resources made available. If the boundaries of the firm were established in this fashion, an employee may therefore see their employer as either a corporation (the firm) or a JOC (the market). Billing their time to either. Again I would state that some would see this as already happening. I would assert that may be the case but the software that is used by companies is not recognizing the important role of the JOC in the industry. The software defines the organization, in order to move to a more natural form of organization of the industry requires that the software needs to be built first. This could be attained easily by disregarding which company is listed as the operator of the JOC, and recognizing the role of each company that is in essence pooled in the JOC. This role management being enforced through a "Military Styled Command and Control" type of governance structure, and I have renamed that in the module specification as the Governance and Compliance Module.

"In the long run, I have argued, transaction costs might be expected to approach zero. One might also argue this for governance costs generally. In the long run. activities have become increasingly routine. This reduces the cost of contracting, not in the sense that contracts have become cheaper to write but in the sense that contracts are increasingly unnecessary: everything is done tomorrow the way it was done today. In this sense, then, the long run also arguably reduces the cost of internal management by reducing decision making costs. Thus, one might argue that, in the long run as I have defined it, the boundaries of the firm are determined entirely by the capabilities of the firm relative to the capabilities of the market." (Italics mine.) p. 110

What other alternatives are there? The industry has developed the models that form the JOC and have provided it with the requisite authority. The capabilities and boundaries of the firm and market are very clear to all those that have reasonable experience in the oil and gas industry.

"If however, we follow Marshall in seeing the long run as the asymptomatic end-state of a process of learning, then we also have to consider the ways in which capabilities change over time. And here, it seems to me, there are also two opposing effects. On the one hand, the firm is likely to become more capable over time. As more and more of the firm's activities take on the nature of routines, and as the firm's routines become more finely tuned, both the firms total managerial capability and its free managerial capacity will increase. On the other hand, however, the market will also become more 'capable' as time passes. Other firms will also be increasing their capabilities and techniques pioneered by one firm may diffuse to and be imitated by other firms." pp. 110 - 111

The basic premise that I am operating at in these writings is that the innovative producer will be able to assimilate the rapid increase in the earth science and engineering disciplines, and, innovate from that base. This implies the ability to learn is inherent in the proposed reorganizations. How is answered, in my opinion, in this next quotation and also the work of Professor Giovanni Dosi in my original thesis.

"The firms learning ability will depend on its internal organization. And the learning ability of the market will depend on technical and instructional factors, as well as on the learning abilities of the firms it comprises, considered both individually and as a system. The remainder of this paper is devoted to considering these two learning systems in slightly more detail. More specifically, it will set out some preliminary generalization about how the level of capabilities in the firm and the market - and the nature of change in those capabilities - effects the boundaries of the firm." pp. 111 - 112

It was also in my thesis that based on my opinion, for the industry to continue on in the fashion that it is currently operated, there would be a failure in the response to the energy marketplace. Drawing a parallel to the failure of the French deployment of the Maginot Line as a defence in WWII. Dr. Daniel Yergin may be correct in his assertions that their are large volumes of production available for the future, however, if he is wrong, this failure could be seen as catastrophic for the way that Western civilizations operate. Clearly the capabilities of the industry as a whole have to be built to higher level within the firms and marketplaces, and a reorganization based on using the JOC appears to me to be the manner in which this is done. Again I ask, is the hierarchy up to the challenge?

"I propose to call these dynamic transaction costs. They are a kind of cost that has been largely neglected in the explanation of the boundaries of the firm. As I will explain more fully below, I will mean by dynamic transaction costs the costs of persuading, negotiating, coordinating and teaching outside suppliers. Another - if perhaps fast and loose - way to look at these transaction costs is as the costs of not having the capabilities you need when you need them." p. 113

4. Capabilities, learning, and vertical integration.

Internal capabilities.

In Canada at least, the oil and gas industry has been well established for at least 60 out of the 140 years of the energy age. Few places in the world operate in an undeveloped area where the needs of the industry have to be imported. Much of the understanding and infrastructure of the industry can be applied to any country or region in the world. Some of the most innovative developments could conceivably come from anyone of these areas and provide real value to the industry throughout the globe. It's not that the industry is "mature" as many like to call it, but the developments of the industry demand that it respond to any and all geological anomalies mother nature can throw at it. Many of the capabilities are internally captured by the management, and some are inherent in the suppliers that provide many capabilities to the producer. It is with this in mind that I note Langlois stating.

"As we have seen, the distinction between capabilities and transaction costs suggest two (non-exclusive) possibilities. On the one hand, a firm may need to internalize a stage of production because the complementary capabilities that stage represents do not exist or are more expensive in the market. This would be a pure capabilities explanation for internalization. Perhaps the case of Henry Ford and the moving assembly line might fit this possibility. His process innovation gave him a cost advantage over outside suppliers, motivating a high degree of vertical integration. On the other hand, a firm may wish to internalize a stage of production even when the market possesses the requisite capabilities to at least the same degree as does the firm itself. If the firm does internalize, it must be because there are other costs to using the markets. An explanation along these lines would be a pure transaction-cost explanation." p. 114

Therefore in light of what Langlois states, there are transaction costs associated with this capability. And in a marketplace such as energy there does not seem to be a need to internalize many of these capabilities, but push them into the marketplace to provide. This in a nutshell are the boundaries of the firm and the market. How much of the capabilities inherent in the current "company" can be further pushed out to the marketplace? It would seem to me that the performance of a global industry that is challenged in its productivity and deliver-ability needs to augment their performance through the marketplace. The rapid pace of change of today may seem like a snail's crawl in just a few years. How will this industry, as represented by the current makeup of capabilities be able to keep up? According to Lanlgois the ability to keep up can be handled by the firm or the market. The firm will command and control the resources it has to achieve its goals, or alternatively, the firm can contract the resources necessary to achieve its goals. As I have proposed here in this blog, the move to a market for transaction costs will incur Langlois' "Dynamic Transaction Costs" associated with the move.

"Another way to say this is that unpredictable change makes it costly to specify contractual provisions, implying the need for expanded residual rights of control. Teece mentions this possibility as one of a string of possible explanations for vertical integration. My contention is that this is in fact the general explanation, and that all other transaction-cost explanations are either derivative of this argument or apply only on an ad-hoc basis to special situations. Ultimately, the costs that lead to vertical integration are the (dynamic) transaction costs of persuading, negotiating with, coordinating among, and teaching outside suppliers in the face of economic change or innovation. (Teece, 1986)." pp. 115 - 116

The stated benefit of making this software for the energy industry is to enable a higher level of innovation. As we have discussed elsewhere, innovation is not derived from some great scheme, it is the individual who determines what is a better way to do his job and become more efficient in the process. These innovations are then built upon by others and these changes are incorporated in the processes of production. This in turn generating the demand for a software vendor that can work intimately with the industry to ensure these benefits are realized on a permanent basis. The software defines the organization, the innovation is the objective, and these both imply that change will be fluid. How can the industry, or any industry, move forward without these inherent capabilities being built within the software?

"It was autonomous innovation that Adam Smith had in mind when he argued that the division of labor enhanced innovation: each operative, by seeking ways to make his or her lot easier, would discover improved methods of performing the particular operation (Smith, 1976, I.i8, p. 20). The improvement he had in mind were such that they improved the efficiency of a particular stage without any implication for the operation of other stages. Autonomous innovation of this sort may even further the division of labor to the extent that it involves the cutting up of a task into two or more separate operation. Instead of being differentiating in this way, however, an innovation may be integrating, in the sense that the new way of doing things - a new machine, say - performs in one step what had previously needed two or more steps (Robertson and Alston, 1992). More generally, a systemic innovation may require small modifications of the way work is performed at each of a number of stages, and would thus require coordination among those stages." pp. 116 - 117

Innovation in a pin factory pales in comparison to the scope of capital and operations of an oil and gas producer. Exxon Mobil alone has a greater then $250 billion in annual operating costs. This is Exxon's share of joint operations of possibly double that amount. The autonomous and particularly the systemic innovation, I would suggest, has been left dormant within the industry due to the inability to make the changes necessary within the bureaucracy. The symbiotic relationship between the software vendor and the firm's bureaucracy have achieved a total lock out of any innovations. With no ability to change what has inherently been done for decades, the industry will never be able to optimize its future opportunities and meet the consumers demands for energy. Langlois notes;

"This possibility of interconnectedness has been the basis for an argument that vertical disintegration may retard innovation. Innovation may mean replacing assets at more than one stage in the chain of production. If decision making is decentralized, the costs of coordinating the innovation may be high, and the innovation may never take place. This is particularly significant if some of the existing asset-holder, or the suppliers of factors complementary to the existing assets, have the power to block innovation (though trade unionism, for example) to protect their rent streams. If innovation does occur, it may take place elsewhere in the economy (and perhaps elsewhere in the world) under the direction of a unified asset holder and decision maker who can ignore existing task boundaries." p. 117

I wrote about the impact of what I thought the industries solution to a shortage of rigs was here. Large producers buying several rigs for their exclusive use may have provided them with some short term ability to drill more wells. I would assert that in the long run it will do the exact opposite. The drilling contractor only has to wait for his next order for rigs to come from Y producer and to drill Z wells for them. Completely eliminating the focus and demand expected of him in the marketplace. The drilling contractor can now adopt the position of a bureaucrat and mine his contract for the gold that is his claimed share. This also has the subsequent effect of eliminating any start-up drilling contractor taking any risk and reaping any opportunity.

"The empirical significance of this argument, especially as applied to the case of Britain at the turn of the twentieth century, is a subject of intense dispute. As a theoretical matter, however, this argument would seem most applicable to particular kinds of innovation, namely those that integrate operations. And what kinds of innovation do this? Surely one class of important systemic innovations comprises major organizational shift. Examples would include the factory mode of production (Leijonhufvud, 1986), the moving assembly line (Hounshell, 1984), refrigerated meat packing (Silver, 1984, pp. 28 - 29), and containerized shipping (Teese, 1986). All of these examples are ultimately process innovation. And one might argue that although process innovation may also proceed in an autonomous way, there are typically advantages to systemic process innovation. For one thing, process innovation is often integrating, requiring the consolidation of several stages of production in a single (usually mechanized) stage. More generally, process innovation is frequently a matter of fine-tuning the production process in the face of steady and predictable growth in demand: learning how to shave time off operations, to eliminate steps, to substitute stamping technology for casting, etc. This class learning - or experience curve effect arguably proceeds faster in an integrated environment in which systemic change is relatively inexpensive." pp. 117 - 118

Systemic innovations, and for that matter the autonomous ones, are very expensive to incorporate within the oil and gas industry. The industry can't change due to the high costs of implementing any innovation. The ability to support the innovations is the objective of this software development proposal. The ability to change is supported through the long term capabilities of this software vendor. The associated costs of change or the "Dynamic Transaction Costs" will be reduced, making these changes not only possible but profitable.

"The extent to which this happens will depend on the relative learning abilities of the firm. If capabilities diffuse easily to the market, we would expect more spinning off and thus less integration with time. If capabilities do not diffuse easily, disintegration will be slowed. Moreover, the firm may be more or less able to learn over time. For example, it may have an R&D lab, or possess a structure and culture conducive to learning. Cohen and Levinthal (1989, 1990a, b) argue that a firms ability to learn is governed by its 'absorptive capacity'." p. 118

External Capabilities

I have noted in my writings that I believe the industry needs to employ the market more effectively. The market for oil and gas will achieve the innovation that is necessary to meet the consumer markets demands for energy. Defining the market operations and JOC as the same thing is the optimal organizational construct for the industry. The firm's role is not diminished in this new perspective. In our module specification the Compliance and Governance Module and the Research Module are the sole domains of the Firm. It is the Governance component of the proposed Compliance and Governance Module that manages the human resources of the JOC's that the Firms have a financial interest in. Deploying these resources in the Military Styled Command and Control manner of effectively managing the capital, operational, revenue and royalty aspects of their JOC's.

"A market form of organization is capable of learning and creating new capabilities, often in a self reinforcing and synergistic way. Marshall describes just such a system when he talks about the benefits of localized industry."

"The mysteries of the trade become no mysteries; but are as it were in the air and children learn many of them unconsciously. good work is rightly appreciated, inventions and improvement in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. And presently subsidiary trades grow up in the neighbourhood, supplying it with implements and materials, organizing its traffic, and in many ways conducing to the economy of its materials. (Marshall, 2961, IV .x.3, p. 271)" p. 120

How I see this happening is the person that is tasked with managing the JOC for company A doesn't literally leave the firm of which he is employed. However, in his / her role of participating with the other seconded designates that participate in the facility. Work to effectively manage the joint assets and optimize the reserves held within. The mechanisms for dealing with almost every situation have been developed as the Cultural Framework of the industry throughout the globe. The AFE's, Mail-Ballots, agreements, operating and accounting procedures, and others, have all been counterpart executed. These documents also provide a tacit framework of whom will be responsible for which and what methods of ensuring accountability are available. It is this organization that is the market. It is this organization that is the business of the energy producer. Yet none of the software applications that are currently operating within the industry explicitly recognize the JOC. They don't recognize its critical role in getting things done. Their perspective is one from an administrator or accounting perspective that may have provided value in the structured hierarchy, however, the only thing those applications support is the structured hierarchy. And as I have said many times before SAP is the bureaucracy.

What I propose is that we recognize the markets, the cultural, financial, legal and operational decision making of the industry and place it firmly in the market. Then with the proposed software that this blog reflects can explicitly recognize the JOC and its associated markets and support them in the mindset that the industry has developed under. This is the business. The person that was seconded to the JOC at Company A still has a role and responsibility in the company. The Compliance and Governance module will maintain the integrity of the business model for the associated stakeholders. The SEC, Tax, Royalty and other groups that the firm, as representing the ownership in many JOC's, must also report to. But there is also an enhanced role in the Firm. One that is a pursuit of the most effective and innovative means of deploying the various scientific developments that are the core of the Firms value creation.

"In this sense, the ability of a large organization to coordinate the implementation of an innovation, which is clearly an advantage in some situations, may be a disadvantage in other ways. Coordination means getting everyone on the same wavelength. But the variation that drives an evolutionary learning system depends on people being on different wavelengths - it depends, in effect, on out-breeding. This is something much more difficult to achieve in a large organization than in a disintegrated system. Indeed, as Cohen and Levinthal (1990a, p. 132) point out, an organization experiencing rapid change ought in effect to emulate a market in its ability to expose to the environment a broad range of knowledge gathering 'receptors'." p. 120

Emulation of a market is what the JOC was designed for from the outset of the development of the energy industry. The patent disregard for any and all manner of how the market has developed is the fault of the software vendors. The moves toward vertical integration and the various compliance demands on a firm has distracted the software developers, whom themselves have a fast developing science of their own, and have adopted the global concept of what a firm is and applied to the energy industry in the same manner as all their other clients.

"Vertical integration, I argued, might be most conducive to systemic, integrative innovation, especially those involving process improvements when demand is high and predictable. By contrast, vertical integration may be less desirable - and may be undesirable - in the case of differentiation or autonomous innovations. Such innovations require less coordination, and vertical integration in such cases may serve only to cut off alternative approaches. Moreover, disintegration might be most beneficial in situations of high uncertainty: situations in which the product is changing rapidly, the characteristics of demand are still unknown, and production is either unproblematical or production costs play a minor role in competition. In such cases the coordinating benefits of vertical integration are far outweighed by the evolutionary benefits of disintegration." pp. 120 - 121

As I have stated before the compliance frameworks that are currently what most people are exposed as the "business" of oil and gas. The purpose of the business is to find and produce oil, not meet the SEC's requirements of... These compliance frameworks have moved to the publication of their business rules and managing their interactions. It is these business rules that are the "things" that software developers should be using to meet the compliance obligation of the producer. The compliance being a natural part of the process of doing the business of the firm and market, as proposed here. And lets not forget the far more complex demands of how the industry moves forward with innovations on its sciences.

"How would learning proceed in a system of decentralized capabilities? As I have already suggested, progress would take place autonomously within the decentralized stages. There would be no need for integration unless a systemic innovation offering superior performance arrives on the scene. Indeed, as we have seen, fixed task boundaries and standardized connections between stages might make innovation difficult with the existing structure, requiring a kind of creative destruction. (Schumpeter, 1950)." p. 121

Markets and Hierarchies

Or what I would like to categorize the energy as "Joint Operating Committees and Producers". If a hierarchy needs to be maintained today, then so be it. There is adequate calls to action and much "noise" that says otherwise. I thankfully was the first to say this and as a result have lived with the consequences of that idea since. As I aspire to secure funding for these developments in the Fall budget cycle of the producers, I expect the hierarchy to fall on its sword and to do the right thing. As time passes, I believe fundamentally that the solutions described here will be built with or without the hierarchy. If the hierarchy expects to have an orderly transition that option is theirs.

"As G. B. Richardson (1972) pointed out some time ago, the easy partition of alternative into markets (relying on price signals) and firms (relying on authority relations or hierarchies) is not a good description of how the world works. In fact, what we see out there is a mixture of modes of ownership and contract. As Imai and Itami (1984) put it, there is typically an 'interpenetration' of organization and market, leading to organization-like markets and market-like organizations as well as the ideal types of pure market and pure hierarchy." p. 122

5. Summary and Conclusions.

The email of this post that I will send to Professor Langlois will contain one word. Wow. This has been a difficult post to write. By far the most difficult of the over 300,000 words on this topic. It is also the most valuable. The tacit understanding of the energy industries development over the past 140 years has been reflected well by Dr. Lanlgois writings. He has also framed this understanding in a usable template for the job ahead.

"I have attempted in this paper to place the theory of the boundaries of the firm within the context of the passage of time. More precisely, I have tried to resurrect and place in a modern frame some of the insights of the classical theory of organization. In the Marshallian long run (correctly understood), transaction costs approach zero, and the boundaries of the firm become irrelevant. Governance costs - the transaction costs of markets and the bureaucratic costs of organizations - are thus short run phenomena." p. 123

The clarity of the thinking of Langlois' document, and the history of the energy industry are remarkable in both of their precision. When the industry is looked through the perspective of the Joint Operating Committee the clarity of thought resonates between Langlios and the industries history.

"One might think that, as governance costs diminish in the long run, the boundaries of the firm would be determined solely by capabilities. But capabilities also change over time as firms - and markets - learn. The classical presumption was that the firms capabilities would diffuse completely to the market in the long run, leading to complete vertical disintegration. This reinforces the point that capabilities are more than a matter of production costs in the neoclassical sense and, more importantly, suggest that the notion of a firms capabilities implies a kind of information or knowledge cost - the cost of transferring the firm's capability to the market (other firms) or vice versa. these costs are a neglected kind of governance cost, which I call 'dynamic' governance costs. These are the costs of transferring capabilities: the costs of persuading, negotiating and coordinating with, and teaching others. These costs arise in the face of change, notably technological and organizational innovation. They are in effect the costs of not having the capabilities you need when you need them." pp. 123 - 124

The quotation above shows me that the transition to a "market" and "firm" structure will incur the "Dynamic Transaction Costs". However, the transition can be done in an orderly fashion. Not a chaotic process as some of my adversaries have claimed.

"In the face of uncertainty and divergent views of the future, common ownership of multiple stages of production is a superior institutional arrangement for coordinating systemic change. This observation is by no means entirely inconsistent with the existing literature. For example, Williamson (1985) stresses the firms superior capacity for adaptive, sequential decision-making in the face of both uncertainty and highly specific assets. I assert, however, that asset-specificity is neither necessary nor sufficient for these dynamic transaction costs to lead to integration. But in cases in which systemic coordination is not the issue, the market may turn out to be the superior learning engine because of its ability to generate rapid trial and error learning." p. 124

There is much to be learned from this. The first will be that I have now effectively changed the "Software Development Process" that is what I referred to as my role in this transition. It is clear to me that the "Dynamic Transaction Costs" that will be incurred in the energy industry will have the components of this software developments costs. And that to call this process anything other then the "Software Development and Learning Process" leaves the real role of this project undiscovered.

Technorati Tags: Genesys, ESNIE, Lanlgois, Market, Firm, Learning

The Next Technological Revolution:

Will the US Lead, or Fall Behind?

I stumbled upon this excellent summary of the way that innovation, research and development have changed in the new globalized economy. Noting the corporate research popularized in the 1960's and 1970's has faded from the landscape. Xerox, IBM, GE, AT&T and others were involved in large volumes of primary research in a variety of areas that may not have had a defined business for the company. Today these research dinosaurs have faded from the modern corporation. With few companies involved in research and almost no primary research being done anywhere.

The authors document how research and particularly innovation occurs today. Defining "Open Innovation" as;

"Open innovation is the new business paradigm in American industry. Under Open Innovation, a company's value chain is no longer fully contained within the company, and ideas, people, and products flow across company boundaries, to and from other companies, universities, and even countries. Innovation is now a global game characterized by both cooperation and competition between firms and between nations." p. 2

The need to collaborate on a much greater scale is necessary for open innovation. I think and firmly believe that in oil and gas, the need to cooperate, compete and collaborate is necessary for "ideas, people and products" to be able to keep up with a large amount of science moving at an ever increasing pace.

Technorati Tags: Genesys, Collaboration, Ideas, Innovation, Research

Adam Smith meets SMP

The title of this post will take you to an article that provides an interesting perspective on some of the actions that are occurring in the technology field. As I have discussed before, one of the theories that Adam Smith was responsible for was Division of Labor. Back in the 1700's Smith proved through re-organization of a pin factory that dividing the tasks amongst the employees produced significant externalities. (240 fold increase.) These externalities are the benefits associated with all economic growth. If you have economic growth it is fair to assume that someone has made an effective and further division of labor. Externalities are the benefits that produce financial returns above and beyond their costs. This theory of course has been proven many times.

The author of this article argues that the development of multi-core processors or Symmetric Multi-Processors is the further division of labor that will bring about externalities for future economic growth. Duh, well of course, but why didn't I think of that? Intel is currently selling quad-core multiprocessors. Sun Microsystem are shipping 32 core processors and are believed to be in the area of 128 core processors in their next chip. Intel claims to be able to provide future iterations that have a logarithmic volume of cores and hence performance.

The other piece of technology that makes Adam Smith so relevant today is part of the Technical Vision that I have developed here. That technology is Asynchronous Process Management or APM and it is a critical (for me) technology of the Java Programming Environment. Recall that processes are either synchronous, like a conversation or telephone call, or asynchronous like an email or letter. Asynchronous processes provide the user with the opportunity to consider their response at a time and a place that is optimal in terms of convenience and availability. To put a half completed Asynchronous process in a restful state, until such time as the user has responded is something that is inherently part of Java. For an oil and gas user think of the joint venture billing process as it travels through the various companies affected. How much of this processing can be asynchronous, and how much of the operational time of the joint venture billing process can be reduced? 90 days?

These technologies in the hands of the right developers will enable the producer to increase the division of labor. And as mentioned, have the operational time reduced in doing so. And receive the externalities that Adam Smith discovered at the pin factory. The producer's being the net benefactors of this division of labor and the user's being highly productive with minimal interruptions.

Technorati Tags: Genesys, Java, Capabilities, Asynchronous, Development

The Firm in a Knowledge Perspective.

Professor Sidney G. Winter, The Wharton School, May 15, 2006, European School of new Institutional Economics presentation slides.

Professor Sidney Winter presented at last Years European School on New Institutional Economics (Esnie). Click on the title of this entry to be taken to Esnie. It appears that Professors Winter, Dosi and Langlois have submitted working papers and participated in this organization. Also, I have included Esnie in both the oil and gas and academic "Google custom search engines" you can find in the first column of this weblog. Although Professor Winter did not submit any working paper, and his presentation is only 23 slides long, there is much to learn from this resource, so lets begin.

Recall that many of the papers that have been reviewed on this blog were authored by Professor Winter and the "Winter" label will pull together the individual blog posts. With only 7 posts to date, Professor Winter's contribution is of very high quality. The firm in a knowledge perspective is something that I recently wrote about in the Life and Times of Humpty Dumpty. I suggested that Chrysler's loss of engineering capability in the move to design teams is something the energy producers needs to consider may also apply to them. In the redefining the boundaries of the firm I have also suggested here that the scientific and engineering research capability reside with the firm. This is so that the losses realized by Chrysler are not symptomatic of the move to "Design Teams", or similarly, the Joint Operating Committees in the energy industry case. And operational performance metrics override the knowledge capability within firms. I have also suggested elsewhere that the competitive advantages of an oil and gas producer depend on their land base and the capability to find and produce oil and gas are the critical competitive strategies and value creators. This article will therefore focus on the role of the firm and particularly the Research Module of our proposed application.

Winter suggests the key competitive advantage of a firm is the "Knowledge Based View" a subset of the "Resource Based View." Clearly arguing that the knowledge of the firm is the key competitive advantage. This may seem contradictory to what I just stated about the land base and engineering and science based capabilities as the competitive advantage of oil and gas producers. I think we are saying the exact same thing. What does a company know and how is it known? What key resources are required to deploy that capability? (Land, Scientific and Engineering Capabilities). These are more direct questions that seek to reconcile the two different "views" of what has been stated. It is the knowledge of the firm and the ability to deploy it that makes the firm more competitive. And Winter concurs with this assertion with the following quotation;

"Some speak of a competence view or a capabilities view or even a dynamic capabilities view -- all to roughly the same, fairly vague, effect." Slide # 2.

As we have discussed before, in determining the boundaries of the firm and the market. I believe the market is ready to take on a greater role in deploying and developing the innovative approaches to how, what, where, when, who, and why of the industry. To have the contracts between firms free the hand of the market to conduct the operations in dare I say a "just in time" basis. These contracts are able to handle the transaction costs better then the bureaucracy is able to micromanage at this time, primarily through enhanced Information Technologies. And it is this thinking that Winter states

"In that view, firms are where productive knowledge lives, the only place it lives, and knowledge does not travel among them. When firms are a "nexus of contracts" or have boundaries determined only by transaction costs, this traditional perspective tends to fade form view." Slide # 3.

Here I think Winter, is also making the assumption that the move to Design Teams at Chrysler is responsible for the slackening in the intensity of global engineering capabilities. And therefore the risk of a degradation in firm knowledge and capability is a potential outcome of organizational change focused on moving to a market perspective only. The firm exists, and it is the firms sole responsibility for knowledge.

On the next slide Professor Winter comes in with a few solid home runs.

"On this view, firms are central to the social arrangements for storing productive knowledge for extending its application, and for advancing it - three very closely related economic functions."

and

"Of course, there are also other players - other types of institutions, organizations and individual roles complement the firm role." Slide # 4.

This last point firmly pointing to the production related transactions, and other activities of the Joint Operating Committee as proposed in this table.

Winter then makes the point of this discussion with a handful of objectives. Slide # 5.

• "Explain what has been added to the traditional understanding of knowledge and the firm."
  
• "Point out some specifically "institutional" aspects of the current view."
• "Take note of recent and potential research topics in this area."
  

It is also at this time Winter takes the entire scope of operations and opens it up for consideration and discussion. Slide # 6

• "Organizational learning."
  
• "Creativity and innovation, and diffusion." (Innovation has been primarily assigned to the market or JOC.)
  
• "Knowledge transfer -- transfer of practices, replication (broad scope), imitation (from afar)"
• "Industrial and technological evolution."
• "Knowledge Management."
• "Communities of practice, networks."
• "Routines, capabilities, dynamic capabilities."

Outside of innovation these items should be conducted primarily by the firm. With the caveat that items like "creativity" are not the sole domain of the firm or the market but the global oil and gas industry.

Next Winter asks for and attempts to define what knowledge is. Noting that "it is to achieve some understanding of how society's work gets done." Let a definition emerge! (If needed.)" And Winter provides an excellent definition of "productive knowledge that guides work" with a few global parameters. Slide #'s 8 & 9.

• "Situated, context dependent."
• "Embedded - in physical, temporal and social contexts at various levels."
  
• "Partly Tacit - skills, pattern recognition, not facts."

If we look at these three parameters and the scope of operation of the upstream oil and gas producer. We see the constraints and opportunities based on this definition of knowledge. I hesitate to discuss the impact of these three categories of knowledge for fear that I may limit the scope of the knowledge base. I will state however that the importance of this definition needs to be codified in this applications Research Module. "How" may have to wait until I complete more of this research into this critical area. That I believe the energy industry needs to move in this direction obviously resonates with the academic community overall. Today there is more research being put into these areas. It is overwhelming in volume and quality of the work being done. I can also assure my readers that the scope of this problem, what I am asserting as the "Chrysler Issue", for purposes of this blog, will not be raised as a reason for any failure associated with this software application. The scope of the "firms" responsibilities has not diminished in my opinion. The firm needs to be as strong, and as involved in their operations then they ever have been. The boundaries of the firm, and the allocation of some responsibilities to the market does not provide any opportunity for the "Firm" to rest. The transition will bring an enhanced focus to the competitive differentiators of its land base and this knowledge stuff. And Winter agrees. With Slide # 10 recreated here.

"Therefore,"

• "We must put aside, probably forever, any ambition of drawing a sharp conceptual line between productive knowledge and the context in which such knowledge is operative."
• "All three of the named considerations point to the infeasibility of that; it is a futile exercise."
  
• "The good news: dropping the idea may be the main key to understanding knowledge."

It is at this point that Winter provides an excellent discussion on the issues around personnel turnover and firm knowledge. Citing a combination lock with three numbers from 0 to 9 on each dial. If each dial were represented as an individual, it is fairly easy to replace only one, in fact it would only take 10 tries to have the key replaced. If all three need to be determined it may require a 1,000 searches and 500 expected in order to restore the combination. A strong analogy to the human resource issues that are being faced in the oil and gas industry as we transition to new leadership and management. The retirement of the baby boomers in the next 5 to 10 years, based on this analogy, may be devastating to the operations of the firm and market. If the knowledge that is contained within the boomer generation isn't captured in the short time available, we could experience serious difficulty.

It is at this time that I want to add this information to our table and module breakdowns. And this is how I see the situation evolving;

Construct	Market	Firm
Joint Operating Committee	P	s
Military Styled Command and Control	s	P
Transaction Costs	s	P
Production Costs	P	s
Innovation	P	P
Routine, compliance and accountability	s	P
Research	s	P
Development	P	s
Financial Framework	P	s
Legal Framework	P	s
Cultural Framework	P	s
Operational Decision Making Framework	P	s

P = Primary
s = secondary

Application Modular Breakdown

So if we take a moment and define some of the modular architecture of this system.

• Partnership Accounting Module,
  

• Petroleum Lease Marketplace,
  

• Human & Supplier Resource Marketplace,

• Financial Resource Marketplace,

• Governance & Compliance Module, (a.k.a. Military Command & Control Structure)

• Research Module (Primary is the Firm)
  
• Firm Knowledge Objectives
• Storing Productive Knowledge
• Extending Knowledge Application
• Advancing Knowledge
  
• Organizational Learning
  
• Knowledge Capture
• Situated, context dependent.
• Embedded - at various levels
  
• physical,
  
• temporal
  
• social contexts
• Partly tacit
• Skills
• Pattern Recognition
• Not facts
• Replication
• Imitation
• Knowledge Management
  
• Industrial and Technological Evolution
• Communities of Practice, Networks
• Creativity, Innovation and Diffusion
  
• Other
• Routines
• Capabilities
• Dynamic Capabilities

I think the primary thing we have learned through Professor Winter's slides is that the firms role is not diminished in this proposed organizational change. And with some concurrence on the issues regarding Chrysler. Some of the aspects and attributes are ceded to the market, however, the firm is as vitally needed in these new capacities as it has in the past 100 years. As we look to the challenging future of the energy industry, the needs to address these points will become more prescient as the knowledge contained within the firm begins to retire, and hopefully left in the hands of those that will able to continue on.

I noted in the entry about Matthew Simmons that May 2005 was possibly the point of peak oil. Which may or may not be the case. It is important to realize an interesting aspect of all declarations of peak oil in terms of a single field or a single country. (Such as the U.S. onshore peak occurring in 1972) Each time that the Peak has been attained it is also the point where half of the recoverable oil or natural gas remains in the ground. So even though the total throughput will continue to decline. At least we know the reserves that remain are what fueled the world economy for the past 140 years.

Technorati Tags: Genesys, Winter, Organization, Governance, Innovation

McKinsey on Vertical Integration.

In honoring of the passing of Alfred Chandler, the McKinsey Quarterly is issuing a reprint of a 1993 article entitled "When and when not to vertically integrate; A strategy as risky as vertical integration can only succeed when it is chosen for the right reasons". The article was originally published in Sloan Management Review and was authored by John Stuckey and David White.

Vertical integration was the survival strategy of the oil and gas industry for many years, particularly back in the days of the "Seven Sisters" Exxon, Mobil, Amoco, Shell, BP, Chevron, Texaco and Gulf. The ability to handle the exploration, production, processing, distribution, chemical processing, retail operations of oil and gas firms was through Verticle Integration. Without the integration, it was believed, the company would not earn any returns. This type of thinking left the industry scene sometime in the 1980's when the then junior producers focused on exploitation. Nonetheless this is a review of some of the criteria that was used to determine the validity of using a vertical integration strategy. I think this review would be worthwhile particularly as many of the writings in this blog are pointing away from integration as a strategy.

The primary message of the article is the company should not consider vertically integrating unless there is some risk of losing value, or if value will be gained in the integration. The reason for this limited view of when integration should be used. Is the difficulty in integrating the various disparate parts and have them operate as a whole. I would also assert that the focus on integration is a management belief that the more sophisticated the domain of operations, the more valuable their services were required.

The authors do a very fine job of defining what Vertical Integration is in the following quotations;

"Vertical Integration is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial. Transaction costs and the risk of exploitation would be high."

We discussed the markets role in transaction costs and this is the issue that causes the vertical integration to be considered. Transaction costs are expensive. It is only the ability to reduce the transaction costs that I have proposed the Joint Operating Committee (JOC) to operate as the market for the industry, and process the markets "production transactions" with the modern Information Technologies.

"Vertical Integration typically reduces some risks and transaction costs, but it requires heavy setup costs, and its coordination effectiveness is often dubious."

The authors note the justifiable reasons that vertical integration is required.

• The market is too risky and unreliable - "it fails".
• Companies in adjacent stages of the industry have more market power than companies in your stage.
• Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments; or
• The market is young and the company must forward integrate to develop a market, or the market is declining and independents are pulling out of adjacent stages.
  

The authors note the first reason is the most important one, and hence, the most applicable justification for proceeding with using the JOC in oil and gas. The markets transaction costs are negligible with today's Information Technologies. The marketplace in oil and gas is where the ability to deal with all that the energy industry needs resides. And this is the point. In immature markets the need for producers to integrate vertically was necessary to ensure that the operations were managed appropriately. Today the level of micromanagement, I would assert, is unable to deal with the level of complexity, innovativeness and speed at which things should be done of even the most focused producer. The other justifications, in my opinion, barely rise to the level of an excuse.

The question I should ask is how many JOC's are there. For every company there may be hundreds and even thousands. Bringing the total population of Joint Operating Committees into the hundreds of thousands globally. Each and every JOC that exists in oil and gas is unique to all the others. I am certain there would be a strong concurrence on that point. This market vs. the vertically integrated firm is determined in favor of the JOC's just on the basis of the number of JOC's that exist in the world. How can the needs of each unique JOC be met in this high demand era of the oil and gas industry. I assert the market, managed in the manner that this software development project has proposed, is the only method that makes sense. By reviewing this article it is clear to me, that in 1993, the decision to integrate vertically was still an option in the managers toolbox. Today, based on my understanding of the industry it makes absolutely no sense. And as we see companies like Daimler shedding many of the Vertically Integrated divisions they managed, the value of the stock continues to climb. How long will it be before someone begins the process of breaking down the vertical nature of the oil and gas companies. In theory, the remnants of the seven sister's would be able to generate larger values for their shareholders by discarding the theory that Vertical Integration is a strategy of value creation. For it is false.

Technorati Tags: Genesys, Strategy, Organization, McKinsey

JavaFX is a go!

Sun Microsystems has announced a new scripting language, JavaFX. Designed to work with Swing, Java's GUI toolkit, JavaFX gives the developer many of the attributes of the current trend to asynchronous page loading and graphics. This trend started off on the wrong foot and has become a nightmare of coding hell. AJAX was the first, Asynchronous Java Script with XML is a dynamic hodge podge of technologies that unleashes the power of coding into any wrong direction it can find. Next was Adobe Flex, then Microsoft SilverLight and they all offer the ability to write anything on the web and the desktop of the user. Very dangerous as the access to the desktop and web provides the developer with the ability to do just about anything malicious that they can dream up. I have cautioned about the use of these products before and they certainly should never be used in a corporate setting. JavaFX is different in that it maintains the security model of Java and is unable to access the local machine. This is the primary reason that there are no associated virus' or related garbage brought to the user through their use of Java.

JavaFX takes another step above the competition in that it is statically typed, not dynamic. Dynamic languages are the easy to implement and are the Swiss army knife of programming. Perl, Python and PHP are all good languages that aid the developer in many of the tasks and routines necessary for their productivity. Few would recommend the use of these languages in an enterprise setting, and that relates to the languages inability to scale to size. JavaFX being statically typed enforces a rigid framework or constraint on the developer that aids in the codes ability to scale.

Other benefits of JavaFX is it applies across the development implementations of J2ME, J2SE and J2EE, Sun's mobile, standard and enterprise editions of Java. Enabling the use of JavaFX in mobile phones and other devices that are proliferating and making the oil and gas worker more productive. This will also aid in the deployment of the many sensors and control devices. I suspect technologies will proliferate under the new Internet protocol IPv6. The prolific use of GPS in vehicles and Google maps could be used to determine who is where. Lastly this years JavaOne conference highlighted the use of the language in the area of robotics. JavaFX also provides access to this developing area of technology.

Therefore, Groovy, the previously proposed scripting language is out. I thought that Groovy would be worthwhile tool to have as a scripting language in the developers toolbox for work being done on this project. Groovy is a dynamically typed language that enabled the Groovy developer to use the same Java classes. The only issue that I had was that it was a dynamically typed language and therefore I stated that in the design specification for this project, it would be inappropriate to have any Groovy code in the final commercial versions.

Technorati Tags: Genesys, Java, Development, Sun, Software

The peaking of Offshore Oil and Gas:

Is the party over?
Or just Beginning to get exciting?

April 30, 2007

Matthew R. Simmons

Although the majority of this information is sourced from this Simmons presentation, little specifically is referenced. I felt that most of the information was factual and therefore not subject to Mr. Simmons copyright. (You can't copyright a fact.) I highlighted only what I thought was Mr. Simmons opinions in the noted references below.

Simmons noted the significance of the earlier period of the years 1859 to the 1930's where "no one had any idea what to do with so much oil"! The 148th year of the oil era is marked this year. 70 Years ago drilling teams began hunting for oil in the Middle East. Scouting for oil in Kuwait, Iraq, Iran and Saudi Arabia. Many of the large commercial fields that still produce in that region where found. Ghawar, the biggest was discovered in 1948, Safaniyah in 1951, up to 1967 with the last great super giant onshore Middle East find being Shaybah.

During 1947 Kerr-McGee moved offshore beyond piers and brings in the era of offshore oil and gas. These initial wells reached as deep as 150' feet of water. 150 feet being the limit of human endurance and safety due to the "bends". 1967 saw the Siberian Samoltar region develop, ARCO discovered the North Slopes Prudhoe Bay in 1968, Phillips found Ekofisk in 1969 and in 1975 Pemex found Cantarell. These regions and discoveries were the last 3 great oil frontiers.

With the development of mixed gas for diving, hyperbaric chambers, and the "Jim Suit" c/w GE's robotic arm. Led to testing and drilling into 1,000 feet of water in the early 1970's. Commensurate with this deeper diving capability Drill-ships and Semi-Submersible were able to conduct drilling into 150 to 400 - 450 feet of water. Further development of sub-sea production systems led to offshore satellite fields. During the 1980's the offshore drilling industry was faced with declining returns due to the costs of these technologies and the relative decline in demand for offshore drilling due to the delcine in the price of oil. As I recall it went to $10 / barrel in 1985 or 86. The pricing problem led to what was believed as the overbuilding of the offshore drilling fleet. This lack of offshre drilling demand dropped the capacity utilization rates to 43% overall. However when 1993 saw new offshore drilling technologies being introduced, the associated declines in costs and the producers earning reasonable returns on moderate oil prices of around $18 - 21 / barrel. This led to the real deep-water / ultra deep-water opportunities. This lead to a rebound or recovery of offshore drilling when in May 1997 Sonat Offshore announced the building of a deep-water rig with a 5 year contract at $200,000 / day day-rates.

"After 1980: all growth in oil output came from offshore oil". In his presentation Matthew Simmons shows the volume of oil production increases since 1980 are attributable to the offshore drilling discoveries. 120% of the 1980 to 2007 increase in the global oil production has come from offshore exploration and production. This is significant in showing the way in which the industry should turn. If the industry was able to make these discoveries with immature technologies and imploding commodity prices, I think the answer as to where the oil and gas industry needs to turn is evident.

Today after 38 years, the contractors for offshore drilling are financially healthy and prosperous. Only the number of rigs has not changed in the last 20 years. And the vintage of that fleet is quickly realizing its useful life. Recall that rust never sleeps and the useful life issue becomes more focused. Only 15% of the total fleet is new, with the majority being 25 years or more in age. It is unknown how quickly the fleet can be refurbished and how fast the fleet could be rebuilt. Simmons asks what does 500 offshore rigs cost. With 126 rigs on order, the delivery dates being from 2008 to 2011 it would seem the drilling platforms are very limited in their opportunities for the energy industries redevelopment capabilities. Time seems to be the greater cost in rebuilding the fleet. One must recall the effort of the United States during WWII, mixed in with some modern day innovation and science in seeing how the number of platforms could be built in time. With all of the oil found from offshore wells since the early 1980's, what is the prospect of the industries productive capacity and uptake?

One of the reasons that I follow Simmons is his analysis is usually unimpeachable. He is / has been a lightning rod for the wrath of the industry soothsayers that state all is well. Dr. Daniel Yergin seems to have sampled some magic cool-aid when it comes to predicting the supply possibilities, and hence his popularity. Simmons on the other hand has consistently put quality analysis that has proven correct over time. I have been following him since 1997 and his comments are stark, to the point and not something that Yergin appears to want to wake up to. For example, in this article Simmons notes the following prospective changes with respect to the supply that Yergin thinks is going to explode in the next 10 years.

• USA's onshore oil totals approximately 4.5 MB/D with an associated produced water of 128 MB/D. A 96.6% overall average water cut.
• Middle Easts giant oilfield now in decline. (Based on reserve analysis and decline in production from the region.)
  
• Mexico's Cantarell complex is beginning its steep decline.
• Lake Maracaibo is a "mess".
• Niger Delta is a rust belt of decay.
• The North Sea is in steep decline.
  

In light of this and the fact that 120% of the increase in oil and gas production in the past 27 years is from offshore oil exploration and production. How is it that Yergin believes the onshore oil and gas industry can respond to today's demand challenge. If it didn't contribute in the past 27 years to the global capacity of production, what is it that Yergin believes will solve this problem? More and more each day I think that Yergin is actively attempting to impeach his history and contribution to the oil and gas industry. As time passes he will become known for getting it all wrong.

Simmons falls definitively in the category of Peak Oil Theorists. He asks if the January 2007 production profile is 1 MB/D lower then May 2005's 74,151,000 B/D. This decline may show that May 2005 was the point of no return from a Peak Oil theory point of view. Unless the number of wells that can be drilled increases size-ably, then Peak Oil starts it's otherwise impossible decline. With the associated growth in the global fleet of offshore drilling capability, production decline will accelerate.

Its at this time that Simmons puts across one of the other phenomenon he has asserted many times before. The ability to accelerate the decline by aggressive exploitation is the only thing that the industry has really done in all of the onshore and offshore fields. This has raised the deliver-ability of oil and gas from known reserves to its absolute optimum, and cleaned out what was producible form the formations quicker then what has been found to replace it. In some companies in Canada this replacement rate is consistently 15% of the production! If you see a hamster in the wheel running at full speed your correct, however, this last point demands a doubling in the speed from the hamster. Our current consumption of energy is enabled by the aggressive and highly technical exploitation of known reserves over the past 25 years. This deliver-ability rate is therefore not sustainable. And if the peak oil theory is proven right, since May 2005 a very large clock has been ticking for the energy consumer who is unawares and unprepared. Thank you Dr. Yergin.

The dire nature of Simmons facts are captured in his 27th slide. Asking "Can the industry survive post peak oil?

• Will the global economy survive post-peak oil world?
• How high could oil prices go?
• When demand outstrips supply are shortages inevitable?
• Will the Offshore Technology Conference (OTC) survive Post Peak Oil? (The OTC is the group Simmons made this presentation too.)
  

How this gets done, and I cannot imagine anyone arguing for the bureaucracy to lead this charge. We need to organize our efforts to scale to this level. The industry is significantly bound by constraints and needs to reorganize around this proposed software development. How much longer will we face an angry consumer regarding the alleged gouging at the pump? How much longer will the bureaucracy feel complacent and wealthy in their deliberate inaction? How much longer will Yergin continue to belittle the Peak Oil theories and Simmons, and tell his customers, the consumers and bureaucracies, things are not as rosy as he has stated?

Technorati Tags: Genesys, Peak-Oil, Simmons, Yergin, Offshore, Engineering

The life and times of Humpty Dumpty

We all know what happened to old Humpty after his fall, all the Kings horseman and all the Kings men... I think today we have an excellent business example of what the nursery rhyme taught us. The example company is Chrysler. Recall in my thesis I noted that Chrysler experienced a strange depreciation of their engineering capability. I said the following then;

"The need to clarify that holding the JOC accountable is not, and should not be, construed as a capitulation of the innovation process and its inherent benefits to the four winds. A study was undertaken at Chrysler to determine why the changes to “teams” were successful in product development, as reflected in their cab forward design, yet the overall engineering and technical capability of the company declined. The Chrysler study reflects that the accountability of the JOC (or team) needs to be augmented by an internal management system that provides an overall focus and direction to the innovations. Management needs to create and guide the internal innovative science and engineering capability that is unique and a key competitive advantage."

Were the "Synergies" that Mercedes sought in the merger with Chrysler an attempt to source and resurrect Chrysler's overall engineering capability? We know Mercedes saw these synergies as the key to the mergers value creation in their 1998 $36 billion purchase of Chrysler. However, did all the Kings horses and men (Mercedes) soon realize they could not put the engineering capability back together again? Selling the firm for $7 Billion (although we don't know what stays and what goes) seems to indicate that there is something fairly seriously wrong with Humpty (Chrysler).

Irrespective of the validity of this possibility, is there a lesson to be learned here regarding the current capability in oil and gas and the potential move to the Joint Operating Committee? Is it possible that during this transition the capacity to function from an industrial engineering capability is somehow lost? I don't think so, for a few reasons. First the industry is showing symptomatic failures at every turn. In the past two weeks we have seen Canadian Natural Resources Ltd. loose control of the building of their tank farm at Horizon, their heavy oil plant. With the lose of life in the second incident being averted, we see these types of failures everywhere. I also see the inability of the industry to capitalize on the higher oil and gas prices as a failure to respond to the market's demands. The oil and gas prices just seem to keep climbing, with no response from industry.

Secondly, I see a fundamental misunderstanding of the supply structure of the energy industry. It's not about the supply. The demand dynamic we are now dealing with has its origins in a world energy supply that catered to predominantly Japan, Europe and the U.S. or 750 million consumers. Now with India and China competing we have 3.15 billion consumers, or 4.2 times the demand for energy. I attribute this inability to identify the competitive demand landscape to a myopic focus on supply that was the industries focus while there were surplus barrels of production available. Now the industry has not switched, in my opinion, and don't have the ability to switch to the demand satisfaction of the equation under the current bureaucratic organizational structure.

In summary I would suggest the risks associated with losing an advanced engineering and scientific capability within the oil and gas industry is limited. For the reasons cited and the history of the industry over the past 25 years. The last quarter century has been a survival game. Living off assets that were innovated on from the perspective of exploitation. This capability will be needed and expanded upon, but what is needed now is for the industry to increase their scientific and engineering capability in the exploration and development areas as well. An area I suggest where little has been done in the past quarter century. The offshore drilling, the Arctic, the Tar Sands and areas that were too risky before the prices rewarded the larger risk profiles.

I also think that the industry having access to the Research Module in this proposed application will be critical to developing the new exploration requirements and at least maintain the exploitation capability. The Research Module will contain the explicit knowledge of the firm, with links to partners, consultants, academics and supplier capabilities. Within this mix will be much of the leading edge thinking in the academic community and the applied project processes the company uses to discover the new techniques, procedures and policies. The more that the Research Module is pursued the greater level of Intellectual Property that the firm will have access too. This will also provide the majority of the industries scientists and engineers to develop their ideas and monetize their intellectual property through their rights of copyright, patent and to a lesser extent trademarks. For that is the stated benefit of Intellectual Property, and particularly, copyright. The ability to copyright the idea is earned through the act of publication. Therefore society as a whole has access on the ideas within the marketplace for others to expand upon and benefit from. What the Research Module will do primarily is provide a forum to capture this knowledge on a global basis and provide a means of transaction processing and cost measurement to the companies, vendors, academics and suppliers who use it. Note, I will be writing more on this important module in the proposed application in the near future.

Technorati Tags: Genesys, Capabilities, Research, Innovation

Modularity on Google Video

"Aspect Oriented Programming: Radical Research in Modularity."

Gregor Kiczales, Professor of Computer Science at the University of British Columbia.

Professor Kiczales does an excellent job in making this presentation (click on the title of this entry for the video). He hints at his past experience throughout the video, and this experience includes leading the Aspect Oriented Programming (AOP) development at Xerox PARC. This is a highly technical video of aspect oriented programming in Java. This is a key technology for this system's developments, and if you have a desire to learn these topics (recommended) this is a good video.

Much of object oriented programming is defining the objects or classes that interact with each other. The net result is an overall hierarchy of your code. In order to invoke one class from one area of the code to the other may be difficult due to the recognition of the hierarchy. (Casting up the hierarchy, over, and then down to the class that you want.) Aspects maintain this hierarchy but allow the developer to "crosscut' the hierarchical structure as if it were modular.

One of the key components of Java is the ability to use different aspects. How these different aspects are implemented in oil and gas is very common in a design such as we have proposed in this system. Not to get into too many of the components of Java code, I want to point out that this video is entitled "Radical Research in Modularity". A key aspect of the system as designed with the research that we have done with Professor Richard Langlois and applied here. Professor Kiczales makes the following points that are critical to the understanding, purpose and value of aspects in programming. This discussion begins around the 50 minute mark (50:10) and carries on to the end.

"Modularity has a cost, the cost being sometimes you get an indirection, and its only worth paying this cost if you get something back. What your getting back here is a couple of things. One thing is;"

The Raw Benefit of Modularity, which is in some sense, I could ship point (cut) without display update."

"Second an ability to reason about the structure now, and this is provided by aspect orientation."

And then later on, at (55:25) Professor Kiczales says

"What can I modularize now, that I couldn't modularize before."

The last point that I wanted to make was Professor Kiczales did point to a text of "Baldwin and Clark" that we were prompted to review by Professor Langlois. Kiczales also has some very good papers that are available on his website if readers wanted to follow through on this topic. Hopefully reviewing this video and a little research in the area of aspect and object oriented programming will begin to reflect on the value of the modularity being discussed on this blog and elsewhere.

Technorati Tags: Genesys, Kiczales, Langlois, Modularity, Java, Aspects

McKinsey Enterprise Software Customer Survey

I participated in a McKinsey study a while back and the results of that survey are now being published. (Sorry no link, the survey hasn't been released yet, email me if you would like a copy.) The topic of the survey was "Enterprise Software Customer", was sponsored by McKinsey & Company and the Sand Hill Group. The survey was completed by 475 senior IT and business executives. The objective of the survey was to;

"determine how software budget levels will change, who will control the spending, what industry trends will most impact their company in the near term, and what role innovation plays in their decision making."

and

"The results draw a picture of continually increasing software budgets, a shift to more decentralized purchase decision with increased roles for the business side in purchasing decisions, and the increasing importance of software innovation that respondents predict will come from small vendors."

Music to my ears, looking at the details of the result of the survey.

Software will account for an increasing portion of IT budgets.

McKinsey notes software accounts for 31% of spending which is expected to grow to 36% of IT costs. No change in the composition of that spending is expected.

The majority of software purchase decisions are still made centrally, although line of business buying is expected to increase.

The survey shows there may be some change in the way that software budgets are controlled. Moving from a centralized model to include business leaders and end users having a greater say.

Innovation and Service Oriented Architecture (SOA) are top of mind issues for software customers.

Respondents noted that "SOA's" were expected to be the top pick at 23% and "Software on New Devices" would total 20%. Other new trends that were noted is the Open Source Software movement.

In another question regarding "which of a list of trends would most impact their business" Software Industry Innovation claimed top spot at 33%, Software as a Service at 21% and Web Services / SOA 18%.

Product Innovation scored highest when asked "where the software industry most needed to improve, our respondents again pulled product innovation into the top slot, ranking it number one with 30% of responses. Followed closely by ease of use and customer service in the second and third spots. Curiously, "Cost" slipped in the rankings "with only 14% of respondents ranking cost as their top issue for improvement", and "48% of respondents omitting this from their top three areas". The study notes "While price will certainly continue to be a factor in purchase decisions, business customers seem to be placing a greater premium on the value that the software industry can deliver in innovative new ways."

We are still early in this software innovation wave with considerable product innovation, business model innovation, and process innovation yet to come.

"The vast majority of respondents clearly think the best innovation is yet to come. Fifty-Five percent of respondents reported they still expect significant new technology innovation to come, and another 22 percent saw the industry near the peak of technology innovation with only business model and process innovations still ahead of us."

and

"We polled our respondents to understand what type of software innovation they were looking for. Across the board buyers want more innovation, citing all of the various types of product, business model, and process innovation as important."

and

"We also inquired about the speed with which respondents were adopting various new software business models. The results showed a great degree of enthusiasm for business model innovation, with respondents predicting that more than 40 percent of their software budgets may be spent in alternative business models over the next 2 years (subscription, transaction, advertising, or another format.) Even more striking in analyzing the fraction of respondents that plan to at least try each of the proposed alternative business models a whopping 80 percent plan some subscription on demand spend, 60 percent plan some transaction based spend and 33 percent plan spend funded by advertising. This broad willingness to experiment indicates alternative business models have hit the mainstream and software vendors of all types and sizes need to ensure their level of business model innovation matches the level of product innovation."

Few customers expect to see innovation coming from large software vendors.

When asked where the innovation likely to come from, 59% of respondent's pointed to the community of small software vendors. With only 19% expected to come from the largest software vendors.

From my point of view I can't be happier with these responses. I have worked on this project as the better model and now the business community is beginning to follow. I can not think of a more timely opportunity for the oil and gas industry to get on with the development of this project. Its scope is too large for someone to come along and throw a usable software application on the table that everyone can use. It has to contain the users and the customers involvement in order for it to be functional. The energy industry can not expect the venture capital people to step up and fund this. By doing so the venture capital would eliminate the key ingredient, the user involvement from the mix.

All in all a very loud call to action.

Technorati Tags: Genesys, Call-to-Action, Software, McKinsey