Continuing on with the review of Professor Richard N. Langlois' submission to the 2006 ESNIE Conference. This article is the third of the four that I will be reviewing and is available for download at this
location. My review of the first document was published
here, and the second document in this series was reviewed in a series of posts
here,
here,
here and
here. The fourth document that will be reviewed in this ESNIE series of Professor Langlois' will be the slide presentation he made at the conference.
In the first of Langlois' four documents "Transaction Cost Economics in Real Time" we learned the Dynamic Transaction Costs were incurred during times of change. The important takeaway was that the Dynamic Transaction Costs would include the software development expenses that will be incurred in the software developments discussed on this blog. That the role of the software vendor would also need to include the learning process of the entire industry. The learning of "what" and "how" it does and needs to do as an industry.
In the second article, we learned of the need for both markets and firms in the makeup of an industry. The definition of production and transaction costs, and that there could and should be appropriate organizational constructs for the market (the JOC) and the firm (the enhanced management role in the Compliance & Governance Module). This paper was written by Langlois in 2002 and begins with the Invisible Hand of Adam Smith, and the Visible Hand of Alfred Chandler.
"In The Visible Hand (1977) and subsequent worlds, Alfred Chandler focused the spotlight on the large, vertically integrated corporation. He did this not merely to chronicle the rise of that institution but also to explain it and give it a prominent place in American economic growth during the last century and a half. The force and originality of Chandler's ideas coalesce in the book's title, a provocation in the direction of Adam Smith (1776). Smith had predicted an increasingly fine division of labor as the response to a growing extent of the market; and, although he was actually quite vague on the organizational consequences of the division of labor, Smith was clear in his insistence on the power of the invisible hand of markets to coordinate economic activity. Chandler's account appears to challenge this prediction: internal organization and managerial authority became necessary to coordinate the industrial economy of the late nineteenth and early twentieth centuries. The visible hand of managerial coordination had replaced the invisible hand of the market." p.2
and
"History is never kind to historicist's, however; and the facts of the last quarter century have made life uncomfortable for those who would project the Chandlerian model into the present. It has become exceedingly clear that the late twentieth (and now early twenty-first) centuries are witnessing a revolution at least as important as, but quite different from, the one Chandler described. Strikingly, the animating principle of this new revolution is precisely an unmaking of Chandler's revolution." p. 2
and
"We are left with the choice of abandoning Chandler or reinterpreting him. This essay takes the latter course. If we take the first reading of the The Visible Hand - that the managerial revolution was an adaptation to particular historical circumstances - then we can explain the organizational revolution of the new economy by embedding Chandler's story within a roomier account that admits of a range of possible historical circumstances. As a byproduct, such a reinterpretation can hope not only to explain the new economy but also to shed light on the organizational changes of the original Chandlerian revolution." pp. 2 - 3
Let the reinterpretation begin. But firstly I would like to re-introduce Dr. Anthony Giddens
Structuration Theory and Professor Wanda Orlikowski's Model of Structuration. Recall that Structuration notes that society, organizations and people will move in harmony during periods of change, and if not, failure will be the result. Professor Orlikowski's model asserts that technology is an element of society that "Interaction with technology influences the institutional property of an organization, and this influence is more likely to be reinforcing rather than a transforming one." (p. 235 The Duality of Technology: Rethinking the Concept of Technology in Organization). Which supports my assertion that SAP is the bureaucracy. Lanlgois' comments appear to be reflective of these theories in that they impute a failure may be imminent.
"The basic argument - the vanishing hand hypothesis - is as follows. Driven by increases in population and income and by the reduction of technological and legal barriers to trade, the Smithian process of the division of labor always tends to lead to finer specialization of function and increased coordination through markets, much as Allyn Young (1928) claimed long ago. But the components of that process - technology, organization, and institutions - change at different rates." p. 3
It is at this point that I reflect on the conflict between those ideas and the reality of managements response to the ideas surrounding the use of the Joint Operating Committee (JOC). Society and individuals to a large extent have moved on, fueled by the available information technologies. Langlois suggests the following changes to central management.
"But with further growth in the extent of the market and the evolution of institutions to support exchange, the central management of vertically integrated production stages is increasingly succumbing to the forces of specialization. Rather it is an argument that, in a population sense, large vertically integrated firms are becoming less significant and are joining a richer mix of organizational forms." pp. 3 - 4
The consumers energy demands are outstripping supply at a remarkable rate. A decade ago OPEC was believed to be choking back production by 10 million barrels per day. No one today would argue that we are not at full capacity. The market prices are providing ample incentive for the producers to enhance their capacity. And the producers are attempting to increase their production with essentially the same methods that were marginally successful in the past, only at a metric of two and one half times as many wells drilled. Is the numerical increase in the number of wells drilled the solution to the markets demands?
The industry in Alberta is beginning to realize the old methods do not work. Even with today's current commodity prices few companies are able to make any money! Drilling 25,000 wells as they did in 2006,(vs. approximately 10,000 in 1997) replaces only small (in the teens) percentages of the production. Many of the producers have scaled back as a result. (And this situation only applies to the wells drilled today. Production from older fields, drilled under other lower pricing scenarios are of course far more profitable then before.) Has the time and costs to effectively find oil and gas now exceeded the capability of the industry, or is it time to consider different approaches to the problems at hand?
"As in Chandler, secular changes in relative prices attendant on "globalization" (driven by technology or politics) affect economic organization not only directly but also, and perhaps more importantly, indirectly through changes in technology. Production costs matter as much as transaction costs (Langlois and Foss 1999) Moreover, the kind of transaction costs that matter in history are often not those of the Williamson kind but those I have labeled dynamic transaction costs (Langlois 1992b). Costs of coordinating through markets may be high simply because existing markets - or more correctly, existing market-supporting institutions - are inadequate to the needs of new technology and of new profit opportunities. But when markets are given time and a larger extent, they tend to "catch up," and it starts to pay to delegate more and more activities rather than to direct them administratively within a corporate structure." p. 5
And it would be through this fundamental belief in the "Invisible Hand" of the market, that this problem will be corrected in the manner that Lanlgois states. Maybe my expectations of the hierarchy to fall on its sword is the misguided part of my idea. That the opportunity to proceed with these software developments will come from different sources and alternate calls. If the individual can figure out a way to get another 5 bbls of oil per day onto the market through his own innovations, the financial motivation certainly exists for him to do so. Is this the transition that management desires to see?
"The evolutionary design problem."
I feel that I would not stand alone in determining that the energy industry is an advanced state of failure. This I have postulated many times before and suggested it strongly in my original May 2004 document. Failure was a real possibility and today it is in my opinion a reality. The market demand for energy is very high and the commodity pricing continues to escalate. But as much as the consumers disappointment at the pricing, the producers are unable to respond. The suppliers costs have doubled primarily out of excess demand. In addition, the effort necessary to produce a barrel of oil or mcf of gas has also increased. What may have been done with two hours of engineering, and because of the difficulty of the remaining and prospective reservoirs, may now take four hours. When an industry is operating at 100% production and exploitation capacity. And expects that it can double its drilling activity with no requisite changes in the organization or methods of doing so. The commodity prices will escalate as an incentive to bring on the higher capacity. Drilling more wells does not provide a solution to the problems of the industry, just as the Hamster is at risk to fail at the higher speed of the wheel. A new approach is required. A new organization based on one that is optimized to handle the expansion in the earth sciences and engineering disciplines, and innovative on those new findings. An organization that uses the modern information technologies supporting the JOC as the key organizational construct of the market. An organizational model that provides the specialization and division of labor that are necessary for the increase in capacity.
"Industrial structure, then, is really about two interrelated but conceptually distinct systems: the technology of production and the organizational structure that directs production. Industrial structure is an evolutionary design problem. It was one of the founding insights of transaction-cost economics that the technological system does not fully determine the organizational system (Williamson 1975). Organizations - governance structure - bring with them their own costs, which need to be taken into account. But technology clearly affects organization. Like a biological organism, an organization confronts an environment that is changing, variable and uncertain. Also like biological organisms, business organizations differ in the mechanisms they use to process information and to deal with variation and uncertainty. Nonetheless, as James Thompson (1967, p. 20) argued, all organizations respond to a changing environment by seeking to "buffer environmental influences by surrounding their technical cores with input and output components." pp. 6 - 7
Lanlgois goes on to note many of the advantages of this modularization and definition of the boundaries of the firm as follows.
"A decomposable system is one that is cut into pieces or "modularized" in such a way that most interactions (which we can think of as flows of information) take pace within the modules; interactions among modules are kept to a minimum and are regularized through formal "interfaces." One of the prime benefits of decomposability, in Simon's view, is that it allows for greater stability in the face of environmental uncertainty: a single piece can be altered, replaced, or even destroyed with out threatening the survival of the whole. This is already a kind of buffering. Levinthal and March point out that decomposition entails (or at least allows) "loose coupling" between organization units, which effectively simplifies the information - processing problem the organization faces." p. 9
and
"Indeed, I will suggest before long that the decomposition of organization into market can sometimes confer additional buffering benefits well known to economists, notably the ability to spread risks." p. 9
and
"The managerial revolution of the nineteenth century was one solution to the buffering problem, appropriate to its time and place. But it is by no means the only solution industry has found; and it is certainly not the approach toward which the new economy is gravitating." p. 10
I would point to the modular breakdown that I have proposed for the software developments I am writing about. This breakdown of modules was on the basis of Langlois' paper "
Modularity and Technology, Organization and Society" and the
modularity label containing all the posts on that topic.
"Antebellum Organization." and "The Managerial Revolution"
For purposes of this review there is little in the way of value regarding the "Antebellum" period. Langlois puts this back to the early 1800's or 19th Century and reflects on the ways of progress from an organizational point of view. The one point that he does assert is that the market was more sophisticated then it appeared and the beginning of specialization was a welcomed and possible activity as the populations in Europe and the US began to expand. I would highly recommend downloading the file and reviewing it in its entirety. The section entitled "The managerial Revolution" has been scrubbed for similar reason.
"From scale to scope: the corporate century."
Langlois, through his description of the origins of the organization in the last hundred years, brings up a fascinating quotation from John Kenneth Galbraith.
"Although the problems of buffering high - throughput production have not made much impression on the mainstream literature on government and business, there is a line of thought along the fringes that takes this problems as central. Running roughly from Thorstien Veblen (1921) to William Lazonick (1991), this literature sees it as crucial that managers be insulated from the vagaries of the environment, especially those caused by financial and other markets. Veblen considered financial markets "industrial sabotage." the most eloquent voice in this tradition belonged, however, to John Kenneth Galbraith, whose 'New Industrial State' distilled through hyperbole the essence of the corporate century he could see stretching behind him in 1967. Galbraith takes it for granted that technological change always leads to greater complexity and scale. This complexity and scale requires "planning"; such is the imperative of technology, an imperative that can only grow stronger in the future. Planning means not only the attempt to foresee and prepare for future contingencies but also the removal of transactions from the market to the realm of managerial authority. "If, with advancing technology and associated specialization, the market becomes increasingly unreliable, industrial planning will become increasingly impossible unless the market also gives way to planning. Much of what the firm regards as planning consists in minimizing or getting rid of market influences" (Galbraith 1971, pp. 42 - 43)" pp. 35 - 36
And it is in this description of "planning" that we see the alternative for today's organization. Planning for all contingencies and removal of transactions from markets. Its hard to imagine that Galbraith lived in what we call Western Civilization. The level of planning certainly provided the Former Soviet Union (FSU) with the means to continue on with its form of organization. In my thesis I postulated that the Western methods of organization looked as old and tired as the FSU in the 1980's and therefore should realize a similar history. The logic of supporting the Joint Operating Committee is compelling on its own. These quotations here open a new debate on how the alternatives, that seem to be operated in the organizations today, are truly limited and futile, as I can foresee no alternative to the vision of Galbraith's methods.
"It is perhaps a fitting reward for the hubris this view of planning implies that the not too distant future had in store a picture of technology and organization that would be virtually the diametric opposite of the one Galbraith painted." p. 36
"From internal to external capabilities: the new economy."
So much of what I wanted to comment on begins at this point in Langlios' document. If I should find an audience for the work that I am doing here, it is very evident that it is not sourced from the traditional powers within the corporate community. They have been given plenty of opportunity to act, and indeed have collectively not acted. How then will these remarkable new concepts and technologies influence the organizational manner of the oil and gas industry.
"Ruttan Hayami (1984) have proposed a theory of institutional change that is relevant to my story of organizational and institutional change. As they see it, changes in relative scarcities, typically driven by changes in technology, create a demand for institutional change by dangling new sources of economic rent before the eyes of potential institutional innovators. Whether change occurs will depend on whether those in a position to generate it - or to block it - can be suitably persuaded. Since persuasion typically involves the direct or indirect sharing of the available rents, the probability of change increases as the rents increase. And the more an institutional or organization system becomes misaligned with economic realities, the more the rents of realignment increase." pp. 36 - 37
But of course. It is not the corporation that will fall on their swords but the people who are active in the oil and gas industry. They will be motivated by how they can add value to the process for the betterment of themselves. And as those employees and managers in the organizations today will retire soon to undertake those opportunities for themselves. Literally with the majority of the industry retiring in the next 5 to 10 years, the opportunity for them to keep themselves active and earn a living on top of their retirement funds. That possibility would make their lives very prosperous and full. Accessing this system through the Internet would enable them to work from home, or if they wanted to travel, anywhere there is electricity. When we think of this opportunity with this next quotation in mind, it makes it even more evident that this is the way to go.
"The American corporations mechanisms of environmental control and its charmed life in the 50s and 60s had permitted it largely to ignore ongoing changes in the scale of technology as well as the increasing thickness and realignment of markets. In startling contrast to Galbraith's (rather nineteenth-century) view of technological change, innovation often - and perhaps mostly - proceeds by simplifying and by reducing scale." p. 38
Applying this method of participation "simplifies" and "reduces" the scale of the industry. Markets are what will spring up and make things happen. Does this mean chaos and anarchy for the corporation?
"Driven by the Chandler-Penrose imperative to apply existing managerial skills and other capabilities more widely, the corporation in the 1960's took the idea of diversification to new levels." p. 40
"Conglomerates were assembled from separate firms, with a central headquarters directing the firm. Their widespread use in the 1960's taught managers that it was possible to mix and match corporate divisions. It was only a small leap of an organizational idea for a conglomerate to bring in an outside firm via a hostile acquisition by buying up the target's stock and tucking the formerly independent firm in as one now managed from the conglomerate headquarters. Form there it was only another small mental jump in the 1980's to understand that once the pieces of a conglomerate had been assembled, they could be disassembled as well. (Roe 1996, p. 114)" p. 40
and
"By and large," write Bhagat, Shliefer, and Bishny (1990, p. 2), "hostile takeovers represent the deconglomerization of American business and a return to corporate specialization." p. 41
And, to a large extent we have seen the integrated oil and gas firms fade to the background. The Tenneco's, Canada Development Corporation, Canadian Pacific and Dow Chemicals with extensive interests in oil and gas as well as farm machinery and railroads are broken down, or deconglomerized. The oil & gas firms that are considered integrated today, the Shell's, Exxon's, BP's and Chevron Texaco's are integrated from the point of exploration, exploitation, production, refining and marketing. I could see the latter two, refining and marketing, being further deconglomerized in the future. But this vision of Langlois' goes further then that. Such that my interpretation would be the corporation is the rightful interest owner in a number of JOC's. These firms, in turn, are provided the resources necessary to conduct the exploration, production and exploitation operations through the market. The corporation would also be in compliance with the various legislation and regulatory requirements. And this compliance would be automated to a level where the compliance was a natural fall out of the firm's participation in the market activity. Furthermore, the firm would focus on its key competitive advantage and capabilities, that being the capacity to innovate on the various earth sciences and engineering disciplines. In summary, the firm would be charged with the areas of research, compliance and governance responsibilities.
"As G. B Richardson (1972) pointed out, it is highly unlikely that the various vertical stages of a production process should all call for similar kinds of capabilities. And this is what has happened. "even a cursory examination of the industrial system of the United States in the 1990's reveals organizational patterns that look not at all like the modern corporation," writes Timothy Sturgeon." pp. 41 - 42
"If what we see today seems to have little relation to the ideal type of the modern corporation, there may be good reason. Perhaps the American industrial system has begun to adapt to the new, more intense global competitive environment that triggered the competitive crisis in the first place. Perhaps we are witnessing the rise of a new American model of industrial organization, and not simply the resurgence of the old (Sturgeon 2002, p. 454)" p. 42
And to a large extent, that is the point. Change driven by the need for higher productivity, a forced reduction in human resource availability, and greater financial returns through lower costs. These are the practical issues the industry will be faced with. Will the model of today's corporation meet these needs and demands?
"Decentralization implies an ability to cut apart the stages of production cleanly enough that they can be placed into separate hands without high costs of coordination; that is to say, decentralization implies some degree of standardization of "interfaces" between stages. In an extreme - but far from rare - case, standardized interfaces can turn a product into a modular system (Langlois and Robertson 1992)." p 46
Lanlgois' discussion of modularity rings a strong note of truth with respect to the proposed
modular structure of this software application. Looking at the competitive choices (Only
Oracle is 'in' the market) their modular breakdown shows how the past model of industrial organization is supported, defined and constrained within their modular description. Comparison of these two software definitions reflect the fundamentally different worlds of which they operate in. There will be no JOC or market in the Oracle software version, and hence no benefits.
"When a modular product is embedded in a decentralized production network, benefits also appear on the supply side (Langlois and Robertson 1992)." p. 47
and
"Moreover, because it can generate economies of substitution (Garud and Kumaraswamy 1995) or external economies of scope (Langlois and Robertson 1995), a modular system is not limited by the weakest link in the chain of corporate capabilities but can avail itself of the best modules the wider market has to offer. Moreover, an open modular system can spur innovation, since, in allowing many more entry points for new ideas, it can create what Nelson and Winter (1977) call rapid trial and error learning. From the perspective of the present argument, however, the crucial supply side benefits of a modular production network is that it provides an additional mechanism of buffering." pp. 47 - 48
"Transaction costs and the new economy."
It would be difficult to effectively argue that transaction costs and dynamic transaction costs (those that are incurred during times of change), of negotiating, persuading, coordinating and teaching have not been a large part of the oil and gas industry for many years. The capital intensive nature of the industry requires relatively few head office staff, key field personnel and almost all operations conducted through contracting. This software system does not therefore ask for radical change. It asks that we should align ourselves more clearly with the manner in which the industry is run. The JOC, the contractors and suppliers are how the industry develops and commercializes its latest land acquisition and scientific theory. None of the competitors of this software development proposal even partially recognize these facts. So when the discussion of whether the industry should make or buy, the buy decision is almost unanimously taken. It would be a fool who would attempt otherwise.
"In his famous 1937 paper, Coase had argued that transaction costs drive the make-or-buy decision; thus, since the Internet has reduced transaction costs, Coase had effectively predicted a principal feature of the new economy: the increasing devolution of transactions from firms to markets. Of course, what Coase actually said is that the scope of the firm is determined in Marshallian fashion at the margin: the firm will expand (in terms of number of activities internalized) until the costs of internalising one more transaction just balance the costs of an equivalent transaction on the market." p. 51
The concepts that originated in the minds of the software developers for SAP and Oracle were different then what has been stated here. I believe that whatever that vision may have been, for oil and gas it is misguided as it does not recognize the unique nature of the business. The unique nature of the industry had developed solutions to the problems and manner of operation. Those solutions consist of the JOC and the dependence on the market to provide its needs. I can't think of an industry that comes close to the nature of the energy business. Where even a start up may pursue global operations.
Today the technologies involved in the Internet provide the industry with the opportunity to realize the fashion that it operates is unique, and deal with those anomalies in the best Interests of the industry. A dedicated software developer to build the systems that mirror the manner of the industries operations, will enable greater innovation by relying on the marketplace and allowing the innovation to flow from where-ever and whomever.
"The coordination technologies of the industrial era - the train and the telegraph, the automobile and the telephone, the mainframe computer - made internal transaction not only possible but advantageous." It is only with the very recent development of powerful coordination technology - personal computers and broadband communication networks - that markets have been favored. "Because information can be shared instantly and inexpensively among many people living in many locations, the value of centralized decision making and expensive bureaucracies decreases. (p. 147)". pp 51 - 52
The prescription of the software development proposal is not something that can be argued as revolutionary. But in reviewing these papers of Lanlgois' it is important to remember that he is discussing all industries and all businesses. For oil and gas this prescription is not revolutionary but the results will be.
"Thus the vanishing hand is driven not just by changes in coordination technology but also by changes in the extent of markets - by increasing population and income, but also be the globalization of markets. Reductions of political barriers to trade around the world are having an effect analogous to the reduction of technological barriers to trade in the America of the nineteenth century (Findlay and O'Rourke 2002). Is this a revolution or the continuation of a long - standing trend? Again, the answer depends on one's perspective. My argument is that, just as the American "globalization" after the Civil War was revolutionary in its systemic reorganization of production toward standardization and volume, the new era is revolutionary in its systemic de-verticalization in response both to changes in coordination technology and to plain-old increases in the extent of markets."pp. 52 - 53
Change is demanded of us from many directions, but particularly the consumers demand for more energy. Whether there is a greater capacity or deliverability is questionable, but even if energy production has peaked, the remaining reserves of oil and gas are almost exactly equal to what had been produced before. With a 140 year history of providing the world with its energy needs, the industry can look forward to many new innovations, fields and methods of capturing the remaining oil and gas. That although the energy is there it will require the industry to apply much more effort in producing each barrel. The hierarchies attempt in the last 5 years has accelerated the number of wells drilled by a factor of 2.5 times. Impressive. However, only 17% of the production was found, with 33% annual decline rates, the future looks very shallow for this type of activity. For it has failed in any metric you could ask. What the industry appears to be moving towards is a more focused move into the areas of exploration. Exploration in the remote areas with complex politics, logistics and scientific challenges. In order to address these enormous tasks, I believe the industry should require that any and all producers re-organize themselves first. The first bit of good news is the following comments from Professor Langlois.
"In my view, the relationship among coordination technology, transaction costs, and industrial structure remains an open research agenda." p. 54
and
"Over time, two things happen: (a) markets get thicker and (b) the urgency of buffering levels off and then begins to decline. In part, urgency of buffering declines because technological change begins to lower the minimum efficient scale of production. But it also declines because improvements in coordination technology - whether applied within a firm or across firms - lower the cost (and therefore the urgency) of buffering." pp. 55 - 56
It is probably best that I mention that I discovered Professor Langlois' work through him being awarded the Schumpeter Prize. The changes we face are clearly in line with one of Professor Schumpeter's more famous theories, that of creative destruction.
The last article in this four article review of Professor Langlois' ESNIE presentation are his slides. These slides provide an interesting summary of all the concepts that he has generated and reflects the open research agenda that we all face.
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David Sifry
