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.
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