Barriers to diversification

July 1, 1999
In the distant past, oil and gas producers invested vertically and horizontally to diversify business. The most productive moves were along the value chain in refining and chemical derivatives, where product prices moved counter-cyclically to wellhead prices. In recent years, increased competition has prevented producers from profiting downstream during low oil price periods or capturing value in derivative enterprises. Integrated producers' drive to re-capture that profitability is evident

In the distant past, oil and gas producers invested vertically and horizontally to diversify business. The most productive moves were along the value chain in refining and chemical derivatives, where product prices moved counter-cyclically to wellhead prices. In recent years, increased competition has prevented producers from profiting downstream during low oil price periods or capturing value in derivative enterprises. Integrated producers' drive to re-capture that profitability is evident in the push to merge laterally.

Each time producers get into trouble, strategists push for diversification. Before anyone moves in that direction - again - here are some salient issues:

  • Culture: The management culture of oil and gas producers remains heavily vertical (top down), not unlike that of most commodity or industrial businesses. Managers oriented or trained in vertical businesses often find it difficult to accept or adopt to more horizontal cultures when diversifying.
  • Risks: Oil and gas exploration and production involve a different set of risks than non-commodity businesses. Managers at ease dealing with geological, drilling, production, and transportation risks often find it tedious extracting more modest financial rewards from product differentiation, quality-price tradeoffs, and market acceptance.
  • People: In the petroleum business, keeping very expensive customized systems online is as important to the bottom line as finding the right people to manage, thus a great tendency for technical people to rise through management. In other businesses, people factors often outweigh equipment concerns, and management team assembly might rely as much on social factors as on skill.
  • Investment: Although the petroleum industry is turning increasingly to debt and equity markets for expansion capital, internal financing remains the preferred source. As a result, the industry often does not have the degree of sophistication in packaging projects to attract finance and venture capital interest as other businesses.

In fact, the petroleum industry has such a weak record in diversification that equity markets tend to over-penalize efforts. Not helpful either is the industry attitude that diversification spreads management attention too thin.

Successful diversification depends on finding or creating businesses with profitability independent of oil and gas prices - no small order, because such businesses are often not related. Other commodity businesses won't do. All commodity prices, necessarily dependent on economic conditions or cyclical events, tend to move in lockstep.

As producers re-build their balance sheets in the coming months, they also will consider whether the pain of diversification is greater than the pain of weathering severe business cycles. At some point, someone is going to have to take an uncomfortable risk - and perhaps lead the way.

Y2K - no good choices

The first problem with the year 2000 date rollover (Y2K) impact on microchips is that no one - repeat, no one - can predict with sufficient certainty what will fail and how it will fail. Testing of devices now underway is producing a variety of results - many of which were not predicted. The second problem is that Y2K is a one-time event, and most companies are having difficulty funding measures to combat shutdown as well as measures to weather Y2K shutdown consequences.

A common fear within the offshore petroleum industry is that microchips are so pervasive that failure is possible regardless of preventative measures. Unlike land and surface based industries, devices are deeply imbedded (downhole or deepwater, for example) and costly to access, such that changing them out in advance makes little sense.

One way to examine Y2K risk is estimating liability in worst case scenarios. To prevent liability on anything other than product delivery, some companies plan to shut down completely just before Y2K, and start up gradually afterward, fixing problems as they occur.

This procedure makes sense when devices are difficult to access and there is no certainty of failure. It also makes sense if malfunction of an oil and gas downhole or production train component may not provide shutdown signals to critical downstream devices. In such cases, the catastrophic destruction of equipment far outweighs the cost of an early shutdown.

Another consideration is conversion to manual operation during or after Y2K, if an electronic failure occurs. Is it prudent to expose standby personnel to the risk of a catastrophic event? For offshore operations, there is no safe standoff distance for switching to manual. A worker is either on an offshore vessel or structure - or not.

Y2K has no risk history. The failure to operate, service, or deliver product by deliberately shutting down before Y2K is a business risk, while unplanned shutdown during Y2K could become a catastrophic risk. There are no good choices.

Source: Energy Capital & Power
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