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- 1. Diversification Risk of Emerging Technology: Case Study of British Petroleum H. Patrick Davis NASA PM Challenge Long Beach, CA February 9-10, 2011
- 2. “ On the evening of April 20, 2010, a well control event allowed hydrocarbons to escape from the Macondo Well on to Transocean’s Deepwater Horizon, resulting in explosions and fire on the rig. Eleven people lost their lives, and 17 others were injured. The fire, which was fed by hydrocarbons from the well, continued for 36 hours until the rig sank. Hydrocarbons continued to flow from the reservoir through the wellbore and the blowout preventer for 87 days, causing a spill of national significance” (BP, 2010, Deepwater Horizon Accident Investigation Report). (Herbert, 2010)
- 3. Hydrocarbon Containment Well Control Response Well Monitoring Pressure Integrity Testing Mechanical Barriers Annulus Cement Explosions Fire and Gas System BOP Emergency Operation Well integrity was not established Hydrocarbons entered the well and well control was lost Hydrocarbons ignited Blow out preventer did not seal well Fire & Spill Hydrocarbons (BP, 2010, Deepwater Horizon Accident Investigation Report) Risk Systemicity
- 18. (Riedel, 2010) "ESG and SRI (research) agencies were not capable of properly recognizing the environmental risks of BP” – Christoph Butz, sustainability expert at Pictet Asset Management (Carter, 2010).
- 20. Analysis of Strategic Risk Strategic Risk Decisions Statistical Decision Theory Prospect Theory Agency Theory Multiple Reference Point Theory Bowman’s Paradox Theory
- 23. Strategic Risk Factors L&C Mitigation Systemicity Performance Score 2 large mergers and 2 acquisitions in a 5 year span High Medium Structural Above 36 Safety and risk decisions appear consistent with the industry culture yet inconsistent with BP’s overall portfolio objectives Medium Medium Overall Meets 24 The BP BOD brought in a CEO with a risk posture consistent with the company’s direction yet they appear to have not fully invested in the proper oversight of emerging technology risks Medium High Structural Meets 24
- 24. Strategic Risk Factors L&C Mitigation Systemicity Performance Score 3 consecutive years of increased risk activities with deep water projects High High Structural Above 54 A large percentage of their future prospects are high risk – beneath salt drilling in the Gulf High High Structural Meets 36 Complete re-engineering of their production system for deep water drilling High High Component Above 27 Wells susceptible to explosive gas escapes yet BP rejects increased monitoring by DOI High Medium Overall Below 18
- 25. Strategic Risk Factors L&C Mitigation Systemicity Performance Score 42 major projects plus additional $3B annual profit planned for the next 5 years simultaneous with major improvements Medium Medium Overall Above 36 BP was overconfident in the DOI risk model High High Overall Meets 54 No incentive from government, insurers, or industry to reassess risk posture Medium Low Overall Meets 12
- 32. Strategic Risk Factors L&C Mitigation Systemicity Performance Score Technology readiness depends on cooperation from other NASA programs and multiple national and international partners. Medium Medium Structural Meets 16 New technologies are needed in multiple areas where technology growth with cost reductions has been challenging. High High Structural Meets 36 The same skills needed in these areas will be needed to address multiple technology R&D and may not be available to support NASA schedule. Low Medium Overall Above 18
- 33. Questions? (www.nola.com, 2010) Questions? (Riedel, 2010) Questions? (Riedel, 2010)
Notas del editor
- As stated in the title, this presentation focuses on the strategic risks companies face as they pursue emerging technologies. Although I am using BP as a springboard to discuss this topic, it is not meant to present BP in a negative manner. However, it is important to understand the full consequences of risks before they are accepted so that we can determine whether extra measures need to be put into place to prevent, mitigate, or in BP’s case, clean up the worst case scenario.
- Although we will examine BP’s risk culture from a strategic perspective, we will use the Deepwater Horizon oil spill accident on April 20, 2010 that resulted in the deaths of 11 men and millions of barrels of oil spilled into the Gulf of Mexico over an 87 day period to understand the consequences of not employing a rigorous and comprehensive approach to strategic risk management.
- BP performed its own investigation without coordinating with other investigations including the US Coast Guard, Bureau of Ocean Energy Management, Regulation and Enforcement, and the President’s National Commission to help prevent a reoccurrence. Eight key findings 1 – There were weaknesses in the cement design (Halliburton) and testing, quality assurance and risk assessment that allowed the cement to experience a nitrogen breakout and migration which created an environment for the hydrocarbons to enter the wellbore annulus 2 – Hydrocarbons entered the production casing due to failures in the shoe track and float collar that are designed to prevent fluid ingress into the casing 3 – The well was supposed to be temporarily abandoned to change its intended purpose. A negative pressure test was conducted to verify the integrity of the mechanical barriers. Testing personnel misread the data during testing and incorrectly assumed that well integrity had been established 4 – Between the testing, well monitoring, and well control response, hydrocarbons traveled from the casing to the well. In other words, the rig crew did not know about or take action on the influx of hydrocarbons until they had already passed through the BOP and riser. 5 – The first well control response was to close the BOP and diverter which routed the fluids exiting the riser to the mud gas separator instead of overboard. The accident would have been smaller if the fluids were routed overboard. 6 – Routing the hydrocarbons to the mud gas separator vented the fluids directly to the rig. They were unable to contain the flow at this point. 7 – The heating, ventilation, and a/c system transferred the hydrocarbons to the engine room causing an overspeed condition creating a potential ignition source. There were two explosions. 8 – There are three emergency modes for sealing the well using the BOP which all failed. The investigation found problems with the BOP maintenance and testing regime. We’ll spend most of our time today on the actions prior to these events, but I wanted you have an appreciation for the possibility that there are several potential causes, some technical, some related to knowledge and skills and some to the integration of it all. We will use a term called systemicity of risk which helps us characterize the interconnectedness of risk through the business.
- Today we will take a journey through BP and the oil and gas industry that starts with ensuring we have a common understanding of few terms in the definitions section Then we will examine the previous events that characterize the risk culture at BP Next we will identify a few consequences of the accident to gain a full appreciation for the absence of an effective strategic risk management approach I will show you my approach for analyzing their risk posture using theories from strategic management research I will present lessons learned from the DOI as well as generic lessons that we can all learn from this situation Finally, given this NASA forum, I offer a NASA application of my approach to strategic risk management
- PMI defines Portfolio or Strategic risk management as uncertainty that impacts our strategic objectives or risks that affect how the entire corporation is managed. The risks that we will discuss today are mostly structural and overall risks to the BP portfolio. Based on designs by Oliver (2008) and Boeing (2007), I created a new risk analysis tool that improves how we categorize risk. The Davis Risk Assessment Cube (RAC) is a three-dimensional risk prioritization tool with probability on the y axis, impact on the x axis, and complexity of mitigation plans on the z axis. We will include complexity of mitigation in the analysis section of this presentation because it is another factor that can help eliminate potentially problematic decisions.
- BP’s mergers were related diversification through upstream and downstream integration which means they were expanding into areas that were related to their core business objectives and were adding capabilities that typically were done by their suppliers and customers. Secondary Amoco objective: Be able to respond to change to gas and higher quality and cleaner fuels and renewable energy. ARCO owned two of the best refineries in the US that produce clean fuels. BP’s acquisitions were related diversification through downstream integration. So, they chose to focus only on the customer side integration into service stations and extending the Castrol oil brand to BP consumer and industrial customers. Within BP, Gulf E&P staff were heroic champions who could perform impossible feats and were rewarded accordingly. Of the world’s biggest oil companies , the author Crooks wrote that BP has been the most “swashbuckling, the most entrepreneurial, the most creative” under Lord Browne. While these activities had positive growth impacts to BP, they also show a risk seeking posture across the company.
- However, often risk seeking behavior doesn’t come without a price. I included the BP trader’s attempted conspiracy to corner the propane gas market because it shows how risky the culture had become that they would risk everything they had created for control and greed. These events representing BP’s safety, risk, and ethical culture continued to chip away at how investors viewed BP as evidenced by its stock price that stabilized around $70/share in late 2005 after more than 3 years of steady increase. The stock started to decline starting in 2006 until Tony Hayward was brought in as the new CEO in 2007 with a new emphasis on safety.
- Tony Hayward brought in a new focus on safety in 2007. Operating Management System was established at many E&P sites to address risks, eliminate defects, identify gaps, establish priorities, set targets, and assign responsibilities (according to BP’s website). Primary strategic objective was to achieve safe, reliable, and compliant operations. Focus on process safety to reduce oil spills. The results were 100 fewer oil spills between 2008 and 2009.
- Although they had a new safety philosophy, taking large risks was still a big part of the culture. We will see later that the board was not as successful as it could have been in managing the risk.
- In 2007, BP built the longest single riser tower system in the world in the Angolan deep water project in Greater Plutonio. Thunder Horse established as the largest single producing field in the Gulf with a network of more than 25 subsea wells. The Tiber well shown in the diagram is deeper than Mount Everest and just about equal to the cruising altitude of most commercial airplanes. BP’s shares rose by 4% in one day once investors heard that this field had the potential for over 500 million barrels of recoverable oil. These wells are so deep that they are into the Paleogene layer which represents between 65 million and 23 million years ago (the time just after the extinction of the dinosaurs – also referred to as the beginning of the age of the mammals).
- Given BP’s difficulty maintaining an essential process in the BOP for maintaining the ability to seal a well in an emergency, challenges in maintenance and monitoring were probably larger than BP anticipated. Also, 80% of their future strategic hydrocarbon operations would involve high risk drilling through large salt deposits as shown in the diagram. It appears evident that BP underestimated the amount of structural risk to exploration and production and overall risk to the company.
- This is a peek into a BP deep water production system called Marlin. We can get a taste of how the wells are connected to each other via pumps and lines to the production platform. They knew it would cost them labor, time, and monetary resources to make the necessary improvements listed here (and on their website) in their infrastructure to accommodate deep water drilling. Yet, they did not seem to value the increased risk in their strategic approach.
- Macondo was in water that was 900 ft deeper than Tiber, but only 13,000 ft below the sea floor. In its well permit, BP said it could handle a leak of 250,000 barrels of oil per day implying a spill on the scale of the Exxon Valdez every two days. Macondo leak was initially estimated by BP at 1,000 bpd but culminated closer to 100,000 bpd. I imagine that they never considered that the rig would completely sink to the bottom of the ocean as part of an oil spill.
- Prior to the accident, on their website, BP had these targets identified as their new strategy through 2020. 42 major projects in a 5 year period simultaneous with increased profits, boosting efficiency, centralizing project management (which they admit is a significant restructuring effort) and gaining competitive financial leadership within the industry. It is a lot for any company to endeavor. Was this truly a new strategy from a risk perspective or just a reflection of the old risk seeking strategy? Success in the Gulf Despite Challenges… 7 BP had the largest number of net leases in the Gulf with a record of high recovery even in deep water BP is the top explorer having found more than 30% of all large fields in the last decade To their credit, perhaps centralizing project management was part of the risk mitigation strategy to reduce the uncertainty around maintenance and monitoring of the production sites.
- DOI is charged with protecting America’s natural and cultural resources. BOEMRE, formerly known as the Minerals Management Service, is the regulatory agency responsible for offshore drilling. The risk model was scheduled to be updated to handle new deep water technology in 2000. 2004 risk model still required companies to base risks and contingency plans on surface spills. Far below the surface, oil travels unpredictably, hitting land faster and in more volume than the model predicted. BP’s outdated risk plan was based on their confidence in the outdated DOI risk model. It is a key domino in this case study because it was a huge catalyst for the severity of the consequences. The comment from Exxon’s CEO indicates that they also relied heavily on DOI for their internal risk planning.
- BP’s contingency plan said it had enough dispersants and skimmers to deal with a spill far in excess of the volume it struggled to contain, and placed low probabilities on oil reaching land in the event of a major spill. BP’s risk plan was similar to other oil and gas companies including Exxon-Mobil, Chevron, and Conoco-Philips. It was based on the shallow water technology risk model provided by the DOI BOEMRE. It contained the name of an expert (Peter Lutz) who died in 2005 that BP said they would call in an emergency situation. And, it called for protecting walruses in the Gulf of Mexico. However, there have not been walruses in the Gulf for 3 million years.
- We have discussed primarily the internal risk factors at BP. As with most strategic risks, there are external factors involved that affect the industry, its suppliers, and customers. Insurance analysts do not know how to deal with environmental, social, and governance (ESG) risks with large oil drilling disasters – they focus on financial risks and operational costs. For example, analysts multiplied the number of barrels of oil spilled by the per-barrel cost of oil as the costs of the spill. Before the spill, analysts didn't have enough information about the risks involved in oil company deep-water rigs. (Carter, 2010)
- As we transition from background information on BP to the analysis of strategic risk, I want to provide a few consequences of the accident because I believe that if BP would have considered any of these consequences, they would have pursued additional safeguards against the risks. The $40B clean up effort was coupled with a decision by BP to reduce its emphasis on pursuing additional deep water projects in the Gulf. BP’s partner in the well, Anadarko, planned to sue BP for gross negligence and avoid its 25% share in the $40B clean up. Increases in insurance premiums and lengthy times to obtain drilling permits may drive smaller firms into mergers/partnerships, international markets, or out of business. I wonder if BP considered these consequences as they positioned themselves for increased risk activities.
- It is important to base our implementation of lessons learned not only on our interpretations of the problems, but also on the many years of experience with empirical testing and experimentation found in the research literature. There are 5 leading decision theories that have the potential to help us glean something meaningful from the BP case study analysis from a strategic risk perspective that will be applicable to many different companies and industries. Decision Theory and Prospect Theory have similar roots as do Agency Theory, MRP Theory, and Bowman’s Paradox. So let’s look at each set of theories and the possible lessons learned that emanate from them.
- Agency Theory Shareholders as principles have given authority to the board of directors to select the right team to make effective decisions considering the risk to the shareholders. Self-interested behavior can cause agents to establish a risk posture that is inconsistent with the interests of the principals (Mukherji, 2008) MRP Theory Companies that are meeting or near their strategic targets (reference points) will be less inclined to pursue higher risk opportunities - increased slack, aspirations depend on whether they are below or above their industry target. Companies that are below their industry target will decrease aspirations based on performance while those that have performance above the industry average will increase aspirations. Companies that are below their survival targets or above their success targets will be more inclined to pursue higher risk opportunities – decreased slack Slack represents unexploited opportunities or undiscovered economies. It is the difference between actual performance and potential performance. A behavioral view of slack suggests that managers accept greater risk when faced with both high and low levels of slack. Aspirations reflect a company’s desired level of performance. It is heavily based on past performance and whether a company’s decision makers are risk seekers or risk averters. Theories predict that as long as performance exceeds aspirations, search for new alternatives is modest, slack accumulates, aspirations increase, and risk decreases. When performance falls below aspirations, search is stimulated, slack decreases, and aspirations decrease. Risk may remain constant or it may increase depending on how far actual performance is from the aspiration. Bowman’s Paradox BP is now selling $350 million of deep water Gulf assets to pay off financial obligations to the oil spill. Severe impacts to their core growth strategy. Too much unidentified and unmitigated risk.
- For more than 2 decades, we have used beta from the Capital Asset Pricing Model and simple variance (ROA, ROE, or ROI) to define financial risk to a portfolio in accounting and marketing terms to support strategic decision making. Beta is the relative volatility of a security measured by the risk adjusted return of the market portfolio. A beta of 1.25 provides the firm with 25% more return than the market which is compensation for the extra risk. Although current literature is beginning to question the validity of using these in this manner, they can still be used as part of the decision making process. However, there may be opportunities like with BP where it is helpful to augment CAPM and variance with other methods like the theories identified here that can account for the higher risk. We can use PMI’s portfolio risk management tools like tornado diagrams within a sensitivity analysis to help generate subjective decision weights for each potential outcome (PMI, 2008). For example, for π 1 , the gain weighting could be expressed as $13M in the green region divided by the total uncertainty of $28M (0.46) while the loss weighting is characterized by $15M in the red region divided by $28B (or 0.54). We can make more informed decisions by quantifying and ordering the risk of each option and applying subjective factors to account for uncertainty within the probabilities. If we analyze the risk factors involved with the uncertainty within expanding deep water drilling, we can gain a better perspective of the decision weight (w).
- I analyzed the data according to 5 criteria: Strategic risk factors Likelihood that there will be a negative impact to a strategic objective and the size of its consequence Complexity of mitigation Systemicity or interconnectedness of the risk to other projects, programs, or portfolio elements. For simplicity, we will use PMI definitions for component, structural, and overall portfolio risk. Whether the company is consistent with industry expectations, above expectations, or below expectations Quantify categories: Low/below/component = 1, med/meets/structural = 2, high/above/overall = 3 Multiply the categories: L&C x Mitigation x Systemicity x Performance 1 – 12 = increase risk level 13 – 24 = maintain risk level 25+ = reduce risk level While there are other ways to evaluate the culture and these specific set of events, the four that are mentioned can help us make decisions about the lessons we can learn from BP’s accident. 2 large mergers and 2 acquisitions in a 5 year span Too aggressive? Able to address risks of integration appropriately? Diversifying into emerging technology too fast? Safety and risk decisions appear consistent with the industry culture yet inconsistent with BP’s overall portfolio objectives – optimistic planning. Industry was lulled to sleep that a big accident could not occur.
- Each one of these occurred without any corresponding changes to the outdated risk plan. Each alone would justify changes. You will notice that the likelihood and consequence ratings are high for all four of these risk factors, yet the final risk scores are different and could have helped BP make more rational decisions about prioritizing how they protect their assets and interests. Balancing their portfolio with fewer high risk deep water projects with more lower risk ventures would have been advisable. You might ask why it would be feasible to prioritize mitigation steps for rejecting increased monitoring by DOI. If BP mitigates other deep water risks for instance by improving internal maintenance and testing, they would not need the extra external monitoring as much as they would need to account for the risk of completely re-engineering their systems for the new technology.
- 42 major projects plus additional $3B annual profit planned for the next 5 years simultaneous with major improvements in process safety and centralization of project management – was their focus too dispersed? BP was overconfident in the DOI risk model which did not incorporate emerging deep water technology. This is a significant risk factor comparable in score to the risk of 3 consecutive years of increased risk without changes to their risk plan. There are potentially 6 structural risks and 3 overall risks to BP. 7 have mostly negative impacts and the remaining 3 have a mixture of positive and negative impacts. 4 risk factors indicate that the company had above average performance in those areas compared with industry, 5 in the average range, and only 1 below which created a success orientation for them from a past experience perspective, but also shows that they are pursuing higher risk activities than the industry and may warrant reducing that risk or at least putting plans in place to better protect themselves. The mitigation complexity ranges from 1 (low) to 6 (medium) and 3 (high) which almost represents a traditional bell curve. Together, this leads us to believe that these risks/issues are significant strategically and many can and should be mitigated without obvious undue hardship on BP especially considering the degree of the loss BP incurred through its stock price during the episode.
- Now we transition from the analysis of the risks to the lessons we can learn based on the analysis. From politics to finance to oil and gas, there was consensus amongst interested parties on the need for change in the oil and gas industry.
- BP’s lessons learned produced tactical improvements designed to mitigate another accident, but not systems and processes to understand its risk posture and adjust its strategic plan accordingly. Recommendations from their internal accident investigation include: Clarifying procedures and strengthening their engineering practices Developing their technical ability to operate in the deepwater environment Responding more appropriately to audit findings Enhancing their ability to detect problems with safety critical equipment Ensure integrity of management systems, competence, and compliance of cementing providers Well control practices performed by contractors are clear and easy to implement consistently Require hazard reviews for rig acceptance and rig audit Establish and enforce requirements for reliability, redundancy, testing, maintenance, auditing, and emergency operations
- Here are lessons learned from DOI Increased safety rules for offshore drilling (well design, risks, cementing, BOP, Remotely Operated Vehicles, etc). Require oil companies to estimate size of spill and describe steps to reduce the risk of a disaster and to respond more quickly to a spill if one does occur. Reorganize BOEMRE to avoid conflicts of interest between promoting energy development, regulating offshore drilling, and collecting revenues. It’s evident from the graph that no one including BP, NOAA, DOI, and independent analysts had a good process initially for evaluating the potential impacts of the spill.
- We must augment external regulations with internal risk analysis to determine proper mitigations for predicted risks and their consequences. Quantify assessment of risk to the portfolio considering the systemicity of risk, performance, and complexity of mitigation in addition to likelihood and consequence. Application to BP: They could have accounted for the lack of updates to the DOI risk model by compensating in their internal risk response plan until the model was updated and preparing mitigation steps to address a worst case scenario based on their own understanding and experience with the technology.
- A Portfolio Governance body (e.g., Board of Directors) should be involved in shaping the strategic risk direction (risk adverse vs. risk seeking) where the company risk profile is inconsistent with the industry’s current practices or future direction and the company’s current abilities and performance or future direction. PMI (2008) advocates for feeding inputs from risk plan changes into portfolio budget updates. However, the reverse can be effective for triggering updates to the risk plan – are there sufficient funds to cover preventive actions or for contingency reserves, schedule, and resource assignments? A Portfolio Risk Review Board can be established as a tool for determining when changes to the risk posture are warranted based on incorporation of emerging technology, changes to strategic goals, tornado diagrams and sensitivity analyses, or changes to the budget.
- In NASA’s 5 year strategic plan through 2015, it shows funding for a few new items and deletions in funding for others. These are areas where new diversification risk can creep into a plan if it isn’t directly addressed. Let’s look at the largest piece of their plan which is in Exploration R&D and examine a few emerging technology strategic risk factors using the model I introduced.
- This is an initial look at potential risk factors for implementing parts of NASA’s strategic plan. Although there are certainly other risks involved and we may disagree on the specific categorizations, the process more accurately describes the uncertainty to the NASA portfolio than just using technical, schedule, and cost likelihood and consequence or financial risk by themselves. Not only does this assist risk prioritization, but it helps us make consistent decisions considering the appropriate aspects of the portfolio.