Alliancing: A Paradigm in Transition, Getting the Incentives Right

SPECIAL REPORT

ALLIANCING: A PARADIGM IN TRANSITION, GETTING THE INCENTIVES RIGHT
By Peter D. Loftspring

Part Three: Alliances of the Future

Editor's Note:

This series of articles is based upon a paper presented by Mr. Loftspring at the "Partnerships, Contracting & Strategic Alliances" Conference presented by the Strategic Research Institute in New Orleans on February 26-27, 1997.

CONSIDERATIONS FOR THE ALLIANCE OF THE FUTURE

In General

While the "right" form of supplier/customer alliance is still evolving, those in existence and presently taking shape still vary widely from customer to customer and from project to project. Just as each company has developed its own unique management style and organization, it is unrealistic to assume that alliances will ever achieve a common structure. Nevertheless, Halliburton and Brown & Root's experience with several major alliances in the North Sea, the North Atlantic, North America, and numerous smaller arrangements elsewhere have shown that certain central issues must be addressed. Among these issues, restated throughout this article because they are the most important elements of a successful supplier/customer alliance and because inadequate attention to these issues will potentially lead to acrimonious dissolution, is the notion that there must be a "proper" alignment of interests and an appropriate risk allocation structure to effectively achieve the goals desired. Any thorough discussion of the supplier/customer alliance, therefore, requires adequate attention to the critical nature of these seemingly obvious concepts.

A Legal Perspective - The Changing Nature of Risk Allocation

The supplier/customer alliance of today evolved from a much more pervasive relationship: the simple contract for goods and services. The conventional roles and expectations of a "customer" and "supplier" could not be more clear. Documented through the ages in numerous purchase orders, construction contracts, service agreements and the like, this relationship has developed certain preconceived notions of fairness and appropriate risk allocation. These concerns are reflected in standard provisions for indemnity, insurance, warranty, etc. that, interestingly enough, tend to shift responsibility and liability to the party generally least able to shoulder these burdens (usually the smaller, less financially strong entity or the entity with the most competition/smaller margin for the goods and/or services it supplies). The important thing to recognize is that insurance for injury or damage will be paid for one way or another, either through increased delivery cost (if the supplier bears or self insures the risk) or through increased insurance cost paid for by the customer. Rarely is the risk so small and the supplier's profit so large relative to the overall profit from a project that significant risk can be absorbed without additional cost.

As discussed above, one of the most powerful tools for realizing both savings and improvement has become the "properly" structured alliance. Although the formal legal relationship between parties often provides the necessary paradigm for the pursuit of a commercial venture (e.g., shareholders, joint venturers, general partners, limited partners, etc.), the uncertainty of what is required from each party in an alliance relationship often presents an initial hurdle to companies not familiar with the potential benefits. From a purely legal perspective, an alliance is like any other consensual commercial relationship based upon contractually agreed upon duties and obligations. Under the laws of most jurisdictions, an alliance or any other joint venturing arrangement between parties (e.g., informal common commercial pursuits, unincorporated joint ventures, etc.) is treated for many purposes like a partnership. As such, responsibility for tortious injury or damage to third parties will be assessed jointly and severally between the alliance participants, while contractual obligations to third parties will depend upon the terms agreed upon or the representations made to the third party. Unlike a simple joint venture, however, a properly structured alliance depends upon a thorough analysis, understanding and allocation of the parties' risks and opportunities. Careful attention must be paid to not merely establishing the parties' common goals, but aligning their interests (risks as well as rewards) thoroughly such that the members can work efficiently toward achievement of the alliance objectives.

While implementation of proper incentives cannot be overemphasized, the significance of an appropriate risk allocation strategy must not be overlooked. Conventional contracting philosophy generally dictates that each party be responsible for the injury or damages that it causes (responsibility for injury or damage apportioned according to common law principles). This protects the parties not involved in an incident from losses beyond their control but almost inevitably leads to disagreement and often litigation among the affected parties. To preclude some of these problems, the members often agree to take responsibility for injury to their personnel or damage to their property regardless of whose negligence or other fault caused the loss ("knock-for-knock"). Furthermore, where one party has superior bargaining power (and state anti-indemnity law allows), it may insist that any injury or damage caused by the joint or concurrent negligence (e.g., even where the customer is 99% responsible and the supplier only 1% responsible) of a supplier be the supplier's responsibility.

Recent schemes in some alliances, however, have opted for an equitable distribution of losses that spreads losses among all of the alliance members. The rationale behind this strategy being to eliminate the likelihood for disputes, motivate the members to work together toward common resolution of problems and enhance the attitude of cooperation. One method to accomplish this level of integration is to structure the liabilities in such a way that each member shares responsibility for injuries, damages, delays, etc. according to a formula based upon the relative profit anticipated by each party from the entire project. Alternatively, the members can utilize a fairly conventional risk allocation scheme in which each member's responsibility for injury or damage to third parties, existing structures and project assets is based on specified project milestones (each member responsible during the time that its contribution is taking place) or an agreed upon assessment if several parties are actively involved during specific phases.

In any event, individual member liabilities (e.g., injury to member personnel and property), are generally most efficiently managed through each member's risk management program and a blanket knock-for-knock agreement that requires each member to indemnify the others for such injury or damage. Finally, project insurance, where available and cost effective, should always be considered. By thus eliminating any need for alliance members to dispute whose action or inaction caused a given loss, the members can focus their attention and resources on the project objectives and toward preventing future losses. In addition, once these issues are resolved, much of the controversy routinely encountered when negotiating the indemnity and insurance sections experienced with conventional supplier/customer contracts is circumvented.

A Commercial Perspective - The Need for Aligned Interests

Experimentation with a variety of incentive schemes over the last several years has demonstrated that when alignment is achieved, each party shares responsibility for both success and failure in such a way that the investment of scarce corporate resources and technology is encouraged and ultimately rewarded with greater returns. The key is not in developing novel ways to "slice the pie," but to allocate both risk and reward to the party best able to control each aspect of the alliance's objectives and thereby "grow the pie" so that there is ultimately more to slice. The members must be appropriately incentivized so that the alliance is able to become significantly more efficient and effective than the sum of the individual constituent parties. This synergy derives from the collective ability of the parties to overcome traditional obstacles that inhibit creativity and innovation in the implementation of the members' mutual objectives. Several subtle distinctions illustrate the unique advantages of an alliance over traditional contracting methods for the implementation of oil and gas projects.

To begin with, an examination of the "ownership" of the risks and rewards of a conventional project is useful. In most such projects, this yields an organization that is generally composed of a number of oil companies and/or investors with relatively similar skill sets participating with varying equity interests commonly through a Joint Operating Agreement. Just as with other joint ventures and partnerships (as mentioned previously, legal and accounting firms, medical groups, real estate investment joint ventures, etc.) each member provides a different, though similar, perspective on a given problem and is able to assist by consulting and verifying the findings of the other members. Expertise with certain special purpose equipment, non-traditional methods and leading edge technologies that are not part of the members' collective experience must be sought from outside the "venture." Success or failure of this type of joint venture ultimately depends upon the ability to (i) accurately identify the asset, (ii) efficiently utilize the resources and expertise of third parties to harvest the asset (well and facility construction), and (iii) economically market the asset. Thus, third parties to the venture are most responsible for the implementation of the most significant capital expenditure portion of the project and generally have very little to gain (and often only lose) by reducing costs and altering procedures to yield savings.

By contrast, an alliance between one or more oil companies and service companies consists of members able to contribute complementary skills to the effort with little or no duplicate expertise. One of the most common examples touted as an "alliance," as mentioned previously, involves the mere dedication of service company resources in exchange for additional work. Although this is an effective way to promote tighter integration, lower the customer's costs (less customer manpower required and supplier discounts usually offered) and increase the supplier's profits (more efficient job scheduling possible, greater volume, etc.), little is done to encourage the investment of resources necessary to bring about innovative design and process improvement. Similarly, efforts to provide "lead contractor" services or "project management" expertise go a long way toward expediting project implementation, yet these techniques do little to foster commonality of interest or alignment between the parties.

In a truly aligned relationship, however, the supplier(s) has a vested interest in both the capital and operating phases of the project. Thus the "owner" of the asset becomes the same as the "owner" of the technologies and resources necessary to harvest the asset. Design decisions can be made at the very earliest stages of the analysis to permit introduction of processes and technologies that will provide for the most cost efficient (both capital and operating) and effective means to implement the development project. Instead of relying upon performance gains made by third parties for significant portions of the development work, internal expertise is available to review each step of the process and experiment as necessary to develop efficiency improvements. As discussed further below, such a situation exists where each member of the alliance has a financial stake or other economic incentive in the entire project. If properly structured, the alignment of each party's interests enables the members to rely on each other's intentions, competencies and abilities throughout the course of their joint pursuits. Just as different departments within a single company have the incentive to work closely together to assure their common benefit, alliance members and their employees must have the necessary incentives to work together in the most effective manner the parties can determine. Likewise, a well run alliance enables the relationship between the entities to improve as the undertaking proceeds and creates a strong foundation for future projects.

The automobile manufacturers' alliance with their suppliers acutely demonstrates the successes that can be achieved. Faced with a need to drastically reduce the cost of inventory and the cost to make annual modifications, suppliers are brought into the design process at the very earliest stages to determine the most efficient design alternatives for significant components based upon manufacturing capabilities. Clear goals and incentives are established and measurement techniques implemented, consequently, all parties benefit from savings and efficiency gains and the parties can work closely to promote communication and technology. Focused solely upon bottom line costs, of course, the customer would rarely look past the initial cost of an internally specified design and gains achievable from overall process improvements would never enter into the analysis.

Properly Incentivizing to Assure Alignment

The traditional supplier/customer relationship presents a classic "zero sum" scenario. Under these conditions, the gains of one party are based upon the losses of the other. In the conventional contractual arrangement, the customer strives to obtain the most value for the budget available. Any savings or process improvements that are realized usually result in a loss of potential revenue for the supplier that provided this additional benefit. The supplier performs or delivers as agreed with only the promise of future repeat business as the reward for successful delivery and the threat of (expensive and time consuming) legal and commercial repercussions for failure. With the success of early alliance efforts however, it became apparent that when well aligned, the parties' concerted efforts were not only likely to decrease costs due to better project design and delivery management, but overall NPV could be increased through expedited performance, higher quality and increased revenue. This situation, commonly characterized as a "win/win" scenario, makes economic sense if the increased total benefit is much greater than the benefit ordinarily experienced by the customer alone. The effect of this strategy can be demonstrated intuitively by considering the relative NPV improvement between individual wells brought on in series versus the same production initiated simultaneously. A commonly held paradigm must be changed so that the focus is no longer upon retaining as much of the overall NPV available from each individual reservoir as possible. Instead, the more financially responsible position is to evaluate the company's overall position with regard to all of its assets (prospective as well as proven). Where management's emphasis is not on scrutinizing each individual well, but instead concern is directed toward increasing overall shareholder value, the additional benefit given up (potentially higher price paid to the supplier) is more than offset by the enhanced NPV earned by leveraging the company's available resources to concurrently develop as many prospects as possible.

The oil and gas industry has witnessed a number of both large and small scale alliances develop over the last 20+ years. While a number of these have been supplier/supplier alliances attributable to the industry's restructuring, several industry players have been experimenting with different forms of supplier/customer alliances. These take a wide variety of shapes, including volume/discount transactions, in-house engineering support, lead contractor arrangements, "integrated" project management, "integrated" services, "integrated" solutions, equity plays, etc. with differing levels of alignment and overall benefit. The tighter the interdependence, naturally, the more sophisticated and complicated the arrangement. Ultimately, companies able to formulate the relationship such that all members benefit are able to take full advantage of the strengths and synergies that the combined organization has to offer. It is precisely this well aligned relationship for any given project or series of projects that provides the necessary motive for each company to (i) commit its best and brightest personnel, (ii) evaluate additional alternatives to explore creative and innovative solutions to problems, (iii) expedite implementation schedules, (iv) coordinate efficiently with other operations running in the region, and (v) focus on improving the processes involved in delivering the product(s) and service(s) with the experience gained from previous attempts. Experience in the development of oil and gas assets through supplier/customer alliances has demonstrated that there are a wide variety of ways to achieve satisfactory alignment. Furthermore, alliances can be structured in a variety of ways that involve varying degrees of alignment between the parties as necessary to accomplish different objectives. Several common methods used to achieve alignment between customers and suppliers that have been touched upon previously are summarized below:

1. Cooperation . The in-house service company engineer, previously mentioned, has gained wide acceptance. While this tight integration of design and implementation skills can provide significant benefit for both parties, no incentive exists for additional investment of resources in technology or process improvements and little impact on overall placement and well design can be accomplished. Interestingly enough, when approached with the idea of furthering the scope of the alliance, many customers, convinced that they are achieving maximum value from the existing relationship, routinely question the supplier's ability to enhance the value of the consulting service and discounts already offered. "What can your company do for us that can't be accomplished with your engineer already in our office?" and "Are we not already receiving access to all of your company's skills and expertise?" are not uncommon or unreasonable questions. What is often overlooked, however, is the significant value that can be created for both parties by broadening the composition and extending the scope of the relationship.

2. Shared Ownership. Among the most basic ways that parties can be made to share a common interest in the achievement of specified goals is for each party to take an ownership interest in the undertaking. The alignment achieved is clearly illustrated in one of the most common relationships in the oil and gas industry: the joint operating agreement, wherein joint interest owners in a reservoir development project document obligations toward their common goals and objectives. This approach inherently supplies the motive necessary to assure that cost saving measures undertaken during the implementation phase of the project do not adversely affect the operational phase. In an alliance to develop a new reservoir or to enhance production from an existing field, common ownership reduces the tendency to fixate upon cost savings at the expense of higher flow rates, water conformance problems, mechanical failures and similar inadequacies that contribute to an overall lower net present value (NPV).

Payment for such ownership interest may take several forms depending upon the needs and abilities of the parties. In situations where the customer's financial resources are constrained, some combination of cash payments, discounts below market rates for services supplied or even a form of "vendor farmout" can be utilized to align the parties' interests. Where financial constraints are not significant but personnel resources are at a premium, the supplier's reservoir description, drilling and completions engineering and project management expertise can be seconded in exchange for an ownership interest. In any event, the technique chosen should provide maximum alignment for every phase of the project. Success will not be achieved, for example, if the alliance is able to enhance production but the member responsible for transporting and marketing the production has little incentive to finance improvements or supply the resources necessary to accomplish this task.

3. Incentivization Schemes. A supplier/customer alliance need not require each member to have legal title to a portion of the subject asset to assure the commonality of interest necessary for satisfactory alignment. In fact, due to tax consequences and other limitations in certain jurisdictions, an ownership interest is often undesirable. Fortunately, a number of other techniques involving various forms of incentive can be utilized to accomplish similar results.

Alignment requires an allocation of responsibility for processes over which each party has expertise and control. Obviously, no alignment would be fostered if the owner and completions contractor tried to work out an arrangement to split over/under runs attributable to the work performed by the drilling contractor. Significant advantage, however, can be achieved if the incentivization scheme rewards members for each portion of the project that their expertise, technology, equipment and personnel resources contribute to capital and operating cost savings. Often, this is not easily determined at the beginning and empirical methods or historical experience must be relied upon. Flexibility may be necessary in the incentivization scheme to encourage experimentation and innovation while maintaining total alignment toward maximizing overall net present value.

The NPV for a project can be enhanced tremendously by providing the supplier with the incentive to invest its own resources. As the "level" of alignment increases, additional incentive is provided for increased investment in the project. Clearly, a "turn-key" field development or production enhancement project (whether 5 wells or 50 wells) with payment based on results gives the supplier a much greater vested interest than merely performing the work specified by the customer on a well by well basis at rates based on time and materials. Other common incentives include performance measures such as time, quality, safety/environmental, gain share (based upon incremental increase in production), and financial performance (objectives for cost savings exceeded). 1 While the range of incentives to accomplish the desired result is quite broad, properly utilized the incentives allow the alliance to share the increased overall project value. Ideally, the supplier can even be incentivized to finance the implementation of its own new technologies in areas where success is uncertain and the potential savings are substantial. The alliance is thus able to allocate operational risk of failure to the party most able to control the risk.

Inappropriate Application of an Alliance

An alliance, and for that matter even outsourcing, is by no means a panacea to enable every customer or supplier to achieve its highest efficiency. In fact, a number of situations argue strongly against the use of either approach. In situations where the customer has adequate internal resources to staff every prospective project available to it, the financial ability to fund each of these projects and the expertise to bring best in class technology to the resolution of potential problems, an alliance would potentially give away some of the producer's prospective profit. Likewise, where low-level technology solutions are required and personnel cannot be more effectively re-deployed to higher yielding operations, an alliance or outsourcing arrangement brings little additional value. A supplier/customer alliance, therefore, would be of little incremental benefit in an instance where the customer's own core competencies are notably superior to those available from its suppliers and the success of the customer's projects do not require significant additional innovation. In these situations, conventional contracting arrangements can be most economically utilized to bring in the required personnel to carry out the work. Simple incentivization schemes can be used in many of these instances to entice those individuals that may have some discretionary ability to accelerate time sensitive components of a project and detailed commitments from suppliers can be used to lower inventory and standby costs. Even executional risk can be minimized by spreading the inevitable losses over an adequately large number of applications (e.g., new wells or workovers).

In the oil and gas industry, many producers cite the 80/20 rule when it comes to staffing for production levels - personnel are thus focused on the 20% of the company's properties that produce 80% of the company's revenue. Enhancement opportunities for the remaining properties generally present such a low rate of return, that the producer's capital funds and personnel are rarely made available. While this would seem a prime opportunity for an alliance that is funded and staffed by suppliers willing to invest high margin technology (i.e., leading edge tools, techniques and equipment that may cost significantly less to implement than the actual market value - a situation which occurs, for example, when buyers are willing to pay more for a patented device due to the significant savings generated), in many instances internal politics, institutional inertia and organizational constraints, not to mention the potential for alienating responsible individuals, militate against the intense effort necessary to convince management (at this stage in the evolution of the alliance concept) that a trial is worth pursuing.

Alliances are also not well suited for small scale, short term endeavors because the effort required to determine measurement criteria, delineate goals, negotiate terms and establish the necessary relationships does not warrant either the relatively high risk of such a project or the generally small opportunity for enhanced benefit. This is not to say, however, that the scope cannot be broadened such that several smaller projects are combined into a larger project to form the initial alliance project upon which the relationship is built. In fact, experience has demonstrated that once the alliance relationship has been established, the kinks worked out and satisfactory results proven, the template utilized for initial operations can be quite easily expanded to additional opportunities.

1Integrated Solutions Handbook, Halliburton Energy Services, (Houston, 1996)

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