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Organizational Policy Fall 2017

Raynard Porter

BADM 450 Spring 2016

Texas Southern University

Table of Contents

The Global Oil and Gas Industry......................................................................................................5

Royal Dutch/Shell: A Shell Game with Oil Reserves--Governance Overhaul after Scandal (B).....23

CrossFit (A).....................................................................................................................................35

BP's Macondo: Spill and Response................................................................................................59

McDonald's China: The Expired Meat Scandal..............................................................................81

Reinventing E-Commerce: Amazon’s Bet on Unmanned Vehicle Delivery....................................97

Enron - What Went Wrong?..........................................................................................................121

Apple Inc.: Managing a Global Supply Chain...............................................................................135

The Offshore Drilling Industry in 2011..........................................................................................157

The Rise and Fall of Petrobras.....................................................................................................185

Organizational Policy Fall 2017 BADM 450 Spring 2016

Raynard Porter Texas Southern University

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Copyright © 2016 Thunderbird School of Global Management, a unit of the Arizona State University Knowledge Enterprise. This case was written by Professor Andrew C. Inkpen for the sole purpose of providing material for class discussion. It is not intended to illustrate either effective or ineffective handling of a managerial situation. Any reproduction, in any form, of the material in this case is prohibited unless permission is obtained from the copyright holder.

Andrew C. Inkpen

The Global Oil and Gas Industry The oil and gas industry is one of the largest, most complex, and most important global industries. The industry touches everyone’s lives with products such as transportation, heating and electricity fuels, asphalt, lubricants, propane, and thousands of petrochemical products from carpets to eyeglasses to clothing. The industry impacts national security, elections, geo-politics, and international conflicts. The prices of crude oil and natural gas are probably the two most closely watched commodity prices in the global economy. In recent years, the industry has seen many tumultuous events, such as the growth in oil and gas production in the United States; sanctions on Russia and improved international relationships with Iran; continued technological advances in unconventional oil and gas; ongoing strife in Iraq, Libya, and various other oil-exporting nations; continued heated discussion about climate change and non-hydrocarbon sources of energy; and continued uncertainty in crude and gas prices. All of this comes amid predictions that the global demand for energy will increase by 30%–40% by 2040.

Oil and Gas Industry Background When Colonel Edwin Drake struck oil in northwestern Pennsylvania in 1859, the first phase of the oil industry began. John D. Rockefeller emerged in those early days as a pioneer in industrial organization. When Rockefeller combined Standard Oil and 39 affiliated companies to create Standard Oil Trust in 1882, his goal was not to form a monopoly, because these companies already controlled 90% of the kerosene market. His real goal was to achieve economies of scale, which he did by combining all the refining operations under a single management structure. In doing so, Rockefeller set the stage for what historian Alfred Chandler called the “dynamic logic of growth and competition that drives modern capitalism.”1

With the Spindletop discovery of oil in East Texas in 1901, a new phase of the industry began. Before Spindletop, oil was used mainly for lamps and lubrication. After Spindletop, petroleum would be used as a major fuel for new inventions, such as the airplane and automobile. Ships and trains that had previously run on coal began to switch to oil. For the next century, oil, and then natural gas, would be the world’s most important sources of energy.

Since the beginning of the oil industry, there have been fears from petroleum producers and consumers that eventually the oil would run out. In 1950, the U.S. Geological Survey estimated that the world’s conventional recoverable resource base was about one trillion barrels. Fifty years later, that estimate had tripled to three tril- lion barrels. In recent years, the concept of peak oil has been much debated. The peak oil theory is based on the fact that the amount of oil is finite.

After peak oil, according to the Hubbert Peak Theory, the rate of oil production on Earth will enter a terminal decline. At various times, some analysts have argued that the peak has occurred, whereas others have argued that peak oil is a myth. An article in Science stated:

Although hydrocarbon resources are irrefutably finite, no one knows just how finite. Oil is trapped in porous subsurface rocks, which makes it difficult to estimate how much oil there is and how much can be effectively extracted. Some areas are still relatively unexplored or have been poorly analyzed. Moreover, knowledge of in-ground oil resources increases dramatically as an oil reservoir is exploited. To “cry wolf” over the availability of oil has the sole effect of perpetuating a misguided obsession with oil security and control that is already rooted in Western public opinion—an obsession that historically has invariably led to bad political decisions.2

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Regardless of whether the peak has or has not been reached, oil and natural gas are an indispensable source of the world’s energy and petrochemical feedstock, and will be for many years to come. The difficulty in determin- ing oil and gas reserves is that true reserves are a complex combination of technology, price, and politics. While technical change continues to reveal new sources of oil and gas, prices have demonstrated continued volatility, and resource owners have sought more control over access. As prices rise, reserves once considered non-economic to develop may become feasible. As prices fall, the opposite occurs.

The oil and gas industry has always been cyclical, with the price of oil and gas moving up and down. Exhibit 1 shows oil prices over the period 1970–2015. The Arab oil embargo of 1974 resulted in a large price increase and events in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980. The period 1985 to 1998 was largely a period of low prices. Prices then started back up, only to fall after September 11, 2001. After 9/11, prices rose until the recession at the end of the decade, continued rising until 2014, and then fell significantly.

Oil and Gas Reserves Discovering new oil and gas reserves is the lifeblood of the industry. Without new reserves to replace oil and gas production, the industry would die. However, measuring and valuing reserves is a scientific and business challenge because reserves can only be measured if they have value in the marketplace. The oil sands of Alberta, Canada, are a good illustration of how difficult it is to accurately measure oil and gas reserves. Oil sands are deposits of bitu- men, a molasses-like viscous oil that will not flow unless heated or diluted with lighter hydrocarbons. Although the oil sands in Alberta are now considered second only to the Saudi Arabia reserves in the potential amount of recoverable oil, for many years these were not viewed as real reserves because they were non-economical to develop. For most of the 2000s and through 2014, the main town in the oil sands region, Fort McMurray, was in the midst of a boom not unlike the gold rush booms of the 1800s. Housing and labor were scarce and the infrastructure struggled to keep pace with the influx of people, companies, and capital. The development of the oil sands occurred because of a combination of rising oil prices and technological innovation. With the fall in oil prices after 2014, the oil sands region has seen many projects postponed or canceled. In 2016, the housing market in Fort McMurray was being called a housing bust.

Exhibit 1. The Price of Oil, 1970–2015 (US$ per barrel)

Source: Annual average prices in U.S. dollars per barrel from BP Statistical Review of World Energy, 2015; 1970-73 is Brent Blend.

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Oil and Gas in the Global Economy Oil and gas play a vital role in the global economy. The International Energy Agency (IEA) predicts that energy demand will rise significantly over the next three decades, with most of the increase coming from developing countries. Most of the world’s growing energy needs through 2040 will continue to be met by oil, gas, and coal. With increased energy efficiency, energy as a percentage of total GDP has fallen and is expected to continue to fall.

Oil and Gas Supply All countries are consumers of products derived from the oil and gas industry, but only a small set of nations are major oil and gas producers. Over the past decades, the large developed economies of the world have become net importers of oil and gas, giving rise to challenging geopolitical issues involving a diverse set of oil consumers and producers. Exhibit 2 shows the major oil- and gas-producing nations. The impact of unconventional tech- nologies can be seen in the significant increases in U.S. and Canada production. From 2000 to 2014, Canadian oil sands production more than tripled, from about 600,000 b/d to over 2.2 MM b/d. The United Kingdom is a notable absence from the list of top oil producers, having dropped from 2 MM b/d in 2004 to less than 900,000 b/d in 2014.

Industry Financial Performance The oil and gas industry has been regularly criticized by politicians and the media for its high profits. In the U.S., proposals for industry excess profits taxes are common during high price cycles, prompting Lee Raymond, former ExxonMobil CEO, to comment in 2005, “I can’t remember any of these people seven years ago, when the price was $10 a barrel, coming forward and saying, ‘Are you guys going to have enough money to be able to continue to invest in this business?’ I don’t recall my phone ringing and anybody asking me that question.”3

The oil and gas industry is highly cyclical and the cycles can last many years. In the 1990s, crude oil prices stayed low, and for the first 14 years in the new millennium, prices steadily rose (except for a brief dip in 2009). In 2014, oil prices fell significantly and continued downward in 2015. Many independent exploration and production (E&P) firms found themselves in financial distress.

Exhibit 2. Major Oil- and Gas-Producing Nations

Oil-Producing Nations Gas-Producing Nations

Country Production

Million bpd 2014 Change

Over 2013 Country Production

Billion Cubic Meters, 2014 Change

Over 2013 United States 11.6 5.9% United States 728 6.1% Saudi Arabia 11.5 .9% Russia 579 -4.3% Russia 10.8 .6% Qatar 177 5.2% Canada 4.3 7.9% Iran 173 3.8% China 4.2 .7% Canada 160 3.8% United Arab Emirates 3.7 .9% China 134 7.7% Iran 3.6 2.0% Norway 108 .1% Kuwait 3.1 -.5% Saudi Arabia 108 8.2% Iraq 3.3 4.6% Algeria 83 2.2% Mexico 2.8 -3.3% Indonesia 73 1.7% Venezuela 2.7 1.1% Turkmenistan 69 11.1% Nigeria 2.4 2.5% Malaysia 66 -1.2% Brazil 2.3 11.2% United Arab Emirates 58 5.8% Qatar 2.0 -.9% Mexico 58 -.2% Norway 1.9 2.9% Uzbekistan 57 .7% Angola 1.7 -4.9% Netherlands 55 -18.7% Kazakhstan 1.7 -1.2% Australia 55 3.6% Algeria 1.5 1.8% Egypt 48 -13.1% Colombia 1.0 -1.4% Thailand 42 .8% Oman .9 .3% Pakistan 42 -1.6% World Total 88.7 World Total 3460 Source: BP Statistical Review of World Energy 2015.

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Although the oil industry is highly profitable in some years, its long-term profitability is not much higher than average profitability across many industries. As evidence, some years ago Fortune reported that the oil industry ranked 30th out of 36 industries in return to investors over the 1985-95 period, 34th out of 36 U.S. industries in return on equity in 1995, and 32nd in return on sales.4 In the U.S., the oil and gas industry has earned return on sales (net income divided by revenue) of about 8%, compared to an average of about 6% for all U.S. manufacturing, mining, and wholesale trade corporations.

The Role of OPEC The oil and gas industry has seen a remarkable bevy of government regulations and interventions over the past century, from heavy taxation of petrol in Europe to U.S. price controls on domestic production in the 1970s. The creation of the Organization of the Petroleum Exporting Countries (OPEC) represents government intervention on a global scale. OPEC was founded in 1960 with the objective of shifting bargaining power to the producing countries and away from the large oil companies. In 2006, Angola became the 12th member of OPEC.

OPEC’s mission is “to coordinate and unify the petroleum policies of Member Countries and ensure the stabilization of oil prices in order to secure an efficient, economic, and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital to those investing in the petroleum industry.”5 Despite being a cartel, OPEC’s ability to control prices is questionable. Surging oil prices in the 1980s resulted in energy conservation and increased exploration outside OPEC. Maintaining discipline among OPEC members has been a major problem (as is typical in all cartels). Massive cheating was blamed for the oil price crash of 1986, and in the 1990s Venezuela was considered one of the bigger OPEC cheats in regularly producing more than its quota.

Exhibit 3 shows OPEC production and crude oil prices. Although OPEC in the past was instrumental in sending periodic shocks to the system, by 2016 it appeared that OPEC’s influence was waning.

Exhibit 3. OPEC Production and Crude Oil Prices

Source: BP Statistical Review of World Energy, 2015. Data are annual average.

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The Resource Curse The resource curse is a paradox of the oil and gas industry. Despite high resource prices, the living standards in many oil-producing countries are low because of the inability of countries rich in natural resources to use that wealth to strengthen their economies. Counter-intuitively, many of these countries also have lower economic growth than countries lacking an abundance of natural resources.6 When times are good and oil prices are high, oil-rich countries may prosper. When oil prices fall, as they inevitably do, an overreliance on the oil sector can leave a country in a perilous situation. For example, Russia’s GDP fell by 4% in 2015, inflation increased, and the country was running a sizeable budget deficit. Moreover, the oil industries of the petroleum-nationalistic countries often suffer from a lack of investment and heavily subsidized domestic petroleum products. As another example, Iran has huge oil reserves but the country’s upstream oil industry is in a shambles. Iran’s 2015 oil pro- duction, although up from a decade ago, was only about two-thirds of the level reached under the government of the former Shah of Iran in 1979. Although new refining capacity was added in recent years, Iran was still importing refined products to meet domestic needs. With Iranian sanctions ending, Iranian production could significantly increase in future years.

Mexico has declining production and significant imports of refined products. Until recently, the Mexican

constitution did not allow foreign direct investment in the oil and gas industry. After many years of under- investment and of Mexican governments using the oil industry as their primary source of revenue, the industry is in dire straits. Without major investment and new technology, Mexico’s oil production is poised to fall. For example, production at the Cantarell oil field, one of the largest fields in the world, fell from more than 2 million b/d in 2004 to about 340,000 b/d in 2014.

Major Industry Players and Competitors The organizations that dominate the global oil and gas industry have changed dramatically over time in who they are, what they do, and, of critical significance for the future of the industry, how they compete.

Integrated Oil Companies The term integrated oil companies (IOCs) refers to companies that operate in many industry segments from exploration to refining, marketing, and retail. In the early days of the industry, there was true vertical integra- tion in which producers refined most of their production and then marketed refined products through their company-owned retail outlets. In the modern industry, the IOCs operate in many segments, but the true vertical integration seen in the days of John D. Rockefeller is long gone. Somewhat confusingly, the term IOC can also refer to international oil company.

For many years, the largest IOCs (also known as oil majors) were the Seven Sisters, and included:

• Standard Oil of New Jersey (Esso), which later became Exxon and then merged with Mobil to create ExxonMobil

• Royal Dutch Shell • Anglo-Persian Oil Company, which became British Petroleum, then BP Amoco following a merger with

Amoco (which was formerly Standard Oil of Indiana). The company is now known as BP. • Standard Oil of New York (Socony) became Mobil, which merged with Exxon • Standard Oil of California (Socal) became Chevron • Gulf Oil, most of which became part of Chevron • Texaco, which merged with Chevron in 2001

Exhibit 4’s list of the largest oil and gas companies by stock market capitalization is evidence that the indus- try is dominated by a mix of global IOCs and national oil companies (NOCs). Based on market capitalization, the largest publicly traded (and in some cases, government-controlled) companies are a diverse and global set of firms such as Petrochina (China), Gazprom (Russia), Sinopec (China), Total (France), and Eni (Italy).

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The urge to get larger and more integrated can be seen in comments from the Oil and Natural Gas Cor- poration (ONGC) chairman. ONGC, an Indian state-controlled firm and primarily an upstream company, had made public its commitment to participate in the entire hydrocarbon value-chain. According to the former chairman of ONGC:

We have to be an integrated oil company. Every major global oil company is an integrated player. I’m not being arrogant, but oil and gas is big business where the big boys play. You can survive in this business only if you are integrated; otherwise, you will be out.7

Given the long product life cycles and the huge capital investment required in the oil industry, the large IOCs are often described as stodgy and conservative. Before its bankruptcy, Enron executives regularly derided the oil majors as dinosaurs that were too slow moving and that would eventually become extinct. The reality, of course, is very different. Oil majors like BP, ExxonMobil, and Shell and their predecessor companies have been around for more than a century. Through experience that is occasionally painful, the IOCs have learned how to deal with the enormous financial and political risks of the oil and gas industry. The IOCs take a long-term view and recognized that cycles and uncertainty are an inherent part of the industry. Lee Raymond, former ExxonMo- bil CEO, said: "We’re in a commodity [business]. We go through peaks and valleys but our business is to level out the peaks and valleys, so that over the cycle our shareholders see an adequate return on their investment."8

On the surface, the IOCs looked similar in terms of the activities they performed. All appear to be verti- cally integrated from exploration to distribution of refined products. However, there are fundamental cultural, organizational and financial differences among the firms. The IOCs used various organizational designs to deal with vertical integration. The IOCs had different portfolios of projects and business lines around the world and over the years developed different relationships with various governments and national oil companies.

Exhibit 4. Largest Oil and Gas Companies, 2015

Source: Financial Times Global 500 list, March 2015. PetroChina, Sinopec, and CNOOC are National Oil Companies with both publicly traded shares and government-owned shares. ENI is partially owned by the Italian government.

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Exhibit 5 provides one perspective on the origins and distinctive capabilities of a few major companies.

National Oil Companies One of the most important trends of the past few decades has been the growing importance of NOCs. Although BP, ExxonMobil, and Shell are among the largest publicly traded companies in the world, they do not rank in the top ten of the world’s largest oil and gas firms measured by oil and gas reserves. The largest firms based on reserves are, by a large margin, NOCs partially or wholly state-owned. The NOCs control about 90% of the world’s oil and gas and most new oil is expected to be found in their territories.

Viewed from a business perspective, the NOCs have a mixed reputation. The national oil company of Indonesia, Pertamina, was described a few years ago as a bloated and inefficient bureaucracy:

. . . [Pertamina] operated almost as sovereignty unto itself, ignoring transparent business practices, often acting independently of any ministry, and increasingly taking on the role of a cash cow for then-President Suharto and his cronies. During the 32-year tenure of President Suharto, Pertamina awarded 159 contracts to companies linked to his family and cronies. These contracts were awarded without formal bidding or negotiation processes….Indonesian petroleum law dictated that every aspect of operation in the country was subject to approval by Pertamina’s foreign contractor man- agement body, Bppka. Dealing with the incomprehensible Bppka bureaucracy on simple matters, such as acquiring work permits for expatriate personnel, can take hours of filling in applications and months of waiting.9

Venezuela nationalized its oil industry in the 1970s and created Petróleos de Venezuela (PDVSA). PDVSA developed a reputation for professionalism and competence and was relatively free from the corruption and cronyism that pervaded, and continues to pervade, so many of the NOCs.10 By 1998, 36 foreign oil firms were operating in Venezuela, and PDVSA had ambitious expansion plans. In 1999, Hugo Chávez became president and almost immediately began to question the management and autonomy of PDVSA. After a bitter strike in 2002, PDVSA lost about two-thirds of its managerial and technical staff. From a peak of 2.9 million b/d in 1998, output was 2.7 million b/d in 2014 and the company imported a significant amount of motor fuel. As a company, PDVSA is indistinguishable from the government. Its top officials are appointed from the govern- ment. The company is required to spend much of its investment budget on social programs. Company hiring policy is based on social and political goals; e.g., candidates from larger families are given priority. In 2006, the Venezuelan Congress approved new guidelines to turn 32 privately run oil fields over to state-controlled joint ventures. ExxonMobil, alone among the foreign oil companies, rejected the new joint venture agreements and sold its stake in the 15,000 b/d Quiamare-La Ceiba field to its partner, Repsol YPF. ExxonMobil subsequently filed an arbitration claim.

According to many analysts, nationalization has failed to live up to expectations almost everywhere. NOCs often suffer from excessive and misguided government intervention. Many NOCs operated as the de facto trea- sury for the country. In Nigeria, for example, the oil industry contributed about 75% of the government’s total revenue and about 90% of export revenue. It is estimated that hundreds of billions from the oil industry have

Exhibit 5. Distinctive Capabilities as a Consequence of Childhood Experiences: The Oil Majors

Company Distinctive Capability Historical Origin Exxon Financial management Exxon’s predecessor, Standard Oil (NJ), was the holding

company for Rockefeller’s Standard Oil Trust

Royal Dutch/Shell Group Coordinating a decentralized global network of 200+ operating companies

Shell Transport & Trading headquartered in London and founded to sell Russian oil in China and the Far East

BP “Elephant hunting” Discovered huge Persian reserves; went on to find the Forties field (North Sea) and Prudhoe Bay (Alaska)

Eni Deal-making in politicized environments

The Enrico Mattei legacy; the challenge of managing government relations in post-war Italy

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been stolen or misused since 1960. Some of the Middle Eastern NOCs are required to hire large numbers of locals, leaving them heavily overstaffed. PDVSA and all of the Gulf country NOCs must sell their products at hugely subsidized prices. Underinvestment in the downstream is a chronic problem for many NOCs, resulting in countries like Indonesia and Iran, with huge reserves, having to import petroleum products. Monopoly positions held by many NOCs contribute to underinvestment. In Russia, Gazprom controls the pipeline network, making it difficult for other Russian gas producers to expand their production. Russia also uses its NOCs as agents of foreign policy. Disputes between Russia and its neighbors Belarus and Ukraine have resulted in disruption of oil and gas shipments to Western Europe.

Some NOCs are well-run and profitable enterprises. Statoil of Norway is considered among the best of the NOCs. The NOCs of Brazil and Malaysia are viewed as reasonably well-run companies. Petrobras has developed leading technology in deepwater drilling and, until its 2014 corruption scandal, had a market capitalization rivaling that of the IOCs.

The role that NOCs will play in the future is not clear. Some analysts see NOCs as inefficient and corrupt arms of government that will never compete in a true economic sense. Other analysts raise different issues, sug- gesting that the NOCs are in a period of transition and will become competitive forces to be reckoned with. Regardless of what happens, the NOCs and their sovereign owners control most of the world’s oil and gas reserves. As Paolo Scaroni, the chairman of ENI, the Italian IOC, commented:

Big Western oil firms are like addicts in denial. The oil giants are trying to do business as usual as if nothing was wrong. Yet they are, in fact, having trouble laying their hands on their own basic product. State-owned national or state-controlled oil companies are sitting on as much as 90% of the world’s oil and gas and are restricting outsiders’ access to it. Worse, the best NOCs are beginning to expand beyond their own frontiers and to compete with the oil majors for control over the remaining 10% of resources. The first step in overcoming this predicament is admitting that it is a problem.11

Independents Independents are the non-government-owned companies that focus on either the upstream or the downstream. Many of these companies are sizable players and rank in the top 50 of all non-government-owned oil and gas companies. Among the largest E&P independents are U.S. firms such as Occidental, CononcoPhilips, Anadarko, and Woodside of Australia.

In the downstream sector, the largest independents are scattered around the world’s largest energy-consuming countries. The downstream independents include Phillips66 and Valero in the United States and Neste and Tamoil in Europe. Some downstream independents are involved in multiple businesses such as refining, pipelines, and retail distribution, and others in only one core business area. The downstream independents tend to have lower market capitalizations than the upstream independents.