Sometimes Bigger Is Better: Big Oil as Radical Innovators in E&P

Robert K. Perrons, Shell Intl. E&P

The 20th century economist Joseph Schumpeter famously aspired to be the greatest economist in the world, the greatest horseman in Austria, and the greatest lover in Vienna. He would therefore be quite pleased to discover that the first and most public of these objectives was at least partially achieved: One of his more famous economic predictions is apparently true. In the latter part of his career, Schumpeter postulated that large firms have many advantages over smaller ones in the development of radical new technologies. Whereas small and medium-sized enterprises frequently have to pay an undue amount of attention to their short-term balance sheets, large companies with deep pockets do not have to be nearly as sensitive to immediate profit constraints. Schumpeter accordingly reasoned that larger firms have both the resources and the time to pursue new ideas, and they are better positioned to explore the implications for their business of technological discontinuities before deciding whether to bring these technologies into the folds of the company’s core activities and operations.

This is not to say that smaller firms will not have an important role to play in the development of new technologies within the E&P industry. Product and process life cycles are steadily growing shorter, and it is becoming increasingly difficult for any one company to support an aggressive R&D agenda single-handedly. Robert Z. Gussin, former Vice President for Science and Technology at Johnson & Johnson, once drove this point home by musing that technology in his industry “has become so sophisticated, broad, and expensive that even the largest companies cannot afford to do it all themselves.” Responding to these same forces in the E&P industry, many large integrated majors have turned to their supply networks as a source of innovation.

Hit and Miss

To be sure, there is evidence from other industries that it is quite healthy for companies to rely to some degree on collaborative suppliers for new ideas. History has shown on many occasions that even the most focused R&D programs fail to guarantee results consistently. Many of the significant and commercially celebrated innovations that have emerged over the years have not been the result of tightly managed research agendas, but instead were brought about by a convoluted process of serendipity and unique circumstances. The hit-and-miss nature of R&D is such that managing science has been compared to herding cats: It is usually not done well, but one is surprised to find it done at all. Realizing that it is almost impossible to forecast where their next “new big thing” will come from, many companies across a wide variety of sectors are starting to broaden the radius of ideas that they might tap into by turning to their supplier base.

Not all innovations are equal, however. To help managers devise appropriate strategies to contend with different varieties of new technologies, management researchers have made considerable progress in characterizing and categorizing different types of innovation. One particularly important distinguishing feature of an innovation is the amount of change it brings about in the industry into which it is introduced. Some technologies dramatically and obviously change the world around them, while others do not. New technological developments typically fall into one of two categories: incremental innovations, which move things ahead modestly in a way that more or less preserves the status quo; and radical innovations, which conspicuously disturb various states of equilibrium in an industry.

Upstream oil and gas companies historically have been relatively averse to risk in comparison to other industries, and consequently have tended to pursue incremental innovations. New technologies often are adopted very slowly in the upstream sector, because these firms tend to wait patiently for new concepts to be validated and given credibility elsewhere before adopting them. It is questionable, however, whether this relatively cautious approach to innovation within the industry will continue to be the right one in the years ahead. It has been widely suggested that technology is the key to the future growth and profitability of the E&P sector, and that more innovation will be required as time goes on. Whereas E&P companies frequently looked on technology as a nice-to-have feature in the past, innovation will almost certainly become a must-have aspect of the business in the years ahead.

But it also stands to reason that there will be a fundamental shift in the nature of the technologies being developed. Most of the “low hanging fruit” within the industry already has been harvested—that is, many of the reservoirs that were easy to get at already have been accessed. An increasing fraction of the industry’s future reserves quite likely will come from geological structures that are much more complex and that are located in less forgiving environments. The industry will need to overcome several major technological hurdles to achieve these ends. There can be little doubt that many of these breakthroughs cannot be achieved by modest incremental technology developments; rather, they will require radical departures from traditional methods and ways of working.

A Major Advantage

Therein lies an important advantage for large, integrated E&P companies. As Schumpeter surmised, this industry’s larger companies may have a natural advantage over smaller firms where radical innovations are concerned. Management researchers have uncovered three principal reasons for this. First, the channels of communication within an R&D team are a key ingredient in a radical innovation’s success. When a group of people are trying to develop a fundamentally different technology, knowledge is often tacit—that is, uncoded and nonverbalized. People can therefore work better and develop ideas faster within a single organization than among different ones. These kinds of technology developments require frequent, often in-person, interaction between the different units with the knowledge that underpins each of the components of a system. Research colleagues who engage in regular face-to-face communication with one another are typically more productive in these situations than those who do not have a high degree of direct interaction.

Second, the architectural nature of innovations developed within a single firm is often different from those developed by several firms working together. A product’s architecture determines its constituent components and subsystems and defines how they must fit and work together in order to achieve the desired outcome. Products that have an interdependent architecture—like an airplane, for example—will typically consist of components that are designed to fit exclusively with each other. On the other hand, a product with a modular architecture, such as a stereo system, can be mixed and matched with other components by means of standardized interfaces that are agreed upon by industry standards. In a modular architecture, by contrast, the fit and function of all elements can be specified so completely that the components in the new technology can be developed by different companies working at arm’s length.

Radical Innovation

Harvard Business School’s Clayton Christensen reasons that successful attempts at radical innovation in the marketplace tend to be those whose products are based on a relatively integrated architecture. This happens, he says, because “competitive pressure compels engineers to fit the pieces of their systems together in ever more efficient ways in order to wring the best performance possible out of the available technology.” By contrast, having predefined interfaces—a frequently necessary tradeoff that a company might feel pressured to agree to when developing a new technology with other companies—often inhibits the degrees of freedom for engineers working on the new product, and forces them to back away from the frontier of what is technologically possible.

Third, larger integrated firms are frequently better equipped to tackle the radical-innovation process because of their greater ability to resolve conflicts. The act of developing new products and processes necessarily requires the making of many decisions and tradeoffs by groups of people. This is often a major, albeit unforeseen, barrier faced when several companies work collaboratively to develop a radically new technology. So-called “virtual organizations” and the idea of outsourcing innovation are attractive concepts because many people have come to believe that bureaucracy is bad and flexibility is good. However, while larger, integrated companies do not generally reward people for taking risks, they do have established processes for settling conflicts and coordinating all the activities necessary for handling these more ambitious and less predictable types of innovation.

Deeper Pockets

There seems to be no shortage these days of eulogies and epitaphs for large E&P companies in trade magazines and business papers. And, to be sure, it is clear that the fundamentals of the oil and gas market have changed such that smaller firms and suppliers can participate in ways that simply were not possible a few decades ago. But at the same time, it would be a mistake to underestimate the important and rather unique contribution that large, integrated E&P companies can make in the industry’s future. As Mark Twain, a contemporary of Schumpeter, once quipped, “The rumors of my death have been greatly exaggerated.” Radical innovation is precisely what the E&P industry needs to prosper in the future, and large companies may be in the best position to provide it. This may in turn help to spur further merger and acquisition activity within the oil and gas sector as the market realizes that large R&D programs with deeper pockets will frequently prevail over smaller ones. “Big Oil” may get even bigger, but there is reason to believe that the industry—and, indeed, the global economy as a whole—will benefit as a result.

This article reflects the personal views of the author and should not be interpreted as a reflection of Shell’s official position or opinion.

Robert K. Perrons, SPE, is a Smart Fields Consultant in Shell Intl.’s E&P Div. He is chartered as both a C. Eng. (IMechE) and Eur Ing professional engineer. He earned a B.Eng. degree in mechanical engineering from McMaster U. in Canada, an S.M. degree in Technology and Policy from the Massachusetts Inst. of Technology, and a PhD degree in engineering from Cambridge U., where he was a Gates Cambridge Scholar.