The Nature of the Firm in the Oil Industry

Basak Beyazay

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317575177
• Edition: 1
• Topic: Business
• Subtopic: Energy Industry
• Index: Business

Firm-to-firm relationships, along with the overall structure of industry, have changed markedly over the past decades. Replacing the model of vertical integration with one of global business, firms have started to outsource more by using a wider global network. At the same time, they have begun to increase their control and coordination along the value chain to remain competitive, blurring the boundaries between companies. Understanding the nature of the firm and its role in coordinating the supply chain will help firms to better define global competitive strategies.. The challenges that lie ahead for global business render obsolete the traditional model of procuring each service without long-term supply chain management. Current trends suggest that in the future there will be even deeper supply chain integration in most industries.

The Nature of the Firm in the Oil Industry aims to facilitate the understanding of 'the firm' via the analysis of the specific relationship between international oil companies, which are among the world's biggest firms and which act as 'core system integrators', and the oil services companies, which help to find, extract, produce and distribute oil along the petroleum industry supply chain. This relationship serves as an example of deep integration by core system integrators and provides insights into the change in the nature of the firm in the era of modern globalization. Aimed at researchers and academics, The Nature of the Firm in the Oil Industry offers a thorough examination of this relationship in an effort to shed light on the nature of the firm, both in the oil industry and in global business today. It is a humble attempt to better understand the firm in a crucial industry.

1 Global Value Chain & Changes in the Nature of the Firm

1.1 The Nature of the Firm

Since the publication of Coase’s 1937 essay ‘The Nature of the Firm’, competing and complementary theories have emerged to explain why individuals might choose to form partnerships or companies rather than trade bilaterally through markets.

Prior to Coase and within the context of price theory, firms were viewed as identical production functions where homogenous inputs were transformed into homogenous outputs. From this perspective, the firm was no more than a theoretical link, explaining the relationship between changes in price and quantity in response to variations in exogenous factors (Langlois and Koppl 1991; Loasby 1976). In reality, the price theory was never intended to be a theory of the firm as an organization or as an institution (Machlup 1967). For this reason, price theory has proved unsatisfactory in its ability to explain the existence, boundaries and internal structure of the firm (Langlois and Foss 1997).

Coase confronted and challenged price theory by highlighting the existence of transaction costs in order to explain the raison d’être of the firm. He argued that the main reason for establishing a firm is to avoid the costs of using the price mechanism; in other words, to avoid what he termed ‘transaction costs’. According to Coase, it is transaction costs, such as the cost of researching prices, marketing, organizing production and negotiating contracts, that explain how firms are structured and developed. Accordingly, a firm aims to minimize transaction costs and the uncertainty that comes with the use of short-term contracts in an exchange market (Coase 1937).

More recently, the Coasean literature has focused on the choice between firms and markets and has viewed the ‘nature’ of the firm as fundamentally contractual. That is, firms are bundles of contracts creating and realigning incentives (Langlois and Foss 1997; Williamson 2002). However, complementary theories have emerged, including the resource-based view proposed by Edith Penrose and the capabilities perspective developed by a consortium of researchers including Langlois, Foss and Richardson.

In her ‘resource’ theory, Penrose (1959) proposed that firms are a collection of productive resources and the disposal of these resources is determined by their differing uses and by administrative decisions. Firms create economic value not only due to the possession of resources but also due to effective and innovative management of these resources. Therefore, optimum growth for a firm involves finding the most profitable balance between the exploitation of existing resources and the development of new ones (Penrose 1959).

A similar theory is proposed by the ‘capabilities’ perspective, which sees the firm as a repository of productive knowledge with certain nonstandard characteristics, namely ‘capabilities’. Capabilities are seen as team-embodied and refer to the partly tacit production and organization of knowledge that can be operated by members of the firm to create economic value. Knowledge, skills and traditions form the distinctive capabilities of a firm and thus determine the firm’s boundaries (Langlois and Foss 1997).

The main implication of the ‘capabilities view’ is that complementarities and similarities of capabilities affect the organizational structure of firms and the firm–market boundary in an economy (Richardson 1998). Capabilities form an independent causal factor behind the patterns of economic organization. The capabilities perspective places the firm at the centre of analysis, instead of the transactions and associated transaction costs. This emphasizes the specific nature of the firm’s facilities and skills as the most significant factor in determining what will be done by the firm and by the market (Chandler 1992).

As a surprising addition to his previous work, Coase also argued in the early 1990s that transaction costs are not the only factor influencing the formation of a firm (Coase 1990).

While transaction cost consideration undoubtedly explains why firms come into existence, once most production is carried out within firms and most transactions are firm-firm transactions, not factor-factor transactions, the level of transaction cost will be greatly reduced and the dominant factor in determining the institutional structure of production will in general no longer be transaction costs but the relative costs of different firms in organizing particular activities.

(Coase, as quoted in Langlois and Foss 1997, 19)

The function whereby firms plan and organize the activities of other economic actors is referred to as the ‘coordination’ function. While many competing and complementary theories seek to explain the existence of firms, the main function of the firm that will be used here to facilitate discussion of the nature of firms in the oil industry is precisely this coordination function.

A close reading of Coase’s article on the nature of the firm suggests that his explanation for the emergence of the firm is ultimately a planning and coordination one (Langlois and Foss 1997).

Owing to the risk attitude of the people concerned, they may prefer to make a long rather than a short-term contract. Now, owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do. It may well be a matter of indifference to the person supplying the service or commodity which of several courses of action is taken, but not to the purchaser of that service or commodity. But the purchaser will not know which of these several courses he will want the supplier to take. Therefore, the service which is being provided is expressed in general terms, the exact details being left until a later date. All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser, When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a ‘firm’ may be obtained. A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory.

(Coase 1937, 391–92)

Coase also argues that firms continue to exist only if they perform their coordination function at a lower cost than could be achieved by market transactions and also at a lower cost than that of other firms. To have an efficient economic system, it is necessary to have not only markets but also areas of planning within appropriately sized organizations (Coase 1992).

1.2 Changes in the Nature of the Firm

Vertical Disintegration

As discussed above, the emergence of the firm is linked to necessities of planning and coordination. However, the coordination role of the firm is generally seen as the coordination of production factors within a firm. Nevertheless, as a result of the changes in the structure of the value chain (mainly vertical disintegration), firms have increased their coordination function outside the firm’s legal boundaries and have begun coordinating the activities of companies along the entire value chain (Nolan et al. 2002).

Historically, the continuing growth of modern industrial enterprise arose via horizontal combination, vertical integration (primarily to assure supplies) and movement into new markets. The strategy of backward integration reflected the need to ensure a steady flow of materials through the production processes and distribution networks so they could operate at close to full employment (Chandler 1990). From 1930 to 1960, the majority of advanced capitalist countries were dominated by Fordism¹. Ford ultimately made everything needed for its cars in-house, from raw materials to the finished product. Ford was vertically integrated for two reasons: First, it had perfected mass production techniques and could achieve substantial economies of scale by doing everything in-house. Second, given the information-processing capabilities of the time, in addition to Henry Ford’s scepticism towards accounting and finance, direct supervision could more efficiently coordinate the flow of raw materials and components through the production process than would be possible in arm’s-length relationships (Chandler 1977).

However, vertically integrated production sites did have a wide range of production needs and challenges. The continuing growth of industries and the number of suppliers within them caused many firms that were vertically integrated in the early 1900s to disintegrate and form relationships with key suppliers (Chandler 1990). Some corporations began to disintegrate and outsource part of their activities to outsiders. Vertical disintegration occurred in several industries previously regarded as highly integrated, such as the automobile sector. This led to the emergence of new intermediate markets which divided a previously integrated production process between two sets of specialized firms in the same industry. Standardized information, simplified coordination and the introduction of new intermediate markets were some of the reasons for disintegrating the structure of the value chain, thus allowing new types of specialized firms to participate in an industry and thereby changing the industry’s competitive landscape.

Vertical disintegration has had profound implications. It has changed the nature of the firms that can and do participate in a given industry. For example, in the oil industry, vertically disintegrated structures enabled engineering firms with no production capabilities or facilities to become significant players. The nature of capabilities, the types of entrants into an industry and the structure of competition can all change when disintegration happens. Jacobides (2005) uses an analogy drawn from the field of biology: ‘Vertical disintegration allows a new, vertically co-specialized ecosystem to compete and cooperate with the old, integrated structures, thus altering the landscape for all involved’. The trend of vertical disintegration during the global business revolution caused a narrowing of the range of business activity undertaken by the individual firm. As a result of the disintegration process, a massive restructuring of assets occurred, with firms extensively selling off ‘noncore businesses’ in order to develop their ‘core businesses’ (Nolan et al. 2002).

Outsourcing

The disintegration of vertically integrated firms compelled the majority of firms to face the decision of whether to either keep key production and service activities in-house or to purchase these goods and services from other companies. Because few firms would consider managing an infinite number of activities associated with the production of output, most firms opt to source intermediate products and services from external vendors.

While managing a particular stage of production in-house may give firms the assurance of always having the optimum number of outputs, there are fixed costs associated with each stage of production. From time to time, installed in-house capacity may exceed or fall short of what is needed while fixed costs remain constant. The more activities the firm itself undertakes, the higher its investment in equipment and staffing levels will be; these costs cannot immediately be scaled up or down in response to changes in demand. Flexibility for the firm decreases, while risk increases considerably. Provided that one of the production stages is associated with a vendible good or service, a firm may endeavour to deal with surpluses or shortages by selling directly to the market. To do this effectively, however, a firm must set up and meet the costs of a marketing and buying department that will only operate occasionally as required. Alternatively, the firm may choose to abandon planned in-house production in favour of purchasing through markets and under market coordination principles. The value of resources that firms put at risk is considerably lessened when intermediate goods that serve as substitutes in production are readily available. Interestingly, this reduction in risk for the firm is not offset by an increase in the risk borne by its suppliers, as suppliers benefit from the pooling of resources (Richardson 2000).

The delivery of a continuous volume of supply does not require ownership by a single supplier. Indeed, a high volume of reliable suppliers allows firms to obtain supplies on schedule and to the right specification through enforceable contracts (Chandler 1990a). The practicality of using external suppliers depends on the availability of appropriate intermediate products and services the firm can substitute for stages in the in-house production process. As inputs and intermediary services are often provided by many different suppliers, the recipient firm must ensure careful coordination between these parties to make certain goods are produced to the specifications required.

The firm producing the final product and other suppliers engaged in the value chain have particular functions directly relating to the knowledge and expertise they possess. Not only do they require professional knowledge and technical skill, but they also must possess knowledge of each other—in other words the capabilities, roles and rules of each component of the supply chain. This creates intense interdependence and stability over the years. By working for a particular firm for a period of time, a supplier is able to provide a service which, by virtue of the supplier’s experience in the industry and with the firm, becomes specialized. Therefore, the services of this supplier are no longer directly equivalent to other services available on the open market. The value of this specialization differs according to the function concerned (Richardson 1998).

A primary example of supplier specialization is found in the aircraft industry. Modern aircraft and engines are complex products. A major capability of a firm producing aircraft is the ability to integrate the whole system of suppliers to produce the final product. The core firm (the firm shaping the final product), or the supply chain system integrator, increasingly focuses on coordinating and planning within the supply chain, rather than direct manufacturing. In this industry, as much as 60 to 80% of the value of the end product (the aircraft) is delivered by the external supply network (Nolan et al. 2007). These products are highly specialized and cannot be bought in the open market because previous coordination expertise and a degree of stability in the buyer–supplier relationships is key to the ability of the firm to deliver the final product.

A high degree of stability is required in the relationship between suppliers of intermediate goods and the core firm. This relationship must remain flexible as suppliers and buyers may change and organizations need to adapt to these new relationships. However, without some degree of stability, organized coordination would not work (Richardson 1998).

Coordination by the Core Firm: The System Integrator

The requirement for stability has changed the scope and nature of the coordination function of the firm while expanding the legal boundaries of the firm. After vertical disintegration, a firm’s economic activity has expanded to the coordination of activities of multiple suppliers and service providers, all of which provide input at various stages of production. The result of this coordination is the final product manufactured by the core firm.

The new structure of economic activity requires synchronized coordination of resources and production factors. Firms exist because they enable actions to be carried out concurrently in conformity with a particular design. The concurrent coordination is not an unintended consequence of market transactions; it requires organization and planning, an activity that firms typically provide (Richardson 1998). As previously mentioned, the coordination function of the firm not only encompasses coordination of resources within a firm but also coordination of the activities of other firms. Therefore, firms create a new form of industrial planning in an economy (Nolan et al. 2002).

According to Richardson (1972, 885), the orchestration of development, manufacturing and marketing occurs between retail companies and their suppliers without the existence of any shareholdings or long-term contracts:

Co-operation takes place between firms that rely on each other for manufacturing or marketing and its fullest manifestation is perhaps to be found in the operations of companies such as Marks & Spencer and British Home Stores. Nominally, these firms would be classified as retail chains, but in reality they are the engineers or architects of complex and extended patterns of co-ordinated activity. Not only do Marks & Spencer tell their suppliers how much they wish to buy from them, and thus promote a quantitative adjustment of supply to demand, they concern themselves equally with the specification and development of both processes and products. They decide, for example, the design of a garment, specify the cloth to be used and control the processes even to laying down the types of needles to be used in knitting and sewing. In the same way they co-operate with Ranks and Spillers in order to work out the best...