Mitigating Risk Through Better Information

Scott M. Shemwell, D.B.A

First published in February 2002; reprinted here with permission

In one of the most colossal underestimations in business history, Kenneth

H. Olsen, then president of Digital Equipment Corporation (DEC),
announced in 1977 that “there is no reason for any individual to have a
computer in their home.” The explosion in the personal computer market
was not inevitable in 1977, but it was certainly within the range of
possibilities that industry experts were discussing at the time.1

Preamble

T
he beginning of year 2002, finds the global economy at an increased level of
ambiguity. Political and economic uncertainty in key petroleum geographical areas is
not limited to just the Middle East and post 9-11 issues, but manifests itself in South
America, Southeast Asia, as well as other geopolitical political landscapes long known to
present difficulties.
Well understood by politicians and sociologists, knowledge is power or rephrased it is
competitive advantage. Organizational knowledge is the sum total of the synergy of
normalized data transformed by software applications into information, and interpreted by
the core competency of the firm into competitive engagement. This synergistic effect
requires that value be derived from data being in the right format, at the right place, and at
the right time2
Uncertainty manifests itself as a lack of understanding or the lack of information that
reduces ambiguity to zero. In the real world, this Pareto optimal frontier can never be
measured (Heisenberg Uncertainty Principle3) and even if economic equilibrium were
realized, it would only be for a moment before exogenous forces would disturb the
balance4.

An Uncertain World
The petroleum industry has developed substantial expertise managing risk on a global
scale. Most projects have several components of exposure including geopolitical,
economic, and technology. Successful organizations have developed a formal risk
management methodology using tools such as portfolio management to reach an expected
(statistical) average level of risk, or profile, the firm is willing to bear across its global asset
mix.
1
Courtney et al. developed the following four Levels of Uncertainty along with an
appropriate set of analytic tools necessary for the analyses of the opportunities presented.
Decision-making processes also change depending on the degree of managerial
confidence and availability of the required resources necessary to evaluate prospects.

© Copyright 2002 & 2009. Scott M. Shemwell. All Rights Reserved.

This material is the intellectual property of Scott Shemwell and reflects the specific original research, concepts, and writings
of the author over more than 20 years. It is provided for publication provided authorship is expressly recognized in
derivative works in accordance with the current version of either the American Psychological Association (APA) Style Guide
or the Chicago Manual of Style.

- Page 1 of 5 -
Dr. Scott M. Shemwell

Level of Uncertainty -- Analytic Tools Examples

Definition

A Clear Enough Future – A Ø “Traditional” Strategy Tool Ø Strategy against

single forecast precise Kit new local market
enough for determining entrant
strategy.

Alternate Futures – A few Ø Decision Analysis Ø Capacity

discrete outcomes that Ø Option Valuation Models strategies for
define the future Ø Game Theory Chemical Plant or
Refinery
A Range of Futures – A Ø Latent-demand research Ø Entering new
range of possible outcomes, Ø Technology Forecasting international
but no natural scenarios Ø Scenario Planning markets

True Ambiguity – No basis Ø Analogies and pattern Ø Entering new

to forecast the future recognition international
Ø Nonlinear dynamic models markets after a
prolong period of
political
uncertainty
Uncertainty is a function of the knowledge base of the decision maker. The greater the
understanding of the issue under consideration, the greater management’s confidence
level. This knowledge is often embodied in the organizational culture or sometimes only in
the minds of a few key individuals. The more internalized the knowledge base is
throughout the organization, the better prepared the firm will be to address an uncertain
world.
Moreover, just because an individual or organization has expertise in a specific area it is
still possible to overlook opportunities, not appreciate the risk associated with either
entering a new area, or the opportunity cost / competitive risk associated with not
capitalizing on the prospect. The case of the missed opening for Digital Equipment was
perhaps one piece of ongoing culture that ultimately lead to the sale of that once great
company to Compaq Computer Corporation several years ago.

Risk Management
Risk management is one of the core competencies of any firm. Whether a petroleum
producer, energy trader, or service provider policies should be developed and adhered to
that, insure the organization has developed an appropriate risk profile and stays within
those bounds. Economic shareholder value is realized when the firm returns economic
profit, defined as the surplus of revenue over all costs, including the opportunity costs of
employing all inputs.5
Economic profits cannot be realized if the firm does not develop a strategy that capitalizes
on its core competency and generates earnings at an above market Return On Capital
Employed. To accomplish high ROCE, the firm must be willing to take calculated risks.
However, risk taking without proper governance is a recipe for disaster. The following
steps outline one approach for managing under uncertainty.

- Page 2 of 5 -
Dr. Scott M. Shemwell

The Ten Commandments for Good Policy Analysis6

1. Do your homework with literature, experts, and users.
2. Let the problem drive the analysis.
3. Make the analysis as simple as possible, but no simpler.
4. Identify all significant assumptions.
5. Be explicit about decision criteria and policy strategies.
6. Be explicit about uncertainties.
7. Perform systematic sensitivity and uncertainty analysis.
8. Iteratively refine the problem statement and the analysis.
9. Document clearly and completely.
10. Expose the work to peer review.
This approach is an information centric methodology that provides guideposts for
developing risk policy. Quantitative information forms the basis of stochastic decision
support models that integrate qualitative information to improve processes and build
organizational knowledge. This methodology reduces uncertainty and allows management
to make better-informed decisions.

The Role of Information in Risk Mitigation

Traditionally, firms are identified with the goods and services they deliver in industry
sectors. Tasks are optimized through the division of labor, economies of scale achieved,
and shareholder value created. Or is it?

Information Flow and the Extended Enterprise

The economy and its actors can be viewed as a system of information flow.7 Firms acquire
and utilize asymmetrical information to achieve competitive advantage. Information is
shared and managed across the extended enterprise, and this knowledge is
communicated to the market in the form of price quotes for the organization’s goods and
services.
Economists have developed a systematic understanding
This perspective
of the role of information within the firm and in the overall
capitalizes on
economy. Information movement is the fundamental
information as a
underpinning of the decision making process within the
corporate asset, and
supply chain. Better information leads to better
not just the output of a
competitive decisions and lower quality information leads
to less market efficient choices. cost center.

Treating information as a revenue generating or direct cost saving asset changes the way
firms treat the acquisition and management of information.
· Information flow is the very essence of the firm and its extension into its supply
chain, including both suppliers and customers.
· Information interchange is the intermediation process across the supply chain.
· Information dynamics are the tangible asset of the exchange process.

- Page 3 of 5 -
Dr. Scott M. Shemwell

The Economics of Information

Firms seek asymmetrical information to secure advantage during negotiations or
transactions.8 Game theory with its set of pay-off alternatives, suggests that asymmetrical
information can provide one market actor with advantage over his or her rival.

On a side note, it might be of interest to note that modern game theory was first
postulated by Von Neumann and Morgenstern and much of its development took
place at Princeton University in conjunction with the scientific leaders who developed
the first atomic bomb. Moreover, Von Neumann is credited with developing the serial
architecture still used in modern computer processing.4

There is a cost associated with procuring and managing information. The deployment of a
supply chain network and application infrastructure requires a level of investment. Then
again, in the extended supply chain, this sunk cost may be spread across all firms if
standards are adopted. Once this investment has been made, firms can begin reaping
marginal cost driven benefits.
According to mathematician and economist J.F. Nash, equally efficient firms supplying
homogeneous energy products, all with constant marginal costs must price products at the
marginal cost. Once the information management infrastructure is in place, the firm can
lower its marginal cost structure by reducing direct cost of operations as well as reducing
process cycle time, e.g., reducing time to first oil thus increasing Net Present Value (NPV)
of the project.
The CEO of a telecom firm once stated that “. . . we’ll end up with a much lower marginal
cost structure and that will allow us to underprice our competitors.” 9 The same economics
are at work in the commodity driven energy market place.

Risk Mitigation
As an industry pioneer and leader, Ken Olson was uniquely positioned to capitalize on the
emerging personal computer industry. Indeed, DEC’s minicomputer line had previously
made significant inroads into the mainframe installed base, ominously allowing individual
divisions to drive their own computing needs without depending on corporate MIS
departments. Ironically, DEC led the way for the desktop computer revolution.
Industry stature does not in and of itself confer wisdom. We are all bound by our legacy
and often cannot see the forest as we are mired in our own trees. Rather, developing a
corporate culture, processes, and policies that reward creative intelligent synergistic
thinking by the organization and its strategic suppliers better mitigates risk.
st
As an information-processing engine, the 21 century firm, including its extended supply
chain, is well positioned to capitalize on both quantitative and qualitative information to
make better decisions under conditions of varying uncertainty. Moreover, valid, reliable,
and timely information can positively affect the marginal cost structure of the firm thereby
lowering the return on investment bar management and providing real options when
managing capital assets throughout their life cycle.

- Page 4 of 5 -
Dr. Scott M. Shemwell

Conclusions
The energy industry has evolved to a high level of expertise in risk management.
Moreover, it is a successful global industry that has long had to deal with a declining
product price point in real economic terms. Cost management is a key performance
indicator. Surviving economic actors are very good at managing their risk-reward curves
and driving out shareholder value.
Risk management is typically driven by portfolio assessment techniques. As business
complexity and security requirements increase, firms must deploy new granularity for
dealing with an uncertain world. Valid and timely information is the basis for making better
decisions. It is also the foundation for new or enhanced processes that can lower the
marginal cost to the firm and improve financial posture.

The Author
Scott Shemwell is a leading authority on information management processes with more
than 200 publications on a variety of management issues. He holds a Bachelor of Science
degree in Physics, an MBA, and a Doctorate in Business Administration. His doctoral
thesis was an exploratory study of business process analysis using game theory and
structural equations.

1
Courtney, Hugh, Kirkland, Jane, and Viguerie, Patrick (1999). Strategy Under
Uncertainty. Harvard Business Review on Managing Uncertainty. p. 4 - 14.
2
Shemwell, Scott M. & Rueff, Serge. (September 1996). A 'Value-Add' Analysis of the
Information Exchange Loop between Oil & Gas Service Companies and Exploration &
Production Companies: The Service Company Perspective, Proceedings of the Gulf
Publishing Exploration and Production Data Management Conference. Houston.
3
Halliday, David & Resnick, Robert. (1967). Physics; Parts I and II. New York: John Wiley
& Sons, Inc.
4
Shemwell, Scott M. (1996). Cross Cultural Negotiations between Japanese and American
Businessmen: A Systems Analysis, (Exploratory Study). Unpublished doctoral dissertation,
Nova Southeastern University, Ft. Lauderdale.
5
Rutherford, Donald. (1995). Routledge Dictionary of Economics. London: Routledge.
6
Morgan, M. Granger and Henrion, Max. (1990). Uncertainty: A Guide to Dealing with
Uncertainty in Quantitative Risk and Policy Analysis. pp. 36 - 44. New York: Cambridge
University Press.
7
Casson, Mark. (1997). Information and Organization: A New Perspective on the Theory of
the Firm. Oxford: Clarendon Press.
8
Macho-Stadler, Inés and Pérez-Castrillo, J. David. (1997). An Introduction to the
Economics of Information: Incentives and Contracts. New York: Oxford University Press.
9
Gong, Jiong and Srinagesh, Padmanabhan. (1997). The Economics of Layered
Networks. In McKnight, Lee W. and Bailey, Joseph P. Internet Economics (pp. 63 – 75).
Cambridge: The MIT Press.

- Page 5 of 5 -