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White Paper published in February 2002

An Information Centric Approach to Risk Mitigation:


Portfolio Management in the 21st Century
Differences in judgment exist because different people use
different symptoms to interpret the environment.
- Mark Casson
Information and Organization
1997

D ecisions are made based on an


individual’s assessment of the
current and future situation using
available information. “Gut feel” is a
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
combination of experience and geopolitical political landscapes that
information. However, how many times have long been known to present
have our stomachs led us astray? difficulties.

Like physicians treating the symptoms Well understood by politicians and


and not the disease, management often sociologists, knowledge is power or
makes critical decisions based solely on rephrased it is competitive advantage.
indicators of an opportunity and not solid Advantage also has an economic aspect
facts. Wildcatter “Dad” Joiner of – its value is a function of its marginal
Spindletop fame could live by his wits, cost, or the additional capital required to
but today’s executives do not have that add another economic unit of
privilege. Truth be known, the legendary information. Firms must make decisions
Joiner did not have that luxury either as regarding when the marginal value of
he died almost broke after a long string additional information is zero or even
of failures. negative.

Risk and the management of uncertainty Organizational knowledge is the sum


have always been part of the energy total of the synergy of normalized data
scene. Over the last 150 + years, transformed by software applications into
successful producers have developed a information, and interpreted by the core
core competency addressing economic, competency of the firm into competitive
technical and geopolitical ambiguities. A knowledge. This synergistic effect
Key Success Factor of any risk requires that value be derived from data
management process is the availability being in the right format, at the right
of timely, valid and reliable information. place and at the right time.

Uncertainty manifests itself as a lack of


Prelude understanding or the lack of information
that reduces ambiguity to zero. In the
The beginning of year 2002 finds the real world, this Pareto optimal frontier
global economy at an increased level of can never be measured (Heisenberg
confusion. Political and economic Uncertainty Principle) and even if
uncertainty in key petroleum economic equilibrium were realized, it
© Copyright 2002. 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.

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Dr. Scott M. Shemwell Risk Mitigation White Paper

would only be for a moment before risk management methodology using


exogenous forces would disturb the tools such as portfolio management to
balance. reach an expected (statistical) average
level of risk, or profile, the firm is willing
to bear across its global asset mix.
Project Uncertainty
The petroleum industry has developed Degrees of Uncertainty
substantial expertise in managing risk on
a global scale. This industry is project One approach towards defining
driven and each revenue-producing uncertainty has been developed that
asset may have several ventures models four different “Levels of
underway concurrently. Most projects Uncertainty” along with an appropriate
have several components of exposure set of tools necessary for the analyses of
including geopolitical, economic and the opportunities presenting themselves.
technology. The decision-making process also
changes depending on the degree of
Moreover, petroleum producers have a managerial confidence, availability of the
set or portfolio of assets, each with a required resources necessary to evaluate
different risk silhouette. Successful prospects and accessibility to cost
organizations have developed a formal effective marginal information.

Level of Uncertainty— Analytic Tools Examples


Definition

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


A 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
Source: Courtney, et al (1999). Strategy Under Uncertainty. HBR.

Uncertainty is a function of the knowledge is often embodied in the


knowledge base of the decision maker. organizational culture or sometimes only
The greater the understanding of the in the minds of a few individuals. The
issue under consideration, the greater more internalized the knowledge base,
management’s confidence level. This

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Dr. Scott M. Shemwell Risk Mitigation White Paper

the better prepared the firm will be to following steps outline one approach for
address an uncertain world. managing under uncertainty.

Moreover, just because an individual or In 1990, Morgan et. al., Uncertainty: A


organization has expertise in a specific Guide to Dealing with Uncertainty in
area it is still possible to overlook Quantitative Risk and Policy Analysis,
opportunities, not appreciate the risk established the following Ten
associated with either entering a new Commandments for Good Policy
area, or the opportunity cost / Analysis as one approach to combine
competitive risk associated with not quantitative analysis in conjunction with
capitalizing on the prospect. In 1977 qualitative policy assessment.
Digital Equipment Corporation (DEC)
passed on the idea of the individual · Do your homework with
desktop computer even though there literature, experts and users.
was ample evidence, to industry insiders,
that this was possibly an emerging · Let the problem drive the
market. This case of opportunity lost analysis.
was perhaps one piece of ongoing · Make the analysis as simple as
culture that ultimately lead to the sale of possible, but no simpler.
that once great company to Compaq
Computer Corporation several years · Identify all significant
ago. assumptions.
· Be explicit about decision criteria
and policy strategies.
Risk Management
· Be explicit about uncertainties.
Risk management is one of the core
competencies of any firm. Whether a · Perform systematic sensitivity
petroleum producer, energy trader, or and uncertainty analysis.
energy service provider, policies should
· Iteratively refine the problem
be developed and adhered to that insure
statement and the analysis.
the organization has developed an
appropriate risk profile and stays within · Document clearly and
those bounds. Economic shareholder completely.
value is realized when the firm returns
economic profit, defined as the surplus · Expose the work to peer review.
of revenue over all costs, including the This approach is an information centric
opportunity costs of employing all inputs. methodology that provides guideposts
for developing risk policy. Quantitative
Economic profits cannot be realized if information forms the basis of stochastic
the firm does not develop a strategy that decision support models that integrate
capitalizes on its core competency and qualitative information to improve
generates earnings at an above market processes and build organizational
Return On Capital Employed. To knowledge.
accomplish high ROCE, the firm must be
willing to take calculated risks – defined This schema reduces uncertainty and
as higher on the Risk – Reward curve as
allows management to make better-
exceeding the return capital could earn
informed decisions. Moreover, it
as bank deposits. provides a vehicle for ranking subjective
managerial and technical opinions and
However, risk taking without proper observations.
governance is a recipe for disaster. The

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Dr. Scott M. Shemwell Risk Mitigation White Paper

The Role of Information extension into its supply chain,


including both suppliers and
in Risk Mitigation customers.
· Information interchange is the
Traditionally, firms are identified with the
intermediation process across
goods and services they deliver in
the supply chain.
industry sectors. Tasks are optimized
through the division of labor, economies · Information dynamics are the
of scale achieved and shareholder value tangible asset of the exchange
created. Or is it? process.

Information Flow and the Information Economics


Extended Enterprise Firms seek asymmetrical information to
secure advantage during negotiations or
The economy and its actors can be transactions. Game theory with its set of
viewed as a system of information flow.
Firms acquire and utilize asymmetrical
information to achieve competitive On a side note, it might be of interest to
advantage. note that modern game theory was first
postulated by Von Neumann and
Information is shared and managed Morgenstern and much of its
across the extended enterprise, and this development took place at Princeton
knowledge is communicated to the University in conjunction with the
market in the form of price quotes for the scientific leaders who developed the
organization’s goods and services. first atomic bomb. Moreover, Von
Economists have developed a Neumann is credited with developing
systematic understanding of the role of the serial architecture still used in
information within the firm and its supply modern computer processing.
chain as well as in the overall economy. pay-off alternatives, suggests that
asymmetrical information can provide
Information movement is the one market actor with advantage over
fundamental underpinning of the his or her rival.
decision
making This perspective However, there is a cost associated with
process capitalizes on procuring and managing information.
within information as a The deployment of a supply chain
the corporate asset, and network and application infrastructure
supply not just the output of a requires a level of investment. However,
chain. cost center. in the extended supply chain, this sunk
Better cost may be spread across all firms if
information leads to better competitive standards are adopted. Once this
decisions and lower quality information investment has been made, firms can
leads to less market efficient choices. begin reaping marginal cost driven
benefits.
Treating information as a revenue
generating or direct cost saving asset According to mathematician and
changes the way firms treat the economist J.F. Nash, equally efficient
acquisition and management of firms supplying homogeneous energy
information. products, all with constant marginal
costs, must price products at the
· Information flow is the very marginal cost. Once the information
essence of the firm and its

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management infrastructure is in place, providing real-options when managing


the firm can lower its marginal cost capital assets throughout their life cycle.
structure by reducing direct cost of
operations as well as reducing process
cycle times, e.g., reducing time to first oil Conclusions
thus increasing Net Present Value (NPV)
of the project. The energy industry has evolved to a
high level of expertise in risk
The CEO of a telecom firm once stated management. Moreover, it is a
“. . . we’ll end up with a much lower successful global industry that has long
marginal cost structure and that will allow had to deal with a declining product price
us to under price our competitors.” The point in real economic terms. Surviving
same economics are at work in the economic actors are very good at
commodity driven energy market place. managing their risk-reward curves.

Risk management is typically driven by


Risk Mitigation portfolio assessment techniques. As
business complexity and security
As an industry pioneer and leader, DEC requirements increase, firms must
CEO Ken Olson was uniquely positioned deploy new granularity for dealing with
to capitalize on the emerging personal an uncertain world. Valid and timely
computer industry. Indeed, DEC’s information is the foundation for making
minicomputer line had previously made better decisions. It is also the foundation
significant inroads into the mainframe for new or enhanced processes that can
installed base, ominously allowing lower the marginal cost to the firm and
individual divisions to drive their own improve financial posture.
computing needs without depending on
corporate MIS departments. Ironically,
DEC led the way for the desktop The Author
computer revolution.
Scott Shemwell is a leading authority on
Industry stature does not in and of itself information intensive processes with
confer wisdom. We are all bound by our more than 250 publications on a variety
legacy and often cannot see the forest as of management issues. He holds a
we are mired in our own trees. Rather, Bachelor of Science degree in Physics,
developing a corporate culture, an MBA and a Doctorate in Business
processes and policies that reward Administration. His doctoral thesis was
creative intelligent synergistic thinking by an exploratory study of business process
the organization and it strategic suppliers analysis using game theory and
better mitigates risk. structural equations.

As an information-processing engine, the http://www.linkedin.com/profile?viewProfi


21st century firm, including its extended le=&key=2628181&trk=tab_pro
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

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