Technological advances as well as markets restructuring in the last two decades have strongly impacted the oil and gas industry, which is characterized by large sums of investments along the entire value chain activities. These activities include, but are not limited to: acquisition of licenses, development of wells, exploration and production, drilling, transmission, gas liquefaction, and regasification.
Due to the sophisticated level of operations, investment in high technology and skilled labor is required. Moreover, the economic viability of the minerals that may exist in the wells being explored is highly uncertain.
Hence, contracts involved in the oil and gas industry are commonly complex in nature.
Parties involved in a contract that includes highly specific assets are in the “condition of bilateral dependency” (Williamson, 1998), where the investment of the parties in this contract locks them into the relationship to some degree (Besanko, et al., 2013). As a result of this contract, “the buyer cannot turn to alternative sources of supply and obtain the item on favorable terms” (Williamson, 1981).
Make or Buy?
According to (Eikeland, et al., 2004), vertical integration entails the development of business activities along the oil and gas supply chain.
A number of vertically-integrated monopolies exist, but relying on the market – decision to buy – is a common practice due to the large number of complex activities in the vertical chain. Takeovers represent a common form of a buy decision.
The main benefits of using the market mainly relate to the economies of scale that can be achieved by organizations that specialize in certain products and services, in addition to the accumulation of experience and know-how at those organizations (Besanko, et al., 2013). A vertically-integrated organization may not be able to achieve these benefits.
Also bureaucracy effects within large organizations can be avoided when management relies on the market.
Despite the benefits of sourcing from the market, management may still prefer vertical integration – decision to make – for several reasons. On the top of these is the concern of confidentiality, where management worries about the leakage of private information, which is the organization’s principle source of competitive advantage (Besanko, et al., 2013). Another important reason why management may forgo the market is to avoid the lack of coordination of production flows through the vertical chain in the case of a buy decision.
Another key concern against using the market is the costs associated with contracts. Organizations use contracts to list the rights and obligations pertaining to the parties involved, in addition to the course of actions in case one party has not fulfilled any of the contractual obligations. Even with these benefits that contracts provide, the costs associated with them need to be carefully studied.
Transaction Cost Economics (TCE)
Transaction costs are those costs associated with using the market, which can be eliminated when vertical integration takes place within the organization. “The primary purpose of TCE is to explain why transactions in certain institutional arrangements operate with different degrees of efficiency” (Yang, et al., 2012).
According to (Joskow, 2010), “Transaction cost-based theories of vertical integration focus on the implications of incomplete contracts, asset specificity, information imperfections, incentives of opportunistic behavior, and the costs and benefits of internal organization”.
Oil and gas companies commonly employ long-term contracts as “a particular organizational form that is situated somewhere between full vertical integration and short-term, market-based trading” (Hirschhausen & Neumann, 2008). In this context, “Long-term contracts can help to minimize the transaction costs for two parties engaging in a commitment involving significant specific assets but where full vertical integration is not feasible” (Hirschhausen & Neumann, 2008).
Transaction costs economics postulates that there are benefits and costs associated with both internal integration and market transactions. Organizations assess each of the two scenarios to select the less costly and more efficient decision.
In spite that vertical integration avoids the transaction costs associated with the market, the potential costs of internal hierarchy needs to be considered, which for many organizations may still be more relevant to employ for a variety of valid reasons. (Eikeland, et al., 2004) show that even though upstream companies moved towards specialization, the market trend was implementing strategic shift at vertical integration in the natural gas supply chain.
Due to technological advances and structural changes pertaining to the oil and gas industry, the need to invest in asset-specific contracts is being reduced and “the industry moves towards more market-oriented coordination mechanisms” (Hirschhausen & Neumann, 2008).
(Hirschhausen & Neumann, 2008) argue that asset specificity of investments pertaining to upstream and downstream operations has been reduced, thus reducing issues of quasi-rent negotiations.
Hattem AlHajery, CMA, CDIF.
Besanko, D., Dranove, D., Shanley, M. & Schaefer, S., 2013. Economic of Strategy. 6th ed. s.l.:John Wiley & Sons, Inc.
Eikeland, P. O., Hasselknippe, H. & Sæverud, I. A., 2004. Energy sector integration in Europe: The role of leading upstream oil & gas companies (Summary version), Oslo: Fridtjof Nansen.
Hirschhausen, C. v. & Neumann, A., 2008. Long-Term Contracts and Asset Specificity Revisited: An Empirical Analysis of Producer–Importer Relations in the Natural Gas Industry. Rev Ind Organ, Volume 32, pp. 131-143.
Joskow, P. L., 2010. Vertical Integration. The Antitrust Bulletin, 55(3), p. 545.
Williamson, O. E., 1981. The Economics of Organization: The Transaction Cost Approach. American Journal of Sociology, 87(3), pp. 548-577.
Williamson, O. E., 1998. Transaction Cost Economics: How It Works; Where It Is Headed. De Economist, 146(1), pp. 1-36.
Yang, C., Wacker, J. G. & Sheu, C., 2012. What Makes Outsourcing Effective? A Transaction-Cost Economics Analysis. International Journal of Production Research, 50(16), p. 4462–4476.