The Carnegie Triple, Transaction Costs, and offshore economics

Any problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost economizing terms…

Williamson, 1985

From my earliest involvement in the offshore industry, the framing device I have always looked at to understand issues is transaction cost economics, a branch of economics that originated in the seemingly mundane question “Why are firms different?”. The question sounds innocuous because it seems so obvious that they are, but neo-classical economics, in particular, sought to argue that all humans are rational actors, and therefore if they all saw the same opportunities all firms would make the same decisions, and the world would be awash with homogenous firms and products, all priced at the same level: utopian perfect competition.

Of course, the world isn’t like that, blatantly there are many different firms and business models, all supplying similar products. The first person to really tackle this (although this is a little unfair on Knight) was Ronald Coase, who earned himself a Nobel prize for the privilege of putting forth an argument based on transaction costs economics (“TCE”): simply put if it was cheaper for the firm to do something internally it would do it, if it was more expensive it would outsource. This might seem tautological now but in 1937 it was a serious advance in knowledge and the full article is an exercise in eloquence an insight that my few words can not do justice to here.  The field was later developed further, by interdisciplinary scholars, particularly Oliver Williamson, who gives a very good introduction here (and I especially like the Carnegie Triple as a philosophy.)

The reason it is so relevant to offshore is because a large part of the contribution in transaction costs research came from legal scholars:

The study of governance also appeals to bounded rationality, but the main lesson for the science of contract is different: all complex contracts are unavoidably incomplete, on which account the parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors, and omissions in the original contract.

Williamson, 2007 (emphasis added)

The above is torturously obvious to anyone who has sat through a project engineer and an opposing client rep trying to explain why the other is to blame for a project overrun.

Asset specificity, which I often mention here has its origins in Coase and Williamson:

Williamson (1975, 1985, 1986) argued that transaction-specific assets are non-redeployable physical and human investments that are specialized and unique to a task…

Like diving or pipelay for example… I was always fascinated that there was a spot market for DSVs in Asia, but not one in the North Sea? Another intriguing conundrum was why Toisa only chartered DSVs by Bibby and others were saturation dive contractors? Offshore construction and maintenance is a contracting business, it involves agency issues and internal organisation questions about efficiency because of its short-and-long run nature. It is almost the perfect textbook example to delve into to understand industrial organisation.

But I digress… the big one that got me was pipelay. Every single company with a pipelay spread was fully vertically integrated and there is no spot market for pipelay vessels (the same isn’t true for barges and work that can be done with a modular spread that were far less common in 2005). And then I started to negotiate a JV between a DSV company and a pipelay company… On paper a good idea between two companies, one turns up and drops the pipe and the other turns up and ties it in… everyone goes home for tea and biscuits after making a ton of money: the DSV company can avoid shelling out on a pipelay vessel it knows nothing about, and the pipelay company can save themselves $120m (in those days) on a DSV…

In theory sound. But the problem comes when you look at the actual costs and coordination problems (where inefficiency in knowledge lowers returns to everyone participating). What happens if the pipelay vessel is late to the worksite? What happens if it lays at a slower speed than budgeted (yet all construction jobs are lump-sum)? What happens if they buckle the pipe? And the same set of issues worry the pipelay guys about the DSV… what happens if the bell-runs are too slow? What happens if they are late and the joint bid suffers from liquidated damages? If they damage the pipe who pays for the pipelay vessel to return and lay the new pipe? The beauty of transaction cost theory is it recognises that if you wanted to you could solve all these problems contractually. But on a risk-weighted basis it is simply easier to internalise these and other coordination issues and make them one firm. It is simply a more efficient form of organisation and both customers and shareholders are happier. Hence Subsea 7, Technip, McDermott, Saipem, and briefly EMAS Chiyoda, were all long the assets that made up the majority of the value of a construction job and brought in DSVs at the margin. They either owned them or just contracted them in. (There is another theory about why business models coalesce buried in institutional theory but I’ll save that for another day).

 

Williamson made a major contribution as well through what he calls “the fundamental transformation”. Space precludes a deep discussion about this, but essentially he argues that there is a change from “thick markets” at contract selection (i.e. lots of choice) to “bilateral dependency” at contract execution. If ever an idea summed up the implicit nature of the complexity of an offshore project to me this is it. I am no disciple of Williamson, I am not sure he and the Great Man would have agreed on a lot, but in the offshore construction industry, he has described it perfectly.

I am constantly reminded of this at the moment because in an industry downturn people are trying to put together solutions that are not economically efficient but operationally can be done. Yes, all the problems can be solved with all manner of subcontractors, suppliers, and different vessels, but really, is it needed? Is is sustainable?

A good example, and I need to stop going on about it, is EMAS Chiyoda and the Lewek ExpressI wrote here about why I don’t think there is a long-term solution other than a liquidation, but to add to this point is that even in addition to the capital issues (which are vast an insurmountable) one of the problems is the owners (lenders) of that vessel are either in for a full contracting company or nothing. There is no charter market for the Lewek Express. No one contracts with an oil company to deliver 20″ pipe at 2000m meters below sea level and then hires the vessel in with all the attendant risks (only a few I have mentioned above for demonstration purposes). It’s not that it’s just not sensible it’s not even sane!

The banks/lenders can’t hope that they grab a few of these vessels and park them up at Loyang and charter them out to other contractors for a few hundred thousand a day to cover their costs until the market picks up. There is no market for these assets on a charter basis, even if the other contractors were short on capacity (which they are not). And unlike CDOs from a mortgage market crash the OpEx/CapEx ratio is painful in the extreme.

So the banks and other creditors either fund a fully new offshore contractor or they sell the assets at a loss. You can’t be half pregnant, and you can’t charter a ship when no one wants to charter one, or the only people who will logic would argue are going to lose money. Unless of course you do it so cheaply it is cheaper for them to do it externally, but that rate will be so low only the other party will win (this is an asymmetric information problem and won Akerlof a Nobel prize for used cars and lemons) which is self-defeating.

Subsea 7 has a market cap of c. 5.2bn, McDermott 1.6bn, Sapiem 4.0bn. You get the idea. The banks and lenders are either funding a new EZRA/EMAS to compete against these types of companies, vertically integrated with appropriate transaction cost business models and equity buffers, or they invent a way to compete against them by virtue of having had a ship redelivered. It’s just not serious.

I have said this a lot before, but it has never been truer in offshore: just because something cost a lot to build doesn’t make it valuable.

2 thoughts on “The Carnegie Triple, Transaction Costs, and offshore economics

  1. Very interesting post again Jeremy.

    Is there an argument though that says people conveniently have short term memory – the lenders need Ezra/Emas to survive to realise any potential return. They support short term with expectation market picks-up. Market returns, cash is flowing and lenders seek exit to another investor with the short term memory. Not wise but hope you’re not the investor when the next downturn hits?

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s