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Sunday, June 13, 2010

BP and outsourcing risk

BP Group Chief Executive Tony Hayward discusses the operation with a US Coast Guard

Richard Posner, a judge on the United States Court of Appeals for the Seventh Circuit in Chicago and a Senior Lecturer at the University of Chicago Law School, recently commented in The Washington Post that the BP oil spill in the Gulf of Mexico is the latest of several recent disastrous events for which the US, or the world, was unprepared. In all these cases, observers recognized the existence of catastrophic risk but deemed it to be small.

He asked why are we so ill-prepared for these disasters and said it helps to consider an almost-forgotten case in which risks were identified, planned for, and averted: the Y2K threat of 1999. The risk of disaster probably was quite small, but the fact that it had a specific and known date made it irrational to postpone any remedies - - it was act now or not at all. Such certainty about timing is rare; indeed, a key obstacle to taking preventive measures against unlikely disasters is precisely that they are unlikely to occur in the near future.

According to the London Independent there were 126 people working on the Deepwater Horizon rig on April 20th, the day of the explosion, yet no more than eight of them were BP employees. Some 79 worked for Transocean, the firm that owned and operated the rig. A further 41 worked for contractors such as Anadarko Petroleum Corp, a BP partner on the well. BP had 65% of it, Anadarko 25% and Mitsui Oil Exploration 10%. There was also a firm called M-I Swaco, a contractor providing mud-engineering services on the rig, two of whose workers were among the 11 killed. Halliburton, former US Vice President Dick Cheney's former company, had four staff on the rig, and was responsible for "cementing" on the sea bed. Another firm, Cameron International, supplied the rig's blowout preventer valves, which, as it happened, prevented no such thing. The rig suffered a catastrophic blow-out, in which the 11 men lost their lives.

It was depressing to see the heads of BP, Transocean, and Halliburton blame one another for the disaster in the Gulf of Mexico when they testified before Congress recently, said Stefan Stern recently in the Financial Times. But they did offer a useful object lesson in the perils of outsourcing. The executives all seemed to “fall for the illusion” that by bringing in help from the outside, they were somehow relieved of responsibility for doing the job right. It’s an attitude that pervades the business world.

Despite a “long list of notorious outsourcing disasters,” executives still think they can whittle their companies down “to an ever-smaller essential core, while handing more and more tasks over to hired - - cheaper - - help.” But businesses are more than a collection of “stand-alone projects.” The good ones have “an overriding purpose and sense of identity” that’s diluted when outsiders take on key tasks. And when something goes wrong, companies quickly discover that the public doesn’t blame the help, it blames the company that hired it. You can outsource your operations, but you can’t outsource your reputation.

Judge Posner said setting aside terrorist attacks, where the element of surprise is part of the plan, that still leaves the Indian Ocean tsunami of 2004, Hurricane Katrina in 2005, the global economic crisis that began in 2008 (and was aggravated by Greece's recent financial collapse) and the earthquake in Haiti in January.

In all these cases, observers recognized the existence of catastrophic risk but deemed it to be small. Many other risks like this are lying in wait, whether a lethal flu epidemic, widespread extinctions, nuclear accidents, abrupt global warming that causes a sudden and catastrophic rise in sea levels, or a collision with an asteroid.

Our tendency to procrastinate is aggravated by three additional circumstances: when fixing things after the fact seems like a feasible alternative to preventing disaster in the first place; when the people responsible have a short time horizon; and when the risk is uncertain in the sense that no objective probability can be attached to it.

Posner said all these forces came together to permit the economic crisis, despite abundant warnings from reputable sources, including economists and financial journalists. Risky financial practices were highly profitable, and giving them up would have been costly to financial firms and their executives and shareholders. The Federal Reserve and most academic economists believed incorrectly that in the event of a crash, remedial measures -- such as cutting interest rates -- would be enough to jump-start the economy. Meanwhile, depending on how they were compensated, many financial executives had a limited horizon; they were not worried about a collapse years down the road because they expected to be securely wealthy by then. Similarly, elected officials have short time horizons; with the risk of a financial collapse believed to be low, and therefore a meltdown unlikely in the immediate future, they had little incentive to push for costly preventive measures.

This in turn discouraged the appointed officials of the Federal Reserve and other regulatory agencies from taking such measures. "We've never had a decline in housing prices on a nationwide basis," Ben Bernanke, then chairman of President George W. Bush's Council of Economic Advisers, said in 2005. It happened the next year.

Finally, with no reliable probability estimate of a financial collapse available, it seemed natural and perhaps even sensible to wait and see, hoping that with the passage of time, at least some of the uncertainty about risks to the economy would dissipate.

Posner said the BP oil leak reveals a similar pattern, though not an identical one. One difference is that the companies involved must have known that in the event of an accident on a deepwater rig, prompt and effective remedies for an oil leak would be unlikely -- meaning that there was no reliable alternative to preventing an accident. But the risk of such an accident could not quantified, and it was believed to be low because there hadn't been many serious accidents involved in deepwater drilling. (No one knew how low; the claim by BP chief executive Tony Hayward that the chance of such an accident was "one in a million" was simply a shorthand way of saying that the company assumed the risk was very small.)

Tony Hayward admitted BP had to find entirely new ways of handling “low-probability, high-impact” risks.

Finfacts article: Day 52: BP is US Public Enemy No. 1; Wall Street should be the world's

2 Comments:

  • Outsourcing involving the contracting out of a business function - commonly one previously performed in-house - to an external provider.In this sense, two organizations may enter a contractual agreement involving an exchange of services and payments. Of recent concern is the ability of businesses to outsource to suppliers outside the nation, sometimes referred to as offshoring or offshore outsourcing. For more details you can visit the website softwaredevelopmentoutsourcing(dot)org and services-outsourcing(dot)org

    By Anonymous Software Development Outsourcing, at October 28, 2010 10:25 AM  

  • Risk managers and various stakeholders have a greater problem than just procrastination, temptation to sort out the mess rather than preventing disasters, short-termism and lack of knowledge.

    The three biggest problems are more to do with one protectionism "this has nothing to do with you risk management people", two "I don't like what you are telling me so I am going to shoot the messanger" and three "I can't be bothered with another job" even although risk management should be at the core of what executives do.

    By Anonymous Keith Lewis, at January 17, 2011 12:13 PM  

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