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.
D ecisions are made based on an
individual’s assessment of the
current and future situation using
available information. “Gut feel” is a
combination of experience and
information. However, how many times
have our stomachs led us astray?
Like physicians treating the symptoms
and not the disease, management often
makes critical decisions based solely on
indicators of an opportunity and not solid
facts. Wildcatter “Dad” Joiner of
Spindletop fame could live by his wits,
but today’s executives do not have that
privilege. Truth be known, the legendary
Joiner did not have that luxury either as
he died almost broke after a long string
of failures.
Risk and the management of uncertainty
have always been part of the energy
scene. Over the last 150 + years,
successful producers have developed a
core competency addressing economic,
technical and geopolitical ambiguities. A
Key Success Factor of any risk
management process is the availability
of timely, valid and reliable information.
Prelude
The beginning of year 2002 finds the
global economy at an increased level of
confusion. Political and economic
uncertainty in key petroleum
© 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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- Mark Casson
Information and Organization
1997
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 that
have long been known to present
difficulties.
Well understood by politicians and
sociologists, knowledge is power or
rephrased it is competitive advantage.
Advantage also has an economic aspect
– its value is a function of its marginal
cost, or the additional capital required to
add another economic unit of
information. Firms must make decisions
regarding when the marginal value of
additional information is zero or even
negative.
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
knowledge. This synergistic effect
requires that value be derived from data
being in the right format, at the right
place and at the right time.
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 Principle) and even if
economic equilibrium were realized, it
Dr. Scott M. Shemwell Risk Mitigation White Paper

would only be for a moment before risk management methodology using

exogenous forces would disturb the
balance.
Project Uncertainty
The petroleum industry has developed
substantial expertise in managing risk on
a global scale. This industry is project
driven and each revenue-producing
asset may have several ventures
underway concurrently. Most projects
have several components of exposure
including geopolitical, economic and
technology.
Moreover, petroleum producers have a
set or portfolio of assets, each with a
different risk silhouette. Successful
organizations have developed a formal
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.
Degrees of Uncertainty
One approach towards defining
uncertainty has been developed that
models four different “Levels of
Uncertainty” along with an appropriate
set of tools necessary for the analyses of
the opportunities presenting themselves.
The decision-making process also
changes depending on the degree of
managerial confidence, availability of the
required resources necessary to evaluate
prospects and accessibility to cost
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
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. In 1977
Digital Equipment Corporation (DEC)
passed on the idea of the individual
desktop computer even though there
was ample evidence, to industry insiders,
that this was possibly an emerging
market. This case of opportunity lost
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
energy 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.
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 – defined
as higher on the Risk – Reward curve as
exceeding the return capital could earn
as bank deposits.
However, risk taking without proper
governance is a recipe for disaster. The
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Risk Mitigation White Paper
following steps outline one approach for
managing under uncertainty.
In 1990, Morgan et. al., Uncertainty: A
Guide to Dealing with Uncertainty in
Quantitative Risk and Policy Analysis,
established the following Ten
Commandments for Good Policy
Analysis as one approach to combine
quantitative analysis in conjunction with
qualitative policy assessment.
· Do your homework with
literature, experts and users.
· Let the problem drive the
analysis.
· Make the analysis as simple as
possible, but no simpler.
· Identify all significant
assumptions.
· Be explicit about decision criteria
and policy strategies.
· Be explicit about uncertainties.
· Perform systematic sensitivity
and uncertainty analysis.
· Iteratively refine the problem
statement and the analysis.
· Document clearly and
completely.
· 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 schema reduces uncertainty and
allows management to make better-
informed decisions. Moreover, it
provides a vehicle for ranking subjective
managerial and technical opinions and
observations.
Dr. Scott M. Shemwell Risk Mitigation White Paper

The Role of Information extension into its supply chain,

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?
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.

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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Dr. Scott M. Shemwell
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 times, e.g., reducing time to first oil
thus increasing Net Present Value (NPV)
of the project.
The CEO of a telecom firm once stated
“. . . we’ll end up with a much lower
marginal cost structure and that will allow
us to under price our competitors.” The
same economics are at work in the
commodity driven energy market place.
Risk Mitigation
As an industry pioneer and leader, DEC
CEO 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 it strategic suppliers
better mitigates risk.
As an information-processing engine, the
21st 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
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Risk Mitigation White Paper
providing real-options when managing
capital assets throughout their life cycle.
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. Surviving
economic actors are very good at
managing their risk-reward curves.
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 foundation 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 intensive processes with
more than 250 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.
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