Lessons Learned on Operational Intelligence Networks

The availability of edge devices for application in remote control or data gathering is on the rise - substantially. With the deployment of these edge devices, new types of data networks will emerge...there will be operational issues and investment traps. How will investors make money?

Some technical recitals

The "network edge" as it were can take on many different forms: it can have a variable population and have a shifting edge, or it can have more of a static population and be geospatially fixed. An example of a variable-population, shifting-edge network is something like Radio Frequency IDentification (RFID) which sticks to shipping pallets loaded with inventory moving between companies. Another example of a variable-population network is obviously the Internet. An example of a fixed-population, geospatially-fixed network is your office local area network.

What are some of the investment problems here?

The complications with a shifting-edge network are many: (i) the edge devices (these are wireless) have to be constantly "visible" to a radio receiver which means receivers have to be everywhere or transmitters have to be very powerful. In either case these requirements increase the cost of deployment to the user. Otherwise you can go to a mesh network where all the edge devices are transceivers (i.e. talk to each other) - the problem with this is that one can't do proximity measurement for geospatial plot (i.e. you will not know exactly where your stuff is). As a rule, the more powerful things are the more power they consume and otherwise have a tendency to be more complex. This in turn makes wireless edge devices more difficult to maintain. This was part of the problem causing the histortically slow adoption rate of RFID. Yet another another issue for investors in RFID was that the world had previously implemented a lower-tech version of the variable-population, shifting-edge network called barcoding (is that what that was?). So since there were a number of pre-RFID inventory and supply chain applications that were geared toward this type of near-real-time-data [barcode], then RFID-based data sourcing was morally more of a product evolution for these barcode-sensitive software applications than a revolution/creation of a new software space based on true realtime. As a result, we have seen a number of RFID middleware application companies coming to life [that link to the pre-RFID apps.] but not really any broad innovation of new business management applications. In the venture world, we have yet to hear the sonic boom of investment returns from RFID-related software at any level.

So what can we learn from this?

The physically distributed energy industry in which we invest has many different needs for operational data and thus a great need for widely distributed networks - some may be variable-population, shifting-edge some may be fixed-point. What we know is that the edge devices had better be low cost to deploy, very low maintenance ("thin" to use an industry expression) else failure rates cause adoption rates to creep at best (see history of RFID).

What we also know is that the data characteristics had better reflect a step change to what the industry is accustomed or otherwise be wrapped around business process that is not currently software-application centric. If not, we are back on the evolution path as investors rather than the revolution front and making very little money as investors in newly-developed software.

One side note and one prediction

The side note - New purpose networks almost invariably start out as device manufacturing entities whose goal it is to get into network services business for the purpose of getting into the software business. Unless you have something special at the networking device/management level...you'd better be planning version 1.0 of your business process software system. I've seen it too many times.

The prediction - Operational intelligence networks today are sold to customers for their internal ownership and management. This is the equivalent of building and maintaining your own phone system. I predict this will change. As the novelty of the new networks diminshes and their size grows they will of course be flipped back out to the technology providers for management - because managing a 1,000-node network is hard to do. This means again that the whole architecture of the network should be geared toward "low-touch" design as opposed to fast-paced version obsolecense revenue models (e.g. desktop computing). This will be a point of distinction between success and failure of many companies.

Some conclusions

In my judgment, there is a significant investment opportunity in the energy industry around real-time, operational intelligence networks. Why?

The raw material underlying the oil industry is (i) flammable/toxic, (ii) fungible, and (iii) is a commodity reflecting material, daily price volatility. This means there are three different motives for knowing exactly how much "product" is where at all times (i.e. environmental/safety, theft, and financial risk). Interestingly to investors, this means a sale to any one of these three corporate interests is possible which creates sales model options - this is good. As a result of the raw material characteristics and where it is found there will be a need for special types of network edge devices that are very rugged, very low maintenance and can operate in volatile environment and still get the data where it needs to go.

These new data types for the oil industry applications will be materially different than those to which the industry is accustomed. They will be instantaneous. As a result there is an application play here. This application play will possibly be a new breed of software required because this new type of data didn't really pre-exist and thus legacy apps. aren't "barcode enabled." As a result, they will have to be created anew and will have to think differently.

What Are the Fundamentals Saying?

Everyday news sources report China and India buying oil reserves to support their growing industrial bases. When I speak with folks on the commodities trading desks they remark that all bids seem to be coming out of China: I saw in the WSJ that India ONGC made a $2 billion purchase of Nigerian oil and gas rights in a single reserve basin.

So what? Why do I care?

The graphic above plots per capita oil consumption by country. As the chart indicates, the US consumes more oil per person than any other country in the world. If you look in the upper right hand corner of the chart, you can see the US position - 25 barrels of oil per person per year. If you look in the lower left hand corner, you can see the relative positioning of China and India - 1 barrel of oil per person per year. The US consumes approximately 20 million barrels per day vs. world consumption of about 80 million barrels day. India and China want to get where we are on the chart - so if this is a fact, the world has a big supply-demand problem that is only going to get worse. If the average per capita consumption of oil in India increased by one gallon per month, India would need an additional 1 million barrels a day or about 5% of the total current daily US consumption. At this point please remember the impact that Hurricanes Katrina and Rita had on US pump prices in the summer of 2005.

And the implications to investors are?

The graph above combined with current offshore industrialization trends together make a reasonable case that the prices of oil are going to stay high on a constant dollar basis. Thus it is arguable that recently expanded capital budgets of the major oil companies are going to stay expanded. This is all good for investors of IT vendors selling to those companies.

However.......

There are some disturbing, lingering questions. O.K. like what? Here are some facts (as an example):

• India is a country filled with mathmaticians.
• Indian knowledge workers work for relatively for low wages.
• India has an increasing demand for oil.
• India has a penchant for developing software.

This might be a form of Deja Vu. Can much of the legwork of app. development be pushed offshore to India? If so, might we see more innovation out of the US companies as resources are free to focus on higher value requirements or might the industry find its way East like so many others? Are the larger software providers thinking this way? I am talking with several of the majors this coming week and will be focused on these questions and the further implications.

Business Process Management

I recently saw a product demo for a form of business process management (BPM) application - and I am certain I have seen the future (company name is Lombardi). This form of BPM enables creation of composite applications - applications which are generally built on top of pre-existing systems using data (an sometimes functionality) from those systems to effect a new business routine. Composite apps are appealing because they are generally lower cost than tweaking the legacy apps. Some designs are good...some are bad.

What is interesting about this version of BPM is that one can script business logic and lift and place data back into old apps without pain. Now what is even more interesting is the business logic thread can be presented in a Microsoft Outlook context. This means an email can show up in your inbox and which represents enterprise strength business process.

So let's suppose you're Microsoft and are trying to invade the space of Oracle and SAP - this has been going on for years. I can now draw on the power of those underlying apps and their monolithic data strcutures into a Microsoft environment rendering visibility of those applications irrelavent to the user. In other words...I don't have to look at them and don't have to know how they work. This then represents an interesting way to invade Oracle's and SAP's space. If business logic is incrementally lifted up into the BPM enviroment...where does this leave the legacy app. vendor...now I am not saying that these companies will be rendered powerless...I am merely observing that a new process layer is going to exist and will consume oxygen - the reason I am most convinced of this is because it will be driven out of the most pervasive user app. in the world - Microsoft Outlook.

Market Research from Energy Insight

Trends in Oil & Gas IT Spending
[12/6/2005 4:16:50 PM]
Oil and gas companies are moving toward greater centralization of information technology for better coordination, standardization, and consolidation of their equipment, processes and technologies. By Rick Nicholson and Sekhar Venkat, Energy Insights (an IDC company)

Energy Insights recently conducted a study of 33 oil and gas companies from around the world (see Figure 1) to determine the trends and directions of their respective IT organizations. The annual revenue of the companies studied ranged from $0.19 billion to $264 billion (average $18.5 billion), and the size of the workforce ranged from 141 to 105,200 employees (average 14,841). The majority of respondents were IT directors of their company; four were corporate CIOs. The survey covered topics related to IT centralization, internal and external IT spending, and key IT initiatives for the near future. Key findings from the study include:

The application portfolio of oil and gas companies is shifting from custom applications to packaged applications to allow for better cross-company communication and to provide the foundation for integration to support merger and acquisition activity.

There is an increased focus on enterprise resource planning (ERP), security, upstream applications and data management, and business intelligence (BI), especially to support digital oil field initiatives.

IT Departments More Centralized. Centralization enables the creation and execution of a collective vision of how IT should support and guide market opportunities and growth. According to our research, 71.4% of the respondents are rapidly moving toward centralization of their IT organizations. This trend is helping companies:

• Create a more strategic vision and approach to IT infrastructure, establishing a foundation for service-oriented architecture for the enterprise as a whole.
  
• Standardize data models and processes across the organization to create greater consistency, more accurate reporting, and efficient information processing.
  
• Streamline IT operations across the enterprise through elimination of staffing redundancies and reduction in the costs of licensing, maintenance and internal IT support by consolidating and rationalizing applications.
  
• Establish enterprise-wide visibility into a consistent set of data across business units and companies while improving the ease of use of IT systems by removing complexities from the end user. Integration, standardization and consolidation of IT systems are the basis for a successful, centralized IT model. For example, integration of application and data warehousing allows oil and gas companies to capture wellhead production information and make that information seamlessly available to multiple applications and users. Integration can also support many business processes, such as execution of royalty payments through matching production data with ownership details.

An immediate consequence of IT centralization and integration is the growing role of systems infrastructure and security. As more companies centralize their IT organizations, data access, backup, security and recovery of relevant data stored in non-centralized locations will become areas of significant challenge.

Internal vs. External IT Spend

Survey respondents reported that external and internal IT spending was split almost equally, with external expenditures averaging 56% and internal expenditures averaging 44%. This comparable spending metric reflects the lack of automation and integration of current IT solutions. The labor-intensive nature of today's software requires a host of personnel to acquire, manage and process data. The high internal spending is a strong motivating factor for companies to outsource their enterprise resource planning applications, software development, and IT infrastructure support and networking. In some instances, another motivating factor for outsourcing was the lack of manpower.

Focus on Productivity, Workloads

Employees of oil and gas companies are often so overwhelmed with just managing today's problems that they do not have any time to research better ways of doing things to optimize their productivity and reduce their workloads. Therefore it is critical to keep sight of new and important initiatives that allow for a more productive and satisfied work force. Respondents from the survey were asked to comment on their top five IT initiatives for the period 2006-2009. In addition to a continued focus on enterprise resource planning, there will be an increased role for upstream applications and data acquisition and management, as well as a growing importance of business intelligence and data warehousing. Since economic scarcity of hydrocarbons is top of mind, it is not surprising that oil and gas companies see upstream applications and business intelligence as top IT initiatives (see Figure 2). Taken together, these initiatives support the digital oil field concept, which we define as the complete automation and integration of the acquisition, processing and management of all data that describes and influences hydrocarbon production from well completion to production accounting and final handoff to midstream and downstream segments. Many of the super-majors have been investigating what investments in this area can do to improve production and reduce labor costs. In fact, nearly 5% of the respondents named digital oil fields as an IT initiative over the next 3 to 4 years.

What They Are NOT Investing In

Despite the widely held belief that liquefied natural gas (LNG) is going to be an increased source of fuel in the energy sector in the near future, a vast majority of survey respondents are not making IT investments to support LNG infrastructure, production or transportation. Only 15% of survey respondents indicated an investment in IT for LNG production. LNG requires sophisticated risk management, distribution management and terminal management systems. The information life cycle for LNG would be very similar to that of crude oil shipped in oil tankers to terminals. Gas production measurements will need to be made at the wellhead, with additional liquid measurements made at each point of custody transfer. Actual LNG volumes would get allocated back to the wells, and based on operating party and ownership agreements, payments would need to be made. Energy Insights believes this represents an opportunity for new software applications.

Guidance for IT Vendors

Vendors of IT solutions are aggressively entering the oil and gas market because of sustained high levels of hydrocarbon prices. Based on our study's results, Energy Insights has the following recommendations for vendors:

• Actively pursue viable partnerships to provide more integrated solutions, i.e., integrating upstream and ERP applications.
  
• Be cautious of increased competition because of the spate of current and future mergers and acquisitions (M&A) in the oil and gas industry.
  
• Focus on providing specific and improved solutions in the areas of computing, simulation and visualization, data capture, analysis and management.
  
• Build custom solutions around the specific needs of the oil and gas business, as opposed to trying to apply solutions across industry verticals without relevant modifications.
  

Guidance for Oil and Gas Companies


Although IT solution providers worldwide are seeing the oil and gas industry as the next hot place to do business, the oil and gas companies themselves remain committed to reducing costs, enhancing recovery from existing and new hydrocarbon reservoirs, and managing demand pressures creatively. Energy Insights recommends that operators:

• Focus on centralization initiatives to reduce the cost of operations through standardization of IT vision and to eliminate workforce redundancies.
  
• Look at ways to bring about consistency in business processes and IT solutions within and across organizations. This will ease consolidation efforts and assist with M&A activities.
  
• Take a leadership role in defining suitable IT solutions and encourage partnerships between leading vendors of different IT technologies to provide mature and integrated solutions.
  The overall move toward centralization and the focus on the top IT initiatives will enable cost savings, improved hydrocarbon productivity, and effective supply chain management. Also, CIOs should seriously consider how the increased importance of LNG as a commodity will affect their corporation's IT needs in the near future.

What matters?

Generally speaking....if it's not producing revenue...it's an expense. In other words...in the oil industry...if it is not about finding oil or getting oil out of the ground faster...then it is an uphill battle in the budget cycle. Today...it seems like every department in the oil company is over budget. They are on a free-for-all to spend and get as much out of the ground as possible as fast as possible. These are good times.

Some folks see industrialization of India and China driving increased oil consumption further squeezing the demand/supply gap that became so "nationally" evident during the 2005 hurricane season. Others remind us that history has evidenced industry cyclicality many times and that under the laws of nature, oil should be around $22/barrel based in year 2000 dollars. One thing that may be different is that production decline curves (i.e. the curves that show the rate of depletion for oil and gas properties) are much steeper for recent vintage wells vs. older wells for the period 1990 through 2004).

What this means is that activity is going to have to pick up just to keep up. This means that a huge capital spending wave will be required by industry just to punch enough holes in the ground to satisfy current demand much less increased demand. There will be more rigs in more remote locations...wait a second.....there is a declining workforce...how the world will we staff the increased activity requirements? One methodology will be more money...in sort of a ".dom" way...hopefully without the black turtlenecks. The other method will be systems and information. Software and data are the replacement mechanisms for men (not really but given no other options it helps cover the gaps).

If this is true.....it is going to be a good time to invest in software and connectivity that sells to the energy industry.

What is happening in front of me?

In the past I talked about the increased power of the CIO within the energy world. In these conversations, I tended to speak about the CIO's role in a somewhat hedged fashion alluding to his increased power within the enterprise - but not correctly identifying the underlying shift. Previously, general IT seems to have been an outsourced function whereby the systems integrators took on the role as shepherd/advisor within the IT stack.

For a time, it seemed that market was increasing its reliance on the system integrators by adopting SAP. Outsourcing was increasing. For a time, this was true. However, I believe that the adoption of SAP really planted the seeds of change in the energy industry. The level of sophistication and talent to manage and supplement these systems increased. And so the industry appears to be hiring internally the sophistication and talent to do these things. So what do I think is happening in front of me?....I think the industry is transitioning from an IT outsource model to an insource model....the industry is INSOURCING.

This means that turnover of intellectual capital will be lower and that IT will think more proactively than reactively. IT will thus start to take on a different life and meaning within the organization. I think this means good things for investing in application companies that serve the energy industry.

How did they do that?

I have asked around because I was curious: curious to know how SAP came to dominate the energy industry. It seems that the industry was ripe for the picking and SAP made some very smart moves.

How ripe is ripe?

As I have alluded to before, after the oil price crash in the early 1980' s the industry went from a functional model to an asset-based model - everything was measured by "what's my return on assets?" As also mentioned before, everything became outsourced and IT investment slowed to a crawl. In the mid-1990's...many of the oil companies were still pushing on legacy mainframe systems. So several things began to work together to create SAP dominance:

Variable #1 - Y2K - The notion of rewriting mainframe-based legacy apps to avoid a system crash was not particularly appealing given advances in client-server technologies.



Variable #2 - The oil industry is highly cyclical and wanted to smoothing strategy. SAP sold the oil companies on the notion that they would be able to manage and replace much of the variable costs associated with outsourcing through investment in information systems. In the next upcycle..the oil companies would reap improved profits.


Variable#3 - Oil companies were very highly distributed as were the totality of their information systems...the were looking for a monolithic system structure.

The SAP play book


Variable #4 - SAP outflanked Oracle with the system integrators promising to not compete with them for deployments as became the case with Oracle...it is interesting that this partnering model alone added a level of risk to SAP as SI's faced many challenges effective timely and competent system installs.



Variable #5 - Business Process Reengineering became a fad and SAP played to it well.

It seems unlikely to find this type of confluence again. Nonetheless....SAP is entrenched...so is this an investment opportunity or investment pediment? Choose wisely.

The Old and the New

Yes...the oil companies operate on a decentralized basis...the legacy of the oil company is that it has, predominantly and rightly so, the mindset of the petroleum engineer. This combination of attributes has meant that many of the decisions and processes of oil companies have historically been architected and overseen and the business unit level. Near the drillbit or within the refinery. However, in the mid- to late-1990's the seeds of change were planted. The oil companies bought SAP and, as a result, significant investments were made in SAP. The investments were so substantial that the CIO took on a new level of import within the enterprise.

General information technology was previously viewed as something that was outsourced. It was not petroleum engineering. As the wheels of SAP began to turn, the reliance on the CIO began to increase. As such, there began a centralization of decision making regarding things that were "IT." Software solutions that may have been never been seen by corporate are now becoming the domain of corporate. CIO's are asking..."what are our business processes and what can SAP do and not do?" This is where some of the investment opportunity resides.

I think we are going to see continued empowerment of the CIO. I think we are going to see near-term definition of gaps in the general IT stack as it relates to general business process and a search for solutions to fill those gaps. The question then becomes will IT budgeting still reflect the apprehension of a volatile industry or can it plow new ground?

Which way are they headed?

I heard an interesting theory today. The topic of discussion was "why oil companies are just now beefing up general IT." The theory of why this is so is based on something called "informational asymmetry." What this means is that the less someone knows about something the more they will discount its value either out of suspicion or perhaps apathy, e.g. a used car that is for sale - buyers become suspicious.In the mid 1980's, the oil industry went from a functional model to an asset-based model. In other words, every action and decision was based on the incremental impact on Return on Assets, Return on Equity. As this operating model prevailed, oil companies began to outsource shedding a great deal of institutional knowledge that didn't revolve around the drill bit. IT for example became something more outsourced and upward mobility within the organization for IT personnel was stifled. As a result, these institutions lost their capacity to contemplate the value of new technologies. This was not the case around the drill bit...but in several other cases it was. Thus the asymmetry gap widened and the value of general IT was, at a level, discounted. So after several years after watching the non-oil world do some very interesting things with general IT (operational intelligence, business process management, etc.) we are starting to see this in the oil world. The theory would hold that the passage of time and the industry's observations of the actions of the rest of the world with regard to general IT have narrowed the asymmetry gap.Nonetheless, we further observe in the oil and power sectors that they run in packs. So how does the pack form and what gets it going a certain direction. The answer we hear over and over in Houston is the pack forms around a bell cow. Find the bell cow make them happy and the rest of the world will follow. In essence, this works to dissolve information asymmetry as well. In the oil sector, service companies (Halliburton, Schlumberger, Baker Hughes) are viewed much like counselors to the oil companies...they need this type of hand holding today as a result of their restructuring actions in the mid-80's. The trick is this..to identify the bell cows in the industry, determine if a heard is forming, and figure out which way they are headed...

The Pack

A pattern emerges. In the energy world it seems to show itself over and over. Reputation is more important than technology. I have watched two companies compete for E&P customers. They offer virtually the same product using off-the-shelf components. They are, in fact, a communications services provider. They don't sell for less and yet the seem to be taking market share from everyone. Why?

They are not arrogant; they answer the phone when it rings; they do what they say they are going to do. Sounds like a good service provider. In the upstream energy sector nothing else has really mattered over time but price among conventional service providers. One dollar cheaper gets you the business.

The reason this doesn't really apply to IT in energy is that those who procure for general IT are different than those who procure for conventional drilling project services and general IT is not so commoditized within energy as the regular service companies. We are at a point of market adoption of general IT tools in the energy sector and so price is less important. Maybe IT is becoming more empowered and they don't want to fail and so, again, price is less important. What I think the market is really telling me (us) us that the value of new, faster information flow is so great price is not the issue.

Whatever it is..oil companies seems to rely on each other's satisfaction and when they agree...you had better hope you are standing in the correct square or else your future is going to be ugly. They are a pack.

Energy & Power Venture Investing

I recently read of venture partners of large technology venture funds setting up blogs. I am always interested to hear perspective from others and share my own thoughts about current trends, etc. There are simply too many educated minds in the world to not use this resource. I hope you will feel free to ask me questions, provide data points to me, and let me do the same to you. Our website is www.smhpeg.com which reflects where we spend our time and investment dollars.

Chip Davis