The Organizational Economics of the BP Oil Spill

20 July 2010 at 11:58 am Peter G. Klein 7 comments

| Peter Klein |

Now that passions are cooling regarding the BP disaster, it’s time to bring organizational issues into the discussion.

1. Everyone knows about the liability caps and the role they may have played in encouraging moral hazard. Just as bank deposits are guaranteed by government deposit insurance, and large banks themselves are probably Too Big to Fail, liability for property damage from oil spills off US waters is limited to $75 million (plus cleanup costs), based on a 1990 law passed after the Exxon Valdiz spill. This presumably mitigates drillers’ incentives to manage environmental risk. Indeed, oil companies enjoy a very cozy relationship with their ostensible guardians; as the NY Times noted, “[d]ecades of law and custom have joined government and the oil industry in the pursuit of petroleum and profit.” The federal agency that oversees drilling, the Minerals Management Service, rakes $13 billion a year in fees in what amounts to a public-private partnership. And does anyone really think the British government would “stand idly by” if BP’s status as an ongoing concern were threatened by criminal or civil penalties?

2. As Bill Shughart points out, BP did not own the Deepwater Horizon platform, but leased it from a company called Transocean. To Bill this suggests “a classic principal-agent problem in which the duties and responsibilities of lessor and lessee undoubtedly were not spelled out fully, especially with respect to maintenance and testing of the rig’s blowout preventer as well as to the advisability of installing a second ‘blind sheer ram,’ which may have been able to plug the well after the first (and only one then in service) failed to do so.” Would BP have paid more attention to safety if it owned, rather than leased, the platform?

3. Jeffrey Stamps and Jessica Lipnack think that BP’s move toward a “flatter” organizational structure, starting in 2007, weakened oversight of its operating units. “The risk an organization faces by eliminating levels — especially when it’s done in a one-size-fits-all way as per BP — is that it will severely damage its capacity to manage complexity. . . . [T]he evidence is in eyewitness reports of management conflicts in the frenzied few hours before the blowout. More proof is in the inept efforts to stanch the flow, the clueless non-mobilization of cleanup resources based on inaccurate information, the convoluted claims process, the lack of sufficient equipment to capture the spewing oil, and finally the finger-pointing and the don’t-blame-me CEO.” Decentralization is usually promoted as a way to improve flexibility and generate faster response times, but it can also cause coordination failure and encourage moral hazard. Is that what happened here?

Entry filed under: - Klein -, Law and Economics, Management Theory, Myths and Realities, Public Policy / Political Economy, Strategic Management, Theory of the Firm.

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7 Comments Add your own

1. Andre Sammartino | 20 July 2010 at 5:29 pm

My colleague Tom Osegowitsch also raised the issue around the extent to which BP has borne the entire brunt of this rather than smaller partner firms (such as Transocean). See:

http://internationalbs.wordpress.com/2010/07/07/have-you-heard-of-anadarko-guest-post-from-t-osegowitsch/
2. John S Cook | 20 July 2010 at 6:09 pm

The caps on liability for particular claims are superimposed on more general limitations of liability. This limitation was regularised in laws related to incorporation of companies – dating from around 1854 in English law.

Different causes can lead to similar symptoms; and an environmental disaster can be the result of misfortune not foreseeable by anyone; avoidable ignorance; carelessness or dishonest appraisals of risk. We need a bit more precision in what we call ‘moral hazard’ because a wrong diagnosis might evoke an unhelpful remedy.
3. Peter Klein | 20 July 2010 at 6:42 pm

Thanks, Andre, for the link. John, yes, that’s a good point.
4. srp | 20 July 2010 at 9:23 pm

The relationship between operator (BP) and drilling contractor (Transocean) is absolutely standard in the oil industry and has been as far back as I am aware of. I regularly teach an old HBS case called SWECO about onshore drilling in the lower 48 and spend a fair amount of time exploring why the industry’s institutional arrangements evolved as they did.

Basically, the operator, who is ultimately paying for everything, has the final say but delegates and/or discusses things with the contractor and the services firms (e..g. Halliburton or Schlumberger) that provides specialized technical products and advice. Reputations are very important in this world.

If the operator owned the drilling platform they would have two interlinked problems. 1) They don’t always need it and 2) The people who do the actual drilling have a big impact on the maintenance and depreciation of the rig. Using the operator’s employees to drill in a vertically integrated fashion on a rig they owned would be awkward when the rig became idle. Maybe they could become a drilling contractor for rival operators but I see some big trust issues there. If they instead rented the rig out when they didn’t need it, then they’d have non-owners and non-employees using and abusing it. Not pretty.

So let’s not condemn the “non-standard” contracting regime here, which actually has been standard for decades, lightly.
5. David Hoopes | 20 July 2010 at 11:15 pm

Remember grading that case. o.O
6. Weekly Leader 59 BP's Back and More Mistakes | Weekly Leader | 22 July 2010 at 10:33 pm

[…] The Organizational Economics of the BP Oil Spill – Organizations and Markets […]
7. WhiskeyJim | 26 July 2010 at 9:52 pm

I realize the purpose of this website does not necessarily lend itself to this response but….

Taking a step back, BP has had hundreds of regulation failures and warnings lately, while Exxon has, I believe, one. Is there a failure of organization that allowed it to drill?

The organization of a vast hierarchical federal government interests me most in this debacle.

It arguably would have been more effective, and certainly quicker, to send 100 bureaucrats down to the Gulf with $500M to dole out on mini-experiments of clean-up technology. That is, a decentralized response. BP could foot the bill later.

No federal bureaucracy is designed to deal with this kind of disaster. They have regulated but can not act. No entity could realistically expect to understand and plan for the warren of regulation and bureaucracy of the clean up alone.

I believe the gulf oil spill is the best example of why the federal government needs to downsize. Arguably allowing the states themselves to develop their own laws and plans would be better. They have to deal with it. Witness Florida during hurricane season. Also witness Louisana. Enough said.