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Déjà Vu: Lessons for the Technology Industry from the Oil Industry

  Article published in DM Direct Newsletter
February 28, 2003 Issue
 
  By Pradeep Anand

The petroleum industry went through speculative "irrational exuberance" from the early 1970s through 1981 after which came the predictable rapid disintegration through the 1980s and 1990s. Having experienced human behavior during this wild ride in the petroleum industry for two decades, reading prognostications of technology industry gurus gives a sense of dj vu. The oil industry, considered a laggard by technology aficionados, offers some insights into to what is in store in the technology market. When bubbles burst, the resultant competitive and market consequences are consistent across industries.

In the 1970s, the oil industry as well as the global economy was in OPEC's clutches. Then, as in the recent past, good old- fashioned greed drove up prices more than tenfold in less than a decade. In 1981, when oil prices were about $34 per barrel, many leading financial firms and economists predicted oil prices to hit $100 the following year. However, when the oil price peaked in September 1981, and dropped thereafter, the bottom began to fall out of the oil field service industry, in slow motion and in waves.

The first wave was almost immediate with a sharp drop in market capitalization for the oil field service sector, with industry recovering somewhat through 1983 as oil prices stabilized at about $24 per barrel. However, in 1986, the oil price dropped abruptly to about $8 per barrel. This began a second wave that decimated the industry, with the industry reaching its bottom in 1987. Since then, it has been a highly volatile ride of mini-booms and mini-busts. Market dynamics during this thirty- year, white-water-rapids-like ride give some idea about what to expect of technology markets in the future.

The most important lesson is that we are still far away from the real bottom. We are still in the middle of the first wave of decline in technology markets. There are many telltale signs that imply this:

Optimism Abounds. Like the oil industry in 1982, technology industry experts, trade journals and newspapers are forecasting minor changes in demand for 2003. These are polls of CIOs who have lost control over their purse strings. Their budgets are going through the first phase of reduction before being slashed.

Valuations across the board are still based on a fast turnaround and are overpriced if traditional  (conventional) wisdom is applied to them Additionally, we have yet to see in the technology business the equivalent of the savings and loan failures of the eighties.

Global corporations are conducting evaluations based on return on investment. Until we see positive results of these evaluations, IT- related budgets will only decline in the near future. In short, demand has hit a wall and will decline, contrary to recent expectations of sustained, infinite growth.

There are too many competitors and too much excess capacity, pursuing share of a smaller pie. Each segment has yet to begin consolidating to two to three major players. Take any technology subsector and we find that there are far too many competitors funded by unrealistic optimism in growth. The other side of this coin is that prices and quality will drop precipitously, thereby hastening the demise of today's seemingly strong players.

Tech industry CEO departures are still a minority rather than a majority. Dismantling cost structures is a horrendous, emotion- draining task in ordinary times. Leaders at the helm of technology companies who led them through the growth phase are typically ill equipped to manage cost cutting during downturns. People like "Chainsaw" Al Dunlap have yet to descend on this industry.

Employment in this sector outstrips earnings expectations. Employment levels are typically based on the unrealistic expectations of growth and are a major aspect of a technology firm's cost structure. When revenue and earnings growth numbers are disappointing, wearing rose colored glasses of optimism, people are kept on board for the inevitable turnaround in the market, and treated as assets. The transition of viewing people as an asset to a variable expense has yet to occur on a broad scale.

Industry consolidation games have yet to begin. The Hewlett-Packard and Compaq merger soap opera is a precursor to what is about to envelop the industry.

These turbulent times will be painful but there will be winners in the end. The oil industry can also provide lessons in winning in these turbulent conditions.

Demand has to turn around. In the oil industry, the motivation to absorb and use new technology grew dramatically after 1986, yielding magnitude-scale improvements in industry economics. Foremost among these circumstances was that industry economics and expectations were stabilized by oil prices. Similarly, if the entire economy is under unyielding pressure, IT will not be absorbed and adopted at previously expected rates. Until the global economy turns around in a robust manner, the bottoming out and the recovery periods in technology sectors will be painfully long.

Change in leadership. More importantly, in the oil industry departure of the old guard created an environment for change. Industry sectors have a tendency to "ring out the old and ring in the new" when faced with major economic shocks, and the oil industry was no different. This change eliminated the internal forces of inertia and resistance to change, unleashing fresh perspectives to utilizing innovation to improve industry economics.

This was a painful process, with false starts, but the next generation ultimately fulfilled its promise. This process of changing of the guard has just begun at global corporations, and its effects will only trickle down to technology companies.

Buying behaviors have to change. In the 1980s, oil companies were similar to today's IT departments, selecting products and services from a smorgasbord and creating and managing unique solutions and their delivery with consultants. These processes were later discovered to be uneconomical and were replaced by outsourcing execution to one-stop-shop service companies, improving the overall economics of the industry.

Because of this disaggregation, firms in the value chain, especially ones with point solutions, were quickly marginalized and were either eliminated or acquired. Most firms will be not be selling to final consumers of technology but often through channels which will have greater leverage. All things being equal, margins are inversely proportional to the number of degrees of separation from the ultimate customer, and many firms at the lower end of the food chain may not survive.

Mergers and acquisitions must gain momentum. In the oil field service business, the financially perceptive big boys grew bigger through mergers and acquisitions. In the technology arena, the adage, "Them that has, gits!" will be eminently applicable, and cash-rich firms with strong balance sheets and customer franchises will be winners in the long term. Like in the oil industry, these larger firms will absorb more and more of their customers' work, responsibilities, competencies and people, thereby reducing the rest of the industry value-chain to low-cost suppliers or specialty firms.

Focus on customers and financials. Many oil industry lessons show that three major dimensions will determine the survivability of technology firms. These are strength of customer franchise (and position in the value chain), strong cash position and balance sheet, and sustainability of competitive edge. With technology half-lives being what they are, the value of the former two will far outstrip intellectual property as a sole source of sustainable competitive advantage.

A battle of business designs (or models). There will be three major survivors: vertically integrated full- service providers, low cost producers and specialty firms that feed the value chain. Of course, there will be various flavors for different industry segments but this polarization is inevitable, creating huge competitive barriers to entry. Consequently, successful garage-based start-ups will be less frequent.

Consolidation of geographic clusters. North America had many regional oil centers serving the oil industry. Most saw net losses in jobs to the benefit of a few cities, such as Houston, Texas. Similarly, regional technology centers can expect net job losses as the number of tech clusters is reduce to the benefit of two geographical areas on the West Coast.

The premise is simple. When the market is filled with irrational expectations of unlimited growth, all competitors have potential to grow. To borrow an analogy from physics, a competitor in a high growth market is like an atomic particle in a gaseous state, with high energy and infinite degrees of freedom and space. When demand starts to shrink, energy is removed from the system, and under sustained decrease in energy, suppliers are forced into the other extreme, approaching a Bose-Einstein condensate state where a winner can take all.

However, during intermediate states between these extremes, markets tend to follow the power law or Pareto's eighty-twenty rule, where a few players own a dominant share of the market, and the rest just feed these giants.

The oil industry is rich in data, information, and knowledge about booms and busts. These are but a few of innumerable parallels that can be drawn to help the tech industry through these turbulent times.

...............................................................................

For more information on related topics visit the following related portals...
Enterprise Intelligence and Strategic Intelligence.

Pradeep Anand is the president of Seeta Resources (www.seeta.com), a Sugar Land, Texas-based consulting firm. He can be reached at (281) 265-9301 and at pradeep@seeta.com.

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