arabella

1.

Organizational Policy Fall 2017

Raynard Porter

BADM 450 Spring 2016

Texas Southern University

Table of Contents

The Global Oil and Gas Industry......................................................................................................5

Royal Dutch/Shell: A Shell Game with Oil Reserves--Governance Overhaul after Scandal (B).....23

CrossFit (A).....................................................................................................................................35

BP's Macondo: Spill and Response................................................................................................59

McDonald's China: The Expired Meat Scandal..............................................................................81

Reinventing E-Commerce: Amazon’s Bet on Unmanned Vehicle Delivery....................................97

Enron - What Went Wrong?..........................................................................................................121

Apple Inc.: Managing a Global Supply Chain...............................................................................135

The Offshore Drilling Industry in 2011..........................................................................................157

The Rise and Fall of Petrobras.....................................................................................................185

Organizational Policy Fall 2017 BADM 450 Spring 2016

Raynard Porter Texas Southern University

2.

A09-16-0002

Copyright © 2016 Thunderbird School of Global Management, a unit of the Arizona State University Knowledge Enterprise. This case was written by Professor Andrew C. Inkpen for the sole purpose of providing material for class discussion. It is not intended to illustrate either effective or ineffective handling of a managerial situation. Any reproduction, in any form, of the material in this case is prohibited unless permission is obtained from the copyright holder.

Andrew C. Inkpen

The Global Oil and Gas Industry The oil and gas industry is one of the largest, most complex, and most important global industries. The industry touches everyone’s lives with products such as transportation, heating and electricity fuels, asphalt, lubricants, propane, and thousands of petrochemical products from carpets to eyeglasses to clothing. The industry impacts national security, elections, geo-politics, and international conflicts. The prices of crude oil and natural gas are probably the two most closely watched commodity prices in the global economy. In recent years, the industry has seen many tumultuous events, such as the growth in oil and gas production in the United States; sanctions on Russia and improved international relationships with Iran; continued technological advances in unconventional oil and gas; ongoing strife in Iraq, Libya, and various other oil-exporting nations; continued heated discussion about climate change and non-hydrocarbon sources of energy; and continued uncertainty in crude and gas prices. All of this comes amid predictions that the global demand for energy will increase by 30%–40% by 2040.

Oil and Gas Industry Background When Colonel Edwin Drake struck oil in northwestern Pennsylvania in 1859, the first phase of the oil industry began. John D. Rockefeller emerged in those early days as a pioneer in industrial organization. When Rockefeller combined Standard Oil and 39 affiliated companies to create Standard Oil Trust in 1882, his goal was not to form a monopoly, because these companies already controlled 90% of the kerosene market. His real goal was to achieve economies of scale, which he did by combining all the refining operations under a single management structure. In doing so, Rockefeller set the stage for what historian Alfred Chandler called the “dynamic logic of growth and competition that drives modern capitalism.”1

With the Spindletop discovery of oil in East Texas in 1901, a new phase of the industry began. Before Spindletop, oil was used mainly for lamps and lubrication. After Spindletop, petroleum would be used as a major fuel for new inventions, such as the airplane and automobile. Ships and trains that had previously run on coal began to switch to oil. For the next century, oil, and then natural gas, would be the world’s most important sources of energy.

Since the beginning of the oil industry, there have been fears from petroleum producers and consumers that eventually the oil would run out. In 1950, the U.S. Geological Survey estimated that the world’s conventional recoverable resource base was about one trillion barrels. Fifty years later, that estimate had tripled to three tril- lion barrels. In recent years, the concept of peak oil has been much debated. The peak oil theory is based on the fact that the amount of oil is finite.

After peak oil, according to the Hubbert Peak Theory, the rate of oil production on Earth will enter a terminal decline. At various times, some analysts have argued that the peak has occurred, whereas others have argued that peak oil is a myth. An article in Science stated:

Although hydrocarbon resources are irrefutably finite, no one knows just how finite. Oil is trapped in porous subsurface rocks, which makes it difficult to estimate how much oil there is and how much can be effectively extracted. Some areas are still relatively unexplored or have been poorly analyzed. Moreover, knowledge of in-ground oil resources increases dramatically as an oil reservoir is exploited. To “cry wolf” over the availability of oil has the sole effect of perpetuating a misguided obsession with oil security and control that is already rooted in Western public opinion—an obsession that historically has invariably led to bad political decisions.2

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

5

2 A09-16-0002

Regardless of whether the peak has or has not been reached, oil and natural gas are an indispensable source of the world’s energy and petrochemical feedstock, and will be for many years to come. The difficulty in determin- ing oil and gas reserves is that true reserves are a complex combination of technology, price, and politics. While technical change continues to reveal new sources of oil and gas, prices have demonstrated continued volatility, and resource owners have sought more control over access. As prices rise, reserves once considered non-economic to develop may become feasible. As prices fall, the opposite occurs.

The oil and gas industry has always been cyclical, with the price of oil and gas moving up and down. Exhibit 1 shows oil prices over the period 1970–2015. The Arab oil embargo of 1974 resulted in a large price increase and events in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980. The period 1985 to 1998 was largely a period of low prices. Prices then started back up, only to fall after September 11, 2001. After 9/11, prices rose until the recession at the end of the decade, continued rising until 2014, and then fell significantly.

Oil and Gas Reserves Discovering new oil and gas reserves is the lifeblood of the industry. Without new reserves to replace oil and gas production, the industry would die. However, measuring and valuing reserves is a scientific and business challenge because reserves can only be measured if they have value in the marketplace. The oil sands of Alberta, Canada, are a good illustration of how difficult it is to accurately measure oil and gas reserves. Oil sands are deposits of bitu- men, a molasses-like viscous oil that will not flow unless heated or diluted with lighter hydrocarbons. Although the oil sands in Alberta are now considered second only to the Saudi Arabia reserves in the potential amount of recoverable oil, for many years these were not viewed as real reserves because they were non-economical to develop. For most of the 2000s and through 2014, the main town in the oil sands region, Fort McMurray, was in the midst of a boom not unlike the gold rush booms of the 1800s. Housing and labor were scarce and the infrastructure struggled to keep pace with the influx of people, companies, and capital. The development of the oil sands occurred because of a combination of rising oil prices and technological innovation. With the fall in oil prices after 2014, the oil sands region has seen many projects postponed or canceled. In 2016, the housing market in Fort McMurray was being called a housing bust.

Exhibit 1. The Price of Oil, 1970–2015 (US$ per barrel)

Source: Annual average prices in U.S. dollars per barrel from BP Statistical Review of World Energy, 2015; 1970-73 is Brent Blend.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

6

3 A09-16-0002

Oil and Gas in the Global Economy Oil and gas play a vital role in the global economy. The International Energy Agency (IEA) predicts that energy demand will rise significantly over the next three decades, with most of the increase coming from developing countries. Most of the world’s growing energy needs through 2040 will continue to be met by oil, gas, and coal. With increased energy efficiency, energy as a percentage of total GDP has fallen and is expected to continue to fall.

Oil and Gas Supply All countries are consumers of products derived from the oil and gas industry, but only a small set of nations are major oil and gas producers. Over the past decades, the large developed economies of the world have become net importers of oil and gas, giving rise to challenging geopolitical issues involving a diverse set of oil consumers and producers. Exhibit 2 shows the major oil- and gas-producing nations. The impact of unconventional tech- nologies can be seen in the significant increases in U.S. and Canada production. From 2000 to 2014, Canadian oil sands production more than tripled, from about 600,000 b/d to over 2.2 MM b/d. The United Kingdom is a notable absence from the list of top oil producers, having dropped from 2 MM b/d in 2004 to less than 900,000 b/d in 2014.

Industry Financial Performance The oil and gas industry has been regularly criticized by politicians and the media for its high profits. In the U.S., proposals for industry excess profits taxes are common during high price cycles, prompting Lee Raymond, former ExxonMobil CEO, to comment in 2005, “I can’t remember any of these people seven years ago, when the price was $10 a barrel, coming forward and saying, ‘Are you guys going to have enough money to be able to continue to invest in this business?’ I don’t recall my phone ringing and anybody asking me that question.”3

The oil and gas industry is highly cyclical and the cycles can last many years. In the 1990s, crude oil prices stayed low, and for the first 14 years in the new millennium, prices steadily rose (except for a brief dip in 2009). In 2014, oil prices fell significantly and continued downward in 2015. Many independent exploration and production (E&P) firms found themselves in financial distress.

Exhibit 2. Major Oil- and Gas-Producing Nations

Oil-Producing Nations Gas-Producing Nations

Country Production

Million bpd 2014 Change

Over 2013 Country Production

Billion Cubic Meters, 2014 Change

Over 2013 United States 11.6 5.9% United States 728 6.1% Saudi Arabia 11.5 .9% Russia 579 -4.3% Russia 10.8 .6% Qatar 177 5.2% Canada 4.3 7.9% Iran 173 3.8% China 4.2 .7% Canada 160 3.8% United Arab Emirates 3.7 .9% China 134 7.7% Iran 3.6 2.0% Norway 108 .1% Kuwait 3.1 -.5% Saudi Arabia 108 8.2% Iraq 3.3 4.6% Algeria 83 2.2% Mexico 2.8 -3.3% Indonesia 73 1.7% Venezuela 2.7 1.1% Turkmenistan 69 11.1% Nigeria 2.4 2.5% Malaysia 66 -1.2% Brazil 2.3 11.2% United Arab Emirates 58 5.8% Qatar 2.0 -.9% Mexico 58 -.2% Norway 1.9 2.9% Uzbekistan 57 .7% Angola 1.7 -4.9% Netherlands 55 -18.7% Kazakhstan 1.7 -1.2% Australia 55 3.6% Algeria 1.5 1.8% Egypt 48 -13.1% Colombia 1.0 -1.4% Thailand 42 .8% Oman .9 .3% Pakistan 42 -1.6% World Total 88.7 World Total 3460 Source: BP Statistical Review of World Energy 2015.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

7

4 A09-16-0002

Although the oil industry is highly profitable in some years, its long-term profitability is not much higher than average profitability across many industries. As evidence, some years ago Fortune reported that the oil industry ranked 30th out of 36 industries in return to investors over the 1985-95 period, 34th out of 36 U.S. industries in return on equity in 1995, and 32nd in return on sales.4 In the U.S., the oil and gas industry has earned return on sales (net income divided by revenue) of about 8%, compared to an average of about 6% for all U.S. manufacturing, mining, and wholesale trade corporations.

The Role of OPEC The oil and gas industry has seen a remarkable bevy of government regulations and interventions over the past century, from heavy taxation of petrol in Europe to U.S. price controls on domestic production in the 1970s. The creation of the Organization of the Petroleum Exporting Countries (OPEC) represents government intervention on a global scale. OPEC was founded in 1960 with the objective of shifting bargaining power to the producing countries and away from the large oil companies. In 2006, Angola became the 12th member of OPEC.

OPEC’s mission is “to coordinate and unify the petroleum policies of Member Countries and ensure the stabilization of oil prices in order to secure an efficient, economic, and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital to those investing in the petroleum industry.”5 Despite being a cartel, OPEC’s ability to control prices is questionable. Surging oil prices in the 1980s resulted in energy conservation and increased exploration outside OPEC. Maintaining discipline among OPEC members has been a major problem (as is typical in all cartels). Massive cheating was blamed for the oil price crash of 1986, and in the 1990s Venezuela was considered one of the bigger OPEC cheats in regularly producing more than its quota.

Exhibit 3 shows OPEC production and crude oil prices. Although OPEC in the past was instrumental in sending periodic shocks to the system, by 2016 it appeared that OPEC’s influence was waning.

Exhibit 3. OPEC Production and Crude Oil Prices

Source: BP Statistical Review of World Energy, 2015. Data are annual average.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

8

5 A09-16-0002

The Resource Curse The resource curse is a paradox of the oil and gas industry. Despite high resource prices, the living standards in many oil-producing countries are low because of the inability of countries rich in natural resources to use that wealth to strengthen their economies. Counter-intuitively, many of these countries also have lower economic growth than countries lacking an abundance of natural resources.6 When times are good and oil prices are high, oil-rich countries may prosper. When oil prices fall, as they inevitably do, an overreliance on the oil sector can leave a country in a perilous situation. For example, Russia’s GDP fell by 4% in 2015, inflation increased, and the country was running a sizeable budget deficit. Moreover, the oil industries of the petroleum-nationalistic countries often suffer from a lack of investment and heavily subsidized domestic petroleum products. As another example, Iran has huge oil reserves but the country’s upstream oil industry is in a shambles. Iran’s 2015 oil pro- duction, although up from a decade ago, was only about two-thirds of the level reached under the government of the former Shah of Iran in 1979. Although new refining capacity was added in recent years, Iran was still importing refined products to meet domestic needs. With Iranian sanctions ending, Iranian production could significantly increase in future years.

Mexico has declining production and significant imports of refined products. Until recently, the Mexican

constitution did not allow foreign direct investment in the oil and gas industry. After many years of under- investment and of Mexican governments using the oil industry as their primary source of revenue, the industry is in dire straits. Without major investment and new technology, Mexico’s oil production is poised to fall. For example, production at the Cantarell oil field, one of the largest fields in the world, fell from more than 2 million b/d in 2004 to about 340,000 b/d in 2014.

Major Industry Players and Competitors The organizations that dominate the global oil and gas industry have changed dramatically over time in who they are, what they do, and, of critical significance for the future of the industry, how they compete.

Integrated Oil Companies The term integrated oil companies (IOCs) refers to companies that operate in many industry segments from exploration to refining, marketing, and retail. In the early days of the industry, there was true vertical integra- tion in which producers refined most of their production and then marketed refined products through their company-owned retail outlets. In the modern industry, the IOCs operate in many segments, but the true vertical integration seen in the days of John D. Rockefeller is long gone. Somewhat confusingly, the term IOC can also refer to international oil company.

For many years, the largest IOCs (also known as oil majors) were the Seven Sisters, and included:

• Standard Oil of New Jersey (Esso), which later became Exxon and then merged with Mobil to create ExxonMobil

• Royal Dutch Shell • Anglo-Persian Oil Company, which became British Petroleum, then BP Amoco following a merger with

Amoco (which was formerly Standard Oil of Indiana). The company is now known as BP. • Standard Oil of New York (Socony) became Mobil, which merged with Exxon • Standard Oil of California (Socal) became Chevron • Gulf Oil, most of which became part of Chevron • Texaco, which merged with Chevron in 2001

Exhibit 4’s list of the largest oil and gas companies by stock market capitalization is evidence that the indus- try is dominated by a mix of global IOCs and national oil companies (NOCs). Based on market capitalization, the largest publicly traded (and in some cases, government-controlled) companies are a diverse and global set of firms such as Petrochina (China), Gazprom (Russia), Sinopec (China), Total (France), and Eni (Italy).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

9

6 A09-16-0002

The urge to get larger and more integrated can be seen in comments from the Oil and Natural Gas Cor- poration (ONGC) chairman. ONGC, an Indian state-controlled firm and primarily an upstream company, had made public its commitment to participate in the entire hydrocarbon value-chain. According to the former chairman of ONGC:

We have to be an integrated oil company. Every major global oil company is an integrated player. I’m not being arrogant, but oil and gas is big business where the big boys play. You can survive in this business only if you are integrated; otherwise, you will be out.7

Given the long product life cycles and the huge capital investment required in the oil industry, the large IOCs are often described as stodgy and conservative. Before its bankruptcy, Enron executives regularly derided the oil majors as dinosaurs that were too slow moving and that would eventually become extinct. The reality, of course, is very different. Oil majors like BP, ExxonMobil, and Shell and their predecessor companies have been around for more than a century. Through experience that is occasionally painful, the IOCs have learned how to deal with the enormous financial and political risks of the oil and gas industry. The IOCs take a long-term view and recognized that cycles and uncertainty are an inherent part of the industry. Lee Raymond, former ExxonMo- bil CEO, said: "We’re in a commodity [business]. We go through peaks and valleys but our business is to level out the peaks and valleys, so that over the cycle our shareholders see an adequate return on their investment."8

On the surface, the IOCs looked similar in terms of the activities they performed. All appear to be verti- cally integrated from exploration to distribution of refined products. However, there are fundamental cultural, organizational and financial differences among the firms. The IOCs used various organizational designs to deal with vertical integration. The IOCs had different portfolios of projects and business lines around the world and over the years developed different relationships with various governments and national oil companies.

Exhibit 4. Largest Oil and Gas Companies, 2015

Source: Financial Times Global 500 list, March 2015. PetroChina, Sinopec, and CNOOC are National Oil Companies with both publicly traded shares and government-owned shares. ENI is partially owned by the Italian government.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

10

7 A09-16-0002

Exhibit 5 provides one perspective on the origins and distinctive capabilities of a few major companies.

National Oil Companies One of the most important trends of the past few decades has been the growing importance of NOCs. Although BP, ExxonMobil, and Shell are among the largest publicly traded companies in the world, they do not rank in the top ten of the world’s largest oil and gas firms measured by oil and gas reserves. The largest firms based on reserves are, by a large margin, NOCs partially or wholly state-owned. The NOCs control about 90% of the world’s oil and gas and most new oil is expected to be found in their territories.

Viewed from a business perspective, the NOCs have a mixed reputation. The national oil company of Indonesia, Pertamina, was described a few years ago as a bloated and inefficient bureaucracy:

. . . [Pertamina] operated almost as sovereignty unto itself, ignoring transparent business practices, often acting independently of any ministry, and increasingly taking on the role of a cash cow for then-President Suharto and his cronies. During the 32-year tenure of President Suharto, Pertamina awarded 159 contracts to companies linked to his family and cronies. These contracts were awarded without formal bidding or negotiation processes….Indonesian petroleum law dictated that every aspect of operation in the country was subject to approval by Pertamina’s foreign contractor man- agement body, Bppka. Dealing with the incomprehensible Bppka bureaucracy on simple matters, such as acquiring work permits for expatriate personnel, can take hours of filling in applications and months of waiting.9

Venezuela nationalized its oil industry in the 1970s and created Petróleos de Venezuela (PDVSA). PDVSA developed a reputation for professionalism and competence and was relatively free from the corruption and cronyism that pervaded, and continues to pervade, so many of the NOCs.10 By 1998, 36 foreign oil firms were operating in Venezuela, and PDVSA had ambitious expansion plans. In 1999, Hugo Chávez became president and almost immediately began to question the management and autonomy of PDVSA. After a bitter strike in 2002, PDVSA lost about two-thirds of its managerial and technical staff. From a peak of 2.9 million b/d in 1998, output was 2.7 million b/d in 2014 and the company imported a significant amount of motor fuel. As a company, PDVSA is indistinguishable from the government. Its top officials are appointed from the govern- ment. The company is required to spend much of its investment budget on social programs. Company hiring policy is based on social and political goals; e.g., candidates from larger families are given priority. In 2006, the Venezuelan Congress approved new guidelines to turn 32 privately run oil fields over to state-controlled joint ventures. ExxonMobil, alone among the foreign oil companies, rejected the new joint venture agreements and sold its stake in the 15,000 b/d Quiamare-La Ceiba field to its partner, Repsol YPF. ExxonMobil subsequently filed an arbitration claim.

According to many analysts, nationalization has failed to live up to expectations almost everywhere. NOCs often suffer from excessive and misguided government intervention. Many NOCs operated as the de facto trea- sury for the country. In Nigeria, for example, the oil industry contributed about 75% of the government’s total revenue and about 90% of export revenue. It is estimated that hundreds of billions from the oil industry have

Exhibit 5. Distinctive Capabilities as a Consequence of Childhood Experiences: The Oil Majors

Company Distinctive Capability Historical Origin Exxon Financial management Exxon’s predecessor, Standard Oil (NJ), was the holding

company for Rockefeller’s Standard Oil Trust

Royal Dutch/Shell Group Coordinating a decentralized global network of 200+ operating companies

Shell Transport & Trading headquartered in London and founded to sell Russian oil in China and the Far East

BP “Elephant hunting” Discovered huge Persian reserves; went on to find the Forties field (North Sea) and Prudhoe Bay (Alaska)

Eni Deal-making in politicized environments

The Enrico Mattei legacy; the challenge of managing government relations in post-war Italy

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

11

8 A09-16-0002

been stolen or misused since 1960. Some of the Middle Eastern NOCs are required to hire large numbers of locals, leaving them heavily overstaffed. PDVSA and all of the Gulf country NOCs must sell their products at hugely subsidized prices. Underinvestment in the downstream is a chronic problem for many NOCs, resulting in countries like Indonesia and Iran, with huge reserves, having to import petroleum products. Monopoly positions held by many NOCs contribute to underinvestment. In Russia, Gazprom controls the pipeline network, making it difficult for other Russian gas producers to expand their production. Russia also uses its NOCs as agents of foreign policy. Disputes between Russia and its neighbors Belarus and Ukraine have resulted in disruption of oil and gas shipments to Western Europe.

Some NOCs are well-run and profitable enterprises. Statoil of Norway is considered among the best of the NOCs. The NOCs of Brazil and Malaysia are viewed as reasonably well-run companies. Petrobras has developed leading technology in deepwater drilling and, until its 2014 corruption scandal, had a market capitalization rivaling that of the IOCs.

The role that NOCs will play in the future is not clear. Some analysts see NOCs as inefficient and corrupt arms of government that will never compete in a true economic sense. Other analysts raise different issues, sug- gesting that the NOCs are in a period of transition and will become competitive forces to be reckoned with. Regardless of what happens, the NOCs and their sovereign owners control most of the world’s oil and gas reserves. As Paolo Scaroni, the chairman of ENI, the Italian IOC, commented:

Big Western oil firms are like addicts in denial. The oil giants are trying to do business as usual as if nothing was wrong. Yet they are, in fact, having trouble laying their hands on their own basic product. State-owned national or state-controlled oil companies are sitting on as much as 90% of the world’s oil and gas and are restricting outsiders’ access to it. Worse, the best NOCs are beginning to expand beyond their own frontiers and to compete with the oil majors for control over the remaining 10% of resources. The first step in overcoming this predicament is admitting that it is a problem.11

Independents Independents are the non-government-owned companies that focus on either the upstream or the downstream. Many of these companies are sizable players and rank in the top 50 of all non-government-owned oil and gas companies. Among the largest E&P independents are U.S. firms such as Occidental, CononcoPhilips, Anadarko, and Woodside of Australia.

In the downstream sector, the largest independents are scattered around the world’s largest energy-consuming countries. The downstream independents include Phillips66 and Valero in the United States and Neste and Tamoil in Europe. Some downstream independents are involved in multiple businesses such as refining, pipelines, and retail distribution, and others in only one core business area. The downstream independents tend to have lower market capitalizations than the upstream independents.

Other Firms In addition to the IOCs, NOCs, and independents, the oil and gas industry includes a huge number of other firms that perform important functions. The oilfield services firms, the three largest of which are Schlumberger (105,000 employees), Halliburton (65,000 employees), and Baker Hughes (46,000 employees), play a critical role throughout the exploration, development, and production phases. These firms provide both products and services that, according to Baker Hughes’ website, help oil and gas producers “find, develop, produce, and man- age oil and gas reservoirs.” Because the oilfield service firms do not seek ownership rights to oil and gas reserves, their role could become increasingly important in the future as partners to the NOCs. Exhibit 6 shows the vast range of activities performed by oilfield services firms.

Thousands of other firms provide a vast array of services and products for the industry. For example, gas utilities such as Gaz de France and Tokyo Gas are major customers for gas producers. Pipeline companies distribute gas, crude oil, and petroleum products. The firms involved in drilling and seismic services provide drilling rigs and expertise for onshore and offshore wells.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

12

9 A09-16-0002

The Oil And Gas Industry Value Chain In every industry, there are various activities that transform inputs of raw materials, knowledge, labor, and capi- tal into end products purchased by customers. A value chain helps identify the independent and economically viable segments of an industry.12 Value refers to what customers are willing to pay for, so the value chain helps identify specific activities that create value throughout the chain. Companies can use value chains to determine where they are strong and where they have limited competitive strength. All industries have upstream (close to raw materials and basic inputs) and downstream (close to the customer) segments. The oil and gas industry value chain is shown in Exhibit 7. In the oil and gas industry, the terms upstream, midstream, and downstream are important descriptors of industry activities.

Upstream: Exploration, Development, and Production Upstream activities include exploration, development, and production. In simple terms, after a lease is obtained, oil and gas are discovered during exploration; the discovery requires development; and production is the long- term process of drilling and extracting oil and gas. Since exploration and development must take place where resources are located and most oil ownership regimes are based on state sovereignty, companies have to deal with complex government policies and regulations. Most countries grant oil and gas development rights to private companies through a process of either negotiation or bidding. The main aim of the private company is profit maximization, whereas the host country government is usually interested in maximizing revenue. Not surpris- ingly, these two aims often conflict.

The method used to bid for, grant, and then renew or extend oil and gas rights varies from country to country. Once the rights to explore are acquired, a well is drilled. A financial analysis is a determining factor in the classification of a well as an oil well, natural gas well, or dry hole. If the well can produce enough oil or gas to cover the cost of completion and production, it will be put into production. Otherwise, it is classified as a dry hole, even if oil or gas is found. The percentage of wells completed is used as a measure of success. Immediately after World War II, 65% of the wells drilled were completed as oil or gas wells. This percentage declined to about 57% by the end of the 1960s. It then rose steadily during the 1970s to reach 70% at the end of that decade,

Exhibit 6. Oilfield Services Firms

Source: The Norwegian Oilfield Services Analysis 2014, EYGM Limited.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

13

10 A09-16-0002

primarily because of the rise in oil prices. This was followed by a plateau or modest decline through most of the 1980s. Beginning in 1990, completion rates increased significantly. The increases of recent years have more to do with new technology than higher prices.13

Most upstream projects are done in some type of partnership structure. For example, a production sharing agreement for the Azeri, Chirag, and Gunashli development in Azerbaijan was signed in September 1994. BP was the operator with a 34.1% stake; the partners were Chevron with 10.3%, Socar 10%, Inpex 10%, StatoilHydro 8.56%, ExxonMobil 8%, TPAO 6.8%, Devon 5.6%, Itochu 3.9%, and Hess 2.7%.

Reservoir Management For companies involved in the upstream, reservoir management is an essential skill. Reservoir management involves ensuring that reserves are replaced and that existing oil and gas fields are efficiently managed. Asset acquisition, divestiture, and partnering are key aspects of reservoir management. Upstream companies try to replace more than 100% of the oil and gas produced. Determining the level of proved reserves (the amount of oil and gas the firm is reasonably certain to recover under existing economic and operating conditions) is a complex process. Consider the following comment on the auditing of reserves:

Though the word “audit” is customarily used for these evaluations, oil and gas reserves cannot be “audited” in the conventional sense of a warehouse inventory or a company’s cash balances. Rather, “proved reserves” are an approximation about formations thousands and even tens of thousands of feet below ground. Their size, shape, content, and production potential are estimated in a complex combination of direct evidence and expert interpretation from a variety of scientific disciplines and methodologies. Added to the science is economics; if it costs more to produce oil from a reservoir than one can sell it for profitably, then one cannot “book it” as a reserve. Reserves are “proved” if there is a 90% chance that ultimate recovery will exceed that level. As perverse as it may sound, under the “production sharing agreements” that are common in many oil-producing countries, when the price goes up, proved reserves go down.14

Exhibit 7. Global Oil and Gas Value Chain

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

14

11 A09-16-0002

Matthew Simmons, founder of the energy-focused investment bank Simmons and Company, commented that “95% of world’s ‘proven reserves’ are in-house guesses,” “most reserve appreciation is exaggerated,” and “95% of the world’s ‘proven reserves’ are unaudited.”15 The pressure to replace reserves has on occasion resulted in some unintended behaviors. In 2004, Shell’s CEO left earlier than anticipated after revelations that the company had overstated its reserves by nearly 25%.

Upstream Profitability The profitability of crude oil is a function of the market value for oil and the costs to extract and transport it to market. The most important cost determinant is the reservoir—where oil is found and how much there is. For example, onshore production in Saudi Arabia and Kuwait had the lowest breakeven price—about $20/bar- rel. For offshore Angola, the breakeven price for new projects was about $70/barrel. New oil sands projects in Alberta had breakeven prices of between $70 and $90/barrel depending on the technology used. For U.S., shale oil breakeven prices depended on the field location. Some analysts were predicting that future production costs for U.S. shale oil could get as low as $5–$20/barrel as technological advances continued.

Production costs change over time. Technological advances continue to drive down costs, especially for deepwater and unconventional oil. The economic cycle also impacts costs. Costs for labor, energy, and materials rise and fall through the cycles. For example, it was estimated that operating costs in the Alberta oil sands fell about 20% in 2014 as the industry went through a down cycle in oil prices.16

The term breakeven price was also used to understand the relationship between oil exporting nations and their fiscal management. In other words, what is the oil price that a country requires in order to match oil revenues to planned government expenditures—its fiscal breakeven price? Many oil-exporting nations have seen their fiscal breakeven prices rise significantly over the past decade as they increased spending on social and military programs. In 2016, the major oil-exporting nations of Africa and the Middle East were seeing huge budget surpluses swing to deficits in the low price environment.

Midstream: Trading and Transportation The midstream in the value chain comprises the activities of storing, trading, and transporting crude oil and natural gas. As shown in Exhibit 7, once oil and gas are in production, there is a divergence in the value chain. Crude oil that is produced must be sold and transported from the wellhead to a refinery. Natural gas must be moved to markets via pipeline or ship; we provide an overview of the gas business in a later section.

Crude oil has little or no value until it is refined into products such as gasoline and diesel. Thus, producers of crude oil must sell and transport their product to refineries. The market for crude oil involves many players, including refiners, speculators, commodities exchanges, shipping companies, IOCs, NOCs, independents, and OPEC. Market-making activities in the oil business have become front page news, and the daily price of crude oil is as frequently reported in the news as the weather.

The ease by which liquids can be transported is a key reason why crude oil has become such an important source of energy. Although pipelines, ships, and barges are the most common transportation platforms for crude oil, railroads and tank trucks are also used in some parts of the world. In recent years, railroads have made a resurgence in the United States and Canada because of the rapid growth in production of oil in North Dakota and Alberta and a shortage of pipeline capacity. The shipping industry is very fragmented and, because oil tankers travel for the most part in international waters, largely unregulated. New technologies in ship building in recent decades have allowed ships to become larger and safer.

Pipelines in Alaska, Chad, Russia, and other countries have allowed oil to be transported from very remote locations to markets. The construction and management of pipelines is fraught with geopolitical challenges, which means the pipeline development process takes many years or even decades. Pipelines that cross national borders are enormously complex to negotiate and build. Countries with pipelines that cross their territory have been known to use them as bargaining chips. Terrorists often sabotage pipelines and, in some countries, such as Nigeria and Iraq, oil theft from pipelines and the associated environmental and safety issues are daily occurrences.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

15

12 A09-16-0002

Downstream: Oil Refining and Marketing The refining of crude oil produces a variety of products, including gasoline, diesel fuel, jet fuel, home heating oil, and chemical feedstock. In the U.S., about 60% of refinery product volume is gasoline. Refined products are sold directly to end users through retail locations, directly to large users, such as utilities and commercial customers, and through wholesale networks. Exhibit 8 shows the world’s largest refining companies.

The financial performance of the refining sector has always been volatile. The primary measure of industry profitability is the refining margin, which is the difference between the price of crude oil and refined products. Crude prices fluctuate for many reasons. Weather in the Gulf Coast states, political instability in oil-producing countries, or economic growth reports from China can all impact the price of crude oil. These fluctuations are not always accompanied by matching changes in the price of finished products, leading to large expansions or contractions in the refining margin.

Refiners also get squeezed between the commodity markets for crude oil (crude is the largest cost to a refiner) and commodity markets for refined products like gasoline. According to the New York Mercantile Exchange:

A petroleum refiner, like most manufacturers, is caught between two markets: the raw materials he needs to purchase, and the finished products he offers for sale. The prices of crude oil and its principal refined products, heating oil and unleaded gasoline, are often independently subject to variables of supply, demand, production economics, environmental regulations, and other factors. As such, refin- ers and non-integrated marketers can be at enormous risk when the prices of crude oil rise while the prices of the finished products remain static, or even decline. Such a situation can severely narrow the crack spread, the margin a refiner realizes when he procures crude oil while simultaneously sell- ing the products into an increasingly competitive market. Because refiners are on both sides of the market at once, their exposure to market risk can be greater than that incurred by companies who simply sell crude oil at the wellhead, or sell products to the wholesale and retail markets.17

Exhibit 8. Largest Refiners

Source: Company data; Energy Information Agency; Saudi Aramco adjusted for joint ventures.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

16

13 A09-16-0002

Profits on refining are usually lower than profits in other lines of business for oil and gas companies. Shell’s head of downstream operations described the business as, “Grubbing [i.e., begging] for pennies in a street… If this industry, and especially the downstream, were to let its cost base slip, then we’re going to have difficulty getting through those down-low cycles.”18 The refining sector typically does well during a period of falling oil prices, then flattens out and starts declining in profit as oil prices stop falling or start rising.

The profitability of refining is driven primarily by the following factors:

• The costs of crude oil and energy to run the refinery. • The supply and demand for refinery products (i.e., if refining capacity is tight, refining margins usually

rise). • Refinery product prices, which are set by a combination of the supply and demand of refinery products

and crude oil prices. • Refinery location. • Company technology and operational skills.

After a so-called golden age of refining from 2002 to about 2006, refining entered a new and more uncertain age. Many U.S. and European refineries were either shut down or on the verge of closure. A report by ATKear- ney concluded that by 2021, every refinery in Western Europe and North America would have to restructure, strategically reposition their assets, or leave the market.19 Interestingly, despite the closure of various refineries in North America, total refining capacity continued to rise through debottlenecking and expansions to existing sites.

Although no new greenfield refineries have been built in the United States for many decades, in Asia, Eastern Europe, and the Middle East, aggressive expansion of refining capacity was the story. In 2009, Reliance Industries completed the world’s largest refinery complex at Jamnagar in India. The Jamnagar complex has a capacity of 1.24 million b/d. In the near term, Jamnagar is expected to focus on export markets. The largest market for Jamnagar is in the Middle East followed by Africa, Europe, and the United States. Shipping costs are only pennies per gallon for finished products, even from India to the United States.

In thinking about the future of refining, various questions can be identified:

1. In 2011, the United States became a net exporter of refined products for the first time since 1949. Will this continue?

2, How will U.S. exports of crude oil impact refining margins? 3. Will the demand for electric and hybrid cars have a major impact on refined product demand? 4. Where is global biofuel (mainly ethanol) demand going? 5. How much refining capacity will open or close in Europe, Japan, and the United States? 6. Will natural gas gain more traction as a transportation fuel? 7. Will there be more integration between refining and petrochemicals assets for the large NOCs?

Finally, there is no best competitive model in refining. In North America and Western Europe, the oil majors were divesting or closing refineries. ConocoPhillips and Marathon split into upstream and downstream compa- nies. In contrast, Petrobras, one of the largest integrated NOCs, was expanding refining capacity. Middle East NOCs were also increasing refining capacity. Russian upstream firms were looking to acquire downstream assets.

Transportation Fuels Retailing In the transportation fuels retail sector, competition is intense and margins have eroded over the past few decades. The entry of hypermarkets, supermarkets, and petropreneurs into retail sales in Western Europe and other markets displaced small dealer networks, and national players found they could make good money from convenience store sales.

In most countries, transportation fuel was seen as a commodity product, which meant spending money on brand development had questionable results. The weakness of brands favored the entry of supermarkets because they compete on price and proximity and can sell fuel as a loss leader. With traditional retail barriers to

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

17

14 A09-16-0002

competition gone, the majors had sold most of their company-owned service stations in countries around the world. The buyers were a mix of convenience store specialists, such as Couche-Tard of Canada (about 15,000 fuel stores around the world), franchisers, distributors, and independent dealers.

Natural Gas In recent years, natural gas has played a much more important role in the global energy mix. Two factors help explain the increased importance of gas. The first is the continued growth in liquefied natural gas (LNG) supply. For many years, natural gas was a niche product because, unlike crude oil, natural gas is not easily transported. Without a pipeline infrastructure, natural gas in its gas form cannot be transported far from its source. In some parts of the world, such as Western and Central Europe and North America, a network of pipelines allows gas to be produced and distributed efficiently. In the U.S., gas pipeline companies operated more than 285,000 miles of pipe. In other parts of the world, such as offshore Africa or Qatar, pipelines to a large customer base are not feasible. To transport stranded gas, it must be converted to LNG. To liquefy natural gas, impurities such as water, carbon dioxide, sulfur, and some of the heavier hydrocarbons are removed. The gas is then cooled to about -259 degrees F (-162 degrees C) at atmospheric pressure to condense the gas to liquid form. LNG is transported by specially designed cryogenic sea vessels and road tankers.

Historically, the costs of LNG treatment and transportation were so huge that development of gas reserves was slow. In recent years, LNG has moved from being a niche product to a vital part of the global energy busi- ness. As more players take part in investment, both in upstream and downstream, and as new technologies are adopted, the prices for construction of LNG plants, receiving terminals, and ships have fallen, making LNG a more competitive energy source. LNG ships are also getting much larger and more efficient.

Major technological and structural changes continue to occur in the LNG business. The floating liquefied natural gas (FLNG) vessel is a technology that allows producers to commercialize offshore gas deposits with- out pipelines and onshore infrastructure. FLNGs create opportunities to commercialize gas fields that would otherwise be untouched. Another innovation is the floating natural gas liquefaction, regasification, and storage (FLRSU) vessel which moves the various industrial processes offshore and makes the equipment available for redeployment at the end of the resource life.

Changes in the LNG market and in LNG shipping increased flexibility for producers and consumers, and shorter contracts were being negotiated. The agreement to develop the huge Qatargas 2 project, jointly owned by ExxonMobil and Qatar Petroleum, was finalized without contracts for gas sales in place. An LNG ship can deliver its gas anywhere there is an LNG terminal, making LNG almost as flexible in delivery as crude oil. There is also speculation that the rapid growth in Middle East LNG supply could lead to a global convergence in gas pricing and markets, with LNG becoming a traded commodity. As well, buyers and sellers have been taking on new roles. Buyers have been investing in the upstream, including liquefaction plants (e.g., Tokyo Gas and the Tokyo Electric Power Company invested in the Darwin liquefaction plant in Australia). Producers, such as BP and Shell, have leased capacity at terminals and are extending their role into trading. New buyers have been emerging, including independent power producers.

The second factor that helps to explain the increased importance of gas is shale gas. The impact of shale gas on U.S. and global gas markets has resulted in a game changer for U.S. energy supply. As recently as 2003, the consensus was that the United States would have to import large quantities of LNG to satisfy gas demand. A decade later, U.S. production easily met domestic gas demand and several dormant LNG import terminals were being converted to LNG export facilities. Although the rest of the world has lagged behind the U.S. shale gas experience, many other countries have the potential to develop shale gas resources. According to the U.S. Energy Information Administration, a number of countries such as France, Poland, Turkey, Ukraine, South Africa, Morocco, and Chile could significantly reduce gas imports if they develop their shale gas resources.

Petrochemicals Petrochemicals are the farthest downstream activity in the value chain. Although all of the major IOCs were involved in chemicals to some degree, they have different strategic approaches. Exhibit 9 shows the world’s larg- est chemical companies. ExxonMobil Chemical, one of the world’s largest chemical businesses, produced both

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

18

15 A09-16-0002

cyclical commodity type products, such as olefins and polyethylene, as well as a range of less cyclical specialty businesses. Many of ExxonMobil’s refineries and chemical plants were co-located, providing opportunities for shared knowledge and support services and the creation of product-based synergies. In the past, BP and Shell had chemical businesses that were among the largest in the world.20 In 2005, BP decided that its chemical business was non-core and divested the majority of the business. BP’s remaining chemicals businesses became part of the refining and marketing division and were no longer considered a separate corporate division. Shell also down- sized its chemicals business. The rising players in chemicals in the Middle East and Asia include state-controlled companies, such as Sabic (Saudi Arabia) and ChemChina, and non-state companies, such as Reliance (India).

The commodity side of the petrochemical sector is capital-intensive and deeply cyclical. Margins and profitability for commodity chemicals depend on scale, capacity utilization, operating cost discipline, and access to low-cost feedstock. Specialty chemicals, at the other end of the spectrum, are sold on the basis of their performance in customer applications, not chemical composition. Patented products or technologies can enhance the value of specialty chemicals. Product differentiation may be the result of proprietary technologies such as unique catalysts or chemical processes, and it can also be the result of brand names, marketing, customer service, and delivery.

Evolution of the Industry

Innovation and Technology Innovation plays a key role across the oil and gas value chain. Innovations in areas such as deepwater drilling and LNG shipping were discussed earlier. In the upstream, many important technologies have been developed in the past few decades, including increased use of 3-D seismic data to reduce drilling risk and directional and horizontal drilling to improve production in reservoirs.21 Innovations in financial instruments were used to limit exposure to resource price movements. In oilfield management, wireless technologies allowed for faster and cheaper commu- nication than the traditional wired underground infrastructure. In refining, nanotechnology has enabled refiners to tailor refining catalysts to accelerate reactions, increase product volumes, and remove impurities, which has led to increased refining capacity. In retailing, innovations such as unmanned stations have reduced retail costs.

Exhibit 9. Largest Chemical Companies

Company 2014 Sales $M 2014 Operating Profit $M Basf 90,011 9,235 Sinopec 68,875 -351 Dow Chemical 58,167 5,265 ExxonMobila 56,393 5,705 SABIC 50,122 10,114 LyondellBasell Industries 45,608 5,736 DuPont 34,723 4,991 Mitsubishi Chemicalb 30,478 1,381 INEOS 27,003 - Bayer 26,962 2,331 Shell a 24,607 - Total a 24,600 - LG Chem 20,675 1,200 Linde Group 20,644 2,283 Sumitomo Chemicalb 19,812 1,062 Air Liquide 18,599 3,209 PTT Global Chemical 17,443 428 Braskem 17,320 1,343 AkzoNobel 17,313 1,195 Torayb 16,791 1,029 a Chemical figures only b Financial year-end 31 March 2015

Source: “Special Report, ICIS Top 100 Chemical Companies,” ICIS Chemical Business, September 2015.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

19

16 A09-16-0002

Mergers and Acquisitions Mergers and acquisitions have been an important element in the oil and gas industry since its inception. Although the mega-mergers, such as BP-Amoco, Total-PetroFina, Chevron-Texaco, and Exxon-Mobil, receive much of the press, there have also been many smaller deals. In recent years, NOCs have done many acquisitions to gain access to resources and to new technology. Private equity-backed acquisitions and start-ups have become more prevalent.

In looking at the mega-mergers over the past few decades, one might conclude that eventually there will only be a handful of oil companies in the world. The reality is different. Research shows that the oil industry is much less concentrated today than it was 50 years ago.22 There are opportunities for new entrants despite the huge size of the largest IOCs and NOCs. In the downstream, new entrants have had a significant impact on industry structure. In chemicals, Ineos, the privately held British company, grew through a series of related acquisitions to become one of the world’s largest chemical companies. In the upstream, the huge financial scale of projects such as Gorgon, Kashagan, or Sakhalin I and II make it unlikely that a new entrant could challenge the majors in the largest and most technological projects. However, if NOCs in China, India, and the Gulf continue to acquire and grow, they may develop the technological and financial skills to compete for large complex upstream projects.

China and India In 1998, China became a net importer of oil for the first time. In 2013, China overtook the United States to become the world’s largest importer. By 2030, China will likely be importing about 80% of its oil. Clearly, China and Chinese companies are going to be major players in the oil and gas industry. Thousands of Chinese gas stations are being built, and Chinese companies are aggressively investing in upstream projects around the world. Unlike the U.S. and Europe, China has no qualms about allowing its oil companies to invest in countries like Sudan and Iran. Chinese companies have also been actively buying assets outside China, including the $15 billion purchase of the Canadian company, Nexen. These acquisitions have met varying success.

India is also a force to be reckoned with in the global oil and gas industry. India, the fifth largest oil con- sumer, needs energy to feed its rapidly growing and industrializing economy. Companies such as Reliance are moving aggressively into the upstream, and stodgy state-owned companies such as ONGC, Oil India Limited, and Gas Authority of India are slowly becoming more productive. Like China, India is far from self-sufficient in energy and must find new energy sources.

Unconventional Oil and Gas Growth in unconventional oil and gas production has had a profound impact on the world’s energy supply. In fact, what is currently called unconventional will likely lose that label in the coming years. Unconventional gas, mainly shale gas, coal bed methane and tight gas (gas locked in impermeable hard rock) will constitute the majority of the growth in natural gas production over the next few decades. The production of unconventional oil, primarily the crude produced from oil sands and shale, will also grow substantially. The exploitation of un- conventional resources is the result of technologies such as hydraulic fracturing and horizontal drilling, as well as the entrepreneurial initiatives of industry participants doing what has been done for more than a hundred years—searching for innovative ways to economically create value from scarce resources.

Industry Substitutes and Alternative Fuels Various factors have contributed to a large investment flow into alternative fuel projects, including the rapid rise in oil and gas prices in recent years, concerns about global climate change, perceived competitive opportunities by energy companies (new entrants and entrenched players), and government subsidies. Despite these invest- ments and the often strong public support for them, hydrocarbons will continue to be the world’s primary energy source for years to come. Renewables will make up only about 8% of global energy by 2035.23

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

20

17 A09-16-0002

What’s Next for the Global Oil Industry? A few predictions seem fairly safe: the global demand for oil and gas will continue to rise over the next few de- cades; NOCs will continue to expand beyond their home markets; finding new conventional sources of oil and gas will get harder and require innovative new technologies; unconventional oil and gas production will grow substantially; investment in non-hydrocarbon energy sources will continue; the oil and gas industry will remain one of the most vital for the global economy; and the industry will continue to go through up-and-down cycles. Finally, oil and gas firms, and especially the majors, will continue to do what they have done for more than a century: take a long-term view, invest for the future, push the boundaries of technology, and seek new resources and markets in every corner of the world.

Endnotes 1 Alfred D. Chandler, “The Enduring Logic of Industrial Success,” Harvard Business Review, 1990, March-April, 68 Issue 2, pp. 130-140. 2 Leonardo Maugeri, “Oil: Never Cry Wolf—Why the Petroleum Age Is Far from Over,” Science, 2004, 304, pp. 1114-1115. 3 Fox News, Transcript: ExxonMobil’s Lee Raymond, Monday, 2005, October 17, http://www.foxnews.com. 4 “The Fortune 500 Medians,” Fortune, 1996, April 29, pp. 23-25. 5 www.opec.org. 6 Richard Auty, “Sustaining Development in Mineral Economies: The Resource Curse,” Thesis, 1993, London: Routledge. 7 “We Have to Be An Integrated Oil Company,” Hindu Business Line, 2003, August 10, www.thehindubusinessline. 8 Fox News, Transcript. 9 “Indonesia Considers Legislation That Would End Pertamina’s 30-year Petroleum Monopoly,” Oil & Gas Journal, 1999, July 26, pp. 27-32. 10 “Special Report, National Oil Companies,” The Economist, 2006, August 12, pp. 55-57. 11 “Face Value: Thinking Small,” The Economist, 2006, July 22, p. 64. 12 The value chain concept was developed by Harvard Professor Michael Porter, and is the main theme of the book Competitive Advantage: Creating and Sustaining Superior Performance (Free Press, 1985). The concept was used by Porter to explain how firms created competitive advantage. Porter’s generic value chain included primary and support activities. Primary activities included: inbound logistics, operations (production), outbound logistics, marketing and sales (demand), and services (maintenance). Support activities included: administrative infrastructure management, human resource management, technology (R&D), and procurement. The extension of the firm value chain to the industry is logically consistent, especially in the oil and gas industry where the IOCs compete across most of the major industry segments. 13 “Oil Price History and Analysis, WTRG Economics,” http://www.wtrg.com/prices.htm. 14 Daniel Yergin, “How Much Oil Is Really Down There?” Wall Street Journal, 2006, April 27, p. A.18. 15 M. Simmons, Harvard Business School, Energy Symposium, October 24, 2006. 16 IHS Energy, “Oil Sands Cost and Competitiveness,” December 2015. 17 New York Mercantile Exchange, “Crack Spread Handbook,” 2000, p. 4. 18 Ed Crooks, “Interview: Rob Routs: You have to Keep Changing,” Financial Times, 2006, October 20, Special Report Energy, p. 10. 19 Refining 2021: Who Will Be in the Game? ATKearney, 2012. 20 Peter Partheymuller, “Chemicals,” Hoover’s, http://premium.hoovers.com. 21 WTRG Economics, http://www.wtrg.com/prices.htm. 22 Pankaj Ghemawat & Fariborz Ghadar, “The Dubious Logic of Global Megamergers,” Harvard Business Review; 2000, July-August, 78 Issue 4, pp. 65-72. 23 BP Energy Outlook 2035.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

21

3.

ROCK CENTER FOR CORPORATE GOVERNANCE

CASE: CG-17B DATE: 08/14/09

Professor David F. Larcker, Robert Lawson, and Brian Tayan prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The Rock Center for Corporate Governance is a joint initiative between the Stanford Graduate School of Business and the Stanford Law School. Copyright © 2009 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business.

ROYAL DUTCH/SHELL: A SHELL GAME WITH OIL RESERVES—

GOVERNANCE OVERHAUL AFTER SCANDAL (B)

We are determined to make Shell a different company, a more performance-orientated, more competitive and less complex one.1

—Jeroen van der Veer, Chief Executive Officer of Royal Dutch Shell

INTRODUCTION

The first six months of 2004 was a tumultuous period for the Royal Dutch/Shell Group of Companies. It began when the British-Dutch company was forced to downgrade its proved oil and gas reserves not once, but four times. The move signaled that the once conservative corporation had grown increasingly aggressive as it sought to maintain its competitive positioning among a rapidly consolidating industry. More embarrassing, however, was the revelation of internal battles and tense exchanges between its senior managing directors as they struggled to meet unrealistically high targets for reserves replacements and attempt to compensate for deficiencies that had begun years before. When these issues were brought to light, the chairman of the committee of managing directors, the head of exploration and production, and the group chief financial officer were all asked to resign. The company ultimately agreed to pay a record $151 million in fines to regulators in the United States and United Kingdom. However, all was not lost. Royal Dutch/Shell used this period to reinvent itself. Sir John Kerr, nonexecutive director, was appointed to lead a committee of senior officials from both Royal Dutch Petroleum and Shell Transport and Trading to review the group’s governance and organizational structure and recommend changes to rehabilitate its reputation for conservatism, 1 Mark Milner, “City Hails Shell Anglo-Dutch Merger,” The Guardian, October 29, 2004.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

23

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 2

accountability, and performance. To this end, Kerr engaged in detailed discussion with shareholders from around the world. When the changes were finally announced in October 2004, they were much more radical than many had expected. The company revealed that it would revamp all aspects of its business—from its century-old corporate structure, to its boards of directors and senior leadership team, business practices, internal controls, and compensation policies. The move was intended not only to redress the shortcomings of its recent past but to position the group for renewed growth going forward.

GOVERNANCE OVERHAUL

In March 2004, as the proved oil reserve scandal continued to unfold at Royal Dutch/Shell, the group announced the creation of a steering committee to undertake a comprehensive review of the company’s organizational structure and corporate governance. The committee was chaired by Sir John Kerr, nonexecutive director of Shell Transport and former diplomat with experience as representative to the European Union and ambassador to the United States. The committee included three other nonexecutive directors (one from Shell Transport and two from Royal Dutch) and Jeroen van der Veer, recently appointed chairman of the committee of managing directors. The steering committee was supported by a working group of Royal Dutch/Shell employees, lawyers and tax advisors from the U.K., the Netherlands, and the U.S., and by bankers from Citigroup and NM Rothschild. According to Kerr, the focus of the committee was not to examine “the entrails of the reserve crisis” but to consider “what would be best for the future of the company.”2 In doing so, the steering group was asked to consider three issues: “(i) how to simplify the boards and group management structures; (ii) how decision-making processes and accountability could be improved; and (iii) ways in which effective leadership for the group as a whole could be enhanced.”3 Kerr solicited input from a broad group of shareholders, eventually meeting with investors holding over 50 percent of the group’s common stock. In some cases, he met with the same investors multiple times. On October 8, 2004, the steering committee put two options before members of the Royal Dutch and Shell Transport boards: either maintain the existing dual company structure but consolidate the two boards into one, or unify the entire group into a single corporate entity. On October 28, the decision was made, and Royal Dutch/Shell announced a comprehensive restructuring which would completely overhaul the company’s governance system and impact all aspects of its operations.

Corporate Structure

The Royal Dutch/Shell Group of Companies was unified into a single corporate entity, Royal Dutch Shell plc. The two previous parent companies, Royal Dutch Petroleum and Shell Transport and Trading, became subsidiaries of Royal Dutch Shell. The new company was incorporated in the United Kingdom, with a headquarters and tax residence in the Netherlands.

2 Chris Redman, “Shell Rebuilds Itself,” Corporate Board Member, March/April 2005. 3 Royal Dutch/Shell press release, “Unification of Royal Dutch and Shell Transport,” October 28, 2004 http://www.unification.shell.com/shell_proposal/general/proposals/press2/ (June 1, 2009).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

24

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 3

Activities of the two central offices for Royal Dutch and Shell Transport were consolidated in The Hague (see Exhibit 1 for the new corporate and organizational structure).4 The shares of Royal Dutch and Shell Transport, which previously traded on the London, Amsterdam, and New York stock exchanges, were cancelled. The 1,500 priority shares in Royal Dutch with favorable voting rights and controlled by the Royal Dutch supervisory board were also cancelled. In place of all cancelled shares, two new share classes were instituted. Royal Dutch shareholders received Class A shares, with dividends sourced from the Netherlands, and Shell Transport shareholders received Class B shares, with dividends sourced from the U.K. Dividends on Class A shares were paid in euros, although shareholders could elect to receive them in pounds sterling. Dividends on Class B shares were paid in pounds sterling, with shareholders having the right to receive them in euros. The new dual-class system was implemented purely for tax purposes; otherwise the classes were identical in terms of economic interest and voting rights.5 Following the distribution of shares, former Dutch Petroleum shareholders maintained their 60 percent ownership of the new entity, with former Shell Transport shareholders owning the remaining 40 percent.6

Board of Directors and Senior Management

As a unified corporate entity, Royal Dutch Shell had a single board of directors comprising ten nonexecutive directors and five executive directors. Aad Jacobs, previously the chairman of the Royal Dutch supervisory board, became the company’s first nonexecutive chairman. According to the company, Jacobs would retain the position until his previously announced retirement in 2006, at which time “it is envisaged that he will be succeeded by an external appointee.”7 Sir John Kerr assumed the position of deputy chairman and senior independent nonexecutive director. In this role, Kerr’s first responsibility was to undertake a search for the Jacobs’ successor. Of the remaining eight nonexecutive directors, five were sourced from the former Royal Dutch supervisory board and three from the former Shell Transport board of directors.8 Former directors who were not appointed to the new Royal Dutch Shell board voluntarily resigned from their duties. Four of the newly appointed nonexecutive directors (in addition to Jacobs) were expected to retire in the coming years: two in 2007 and two in 2008. The company decided to stagger the replacement of nonexecutive directors over time rather than all at once in order to ensure continued expertise at the board level (see Exhibit 2 for the board of directors). Jeroen van der Veer became chief executive officer of Royal Dutch Shell. Reporting to van der Veer were Peter Voser, who assumed the new position of chief financial officer, and the heads of 4 Royal Dutch/Shell press release, “Unification of Royal Dutch and Shell Transport,” loc. cit. 5 Shares in Royal Dutch Shell would also trade on the New York Stock Exchange in the form of American depository receipts (ADRs). Dividends on the ADRs would be paid in U.S. dollars. 6 Royal Dutch/Shell press release, “Announcement of Final Proposal for the Recommended Unification of Royal Dutch and Shell Transport,” May 19, 2005, http://www.unification.shell.com/shell_proposal/stt/other/ (June 1, 2009). 7 Ibid. 8 As a result, the Royal Dutch Shell board would have six directors from Royal Dutch and four from Shell Transport, thus mirroring the 60/40 economic ownership interest by these two predecessor organizations.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

25

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 4

the company’s three business units: Malcolm Brinded, executive director of exploration and production, Linda Cook, executive director of gas and power, and Rob Routs, executive director of oil products and chemicals. This structure replaced the committee of managing directors, which was disbanded. According to van der Veer, “Saying farewell to the collegiate system will enable me to speed up strategic decision making.”9 Van der Veer also became chairman of a newly formed executive committee of the board of directors. This committee comprised himself and the four senior executives, Voser, Brinded, Cook, and Routs. The committee was “responsible for Royal Dutch Shell’s overall business and affairs and has final authority in all matters of management that are not within the duties and authorities of the board…. It implements all board resolutions and supervises all management levels in Royal Dutch Shell”10 (see Exhibit 3 for committees of the board).

Business Practices

Royal Dutch Shell also announced that it would revamp its internal management practices to improve leadership, increase accountability, and encourage teamwork. In a speech to executives, van der Veer asked whether the changes the company made to its matrix structure in the mid- 1990s had a detrimental effect on work processes and culture:

We should be mindful of the lessons of the “transformation” we embarked on in the mid-90s. This achieved some good changes—ROACE [return on average capital employed], costs, global processes and best practices. But did the mid-90s transformation bring desirable behaviors, or did it erode professionalism, corporate cohesion, enterprise-first thinking and loyalty?11

In addition, he noted that:

We have huge project overruns; we have had failures in our production forecasts; we have had the reserves issue. Many downstream assets do not have first quartile performance, but do we kid ourselves that we are first quartile people? And how do we know that the next large project proposal does not have too optimistic economic assumptions?

He blamed in part the decision made in the mid-1990s to relax standards for promotion and encourage a more fluid internal market: “Excessive job movement has created too many gifted amateurs in a world that needs more professionalism, commitment to performance, and discipline.” In order to remedy these shortcomings, van der Veer promised that the company would set more realistic and achievable targets, lengthen job tenures, and reduce reliance on external consultants. Such moves, he believed, would “make our performance more professional and disciplined.”12 9 Chris Redman, “Shell Rebuilds Itself,” loc. cit. 10 Royal Dutch Shell, 2005 Annual Report. 11 Cited in: “Shell’s Problems Go Deeper than Reserves, Chairman Warns Staff,” The Oil Daily, June 1, 2004. 12 Ibid.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

26

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 5

Also, the company would implement single lines of accountability within each division and for each project, further dismantling the company’s matrix structure. According to Brinded, “We simply cannot allow ambiguity as to who is accountable.”13

Internal Controls

In addition, Royal Dutch Shell announced a number of changes to its internal controls relating to proved reserve estimation. The changes included improved oversight by internal audit and the audit committee, and greater independence from potential influence by senior management. Importantly, members of the reserve audit team would no longer report to line management, but would report through channels directly leading to the audit committee. The changes, many of which were recommended by the Davis Polk & Wardwell report commissioned in response to the first reserves downgrade, were intended to reassure investors about the integrity of the company’s financial reporting (see Exhibit 4 for changes to internal controls).

Executive Compensation

Royal Dutch Shell also made changes to its executive compensation program to improve corporate performance. According to van der Veer:

The reserves issue was not caused by our scorecard or bonus system. Nevertheless, we need to consider whether our scorecards and pay system do drive desired behaviors. Scorecards and bonuses were designed to focus the energy of our people. Our remuneration per senior leader has gone up substantially over the past years. Has it brought better performance or a better culture to Shell?14

Van der Veer did not believe so. To that end, Royal Dutch Shell would no longer include reserves booking as part of bonus calculations. Furthermore, the company would discontinue the use of stock options and make long-term incentive awards conditional upon Royal Dutch Shell’s performance relative to that of its largest competitors (Exxon Mobil, BP, Total, and Chevron). The amended compensation policy was intended to better align management incentives with long-term shareholder returns and encourage appropriate behaviors (see Exhibit 5 for changes to the compensation policy).

SHAREHOLDER REACTION

Aad Jacobs described the governance changes made by Royal Dutch Shell as “an historic step forward.”15 Sir John Kerr stated that, “We surprised ourselves by going much further than we thought we would.” He explained that the proved reserves scandal had a “catalytic effect” on the company, adding that the governance changes “would have happened at some point, but the reserves issue precipitated it.” 16 Van der Veer believed that the new leadership model provided

13 Ian Bickerton et al., “Action Aims to Restore Reserves,” The Financial Times, January 19, 2005. 14 “Shell’s Problems Go Deeper Than Reserves, Chairman Warns Staff,” loc. cit. 15 Royal Dutch Shell press release, “Unification of Royal Dutch and Shell Transport,” loc. cit. 16 Chris Redman, “Shell Rebuilds Itself,” loc. cit.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

27

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 6

“more clarity, more simplicity, more efficiency, and more accountability” and allowed for “much more enabling decision making.”17 Investors too were supportive of the changes. According one investor, “This is more revolutionary than what was ever expected.” Another agreed: “The market had not expected these major steps. It anticipated more modest changes…. [The moves] signal the company has taken the appropriate steps to become more transparent and better equipped to deal with future challenges.”18 According to a third, “This new management structure should lead to better accountability for shareholders and should be the backdrop for more streamlined internal systems and improved performance.”19 In a sign of just how positive the market reaction was, Royal Dutch Shell announced the same day that it would downgrade its proved oil and gas reserves by an additional 900 million barrels. It was the fifth downgrade during 2004 and reduced proved reserves by an additional 6 percent. Nevertheless, the company’s share price increased on that day by 2.6 percent.20

SUBSEQUENT EVENTS

In June 2005, federal prosecutors in the U.S. announced that Shell would not face criminal charges for the oil reserves scandal. According to a U.S. district attorney, “Because Shell has cooperated fully with the government’s investigation, has implemented substantial remedial efforts to enhance its reserves reporting and compliance, and has paid a $120 million civil penalty to the [SEC], the public interest has been sufficiently vindicated.”21 In November 2005, the Financial Services Authority (FSA) announced that it would not take personal action against former executives Sir Philip Watts or Walter van de Vijver for their part in the oil reserves scandal. According to Watts’ lawyer, “This vindicates the position Sir Philip has maintained throughout: that he acted properly and in good faith at all times.”22 In April 2007, Royal Dutch Shell agreed to pay $352.6 million to settle a securities fraud lawsuit filed against the company by 50 institutional investors in the Netherlands, U.K., Germany, Sweden, Luxembourg, Denmark, Norway, and France. According to one shareholder, the settlement was “an important step in the process of drawing the Shell reserves misstatements issue to a close.”23

17 Chip Cummins, “Shell to Unify Parents in Broad Restructuring,” The Wall Street Journal, October 29, 2004. 18 Ian Bickerton and Kevin Morrison, “Revolutionary Move Draws Plaudits from Investors,” The Financial Times, October 29, 2004. 19 Mark Milner, “City Hails Shell Anglo-Dutch Merger,” loc. cit. 20 Chip Cummins, “Shell to Unify Parents in Broad Restructuring,” loc. cit. 21 Kara Scannell, “Shell Won't Face Criminal Charges in Reserves Probe,” The Wall Street Journal, June 30, 2005. 22 Thomas Catan and Barney Jopson, “FSA Drops Case over Shell Reserves Scandal,” The Financial Times, November 10, 2005. 23 Carola Hoyos, “Shell Pays Dollars 353m to Settle Reserves Lawsuits,” The Financial Times, April 12, 2007.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

28

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 7

Exhibit 1 Royal Dutch Shell: Corporate Structure

Royal Dutch/Shell Group Royal Dutch Shell plc (previous structure) (new structure)

Sources: Royal Dutch Petroleum Company, Summary Annual Report and Accounts 2003; Royal Dutch Shell, Annual Report 2005.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

29

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 8

Exhibit 1 (continued) Royal Dutch Shell: Organizational Structure

Royal Dutch/Shell Group (previous structure)

Royal Dutch Shell plc

(new structure)

Sources: Case writer depiction.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

30

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 9

Exhibit 2 Royal Dutch Shell: Board of Directors

Name Previous Co. Directorship Committee Chair

Aad Jacobs Royal Dutch Nonexecutive chairman Nomination and succession committee

Sir John Kerr Shell Transport Lead nonexecutive director

Jeroen van der Veer Royal Dutch Executive director (CEO) Executive committee

Peter Voser Shell Transport Executive director (CFO)

Malcolm Brinded Shell Transport Executive director

Linda Cook Royal Dutch Executive director

Rob Routs Royal Dutch Executive director

Maarten van den Bergh Royal Dutch Nonexecutive director

Sir Peter Burt Shell Transport Nonexecutive director

Mary (Nina) Henderson Shell Transport Nonexecutive director

Sir Peter Job Shell Transport Nonexecutive director

Wim Kok Royal Dutch Nonexecutive director Social responsibility committee

Jonkheer A. Loudon Royal Dutch Nonexecutive director Remuneration committee

Christine Morin-Postel Royal Dutch Nonexecutive director

Lawrence Ricciardi Royal Dutch Nonexecutive director Audit committee Source: Royal Dutch/Shell press release, “Announcement of Final Proposal for the Recommended Unification of Royal Dutch and Shell Transport,” loc. cit.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

31

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 10

Exhibit 3 Royal Dutch Shell: Committees of the Board

Executive Committee The executive committee comprises the chief executive, Jeroen van der Veer; the executive director of exploration & production, Malcolm Brinded; the executive director of gas & power, Linda Cook; the executive director of oil products and chemicals, Rob Routs; and the chief financial officer, Peter Voser. The executive committee is responsible for Royal Dutch Shell’s overall business and affairs and has final authority in all matters of management that are not within the duties and authorities of the board or of the annual general meeting of Royal Dutch Shell. It implements all board resolutions and supervises all management levels in Royal Dutch Shell. Audit Committee The audit committee is comprised of four financially literate members that have the necessary ability and experience to understand the financial statements. The key responsibilities of the audit committee are to assist the board in fulfilling its responsibilities in relation to internal control and financial reporting, to carry out certain oversight functions on behalf of the board and to monitor compliance with applicable external legal and regulatory requirements, the Shell general business principles and code of ethics. The audit committee is also responsible for the approval of all services to be provided by the external auditor, PricewaterhouseCoopers LLP and reviews and assesses management’s response to audit findings and recommendations and discusses the adequacy of the risk management and internal control system of Royal Dutch Shell with the auditors including any significant matters arising from the audits with, as appropriate, the chief internal auditor, management and the external auditors. The audit committee also monitors the qualifications, expertise, resources and independence of the internal and external auditors and assesses annually the performance and effectiveness of the auditors. Nomination and Succession Committee The nomination and succession committee keeps under review the leadership needs of Royal Dutch Shell and is responsible for identifying and nominating suitable candidates for the approval of the board to fill vacancies as and when they arise. It is also responsible for making recommendations on the appointment of the chairman of each of the audit committee, the remuneration committee and the social responsibility committee and, in consultation with the chairman of the relevant committee, the membership of those committees. It makes recommendations in respect of corporate governance guidelines for Royal Dutch Shell, monitors compliance with corporate governance requirements and makes recommendations in respect of disclosures relating to corporate governance and its appointment processes. Remuneration Committee (REMCO) REMCO determines and agrees with the board the remuneration policy and individual remuneration packages, including incentive and performance plans and pensions, for the chief executive and the executive directors. REMCO also considers and advises on the terms of any contract to be offered to a director. It also monitors the remuneration for other senior executives and makes recommendations as appropriate. Social Responsibility Committee The social responsibility committee reviews the policies and conduct of Royal Dutch Shell with respect to the Shell general business principles as well as the group’s health, safety and environment policy and other relevant group policies and standards. Source: Royal Dutch Shell, 2005 Annual Report. Edited for length.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

32

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 11

Exhibit 4 Royal Dutch Shell: Internal Controls

Remedial actions on reserves Shell recognises that restoring confidence and credibility in reserves reporting is vital. Shell is determined to resolve all these issues in the most timely and transparent manner possible and to eliminate chances of a recurrence. The following improved controls are either in place or in progress: The CMD [committee of managing directors] now reviews and signs off reported reserves annually.

Reserves auditors now report to group internal audit, outside the business line.

Reserves reporting within EP [exploration and production] now reports through the technical rather than

planning function. The global EP reserves committee is in place, with the approval process requiring peer challenge at a regional

level. Shell reserves reporting guidelines are being urgently revised to remove any ambiguity in the application of

SEC rules and guidance. Reserves auditing now reports through internal audit, which has direct access to the GAC [group audit

committee]. The frequency and depth of audit coverage will greatly increase, with major operating units covered each year.

Audit resource is being increased, and Shell will systematically and consistently involve external reserves

experts in our reserves auditing process. Proved reserves reporting is now specifically included in the existing group assurance process and disclosure

controls review. A major programme of focused training of relevant global EP staff is being initiated, to ensure that SEC rules,

guidance and compliance requirements are fully understood and adhered to throughout the organisation. Source: Royal Dutch/Shell press release, “The report to the Group Audit committee and the reserves recategorisation review,” April 19, 2004.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

33

Royal Dutch/Shell: A Shell Game with Oil Reserves—Governance Overhaul after Scandal (B) CG-17B

p. 12

Exhibit 5 Royal Dutch/Shell: Revised Compensation Policies

The Royal Dutch/Shell Group of Companies today announced the key recommendations of the Remuneration and Succession Review Committee (REMCO) review of remuneration policies for executive directors… Discontinue stock option grants; Enhance conditional awards under an amended Long Term Incentive Plan; and Amend the Deferred Bonus Plan, to introduce long-term performance conditions to the release of most of the

matching shares. In conducting this review, the committee consulted with shareholders and has taken account of current market practices and governance developments …. The proposed amendments would not lead to an increase in the overall value of compensation for executive directors…. Commenting on the review, Aarnout Loudon, chairman of the REMCO, said, “These proposals are designed to reward performance that enhances the value of the group, and we believe they will serve shareholders well.” Long-Term Incentive Plan (LTIP) Under the LTIP, performance shares are awarded conditionally once a year. The amended plan will allow for a conditional award of shares with a face value of zero to two-and-a-half times base pay. REMCO will review the actual number of shares awarded to executive directors each year to reflect competitive market practice. The performance period will be no less than three years. The number of shares received by executive directors at the end of the performance period will depend on the total shareholder return (TSR) performance of the group relative to our industry peers: 200% of an award will be released if the group is in first place; 150% for second place; 80% for third place. Awards will lapse entirely if the group is in fourth or fifth place.

An award will only be released in part in the case of median performance or above, and the maximum only released in the case of exceptional performance…. In reaching this judgment, it will consider the group scorecard results, excluding TSR, over the performance period, as the scorecard measures the group’s financial performance and operational excellence. Deferred Bonus Plan The amended plan will allow executive directors to invest up to 50% of their annual bonus in shares. Participation is currently on a voluntary basis, but from 2006, 25% of any annual bonus will be deferred on a mandatory basis. The deferred bonus shares, together with shares equivalent to the value of dividends payable on the deferred bonus shares (dividend shares) and matching shares, would be released three years after deferral. A participant will receive one matching share for every four deferred bonus and dividend shares accumulated. Provided that the performance condition is met, he or she will receive up to three further performance-based matching shares. The performance condition is the total shareholder return (TSR) of the group against the major integrated oil companies (Exxon, BP, Total and ChevronTexaco), as follows: TSR ranked 1st: three performance-based matching shares. TSR ranked 2nd: two performance-based matching shares; TSR ranked 3rd: one performance-based matching share; TSR ranked 4th or 5th: no performance-based matching shares.

Source: Royal Dutch Shell press release, “Shell proposes revised remuneration policies for Executive Directors,” March 17, 2005.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

34

4.

9 - 8 1 5 - 0 8 9 R E V : F E B R U A R Y 3 , 2 0 1 6

Senior Lecturer Shikhar Ghosh, Ali Huberlie (MBA 2015), and Teaching Fellow Christopher Payton prepared this case. It was reviewed and approved before publication by a company designate. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2015, 2016 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

S H I K H A R G H O S H

A L I H U B E R L I E

C H R I S T O P H E R P A Y T O N

CrossFit (A)

Greg Glassman, the Founder and CEO of CrossFit, arrived early at the San Jose CrossFit location on a Sunday morning in August 2012. He was hoping to address a number of his executives and affiliate owners before giving his scheduled remarks to participants in this week’s Level 1 Certificate course, which would have prospective affiliate owners performing a mix of exercises that would take most of them well outside of their comfort zone.

Glassman’s ex-wife and former business partner, Lauren, had recently announced that she was selling her 50% stake in CrossFit to Anthos Capital, a private equity firm, for $20 million. Rumors had been circulating about what a sale to Anthos would mean for the future of CrossFit, and Glassman needed to know what was being said so that he could set the record straight. He was disappointed that Lauren had sought out a deal with Anthos after he had made what he considered to be a generous offer for her half of the company.

Glassman recalled one of the Anthos partners, Bryan Kelly, telling him over a year earlier to shore up the vulnerability that might arise from the ongoing divorce. Almost a year to the day later, Kelly sent Glassman an email announcing himself and his partners at Anthos as Glassman’s inevitable co- owners of CrossFit. Anthos pledged their full support for his vision and leadership and positioned themselves as passive and supportive investors. Glassman, however, recalled both his own and other senior staffers’ meeting with Kelly, where Glassman recalled Kelly saying that CrossFit was “leaving money on the table. Every time I go into GNC, you are losing money.” Kelly reportedly had suggested that both the company and affiliates could make more money if they pursued opportunities such as

apparel, dietary supplements and equipment sales, which could be quite profitable.1 Did he see the 4,000 independently owned and operated gyms as 4,000 potential points of sale? Or, could Anthos be a supportive partner who would respect CrossFit’s desire to “minimize extraction (from affiliates) while providing the best education, protection, and brand development possible?”

CrossFit had enjoyed remarkable growth, exploding from 50 locations in 2004 to nearly 5,000 in 2012. Despite the rapid expansion, the CrossFit community remained tightly knit, and Glassman knew that the opinions of a few key thought leaders were closely watched. His position on this matter would strongly influence the community. A successful counter-offer could require Glassman and CrossFit taking on close to $20 million of debt.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

35

815-089 CrossFit (A)

2

The Beginning

Greg Glassman grew up in Woodland Hills, California, with a father who was a rocket scientist at Hughes Aircraft. Any argument Glassman made with his father had to have data behind it, and any point had to be “measurable, observable, and repeatable.” This ultimately led to Glassman’s belief that health and fitness had to be measurable—“and you can’t measure anything without a definition.” Glassman would ultimately make a concrete definition of fitness a hallmark of CrossFit.

But while Glassman learned a tremendous amount from his father, his escape was in athletics, not science. After finding moderate success in gymnastics, Glassman began working as a personal trainer full-time in the 1980s. With his background in gymnastics, Glassman firmly believed that "gymnasts

learn new sports faster than other athletes"2 and set out to understand what it was about their training that made this possible. Through observation and experimentation, Glassman set out to study how fitness was created and to develop routines that would help clients develop general fitness instead of sport-specific training, which he felt was irrelevant to most of his clients.

In his early days as a personal trainer, Glassman ran his clients through self-described “wacky” routines, putting together movements that he’d learned from gymnastics and Olympic weightlifting. He had clients race their way through reps on the weight machines, and at one facility, even had clients scurrying up a 30-foot column in the middle of the gym. Eventually, the owner of the gym welded disks to the pole to make him stop. “They added a hazard 15 feet up,” Glassman would gleefully tell clients, before signaling to them to climb up anyway. Unsurprisingly, Glassman soon found himself kicked out of that gym, and then several others. “I’ve never wanted to be told what to do,” Glassman notes. “I think it’s genetic.”3

Glassman also found that he hated the model of traditional gyms. “I was getting my clients to show up every day. I remember my boss once made a surprise visit on a Sunday, and I pointed out that every single person on the floor was one of my clients. He pulled me aside and said ‘I hate your people.’” The traditional gym, Glassman notes, makes money on the clients who never show up. Glassman recalls being shown a box of ID cards that were purchased by clients and then never picked up. Glassman, by getting his clients to show up every day, was actually hurting the business model of the traditional

gym owner. “I hated that model,” he says. “It never felt right.”4

In 1995, Glassman got a call from a friend who worked at the sheriff’s office in Santa Cruz. The department had heard about his unique training methods and wanted him to train officers. By that point, Glassman had burned bridges with several local gyms, so he decided to go to Santa Cruz, setting up shop in a local health center and labeling what he taught to the officers as “CrossFit.”

From there, a movement was born. The Santa Cruz mornings and evenings became packed with fitness clients. As the group sizes grew, Glassman began having clients teach and support each other, a model that enabled a trainer to increase the number of clients he or she could handle while building a sense of community among clients. The owner of the health center eventually showed Glassman the door, but by then Glassman could afford to lease a space in the corner of a jujitsu studio. Eventually, the crew outgrew even that space—but the real jump was still to come. In 2000, when a number of clients asked Glassman if he could put his workouts online so that they could do them when they traveled, he launched CrossFit.com. The site marked the beginning of Glassman’s open-source approach towards running what would eventually become a fitness movement.

Glassman had spent several years coming up with the CrossFit methodology, honing and refining the movements with his workout clients. However, he had little hesitation releasing this information to the broader public for free over the Internet. “The website was originally for clients and friends to

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

36

CrossFit (A) 815-089

3

be able to access the workouts from remote locations,” he notes. But it soon became clear to Glassman that his methodology spread easily as a result of the website, which ultimately led to the growth of the community. For example, the very first CrossFit “certification” course came as a result of a previously unknown individual (who actually turned out to be a member of the U.S. Department of Justice, trying CrossFit at the advice of the Attorney General) who found the website, started following the prescriptions, tracked down Greg’s phone number, and begged him to certify him and his friends as CrossFit trainers.

The CrossFit Program

CrossFit itself is a strength and conditioning program, with the aim of improving the ten main fitness domains, identified by Glassman as Cardiovascular and Respiratory Endurance, Stamina, Strength, Flexibility, Power, Speed, Coordination, Agility, Balance, and Accuracy. As Glassman described, “we design and deliver a broad-based general fitness. The need for specificity in sport is nearly perfectly met within the training and practice of the sport. There's a strong and mistaken belief that every sport requires a separate and distinct strength and conditioning prescription. The notion is

nonsense. ”5

Glassman’s main goal is for his athletes to have what he terms “general physical preparedness” (GPP). The goal is not to specialize in any particular domain, but rather to have a balance in all of them. In order to develop GPP, devotees of CrossFit engage in “constantly varied functional movements executed at high intensity.” In practice, these workouts take the form of combinations of gymnastics movements, with Olympic weight-lifting and high-intensity cardio movements, such as rowing and sprinting. Glassman began calling these workouts the “workout of the day,” leading to the abbreviation of “WOD.”

Glassman argues that these types of movements, such as squatting, are “everywhere…except, ironically, in regular gyms. On construction sites, people lift things using the methods we teach all day long, but in gyms, you do arm lift things that will never be recreated in any natural environment.”6

CrossFit also has a distinct focus on teamwork and competition. Highly competitive individuals are motivated by seeing others perform the same workout; Glassman teases that “It is very motivating to

get publicly smoked by a five-foot female hippie pottery teacher from the local high school.”7 Workouts are also scored for time, or number of reps, and individuals keep their results to track their progress over time. Those who finish the workout first are encouraged to start cheering for their fellow CrossFitters. In this way, each CrossFit workout builds community.

CrossFitters believe that community is also built from the emotional experience of the workouts. Adam Voci, who opened two Affiliates, comments: “CrossFit is incredibly emotional. You struggle against your mind and body every single day. You fail often, you progress often, and you always come back to do it again. People’s lives are completely changed by the transformations that occur both physically and mentally when you do hard things that also happen to make you healthier. When I was in the military, I used to tell people that CrossFit is the best leadership laboratory that I’ve ever known […] at HBS, I also tell people that the most interesting people I’ve met in my life are either CrossFitters or entrepreneurs, and I think that’s because they are both typically intense people who know how to persevere.”

An early client of Glassman’s described the CrossFit experience as “agony coupled with laughter,” a description Glassman loved. So when he decided to come up with a logo for his website, he thought about that combination, as well as the reality that many CrossFitters pushed themselves so hard during

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

37

815-089 CrossFit (A)

4

workouts, they often vomited afterwards. Thumbing his nose at what he saw as meaningless corporate logos of other personal trainers, he came up with his own unique logo: a vomiting clown he named Uncle Pukie. “You might puke,” Glassman notes when describing CrossFit. “That’s fine.”

The focus on competition and emphasis on pushing to extremes had raised concerns about the safety and health risks of CrossFit. Far from denying it, in 2005 Glassman was quoted in the New York Times saying that “it can kill you. I've always been completely honest about that. ” While CrossFit's growth seemed to continue unabated, and despite the great lengths that the company went to in its seminars to train its affiliates to minimize the occurrence of injuries and the lack of any actual data to suggest that there were any more injuries doing CrossFit than any other program, the issue of risk and injury would continue to make somewhat regular appearances in popular media publications.

The CrossFit Affiliate Model

In early 2002, one of Glassman’s CrossFit devotees approached him about opening a gym and calling it “CrossFit.” According to Glassman, the conversation went something like this:

Potential Affiliate Owner: “I want to open an affiliate in Washington state.”

Glassman: “What’s an affiliate?”

Potential Affiliate Owner: “Like CrossFit North. We’ll do the same thing you’re doing, up in Washington. I’ll pay you to use the name. What should I pay you?”

Glassman: “Let’s call it $500 a year. But for you, since you’re the first, we’ll waive your

fees.”8

At that moment, the CrossFit affiliate model was born. From the beginning, Glassman had a unique philosophy regarding his affiliates. “I believe business is the art and science of presenting uniquely attractive opportunities to other people. The market will find and reward excellence.” The model revolved around the affiliate owner – usually a personal trainer. Affiliates are individual CrossFit “boxes” (gyms), which are opened by individual entrepreneurs. These individual owners pay an annual fee to what became CrossFit headquarters (and was originally just Glassman himself). The fee gives them the right to utilize the CrossFit name, and enables their members to participate in CrossFit sponsored events. The flat annual fee is fixed at the initial level and never raised for an individual box. So while affiliates launched in 2003 continued to pay $500 per year, those starting in 2012 were now paying annual rates of $3,000. Beyond paying the fee, the individual box does not owe anything else to CrossFit—the owner keeps 100% of the revenues and is responsible for 100% of his or her own costs. At the request of several affiliates, CrossFit also launched an insurance program which affiliates could participate in, and which would cover claims related to injuries and other common CrossFit-related risks.

Unlike a traditional franchisor, Glassman intended from the beginning to relinquish largely all control over his affiliates. He does not put geographical constraints on where affiliates can open (one “box” can open quite literally next door to another), and does not collect data from his affiliates on revenue or customers. He allows each box to develop its own culture and run their operations as they see fit to meet local needs. This model builds off of Glassman’s personal philosophy. “I’m a rabid libertarian,” notes Glassman. “I’m not going to be told what to do. Markets are unknowable, but excellence is obvious to everyone. And markets, to the extent that they are free and unfettered, will move capital in the direction of excellence.”9

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

38

CrossFit (A) 815-089

5

Glassman’s philosophy of allowing each box to develop its own culture can sometimes take extreme forms. Glassman recalls the story of one early box, where the head trainer had everyone wear tee-shirts that said “CrossFit: Go Find Yourself”--except the four letter word wasn’t ‘Find.’ But the trainer was a positive influence on his clients, and soon regular people were wearing the tee-shirt all over town. While others might worry about the damage this would do to the CrossFit brand, Glassman stayed out of it. Ironically, a few months later, the trainer met a fundamentalist Christian woman, married her, and banned swearing or obscenities in his gym. His original client base still stuck with him, and the gym grew. In another instance, a box established a business catering to the needs of the deaf clients in the community. To Glassman, these examples indicated how strong the culture around a trainer could be and how trainers will adapt their offerings to meet the needs of their clientele.

Notably, this model is entirely different from the traditional gym model (Gold’s Gym, Bally’s, etc.) This is because, as Glassman says, “the traditional model serves large businesses and millionaires who actually have the capital to acquire 10,000 square feet and all of the associated body-building equipment.” For example Planet Fitness requires any person or team applying for a franchise to have

liquid assets of at least $1.5 million and a total net worth of at least $3 million.10 By contrast, the barriers to opening a CrossFit box are much lower: most boxes are less than 5,000 square feet and require significantly less equipment (See Exhibit 1 for the economics of a typical CrossFit box). One observer described a CrossFit box as in the following way, “It looks like the gym that I used in elementary school.

They have jump ropes, some weights, a tire, a pull up bar and a medicine ball.”11 Affiliates had started boxes in alleys, abandoned lots and even parking parks. In order to open a box, trainers paid $1,000 to attend a two-day certificate course and were required to pass a written examination accredited by the American National Standards Institute (ANSI). Trainers were also required to submit an application and satisfy other elements of CrossFit’s affiliation process. Overall, Glassman feels that the CrossFit model is completely opposite that of the traditional gym: “Look at it holistically—we’re high intensity, they’re low intensity. We are low carb, they’re high carb. We don’t use machines. They do.”

As time goes on, Glassman views CrossFit as being fundamentally about the affiliates. He subscribes to what he calls the “least rents model.” As CrossFit grows, headquarters should have “a shrinking share of a growing pie.” Glassman emphasized, “The point is that our revenue is tied to what we do in support of the community. As the community grows, we scale nicely and profitably – but the community is growing at an even greater rate.” All of the surplus should go back to the affiliates. “The trainers are the ones who are truly desirous of actually helping people and impacting them. This is about the professionalization of the trainer. I so wish someone had given me this opportunity when I

was a young trainer.”12 Ultimately, “what could be a better tool for trainers than a methodology that is uniquely effective (CrossFit itself), coupled with a low investment threshold, loosely structured business model that has you in control. You’re in charge, you get to decide everything. It’s all of your choosing and we remove everything between you and your success that isn’t essential.”13

Based on the number of affiliates that have since been opened, it seems like talented trainers tend to agree. A Massachusetts affiliate owner commented that: “The simplest explanation of why I feel opening a gym under the CrossFit name is a worthwhile opportunity is that it gives trainers the opportunity to be recognized across a large network without the restrictions of being part of a traditional franchise. The CrossFit name gets your foot in the door, and from there, it’s sink or swim.”

Affiliate owners are almost always CrossFit practitioners themselves and feel strongly about the community at large. As such, their desire to create a quality product tends to be high. This is further compounded by the fact that they absorb all the downside risk. The same affiliate owner comments: “I founded my gym with my very last paycheck from my old job. That month, I had to find 30 people and keep them happy in order to pay the rent. Since then, I’ve never missed a month’s rent.” With CrossFit

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

39

815-089 CrossFit (A)

6

membership fees averaging around $150 per month, affiliate owners needed to convince clients that the value they received was far more than that of a typical $10 per month gym membership and closer to that of a personal trainer.

The affiliate model stands in stark contrast to the large franchisors in the industry, such as Planet Fitness, Anytime Fitness, and Curves, which charged initial franchise fees between $10,000 and $27,000

as well as fixed monthly fees or royalties of about 5% of revenue.14 In return, franchisees were provided with training, corporate systems and procedures, exclusive rights to their geographic territory, and quality audits and control from the franchisor, some of which required additional fees. The franchisor usually had rights to approve the site, approve marketing plans, specify vendors of equipment and supplies and audit the site to ensure compliance with the agreement. A franchise agreement also typically restricts uses of the corporate name and brand. See Exhibit 2 for a sample franchise agreement. These restrictions are designed to avoid the ‘free rider’ problem where one franchise owner lowers their standards but takes advantage of the standards maintained by others.

Table 1 CrossFit Affiliate Model

CrossFit Model Traditional Franchise Model

Upfront costs $1,000 weekend training course Franchise fee of $10,000 to $27,000.

Ongoing fees $500 - $3,000 per year 5% of revenue

Systems and procedures Affiliate’s responsibility Provided by franchisor

Oversight, monitoring, and quality control

Restricted access with open business operation

Open access with restricted business operation

Geographic exclusivity Contract term

None At Will

Well-defined 10 years or more with renewal option

Source: Compiled by casewriter from company documents and Sarah Turk, “Gym & Fitness Franchises in the US,” IBISWorld Inc., February 2014.

CrossFit Headquarters and Training Seminars

As the number of affiliates began to grow, Greg officially incorporated CrossFit as a company in 2004. Thereafter, the number of affiliates grew from just around 50, to over 100 by 2007, to close to 2,000 in 2010, 3,500 in 2011, and 5,000 in 2012. He also began to assemble a team, largely bringing on individuals who had tried out the CrossFit model and found their lives transformed as a result.

CrossFit’s executive management structure was unconventional and operated through ‘virtual offices.’ Glassman described their structure and decision making as a process that looks “more like a

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

40

CrossFit (A) 815-089

7

church or a biker gang – probably closer to a biker gang.” He explained “We never had offices for most of our existence. We were working out of our homes. We have people all over the country and the world and we had to find a way to do this, to get together. The company has several homes where we bring people together and we hang. And we stay there a week, two weeks, six months. We have meetings at 3:00 a.m.” Glassman rarely wrote anything down. He had on-going conversations with his executives but when the decision had to be made, he was clear. “The C-Suite is me. For good or ill, what I say goes.” Nicole Carroll, one of the key executives at CrossFit and a former instructor on the Level 1 Seminar team explained, “There is a core group of us who operate around Greg. We get the guidance we need in very informal settings. What comes below us is a lot more structured.”

Jimi Letchford, who opened two CrossFit boxes in 2007 after his military tour, started working with Glassman early on. When Letchford first started, the affiliate model had been established, but the CrossFit Training Seminar was also gaining popularity. As time went on, the seminars were formalized and became a significant source of revenue for CrossFit Headquarters. Glassman was adamant that the affiliate process and seminars be the primary sources of revenue for headquarters—he had no real desire to leverage the brand into additional revenue streams. This wish became very clear to Letchford, who spent his first year on the job building an online apparel store of official CrossFit gear. Within a year, the merchandise sales went from $50,000 to $1,400,000. When Letchford reported his success to Glassman, Glassman demanded that Letchford shut down the store, saying that he “didn’t want CrossFit to be a tee-shirt company with a fitness program.”

“Greg is very good at not chasing big, shiny objects,” says Letchford, referring to Glassman’s ability to focus on his core business rather than chase potentially profitable side opportunities. Ultimately, Glassman would expand the headquarters team and, while not focusing on shiny objects, focused instead on protecting the CrossFit brand. Realizing that the trademark of CrossFit was his main asset, Glassman hired a large legal team. Dale Saran, CrossFit’s General Counsel, says that “CrossFit Inc. leads the fight and regularly goes to battle in court to protect its trademarks and the affiliates who

license them.”15 Glassman and his team saw the risk of commoditization of the CrossFit brand as one of the major long term risks to the company. They often pointed to the term ‘escalator’ as an example of a term that was owned by Otis Elevator Company but became a generic word after the owners allowed it to be used as a generic descriptive term.

CrossFit has filed suit against many wrongful uses of the name. For example, CrossFit once sued a Bay Area retailer for using the term “crossfit equipment” on its website. The ultimate goal, here, is to ensure that “CrossFit” remains a trademarked name, and doesn’t become “crossfit,” a term that can be used generically.

The CrossFit Games

In addition to training affiliates and defending the brand, the other primary role of CrossFit headquarters was to market and promote the CrossFit brand. In 2007, Glassman gathered about 70 athletes at a ranch in northern California for a competition dubbed the CrossFit Games. With competition already built into the CrossFit program, the idea of an event was a natural progression, and something which Glassman thought would be a fun thing to do to bring together a dedicated group of CrossFit athletes.

The first event was deemed to be a great success by all involved, and the Games quickly became an annual fixture on the calendar and a core component of CrossFit's marketing budget. Just two years after the first Games, CrossFit introduced international qualifiers and hosted 4,000 fans at the event.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

41

815-089 CrossFit (A)

8

The following year brought an additional qualifying step and a move from the ranch to the Home Depot Center in Los Angeles.

By 2011, the costs of putting on the Games were growing rapidly, and Glassman worried that the Games were becoming a financial drain on the company. Not only were the expenses large in comparison to anything else that CrossFit did, but they could also be extremely unpredictable.

However, instead of scaling back, Glassman wanted to continue developing the Games as a sporting competition. “If you want to grow a new international sport, you need to get it on TV” noted Glassman. Corporate sponsorship and television coverage would both be key to continuing the Games.

In 2011, CrossFit signed a 10-year title sponsorship deal with Reebok and an agreement with ESPN to cover the Games. CrossFit would be in charge of producing the coverage, delivering it to ESPN broadcast-ready, with the two companies to share in the revenue. Even with the sponsorship, the Games were not a significant contributor to profits. Tony Budding, Director of Media and Co-Director of the Games at the time, was clear about his mandate: “Greg has been clear. We are not running the Games in order to be a third financial engine. They are designed to support the affiliates. I don’t think anyone thinks about how we add another zero (to the growth). Everyone wakes up thinking how do we make it better. We are in the unique position that the rest of the company is doing well, so as long

as it supports the affiliate community the finances will take care of themselves.”16

CrossFit in 2012

By 2012, CrossFit had grown to 5,000 affiliates. Approximately 75 percent of the affiliates were in the U.S. and Canada, with the other 25 percent divided roughly equally between Europe, Australia and New Zealand, and the rest of the world. Reflecting back on his journey, Glassman noted “I didn’t predict any of this. I’m not an end-point guy, I’m a process guy.”

With a total full-time staff of 60 (see Exhibit 3 for a breakdown of employees by function), as well as a large base of part-time contractors and volunteers, Glassman now oversaw a global fitness program with millions of followers. In keeping with Glassman’s hands-off philosophy, corporate headquarters set no targets for growth. As Letchford described, “we don’t need to push growth, we just feed it any way we can.”

CrossFit’s media operations, on the other hand, operated with a structured plan and a coordinated media effort. Daily workouts were planned out months in advance, and the media center was in many ways the core of CrossFit headquarters. With a staff of 20 employees, plus additional staff dedicated to the CrossFit Games, the production team at CrossFit was constantly creating new material for the website and CrossFit's corporate partners.

As CrossFit grew, it became clear that Glassman was on to something in terms of distributing the workouts for free. Because the workouts were free, CrossFit.com encouraged individuals to post their results. Similarly, during CrossFit Open (the prelude to the Games), CrossFit collected massive amounts of data from participants. As a result of this data, CrossFit was able to improve the workout methodology and produce statistics showing that the CrossFit methodology was indeed making people fitter. For example, the Games staff would often program a workout during one year, and repeat it the next year, while collecting data from hundreds of thousands of participants on their scores each year.

Having made the deliberate decision to avoid entering into ancillary lines of business (including the

athletic apparel market, estimated to be $100 billion by 202017, and the protein bar/drink/supplement

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

42

CrossFit (A) 815-089

9

market, estimated to be $12.4 billion by 201718), CrossFit had three main sources of revenue: affiliate fees, training seminars, and the CrossFit Games. Affiliate fees in 2012 were $3,000 for new boxes coming into the system. Affiliates that had been around for longer paid rates ranging from $500 to $2,000, depending on their date of inception. Level 1 training seminars averaged about 10 events per week, with each drawing approximately 30-50 individuals at a rate of $1,000 each. With training seminars being held at existing boxes in exchange for free seminar passes, industry followers estimated that the direct cost of supporting each participant was limited to between $250 and $300. It was also believed that 10% of Level 1 participants started their own boxes, and that 85% to 95% of these were successful in creating profitable operations.

The CrossFit Games, with sponsorship now in place, cost approximately $20 million to produce, but brought in $15 million in revenue. The Reebok sponsorship covered the gap and provided a small surplus.

Anthos Capital

In a first meeting with CrossFit, Bryan Kelly of Anthos Capital expressed his desire to help CrossFit sustain its growth and maintain its unique culture under Glassman’s leadership. By August 2012, as rumors and speculation circulated throughout the community, Lauren Glassman and Bryan Kelly released two letters explaining their rationale and their intentions (See Exhibit 7 for Lauren Glassman’s letter and Exhibit 8 for Bryan Kelly’s letter). Glassman wondered what the phrase ‘he (Bryan Kelley) gave me the confidence that he and Anthos would take CrossFit to the next level of success at an important point in time’ in Lauren’s letter really meant. Would Anthos really push Glassman to chase revenue opportunities that he felt were counter to the CrossFit philosophy? Might they bring additional discipline and expertise to the company? What other options did he really have? And most importantly to Glassman, what was best for the company, the affiliates, and the CrossFit community?

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

43

815-089 CrossFit (A)

10

Exhibit 1 Representative Economics of a CrossFit Affiliate

Membership Fees 600,000 Merchandise Sales 30,000

Gross Sales 630,000

Merchandise Cost of Sales 20,000

Gross Margin 610,000

Rent 115,000 Payroll 200,000 Marketing 17,000 Office Expenses 15,000 Credit Processing Fees 25,000 Equipment 28,000 Utilities 9,000 Other Miscellaneous 12,000

Total Expenses 421,000

Pre-Tax Profit 189,000

Source: Casewriter estimates.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

44

CrossFit (A) 815-089

11

Exhibit 2 A Sample Franchise Agreement

Note: This is a truncated form. Franchise agreements are typically 30 to 60 pages long.

AGREEMENT effective as of ________, 20__ between XYZ FRANCHISING INC., a __________ corporation (referred to in this Agreement as “we” or “us”), and ___________, a _________________ (referred to in this Agreement as “you” or “your company”).

We and our affiliated companies have developed a system (the “System”) for the operation of fitness centers offering exercise machines, fitness training services [etc.] (the “XYZ centers”). XYZ centers operate under the trademark XYZ and other trademarks (collectively, the “Marks”). You have applied for a franchise to own and operate an XYZ center in a defined territory and we are pleased to grant the franchise to you on the terms and conditions set forth below. Accordingly, you and we agree as follows:

ARTICLE I – GRANT AND OPERATION OF THE FRANCHISE

Section 1.1 – Territory Rights

1.1.1 Grant of Rights. We grant to you the right, and you undertake the obligation, to operate a franchised XYZ center in the geographic area described in Schedule A (the “Territory”) in accordance with the System Standards (as defined below) and the terms and conditions contained in this Agreement.

1.1.2 Exclusivity. So long as you are not in default under this Agreement, we may not operate or grant others the right to operate an XYZ center within the Territory during the Term of this Agreement, except as set forth in Section 1.1.5.

1.1.3 Single Site. You must operate your franchised XYZ center (the “Franchised Business”) only at the location described in Schedule A (the “Site”). You may not relocate the Franchised Business or operate the Franchised Business from any location other than the Site without our prior written approval. You do not have the right to grant subfranchises of the rights granted under this Agreement.

1.1.4 Services Offered. You must offer and sell in the Franchised Business all of the products and services we prescribe. You may not sell under the Marks or in the Franchised Business any products or services we do not specify or approve. If you desire to sell any products or services that we have not specified or approved, you must request our approval.

1.1.5 Guaranty. [Owners must sign a personal guaranty and assumption of nondisclosure and noncompete obligations.]

Section 1.2 – Site Selection and Development; Opening

1.2.1 Site Selection. You are solely responsible for selecting the Site for the Franchised Business. We merely approve the Site if it is acceptable to us.

1.2.2 Site Development. You are solely responsible, at your own expense, for obtaining any necessary financing and all required building, utility, sign, business and other permits and licenses required to operate the Franchised Business, for constructing all required improvements to the Site, and for decorating the premises of the Franchised Business in compliance with plans and specifications we have approved. We will furnish you with mandatory and suggested specifications and layouts for an XYZ center, including requirements for dimensions, design, image, interior layout, décor, equipment, fixtures, furnishings and signs.

Section 1.3 – Supplies; POS System

1.3.1 Proprietary Products and Suppliers. You agree to purchase from us or approved manufacturers or suppliers all articles specified by us that are used in operating the Franchised Business and bear any of the Marks.

1.3.2 Other Suppliers. You agree to use in the operation of the Franchised Business only those brands and models or types of equipment, supplies, furniture, signs and other products and services that we have designated or approved for XYZ centers.

1.3.3 Compensation from Suppliers. [The franchisor may agree to pass supplier discounts or rebates to the franchisee.]

1.3.4 Approval of Supplies and Suppliers. [Procedure for approval.]

1.3.5 Point of Sale and Computer Systems. You agree to install, maintain and use in the Franchised Business such computer hardware, software, point-of-sale and cash register systems as we specify from time to time. We have the right to establish

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

45

815-089 CrossFit (A)

12

requirements that will permit us to access your computer system and to retrieve all information relating to the Franchised Business.

Section 1.4 – Manual; System Modifications

1.4.1 Manual. During the term of this Agreement, we will give you access to the confidential operations manual, training and other materials for use in operating an XYZ center (the “Manual”), in such media as we select, whether hard copy, through the Web or otherwise. The Manual contains mandatory and suggested specifications, standards, operating procedures, policies, methods and rules (“System Standards”) that we prescribe from time to time for the operation of an XYZ center and information relating to your other obligations under this Agreement. The Manual is and will remain at all times our sole property. You may not at any time copy, duplicate, record or otherwise reproduce any part of the Manual except as we may specifically authorize.

1.4.2 System Modifications by Us. We may modify or change the System Standards from time to time, and upon notice to you, we may make additions to, deletions from or revisions in the Manual to reflect such modifications or changes. You agree to adopt or comply with each new or changed procedure, policy, method and requirement as promptly as practicable after notice from us, and in any event within the time period we reasonably require.

1.4.3 System Modifications by You. You agree not to implement any modification or change in the System Standards or in the Franchised Business without our prior written approval, which we may withhold in our discretion. If you or any of your employees makes an improvement to the System Standards or in the Franchised Business, such improvement will be our property. We will have the right to use such improvements and changes anywhere and to authorize our affiliates and other franchisees to use them.

Section 1.5 – Personnel; Training and Support

1.5.1 Management. As used in this Agreement, the term “Operating Manager” means either you (if you are a sole proprietor) or a manager who has successfully completed all required initial training. The Operating Manager must personally manage, oversee and supervise the Franchised Business and its employees at all times and must actively devote his or her full time, attention and effort to the Franchised Business. He or she must attend and successfully complete such ongoing training as we may require from time to time.

1.5.2 Initial Training. Before you begin operating the Franchised Business, we must train your Operating Manager and up to two other managers from your company in the operation of an XYZ center. The training program consists of up to 40 hours per week of training over a period of up to two weeks at our training facility in ___________. We will endeavor to time the commencement of your training pro-gram so that it is completed at least 10 days before the scheduled opening of the Franchised Business.

1.5.3 Opening Assistance. We will provide pre-opening and opening training, supervision and assistance at your Franchised Business by one of our trained representatives for a period of approximately one week (40 hours).

1.5.4 Ongoing Training. At your request, and if we agree, we will furnish additional training. We may charge our then- current fees and expenses for additional or remedial training that is not mandatory or that we require because your personnel are not meeting our standards. We do not charge for mandatory training.

1.5.5 Ongoing Support. We will provide support and guidance from time to time, either in per-son, by telephone, by email or in writing, regarding the operation of the Franchised Business. We will provide regular operational reviews and advise you from time to time based on reports you submit to us and inspections we make, to ensure compliance with the System Standards and to recommend improvements. Your failure to implement any corrective action we require will constitute a material breach of this Agreement and may result in termination.

Section 1.6 – Operation of the Franchised Business

1.6.1 System Standards. You agree to operate the Franchised Business in strict accordance with all System Standards in effect from time to time.

1.6.2 Maintaining the Premises. You will at all times maintain the premises of the Franchised Business in excellent repair and condition. You will make such additions, alterations, repairs and re-placements as may be required for that purpose, including, without limitation, such periodic repainting and replacement of obsolete signs, furnishings, equipment and décor as we may reasonably direct.

1.6.3 Inspections. During the term of this Agreement, we or our designated representatives will have the right, at any time during your regular business hours, without prior notice to you, to enter upon the premises of the Franchised Business to inspect the premises; observe, photograph and videotape the operations of the Franchised Business; and to interview your personnel

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

46

CrossFit (A) 815-089

13

and customers. You agree to cooperate fully with us and our representatives during all inspections, observations, photographing, videotaping and interviews; and to take all steps reasonably necessary to correct any deficiencies in your compliance with System Standards or this Agreement within the time we specify.

Section 1.7 - Advertising, Promotion and Marketing

1.7.1 Signage. You will post prominent signage relating to the franchised business in easily-seen locations both inside and outside the premises of the Franchised Business. We will prescribe or approve from time to time in writing the size, form, color scheme, content and location of all such signage.

1.7.2 Grand Opening. You agree to conduct a grand opening public relations and advertising program for the Franchised Business during the period commencing 30 days before and ending 60 days after its opening and to expend at least $_____ for such program. Such program will use the materials we have developed or approved for public relations and advertising. We will provide you with guidelines and lists of suppliers and consult with you on your grand opening public relations and advertising pro-gram, but you will be solely responsible to develop and implement this program.

1.7.3 Local Advertising. You agree to use all reasonable efforts to promote the Franchised Business. You are responsible at your expense for providing local advertising, marketing, promotional and public relations programs and activities for the Franchised Business. You agree to spend annually for advertising and promotion of the Franchised Business not less than 2% of Gross Sales (as defined in Section 2.1.4). You may spend additional amounts in your discretion, and we encourage you to do so.

1.7.4 Local Advertising Materials. We will create point of sale materials and a toolkit of approved advertising that we will furnish to you for your use. All other materials you use in local advertising, marketing, promotional and public relations programs and activities must conform to such standards and requirements as we may specify from time to time. You agree to submit to us, before you use them, samples of all materials you intend to use that we have not prepared or previously approved.

1.7.5 National and Regional Advertising. We or our designee will exclusively maintain and ad-minister any national and regional advertising, public relations and marketing programs and market re-search, including the System Website and all programs financed by the Marketing Fund described below.

1.7.6 Marketing Fund. We have established a Marketing fund (the “Marketing Fund”), subsidized by fees paid both by XYZ center franchisees and by company and affiliate-owned XYZ centers, for such advertising, promotion, marketing and public relations programs and materials as we deem necessary or appropriate. You agree to contribute to the Marketing Fund in accordance with Section 2.1.5. XYZ centers that we or our affiliate own will contribute to the Marketing Fund on the same basis as franchisees.

1.7.7 Cooperative Advertising. We may establish and coordinate from time to time cooperative advertising, marketing and sales programs, customer satisfaction programs and other programs or activities among XYZ center franchisees. These programs or activities may be on a local, regional or national basis. You will participate in such programs and activities as we may prescribe. Such programs and activities may (at our option) be paid for on any equitable basis by the participants.

1.7.8 Internet Advertising. Any Internet advertising you do must be submitted to us in advance for our approval as described in Section 1.7.4. We will not unreasonably withhold our approval.

1.7.9 Social Media. You may promote the Franchised Business through social media and similar means provided that such promotion is consistent with the Manual including all guidelines we issue from time to time. If any objectionable content is posted to a social media website, you will have 12 hours after notice from us to remove such content provided that it is capable of removal.

1.7.10 Coupons and Gift Cards. You agree to honor all coupons and gift cards you receive from customers that are in a form designated or approved by us. You will sell and issue gift cards and redeem (without an offset against Royalty payments) coupons and gift cards in accordance with procedures and policies we specify in the Manual or otherwise in writing.

Section 1.8 – Website

1.8.1 System Website. We maintain one or more websites to advertise, market and promote XYZ centers, the products sold at XYZ centers and the XYZ center franchise opportunity (the “System Website”). The System Website lists the locations of XYZ centers. We own all intellectual property and other rights in the System Website and all information it contains.

1.8.2 Promotion of the System Website. All advertising, marketing and promotional materials that you develop for the Franchised Business must contain the System Website’s URL in the manner we designate.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

47

815-089 CrossFit (A)

14

ARTICLE II – FEES; PAYMENTS; RECORDS; INSPECTIONS

Section 2.1 – Fees and Reports

2.1.1 Initial Fee. Upon your signing of this Agreement, you will pay us the initial fee specified in Schedule A. The initial fee is fully earned at the time we grant the franchise and is not refundable under any circumstances.

2.1.3 Royalty. You agree to pay us a royalty (“Royalty”) in the amount of 6% of the gross sales of the Franchised Business each accounting period2.1.4 Marketing Fee. You agree to pay us a marketing fee (the “Marketing Fee”) in the amount of 3% of the Gross Sales of the Franchised Business each Accounting Period. The Marketing Fee finances the Marketing Fund described in Section 1.7.6.

2.1.5 Other Fees. You agree to pay us the following fees upon the occurrence of the following events: [Other fees may include fees for relocation, transfer, renewal, remedial training etc.]

Section 2.2 – Records; Inspection

2.2.1 Records. You agree to maintain full, complete and accurate records of the Franchised Business. You agree to preserve all records for a period of at least five years after their creation, or such longer period as may be required by law, during both the term and each renewal term of this Agreement and following the expiration or termination of this Agreement.

2.2.2 Access to Systems. We may use the computer and point of sale systems described in Section 1.3.5 to collect electronically the reports referred to in Section 2.1.8 and the records referred to in Section 2.2.1. We have the right to establish requirements that will permit us to access all cash registers and your computer system and to retrieve all information relating to the Franchised Business.

2.2.3 Right to Audit. We have the right at any time during your regular business hours, without prior notice to you, to inspect and audit the records of the Franchised Business, or to cause such records to be inspected and audited.

2.2.4 Cost. All inspections and audits will be at our expense; but if an inspection or audit is made necessary by your failure to furnish, or your delay in furnishing, reports or other information we require, or if an understatement of Gross Sales for the period of any audit or inspection is determined by any such audit or inspection to be greater than 2%, you agree, upon our request, to reimburse us for the cost of such inspection or audit, including legal and accounting fees and the travel expenses of the inspecting or auditing personnel.

ARTICLE III – PROPRIETARY RIGHTS; CONFIDENTIALITY; NONCOMPETITION

[The franchisor owns all copyrights and trademarks. The franchisee must use them properly.]

[The franchisee may not disclose the franchisor’s confidential information, broadly defined.]

[The franchisee may not compete during the term of the franchise agreement or for a limited period of time after the agreement expires or terminates.]

ARTICLE IV - TERM AND TERMINATION; TRANSFER

[The initial term is typically 10 years, but it can be more or less.]

[The franchisee typically has the right to renew upon several conditions, including giving adequate notice of its intention to renew, signing the then-current form of franchise agreement, renovating the premises of the franchised business, and often paying a renewal fee.]

[Grounds for termination by the franchisor include nonpayment or other material breach.]

[The franchisor’s right to transfer is unrestricted. The franchisee may not transfer the agreement or the business without the franchisor’s approval.]

Source: Thomas M. Pitegoff, Esq., Counsel at LeclairRyan, New York, NY.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

48

CrossFit (A) 815-089

15

Exhibit 3 Summary of Employees by Function

Headquarters 20 Affiliate Team Business Development Accounting Legal Operations IT Games HQ Team

Media Team 20 Seminar Team 20

Total 60

Source: Company documents.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

49

815-089 CrossFit (A)

16

Exhibit 4 A Sample Workout of the Day (WOD)

Three rounds for time of:

 Row 500m

 21 Kettlebell Swings 32/24kg

 15 Burpees

 9 Chest to Bar Pull-ups

Source: CrossFit.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

50

CrossFit (A) 815-089

17

Exhibit 5 CrossFit Affiliation Process

Steps to Affiliation

The first step in the affiliation process is to fill out an application and write an essay. The essay should contain info about your background, what CrossFit affiliation means to you, why you want it, and what you want to achieve. It doesn't have to be long or formal, but it should be from the heart.

The other (informal) step is to educate yourself and become a part of the community. This can happen in many ways. Do the workouts and post your results to the WOD Comments, join the Message Board, subscribe to and read the CrossFit Journal, come to a Seminar, and make friends with (and visit, if possible) other affiliates.

Cost

On acceptance of your application, we license use of the name "CrossFit" for a $3,000 annually renewable fee, effective 1 January 2011. You may use the name to market your CrossFit training and classes.

Requirements

1. We require an applicant to be at least a Level 1 Certificate Holder before applying for affiliation. We offer Level 1 Certificate Courses several times a year. Please check the link for more information.

2. Once you are accepted as an affiliate, you will need to have a live website before we will be able to link you on the CrossFit site. This is our primary vehicle for promoting you; therefore, we expect you maintain a good site. Please DO NOT register a domain with the CrossFit name in it until AFTER you have been accepted. CrossFit is a licensed trademark and its use without our prior permission is illegal.

3. We require every affiliate website to display the CFJ link on the front page of their site.

What You Get

Once your application is approved and we receive your paperwork, we'll link to your website from the main page and the affiliate page of CrossFit.com.

You will also have access to the private Affiliate Forum on the CrossFit Message Boards, where you'll be able to interact with other affiliates and tap their knowledge and experience to help you thrive.

In addition, we hold a yearly Affiliate Conference, where we come together as a community to exchange ideas, learn what works, and celebrate the experience of being a CrossFit affiliate.

Also, your affiliate will be considered for features on the main page if you send us high-quality, interesting photos and videos of your training and events.

Once you have read through all the links and the FAQ, please don't hesitate to contact us with any questions about the program. You can reach the CrossFit affiliate support team at [email protected].

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

51

815-089 CrossFit (A)

18

Source: http://www.crossfit.com/how-to-affiliate and http://www.crossfit.com/cf-contact/form_affiliates.shtml, accessed January 2015.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

52

CrossFit (A) 815-089

19

Exhibit 6 Estimated Costs of Opening a Planet Fitness Franchise

Initial Franchise Fee $10,000

Site Selection Costs $1,000 - $3,000

Leasehold Improvements $250,000 - $1,400,000

Fitness Equipment $50,000 - $750,000

Non-Fitness Equipment $30,000 - $300,000

Pre-Sale Marketing 30000

Exterior Signs $15,000 - $30,000

IT Systems $5,000 - $15,000

Insurance $10,000 - $15,000

Real Estate Lease Deposits $0 - $57,000

Other Deposits $700 - $11,000

Professional Fees $2,000 - $25,000

Out of Pocket Training Expenses $1,500 - $6,500

Licenses/Bonds $100 - $2,500

Operating Cash for First Six Months $250,000 - $650,000

Total $655,300 - $3,305,000

Source: Adapted from http://www.franchisechatter.com/2013/05/19/franchise-costs-2013-detailed-estimates-of-planet- fitness-franchise-costs-2013-fdd/, accessed January 2015.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

53

815-089 CrossFit (A)

20

Exhibit 7 Letter from Lauren Glassman to CrossFit Community, August 10, 2012

Dear CrossFit Affiliates,

There have been many questions since staff from CrossFit HQ, on July 28, 2012, made public my decision, pending court approval, to sell my 50% interest in CrossFit, Inc. to Anthos Capital. Unfortunately, Greg and CrossFit HQ declined my request to have a Q&A with Bryan Kelly of Anthos and myself during the CrossFit Tour in Montana. While I would have preferred that Bryan Kelly and I answer your specific questions in more detail, face-to-face, in Montana, I would like to take this opportunity to provide you the following information, which responds to the most frequent concerns expressed to me and in various social media.

My personal and professional pride and satisfaction starting CrossFit with Greg from a single box in Santa Cruz, California to the world-wide community it is today runs deep. In fact, like you, I am an Affiliate and will continue to be an Affiliate along with my team in Prescott, Arizona. Where I derive particular satisfaction is that like any strong family, while we don’t always see eye-to-eye, we are committed to understand another’s point of view and respect another’s ultimate decision.

As you may know, Greg and I decided to divorce more than two years ago. And as much as I believe and continue to believe in Greg’s vision for CrossFit, we both came to the realization that it would be better for everyone if we no longer continued to work alongside one another on a day-to-day basis. But, as Greg once told the community, CrossFit was “built from Lauren’s wisdom, perseverance, and understanding of [his] vision” as his “most trusted adviser and co-owner of CrossFit Inc.” And I would like to continue to provide that wisdom, perseverance, and understanding.

Some have claimed that I made the decision to sell my 50% interest in CrossFit for personal, rather than business, reasons. Some have said that I even rejected better offers from Greg. These claims are just not true. It is true that I have a definitive agreement subject to court approval to sell my interest in CrossFit to Anthos for $20 million upfront. After discussing the matter with advisors, and considering multiple factors, I came to the conclusion that the Anthos deal was a better offer. While I would like to provide the details of Greg’s offers, this requires permission from Greg to provide those details, and I have not yet received that permission.

When I met with Bryan a few months ago, he gave me the confidence that he and Anthos would take CrossFit to the next level of success at an important point in time. I ask that you take a few minutes and view the video, discussions by me and Bryan Kelly on many of the topics addressed by CrossFit HQ and the CrossFit community.

Thank you for your time, your scrutiny, and your passion.

Lauren

Source: The Rx Review, “Lauren Glassman and Bryan Kelly: CrossFit vs. Anthos,” The Rx Review Web site, http://therxreview.com/lauren-glassman-and-bryan-kelly-on-the-crossfit-vs-anthos-debate, accessed December 2014.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

54

CrossFit (A) 815-089

21

Exhibit 8 Excerpt of Letter from Bryan Kelly to CrossFit Community, August 10, 2012

Dear CrossFit Affiliates and Members,

My name is Bryan Kelly. As you may have heard, my firm, Anthos Capital, has entered into an agreement with Lauren Glassman to buy her 50% interest in CrossFit, subject to court approval. Given the false information that is circulating, Lauren and I offered to host a live Q&A session for you at Big Sky Montana this weekend so we could have an honest and balanced discussion, but HQ rejected us. Instead, I’m providing this letter and video (link below) to give you the facts, so that you have an accurate picture about me, my firm, and our intentions, and can make your own informed judgment.

I’m a committed CrossFitter who cares deeply about this community: I believe that it might be helpful if you know about me, since my desire to invest stems from my passion for CrossFit. I’ve always taken my fitness seriously: wrestling and playing football in high school and competing in triathlons after college. After a co-worker introduced me to CrossFit two years ago, my definition of fitness completely changed. I began training at Bay Area CrossFit affiliates, and currently work out with a CrossFit coach who trains other athletes and is opening his own affiliate. I’m nowhere near the level of the Games-caliber athletes I look up to, but I have torn hands and PRs to show my progress. I am incredibly proud of my accomplishments thus far – I’m in better shape at 34 than I was at 24. My mile time has gone from 6:50 to 5:15, my max pull-up sets have increased from 8 to 24, my latest Fran time was 6:57, and my Helen time is 9:59. I’ve got a lot to work on. My current goals are to go sub 5:00 in both the mile and Fran, complete 30 or more pull-ups, and beat an 8:30 Helen. I know my performance isn’t overwhelming, but it is an example of the power of CrossFit to improve lives.

My experience has also given me a deep appreciation of the substantial commitment that affiliates make to help their members. Affiliate entrepreneurialism and freedom make CrossFit special, and it’s illogical for me (either as a member or an investor) to do anything that would reduce your motivation or happiness.

Anthos will own 50% of CrossFit, not a controlling interest: As a general point, Anthos will not be a majority investor or have any operational control over CrossFit. Our purchase of Lauren’s interest will merely allow us to step into her shoes as an equal owner. This means that Coach will continue to lead and manage CrossFit’s day-to-day operations, just as he has always done. We have no desire to change the Games, corporate partnerships, HQ staff, or cause Coach to take actions he does not believe in. We view our role as supporting HQ and helping the affiliates to achieve their own long-term objectives.

Anthos is a supportive, patient investment partner: Anthos’ philosophy is and always has been to play the role of a supportive investor in all of the companies in which we invest and, should the court approve this transaction, that would include CrossFit. I co-founded Anthos with my equal partner Paul Farr (Paul is also a CrossFitter) to support revolutionary businesses. We only invest in companies and teams whose missions and products we believe in. What makes us unique is that we have always been hands-off and only invest our founding and managing partners’ money. We have no outside interests, influences, pressures or conflicts. Our structure allows us to be committed owners, invest for the long- term, and support transformational businesses.

We want to invest for the simple reason that we strongly believe in CrossFit’s natural growth prospects: Our business is to support rapidly growing companies, and I believe that CrossFit’s ascent in the health and fitness industries has only just begun. CrossFit is on a path to having millions of members under the existing affiliate model. This trajectory will produce a company that is valuable, fun to be a part of, and impactful.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

55

815-089 CrossFit (A)

22

Our only role will be on CrossFit’s Board of Directors: We intend to offer help to CrossFit and Coach at the board level with the guidance essential to long-term viability: strategic development, financial planning, and any other areas that would help the Company and affiliates. Given the time, effort, and money affiliates have poured into building their boxes and servicing their members, they have a vested interest in knowing that HQ has the independence, skills, and systems to operate soundly well into the future. Other companies we have been involved with have welcomed our professional guidance – input that’s helped them strengthen their businesses and long-term prospects without changing their business models, values, or cultures.

We want affiliates to thrive, and we have no interest in the franchise model or other unwanted actions: There has been a lot of talk about franchising, and I want to be crystal clear that our proposed investment cannot and will not turn affiliates into franchises or force them to sell supplements, apparel, or any other products. Despite what has been said by some people on the message boards, we prefer the open market model that currently exists in which affiliates get to run their boxes as they see fit. This model syncs with my personal belief in autonomy, limited interference from big bureaucracy, healthy competition, and the special power of small-businesses. Thus, we intend to fully support affiliates continuing to run their boxes as they see fit. Any statements to the contrary on the message boards are simply wrong.

Lauren has a right to sell her 50% interest in CrossFit for a value she believes is fair: Lauren, along with Coach, played a significant role in CrossFit’s success, and she is now entitled to fair compensation for her hard work and ownership stake. It is understandable that in light of their divorce proceedings, Lauren would want to move on with her life and sell her ownership interest but continue as an affiliate. As Lauren has explained, Coach offered to buy her interest, but his offer was unsatisfactory to both her and her advisors. People have said that Coach’s offer was superior to ours and Lauren is spiteful. This is entirely false. Subject to court approval, we have agreed to pay Lauren $20 million cash up front. Coach’s offer, as Lauren has explained, does not – in our view or the view of her advisors – come close to Anthos’ offer.

Coach is a visionary and important to this community: I believe that Coach is immensely talented, a rare visionary, and important to CrossFit’s future. We want Coach to continue leading CrossFit as CEO and will do what we can to support him. In fact, his vision, determination and creativity are a huge part of why we want to partner with him and invest in CrossFit.

Our desire to invest in CrossFit is driven by a passion for the sport, the affiliate model, and the community, and a belief in a bright future. Hopefully, I have helped to better inform your opinions and address your concerns. We are committed to pursuing this investment, and welcome an open dialogue with you.

Sincerely,

Bryan Kelly

Source: The Rx Review, “Lauren Glassman and Bryan Kelly: CrossFit vs. Anthos,” The Rx Review Web site, http://therxreview.com/lauren-glassman-and-bryan-kelly-on-the-crossfit-vs-anthos-debate, accessed December 2014.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

56

CrossFit (A) 815-089

23

Endnotes

1 CrossFit Max Effort Blog, “WTF is Anthos?” http://www.crossfitmaxeffort.com/wtf-is-anthos, accessed January 2015.

2 CrossFit Maximus, “Quotations,” http://crossfitmaximus.com/resources/quotations, accessed January 2015.

3 Burt Helm, “Do Not Cross CrossFit,” Inc. Magazine, July/August 2013, http://www.inc.com/magazine/201307/burt -helm/crossfit-empire.html, accessed January 2015.

4 Greg Glassman, “March 13, 2013 Full Talk,” lecture given on March 13, 2013 at Illinois Policy Institute, https://www.youtube.com/watch?v=kPAXQtDNLQ0, accessed January 2015.

5 “Interview: Coach Greg Glassman,” The CrossFit Journal, January 2003, http://library.crossfit.com/free/pdf/05_03_Interview_Glassman.pdf, accessed January 2015.

6 ReasonTV, “CrossFit Founder Greg Glassman: ‘I’m a rabid libertarian’,” July 22, 2013, https://www.youtube.com/watch?v=-EB0XyBUl0U, accessed January 2015.

7 CrossFit Contention, “Greg Glassman Quotes,” http://crossfitcontention.com/greg-glassman-quotes, accessed January 2015.

8 Greg Glassman, “March 13, 2013 Full Talk,” lecture given on March 13, 2013 at Illinois Policy Institute, https://www.youtube.com/watch?v=kPAXQtDNLQ0, accessed January 2015.

9 ReasonTV, “CrossFit Founder Greg Glassman: ‘I’m a rabid libertarian’,” July 22, 2013, https://www.youtube.com/watch?v=-EB0XyBUl0U, accessed January 2015.

10 Planet Fitness, “Franchising,” Planet Fitness Web site, http://www.planetfitness.com/franchising, accessed January 2015.

11 Bloomberg TV, “CrossFit: C-Suite with Jeffrey Hayzlett,” October 22, 2013, http://www.bloomberg.com/video/ crossfit-c-suite-with-jeffrey-hayzlett-10-22-clMC3pfxSOChhC~6LKbT1w.html, accessed January 2015.

12 Greg Glassman, “The Founder’s Views Part 1: The Affiliate Model,” July 22, 2012, http://journal.crossfit.com/2012/07/gregglassmansitdown-part1.tpl, accessed January 2015.

13 Ibid.

14 Sarah Turk, “Gym & Fitness Franchises in the US,” IBISWorld Inc., February 2014.

15 “CrossFit Strives To Protect Its Brand Name,” Bidness Etc Web site, http://www.bidnessetc.com/business/crossfit-strives- to-protect-its-brand-name, accessed January 2015.

16 Bloomberg TV, “CrossFit: C-Suite with Jeffrey Hayzlett,” October 22, 2013, http://www.bloomberg.com/video/ crossfit-c-suite-with-jeffrey-hayzlett-10-22-clMC3pfxSOChhC~6LKbT1w.html, accessed January 2015.

17 Sara Germano, “Yoga Poseurs: Athletic Gear Soars, Outpacing Sport Itself,” The Wall Street Journal, August 20, 2014, http://www.wsj.com/articles/yoga-poseurs-athletic-apparel-moves-out-of-the-gym-to-every-day-1408561182, accessed January 2015.

18 Duncan Walker, “The rise of the protein drinks for ordinary people,” BBC News Magazine, June 6, 2013, http://www.foodproductdesign.com/News/2013/06/Market-for-Protein-Products-Surges.aspx, accessed January 2015.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

57

5.

9 - 7 1 1 - 0 2 1

R E V : J A N U A R Y 9 , 2 0 1 2

________________________________________________________________________________________________________________

Professor Julio J. Rotemberg prepared this case. This case was developed from published sources. HBS cases are developed sole ly as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2010, 2011, 2012 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800- 545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

J U L I O J . R O T E M B E R G

BP’s Macondo: Spill and Response

In the fall of 2010, policymakers in Washington were thinking of revamping the U.S. regulatory system for offshore oil exploration. A disaster at BP’s Macondo well in the Gulf of Mexico earlier in the year had led to the largest offshore oil spill in U.S. history, and cries for change were everywhere. President Barack Obama had devoted his first oval office speech to the subject, and his administration had instituted a moratorium on all deepwater drilling. (See Exhibit 1 for excerpts from Obama’s speech, and Exhibit 8 for a list of directly affected companies.) In addition, Interior Secretary Ken Salazar had divided the Minerals Management Service (MMS) into three offices. One would collect royalties, one would lease oil resources, and one would regulate drilling (though the last two would report to the same assistant secretary).

Meanwhile, in Congress, many bills had been introduced. Several sought to punish BP, a few by raising the liability limit of offshore accidents (retroactively to April 15) from $75 million to $10 billion, others by preventing firms that had an accident history similar to BP’s from future exploration and production of oil in the United States. Other bills changed U.S. government institutions. One, for example, created a special-purpose organization in charge of responding to future oil spills. As policymakers thought about these proposed changes, they needed to take into account the role of offshore drilling in the U.S. economy and the lessons they should draw from the spill.

The Explosion

On the evening of April 20, 2010, the well at Mississippi Canyon Block 252 (the Macondo prospect) seemed nearly complete. The Deepwater Horizon rig had reached its goal of digging 13,000 feet starting at a sea depth of 5,000 feet and had found oil 41 miles off the coast of Louisiana. Its goal was now to plug the well so that it could be open later for production. As it was completing the final steps, there was a blowout: a column of methane traveled up the well and exploded. Chaos ensued, with crew members moving into lifeboats or even jumping into the ocean without waiting for instructions. Of the 126 crew members onboard, 11 died. The $560 million rig sank while a mixture of oil and gas spewed from the drill hole at the bottom of the sea. By the time the flow of oil was stopped on July 12, 2010, the U.S. National Oceanic and Atmospheric Administration estimated that 4.9 million barrels of oil had come out of the hole.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

59

711-021 BP’s Macondo: Spill and Response

2

The causes of the blowout were still somewhat uncertain in the fall of 2010. At the hearings conducted jointly by the U.S. Coast Guard and the Interior Department to find out what had happened, several witnesses refused to testify. While the hearings were purely investigative, many civil lawsuits had been filed already and the possibility of criminal prosecution was in the air. Much effort was thus spent shifting blame. Anadarko, a 25% minority partner in the project, squarely blamed BP’s “reckless” decisions concerning, for example, the well’s design.

BP sought to shift some of the blame to Halliburton, a contractor in charge of cementing the well. After drilling an oil well, workers dropped a tubular metal casing in it to stabilize the hole’s walls and then inserted cement around the casing. (See Exhibit 2 for a diagram.) Cement was also used at Macondo to temporarily plug the well so that it could be abandoned until the well was put into production. Mistakes in these cementing processes might have allowed methane to escape. A Halliburton employee suggested that cement failures might have been due to BP’s using too few centralizers. BP, for its part, issued a statement saying, “If Halliburton had significant concerns about its ability to provide a safe and high-quality cement job in the Macondo well, then it had the responsibility and obligation to refuse to perform the job. To do otherwise would have been morally repugnant.”1

What seemed certain was that the well had posed problems for some time; an engineer had even sent an e-mail calling it a “nightmare well.” As a result, it was behind schedule and over budget. On the day of the explosion, some pressure readings were unusual. This led to arguments, some of which were between BP employees and employees of Transocean, the company that owned the rig. In the hearings, there was some jostling concerning which of the two companies had responsibility for which decisions. It was recognized that BP had ultimate authority, but BP claimed that Transocean employees determined much of what went on in the rig.

In drilling an oil well, workers pushed a material called drilling mud down through the drilling string; the mud helped the drilling process itself and was supposed to be heavy enough to help keep gas and oil from rising through the well. In a decision that may have been fatal, crew members at the Macondo well chose to take only limited readings before replacing much of the well’s drilling mud with seawater. Pushing down lighter seawater to recover the mud for future use may thus have made it easier for methane to escape. While several commentators second-guessed this replacement

decision, it was part of a plan that the MMS had approved just a few days before.2

The well’s last line of defense, the blowout preventer (BOP), had clearly failed. BOPs sat on the seafloor and contained several redundant pieces of equipment that were supposed to close wells in emergencies. When the BOP at the Macondo well failed to work, BP dispatched underwater vehicles to turn it on from below. This effort was also in vain, and BP blamed the failure on Transocean’s modifications of the BOP at the Macondo well. Some people speculated that the problem lay in the BOP’s batteries; others suggested that the BOP had in fact been activated but that it had closed the well only partway. Some of its elements might have been unable to fight the strong pressure of the oil rising through the well, while the ultimate line of defense, the shear ram, might have had trouble cutting through the drilling pipe itself.

Drilling crews regularly tested BOPs by interrupting the drilling, closing the well using various components of the BOP, and applying pressure. These tests, which took about eight hours, sometimes revealed problems. A 1999 study reported 117 BOP test failures (of which 20 were safety critical) in a sample of 83 gulf wells operated for 4,009 BOP days. The Deepwater Horizon’s BOP had been tested in this manner on April 10. The industry had been pushing the MMS to reduce the frequency of BOP testing, and a consultant’s study sponsored by the MMS and the industry agreed that some testing

intervals could be lengthened.3

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

60

BP’s Macondo: Spill and Response 711-021

3

The Response

Following the blowout, BP immediately sent skimming vessels and aircraft to the area. The latter released chemical dispersants, whose purpose was to separate oil molecules so that they could be more easily digested by bacteria. Environmentalists were concerned about both the leaking oil and the dispersants, but BP’s CEO, Anthony (Tony) Hayward, said, “Given the current conditions and the massive size of our response, we are confident in our ability to tackle this spill offshore.” At the time, BP and the U.S. Coast Guard estimated that the spill was spewing 1,000 barrels a day (b/d) of crude

oil.4 A week later, the Coast Guard raised this estimate to 5,000 b/d and BP started to burn oil offshore. Environmentalists questioned this estimate also, but BP held to it for a month, even after it had managed to attach a tube to the leaking pipe that was siphoning off about 1,000 b/d. Eventually,

it was thought that the Macondo well had been leaking about 60,000 b/d.5

The oil reached shore around May 1, prompting Louisiana, Florida, Alabama, and Mississippi to declare states of emergency. Oyster beds and shrimping grounds in Louisiana were closed, and lawsuits started to be filed against BP. Hayward accepted responsibility for paying for the cleanup operation, noting, “Where there are legitimate claims for business interruption, we will make them good.” With polls saying that 70% of respondents disapproved of BP’s handling of the situation, Attorney General Eric Holder announced that he was looking into filing criminal charges. The White House’s press secretary, Robert Gibbs, said, “We will keep our . . . boot on the throat of BP to ensure that they’re doing all that is necessary while we do all that is humanly possible to deal with this incident.” Some commentators from the United Kingdom complained that the anti-British rhetoric was going too far, in part because some U.S. policymakers referred to BP by its pre-1998 name of

British Petroleum.6

At around this time, the federal government designated the spill as having national significance and named Coast Guard head Thad Allen as incident commander. The increased federal responsibility led state officials to blame both BP and the federal government for the insufficient supplies of boom, a vinyl material meant to keep oil from physically reaching beaches. The governor of Alabama, Bob Riley, was particularly incensed when the Coast Guard took boom that his state had specially flown in from Bahrain and gave it to Louisiana. Even where boom deployment was approved by the Coast Guard, coordination with BP contractors often led to delays. The governor of Louisiana, Bobby Jindal, was also angered by the federal government’s initial refusal of a permit to build sand berms to prevent the oil from reaching shore. Eventually, the federal government relented, and a little later Allen ordered BP to pay for the berms.7

Some Republican commentators drew parallels with the government’s response to Hurricane Katrina, which Democrats had criticized as being insufficiently vigorous. In a poll at the end of May, only 35% of respondents approved of the administration’s response to the spill, while 45% disapproved. Sentiment had also turned against offshore drilling. While 64% had favored increased drilling in 2008, only 45% were so disposed now. (See Exhibit 7 for other polls.) At this point, Obama

sought to extend a moratorium on deepwater drilling for an additional six months. 8

In mid-June, Obama chose the gulf spill as the topic for his first national address from the Oval Office. The speech sought credit for the government’s efforts, assured viewers that BP would pay for what it had done, and promised to return the gulf to a pristine state. The next day, June 16, Obama met BP executives in the White House. At the meeting they signed an agreement under which BP would put $20 billion in an escrow account for the purpose of compensating victims of the spill. BP and the White House agreed that this fund would be administered by Kenneth Feinberg, an

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

61

711-021 BP’s Macondo: Spill and Response

4

arbitrator who had determined the payments made from the $7 billion fund the government set up to compensate the victims of the September 11, 2001, terrorist attacks.

BP was to deposit $3 billion into the fund in the third quarter of 2010, with the rest coming later. It was also to stop issuing dividends for 2010 and start selling assets. Obama announced that BP would set aside an additional $100 million to compensate workers who had been negatively affected by the administration’s deepwater drilling moratorium. The administration had been suggesting that BP should pay the damages to these workers in full, so this agreement represented a small retreat in its requests. Having lost about $91 billion in value since the explosion, BP’s stock price rose slightly on the day of this announcement.9 (See Exhibit 3 for BP’s stock price from April to September 2010.)

When Tony Hayward next appeared in front of a House of Representatives panel, most members lashed out at him. In reaction to the lashing-out, Texas representative Joe Barton, the ranking Republican on the energy committee, said, “I’m ashamed of what happened in the White House yesterday. I think it is a tragedy of the first proportion that a private corporation can be subjected to what I would characterize as a shakedown, a $20 billion shakedown.” After a furor, Barton apologized for his comment. Individual donations to Barton’s fall 2010 reelection campaign dropped from past levels, although his donations from political action committees (several of which were

funded by oil and gas companies) rose.10

BP’s first major effort at controlling the leak consisted of placing a giant funnel on top of the blowout area to capture the spewing oil. Such methods had succeeded in shallow waters, but the low temperature at Macondo’s seafloor impeded success. Later, BP attempted to clog the leaking pipe by shooting a mix of materials into it. Meanwhile, BP was drilling a well parallel to Macondo. The idea was to reach the same depth as Macondo, then bore horizontally, perforate Macondo, and fill it with cement from the bottom. BP expressed confidence that drilling a relief well would work, though some observers pointed out that this approach had sometimes proved slow due to the difficulty of finding the original well when boring horizontally. Before the relief well was ready, BP succeeded in capping the Macondo well by placing a new blowout preventer on top of the one that had failed. After this, BP let cement flow into the well through the new BOP and, when the cement solidified, removed both BOPs. The government supervised these activities closely. When BP was criticized for not having applied its successful solution more promptly, it pointed to an earlier government veto of

the plan; the government had been concerned that the cap might cause an underground blowout.11

From early on, BP had engaged in an extensive public relations drive to communicate its efforts at dealing with the spill and its commitment to make things right. It had not only purchased traditional advertising but made sure that links to its own stories were widely available on the Internet. Unfortunately for BP, the media paid much more attention to what were seen as signs of insensitivity. At one point in an interview, Hayward had said, “There’s no one who wants this thing over more than I do. I’d like my life back.” He later apologized for that comment; still, BP replaced Hayward with Robert Dudley at the end of July. Dudley, who had not had direct responsibility over either oil production or refining, would become the company’s first American CEO.12

BP’s Pre-Macondo Problems and Successes

In 2009, BP’s revenues of $367 billion placed it fourth on the Fortune 500 ranking of America’s largest corporations (after Shell, ExxonMobil, and Walmart) and its profits for that year totaled $21 billion. While its oil-based products constituted the bulk of BP’s revenue, its slogan “Beyond Petroleum” played up the fact that the company had made substantial investments in solar panels and wind-power generation. The company’s origins went back to its exploitation of Iranian wells at

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

62

BP’s Macondo: Spill and Response 711-021

5

the beginning of the 20th century. It changed its name from the Anglo-Persian Oil Company to British Petroleum in 1954, after Iran expropriated its fields. The British government owned a substantial stake in British Petroleum at the time, though the company was subsequently privatized. It later acquired the assets of several large U.S. oil companies and thereby became a major refiner and gasoline retailer in the United States. In 2010, its U.S. wells in the Gulf of Mexico accounted for 11% of

its production.13

CEO Tony Hayward started BP’s 2009 annual report by saying, “Our priorities have remained absolutely consistent—safety, people and performance—and you can see the results of this focus with improvements on all three fronts.” The report stated that “safety is BP’s number one priority” and Hayward noted that, in 2009, the number of oil spills (234) and “recordable personal injuries” (0.34 per 200,000 hours worked) were the lowest in 10 years. Safety measures determined 15% of one of the bonuses given to executives, headcount and employee satisfaction determined another 15% of this bonus, and financial and operational outcomes determined the remaining 70%. DeAnne Julius, chair of BP’s remuneration committee, noted that in 2009, “Nearly all targets were exceeded, some substantially, with particularly strong performance on cost reduction, exploration success, production startups and refining performance.”14

Hayward had reason to be happy with this performance, particularly in deepwater fields (those that lay beneath 1,000 feet of water), which were regarded as the areas of highest potential for oil exploration. By 2009, BP had become the largest deepwater producer in the world as well as in the Gulf of Mexico, where it extracted about 400,000 barrels of oil a day. In September 2009, it proudly announced a giant find at the Tiber well in the gulf. This well, one of the deepest ever (approximately 35,000 feet of total depth) had been dug by the Deepwater Horizon. BP was its operator, while U.S.- based ConocoPhillips and the partially state-owned Brazilian company Petrobras had minority stakes.

BP also had an active research program. Five days after the Macondo explosion, BP was granted a patent on a new method for testing blowout preventers. BP’s patent covered a method that cut the required time for these tests by using a digital algorithm rather than relying on crude visual observations. BP had validated this test with data from the Deepwater Horizon and had requested that the U.S. Minerals Management Service allow this new testing method to replace the traditional

one.15

Before Hayward became CEO, BP’s safety record was far from exemplary. In 2001, workers at the Prudhoe Bay oil fields in Alaska complained that, as a result of poor maintenance and staff reductions, many critical valves were not being properly tested and did not close properly. The particular spill they regarded as emblematic was initially dismissed by BP as being like a minor “leaking faucet” that had fueled a “candle-sized” flame. A subsequent investigation by BP and a team of consultants revealed that 10% of BP valves failed to pass state tests and that BP’s testing often did

not follow the company’s own written procedures.16

In March 2005, oil gushed out of a relief tank at BP’s Texas City refinery; the resulting explosion killed 15 people. While various pressure readings before the explosion were anomalous, operators did not understand them well enough to prevent the accident. According to U.S. federal investigators, numerous safety system deficiencies lay underneath these human errors. The U.S. Chemical Safety Board (CSB) noted that the Occupational Safety and Health Administration (OSHA) had, at one point, asked for the replacement of the relief equipment that failed. BP convinced OSHA that it should be allowed to make a cheaper change, though OSHA, in turn, never carried out the inspection of the change that it had originally demanded. Beyond blaming the accident on particular

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

63

711-021 BP’s Macondo: Spill and Response

6

equipment failures, the CSB blamed it on maintenance budget cuts, worker fatigue, a routine tendency not to follow written procedures (while still checking boxes as required by procedures), a bigger focus on personal safety (slips and falls) than on process safety, and a culture that did not

encourage the reporting of safety incidents.17

Under Hayward, BP settled all the lawsuits brought against it for the March 2005 explosion, including those brought by the government. It agreed to plead guilty to one felony violation (for not following proper procedures) and to pay record fines to OSHA ($21 million) and for violations of the Clean Air Act ($50 million). It also agreed to modify its procedures and make major investments.

Some victims sought to have the agreement with the government scrapped on the grounds that the penalty was too slight and that BP was not complying with it. While OSHA sided with BP at the end of 2008, saying that “BP has and is making progress at the facility,” it proposed another $87 million in fines in October 2009 on the basis of 270 failures to comply with its earlier agreement and 439 new violations. BP agreed in August 2010 to pay part of this fine. Contrary to OSHA, BP still claimed that its system of pressure relief valves met industry standards.18

Government Involvement in Deepwater Oil Exploration

As of 2010, deepwater oil production accounted for about 6.4% of the 84 million barrels a day of global oil production. (See Exhibit 4 for information about the main producers and consumers of oil.) About a fifth of deepwater oil production came from the Gulf of Mexico, while a quarter came from Brazil, where huge reserves had been found recently. Because about half of new oil discoveries in the last few years had been in deepwater, many observers expected the importance of deepwater to grow over time. In the United States, deepwater production had risen so rapidly in the recent past that, after years of declines, the country had recently experienced some growth in total production. The overall growth had occurred even though production in the shallow waters of the Gulf of Mexico continued to decline. Major oil companies were excited about deepwater in the United States. While the drilling costs were obviously larger than in shallow water, the wells tended to be much more

productive.19

Another important trend was that exploration and production made increasing use of specialized contractors. In the case of deepwater drilling, it was common for a producer to rent the entire drilling rig from a company that also provided most of the rig’s crew. This explains why of the 126 people aboard the Deepwater Horizon on the day of the April 20, 2010, explosion 79 worked for Transocean,

41 worked for other contractors such as Halliburton, and only 6 worked for BP.20

Transocean had Louisiana origins but had recently moved its headquarters to Zug, Switzerland, to reduce its corporate taxes. By the end of 2009, it had become the world’s largest deepwater driller, with a fleet of 39 deepwater rigs. Of these, 13 were in the Gulf of Mexico. By one metric at least, Transocean’s safety record in the gulf had worsened recently. Between 2008 and 2010, the company accounted for 73% of all deepwater incidents investigated by the Minerals Management Service even though it accounted for only 42% of the rigs. These two percentages had been more closely aligned

before 2008.21

The United States also had underwater reserves elsewhere. After a 1969 blowout that spilled 5,000 barrels of oil six miles off the California coast at Santa Barbara, however, a combination of state and federal actions had prevented almost all new offshore drilling except off the coasts of Texas, Louisiana, Mississippi, and parts of Alaska. On March 31, 2010, Obama proposed to partially reverse this moratorium and open up some parts of the mid-Atlantic and Florida coasts.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

64

BP’s Macondo: Spill and Response 711-021

7

In defending this proposal, Obama said, “We’ll employ new technologies that reduce the impact of oil exploration. We’ll protect areas vital to tourism, the environment, and our national security. And we’ll be guided not by political ideology, but by scientific evidence.” Many environmentalists were nonetheless opposed to this move, whereas Governor Bob McDonnell of Virginia said, “The president’s decision to allow energy exploration off Virginia’s coast will mean thousands of new jobs, hundreds of millions in new state revenue and tens of billions of dollars in economic impact for the commonwealth.”22

Until 2010, the government managed the nation’s offshore oil resources through the MMS. The MMS decided what areas to open for bidding, collected the resulting revenue, specified the requirements for drilling plans, and occasionally inspected rigs to verify that oil companies adhered to these plans. As a federal government revenue source, it was second only to the Internal Revenue Service. There was a widespread sentiment that the MMS had too few resources to be effective. A report by the Department of Interior questioned whether the MMS had staff “with the requisite expertise to review and vet standards” developed by trade associations. According to the report, almost half the inspectors said they had insufficient training for their job. Between 1983 and 2007, the inspection staff had been cut by 36% while the number of leases soared. As a result, there were only

55 inspectors assigned to the 3,000 facilities in the Gulf of Mexico.23

Leasing Revenue

One oft-expressed concern with the U.S. approach to offshore oil production was that it was too generous to oil companies. Several studies seemed to show this by comparing the government take in different jurisdictions. (See Exhibit 5 for an example of one such comparison.) Government take was defined as the ratio of a government’s oil-dependent revenue over extracted oil’s value. It thus included any payments that firms made for the right to drill, any royalty charged by the government, and any tax on the profit of oil companies (including the economy-wide corporate profit tax). The precise mix of payments varied from one country to another. For example, Norway had imposed no royalties between 1992 and 2002 and gave out large investment tax credits to this sector. On the other hand, it required all offshore drilling to be made in a 50% partnership with a majority state-owned oil company (Statoil) and subjected the resulting profits to a 50% special corporate profit tax rate on oil

over and above the standard 28% corporate profit tax rate.24

The low government take in the United States helped convince the Alaska legislature to increase its corporate tax rate on oil firms in 2006. Aside from corporate income taxes, the U.S. government take came in two forms. First, the MMS held periodic bids for tracts. Firms submitted sealed bids, and the MMS could then lease the tracts to the highest bidders for the amount bid. One important change in 1983 was that the United States increased the number of tracts, particularly deepwater tracts, it put out for bid on each occasion. The result was a sharp reduction in the highest bid per tract and in the number of bidders per tract. In the case of Lease 206 in 2008, which included Macondo, the MMS put 5,000 tracts out for bid and received 1,057 bids on 615 tracts. The MMS proudly noted that the high-

bid total, $3.7 billion, was a record. The MMS had the right to reject bids but did so rarely.25

Second, well owners had to pay a royalty equal to a fraction of their production. The base royalty had recently been raised to 18.75%. A controversial program remained in place, however, by which companies drilling in deepwater could avoid royalties up to a production cap under certain conditions. Some economists theorized that, even though low royalty rates ought to lead to higher bids, low royalty rates would still lead to overall revenue declines. The reason they gave was that a reduction in the royalty rate should increase the dispersion in bidders’ perceptions of the dollar

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

65

711-021 BP’s Macondo: Spill and Response

8

profits of individual tracts. Bidders would then have less to fear from shading their bids and would therefore bid less aggressively.26

Drilling Regulations

Most offshore drilling regulations were spelled out in a 470-page block of the U.S. Code of Federal Regulations, which could be changed only after a period of public comments. In addition, the MMS issued supplementary Notices to Lessees (NTLs). A relatively small number of the drilling regulations involved specific details, such as “The drilling crew must have ready access to a wrench to fit each manual valve.” There were also regulations mandating tests of equipment and of the well at predetermined intervals. The regulations listed a large number of industry standards, as specified in publications of trade associations such as the American Petroleum Institute, by which firms were supposed to abide. There were also regulations providing objectives such as “You must take necessary precautions to keep wells under control at all times.” This was regarded as important enough that firms were instructed to “use the best available technology to monitor and evaluate well conditions.” One area in which regulations were more specific was in stating the reporting requirements of drillers to the MMS. The MMS had to accept a drilling plan before lessees could drill. Lessees needed to report pollution and to seek approval for particular procedures, such as the method proposed by BP to temporarily cap the Macondo well. The MMS gave BP’s proposal the go- ahead on April 16, 2010.

Drilling plans in the Macondo area of the Gulf of Mexico had been exempted from the requirement of giving a scenario describing a possible blowout. The MMS apparently did not find these scenarios informative. Drillers did have to file an Oil Spill Response Plan, which had to include evidence that the driller had contracts with providers of needed services after a spill. Firms drilling in the gulf tended to file very similar plans. The CEOs of BP, ExxonMobil, Chevron, and ConocoPhillips were ridiculed by a congressional panel for having plans that discussed the protection of walruses

even though there were no walruses in the gulf.27

Environmentalists complained that the MMS had exempted BP’s drilling plan for the Macondo well from having to spell out its environmental impact. As the White House clarified some time later, the MMS had followed a standard procedure based on the MMS’s already extensive environmental impact analyses for all its proposed leases. In particular, an 85-page environmental assessment (EA) for Lease 206 had been written before bids were accepted. This EA discussed effects on air and water quality, coastal regions, and marine life as well as recreational, archeological, and human resources. It provided estimates of the likely effect of the lease on these resources and discussed the steps lessees needed to take to minimize harm. It anticipated, for example, that 38 green turtles would die over the 40-year lifetime of the lease as a result of the drilling. The MMS prided itself on spending considerable resources on environmental analyses.

The MMS also anticipated that the leases would have two to three blowouts, though it expected the impact of these blowouts to be minor. It said that blowouts “could have modest, short-term economic consequences” and “are expected to have temporary localized impacts on water quality.” Not everyone had been so sanguine. At hearings in November 2009, Senator Robert Menendez had pointed to a photograph of an Australian rig in flames and had asked whether he was “just being old- fashioned” in worrying about the possibility of a similar blowout in the gulf.

The dramatic Australian blowout, at the Montara well in the Timor Sea, had leaked 2,000 barrels a day for 74 days before it was stopped. The MMS’s deputy director, Walter Cruishank, responded to Menendez by saying that U.S. regulatory requirements “should have prevented the drilling operations in the Timor Sea, as we understand them.” He pointed particularly to the pressure tests

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

66

BP’s Macondo: Spill and Response 711-021

9

that the United States required after cementing jobs that “would have likely identified the problem with the primary cement job on the Timor Sea well.”28

Another reason for the MMS’s optimism was that past spills from platforms in U.S. waters had been small. A report that the MMS commissioned in 1993, titled “Moving Beyond Conflict to Consensus,” noted that “90% of the wells in the Gulf of Mexico required artificial lifting of their oil with pumps or the use of gas. . . . Such reservoir characteristics make extremely large spills improbable.”29 Although not in U.S. waters, a blowout had caused a 3-million-barrel spill in the gulf in June 1979. The Ixtoc spill had occurred in 160 feet of water off the coast of Mexico. The well’s blowout preventer had failed, as had initial containment efforts, and so Ixtoc spewed oil for almost 10 months.

Critics who accused the MMS of being too cozy with industry could point to a 2008 government report concerning its Lakewood, Colorado, office. This office administered a controversial in-kind royalty program in which the MMS took delivery of oil and had to market it itself. According to the report, 8 of the 60 staff members at the facility had accepted gifts from oil companies in excess of the allowed $50 a year, and there were some inappropriate relations between staff and oil executives. The report painted the office’s organizational culture as “lacking acceptance of government ethical standards.” One of Ken Salazar’s first acts as interior secretary was to visit the Lakewood office and

give a stern speech in which he said, “The ‘anything goes’ will end.”30

Some congressional leaders renewed their cries of outrage at the publication in 2010 of a new investigative report. This one said that, before 2007, a number of employees at the Lake Charles, Louisiana, facility in charge of offshore inspections had received gifts from oil company executives. It noted, however, that the “culture of acceptance of gifts” appeared to have declined after one

employee was fired in January 2007.31

These episodes notwithstanding, the oil industry did not always agree with the MMS. An analysis of accidents had convinced the MMS that firms should be required to have a Safety and Environmental Management System (SEMS) focused on four areas: studying rigs to minimize uncontrolled releases of oil and gas, determining the possible adverse environmental consequences of modifications, reviewing operating procedures, and setting up procedures to ensure the use of environmentally sound equipment. The MMS proposed specific SEMS regulations in 2009 and BP, Chevron, and ExxonMobil responded with critical comments. They agreed that SEMSs were useful, but they preferred a voluntary American Petroleum Institute (API) standard that the MMS had deemed valuable in the past and with which they already complied. They objected that the rules now proposed by the MMS were too prescriptive and therefore burdensome.32

Liability for Damages

On March 24, 1989, the tanker Exxon Valdez struck a reef near the coast of Alaska and spilled around 500,000 barrels of oil. In part because the area was remote, the response was slow. The results included contamination of about 1,300 miles of coastline, deaths of about 250,000 birds and 2,800 otters, and recovery of natural habitats that took years. Exxon paid for the cleanup itself. A jury initially required Exxon to pay $287 million in compensatory damages and $5 billion in punitive damages. Exxon appealed the punitive damage award all the way to the Supreme Court, which in 2008 cut the punitive damages to about $500 million. While the captain of the Exxon Valdez had previously been an alcoholic, had been absent from the bridge when the tanker ran aground, had been seen drinking on the evening of the accident, and still had significant alcohol in his blood 10.5 hours after the accident, he was ultimately cleared of almost all charges filed against him. Explaining why he was found guilty only of a negligent discharge of oil, and not of “reckless endangerment,” a juror said, “Reckless, no; negligent, possibly.”33

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

67

711-021 BP’s Macondo: Spill and Response

10

Congress reacted to the Exxon Valdez spill by passing the Oil Pollution Act of 1990, a law that resembled bills that had been introduced before while also prohibiting any ship that had spilled more than 1 million gallons of oil after March 22, 1989, from operating in Alaska. This law put the federal government in charge of significant offshore oil cleanup operations while still requiring firms that caused oil spills to pay for the cleanup costs. It also limited these firms’ liability for damages. In the case of oil tankers, this liability cap depended on the vessel’s tonnage while it equaled $75 million for offshore facilities. This cap did not apply, however, if the spill was caused by gross negligence or willful misconduct or by the violation of a federal regulation. The cap had been binding in the case of several shipping accidents. Consistent with the 1990 law, further damages had been paid by the government from the Oil Spill Liability Trust Fund, which was funded by a tax on imported oil. When he was appointed head of the Coast Guard, Thad Allen said that the fund had $1.6 billion.

Several witnesses at hearings for predecessors to the Oil Pollution Act of 1990 had argued for modest liability caps on the grounds that operators needed to prove they could cover their liability before operating. They further said that insurance companies would charge high premiums (or refuse to insure) companies subject to large liability payments. The result, they claimed, would be “that only the largest global corporation could afford the expense. This would drive out competition and cause

monopolistic pricing and practices.”34

BP might also be required to make two additional kinds of payments. First, it might have to compensate the MMS for its share of the oil that BP had involuntarily “extracted.” Second, BP could expect fines for spilling oil under the Clean Water Act. The minimum for these fines was normally $1,100 per barrel spilled, with a maximum of $4,300 per barrel if the spill was due to gross negligence.

Several of the lawsuits filed after the Macondo explosion pursued Transocean, on the grounds that it had contributed to the accident. Transocean, however, had gone to federal court in an attempt to curb the impact of these suits. It argued that an obscure maritime law of 1851 limited its overall liability to the remaining value of the vessel and its cargo, which it calculated to be $26.9 million because the rig itself was now worthless. Some observers speculated that Transocean would benefit from filing this claim even though it was unlikely to prevail because the statute required that the loss

be due to forces outside the firm’s “privity and knowledge.”35

Some Similarities and Differences with Regulations Elsewhere

While the oil exploration business was global in scope, each individual country had its own regulatory structure. Nonetheless, there were similarities among different countries’ regulations. Canada and the United Kingdom, for example, also required firms to pay cleanup costs for spills while limiting their liability for the damages caused by those spills. In the United Kingdom, regulations had been changed after 167 people were killed in 1988 by the explosion of the Piper Alpha platform. One change was that regulation and oversight were moved from the Department of Energy to the Health and Safety Executive. Robert Paterson, an executive at a trade association, said, “The disaster prompted the [UK] government to change its set-up from a very prescriptive regulatory

environment towards a more goal-setting system.”36

The Norwegian approach evolved similarly. Norway moved its regulation and oversight function from the Ministry of Petroleum and Energy to an organization called the Petroleum Safety Authority (PSA), which belonged to the Ministry of Labor. Norwegian drillers were required to have a demonstrable management system in charge of compliance. Moreover, the PSA’s regulations prescribed goals such as “Well control equipment shall be designed and shall be capable of being activated so as to provide for barrier integrity as well as control” and “Facilities shall be designed so that no employee is exposed to noise that is harmful to hearing.” The PSA also provided more

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

68

BP’s Macondo: Spill and Response 711-021

11

detailed guidelines. These were not mandatory, though firms that did not abide by them needed to be able to justify why their approach was equally good. These guidelines required blowout preventers to be fitted with remote acoustic switches. All drillers used such switches in Norway, though

alternative control systems were acceptable as well.37

After a fire on a platform killed 11 people in 2007, the Brazilian government also required the use of remote acoustic switches in BOPs. In the United States, the MMS considered mandating such switches but did not act, perhaps because a 2003 study that it commissioned said that “acoustic

systems are not recommended because they tend to be very costly.”38

Oystein Noreng, a professor of petroleum economics at the BI Norwegian School of Management claimed that the Norwegian regime had better performance than the U.S. one, with one example being that its oil spills from production were lower as a fraction of total production. (See Exhibit 6 for a comparison of offshore drilling activity and accidents.) He attributed this not only to Norwegian rules but also to the influence of Norwegian unions. In Norway, elected labor representatives looked after safety and had the right to stop operations.39

Aftermath of the Spill

In early August 2010, the U.S. government announced that only about a quarter of the spilled oil from the Macondo well remained in the water. The number of oiled birds found dead or alive was about 7,000. Some environmentalists continued to express concern about the possibility of adverse long-term impacts, even as the visible damage appeared modest relative to that of the Exxon Valdez spill. They pointed, particularly, to an oily dead layer of several centimeters that covered the seafloor in areas near the spill. On the other hand, a government study had found only 35 miles of the Louisiana coast to be heavily oiled and observers deemed the damage to the coast mild relative to its continued destruction by the reengineering of the Mississippi River. An expert from Louisiana State University declared, for example, “This looks fairly minor.” The difference between the Macondo spill and the Exxon Valdez spill was attributed to favorable currents, to the lightness of gulf’s oil and to the gulf’s higher temperatures, which aided in the oil’s decomposition. An additional difference between the gulf’s and Alaska’s ecosystems was that natural seepage of oil from the seafloor was

relatively common in the former.40

In spite of dire predictions that the drilling moratorium would lead to a massive exodus of drilling rigs, only 2 of the 33 deepwater rigs in the gulf had departed by the end of August. Moreover, the workers in the remaining rigs had not lost their jobs. People working in the paralyzed seafood and tourist industries did not fare as well. To take care of all those who had lost income as a result of the spill, BP had set up 35 offices to process their claims. These offices had made $399 million in payments before Kenneth Feinberg took over as administrator at the end of August 2010.

This late start had given Feinberg an opportunity to hear a range of opinions regarding how payments should be determined, and he had, in turn, started to announce the criteria he intended to apply. Feinberg decided that claimants could ask for six months of emergency funding and receive it without forgoing their right to ask for more. They then had three years to ask for a lump-sum final settlement. Feinberg would then make them an offer conditional on promising not to sue BP (and possibly other companies) for the explosion. In an effort to convince people to file claims under his process, Feinberg said, “I’m determined to be more generous than any state court will be or any

federal court.”41

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

69

711-021 BP’s Macondo: Spill and Response

12

At the end of August, Feinberg publicized that eligibility for payments would depend on the claimant’s location and industry. His decision to base payments on geographic proximity to the spill was met with heated opposition. Even though most of Florida’s coast was far enough from the spill to be undamaged, Florida hotel owners claimed that they had lost business because potential tourists were afraid of finding their beaches sullied. An industry representative said, “It’s clear that the spill is going to cost Florida’s tourism billions of dollars,” and the governor of Florida asserted that BP could end up owing $1 billion in lost tourism taxes. 42

Outside the United States, the response to the spill was fairly muted. Governments promised to review their regulatory structure and to study the lessons of Macondo, but almost all of them kept their drilling programs, including their deepwater programs, on track. Norway did ban the start of new deepwater wells, but it made clear that the ban was temporary and leased new deepwater tracks

in June 2010.43

Policy Choices

The Minerals Management Service was reorganized in June 2010; the new organization in charge of regulating offshore drilling, the Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE), issued new regulations on October 14 and officially lifted the deepwater moratorium. Industry members were concerned, however, that the moratorium would continue de facto unless the agency hired additional personnel to process applications. This worry was also

fueled by the unusually slow pace at which shallow-water wells had been approved since April 20.44

The new regulations required drillers to obtain certificates from approved engineering firms. These would vouch that blowout preventers and cementing plans fulfilled certain specifications. In addition, more documentation was required, further tests of BOPs and cementing jobs were mandated, and rig workers were ordered to obtain more training in well control. BOEMRE estimated that this would cost the industry $183.1 million annually. Using historical data, it estimated that a major spill costing $16.3 billion could be expected to occur once every 26 years, so that the annualized cost of spills was $631.4 million. While it recognized that the new regulations would not reduce the probability of these events to zero, it still thought the benefits of its rule exceeded its costs.45

Congress, meanwhile, was considering a large number of bills concerning offshore drilling. Some were targeted at BOPs, and wanted these to have acoustic shut-off technology or use the best available and safest technology. Others wanted to repeal retroactively the 1851 Limitation of Liability Act, which Transocean was using for protection. Still others wanted to increase safety by providing additional protection to whistleblowers. BP, for its part, sought to thwart congressional efforts to curtail its future operations by, for example, making permits to drill conditional on not having had more than 10 fatalities in a facility and not having had to pay more than $10 million in fines for violations of the Clean Air or Clean Water Acts.

David Nagle, BP’s executive vice president for BP America, responded to this legislation by saying it would make it harder to “fund things, fund these programs.” He was referring to BP’s willingness to honor a variety of requests from state officials. Responding to such requests, BP had already donated $32 million to Florida’s marketing efforts and $15 million each to Alabama, Louisiana, and Mississippi. It was currently contemplating Louisiana governor Bobby Jindal’s call for $173 million to test, certify, and promote Gulf of Mexico seafood. Faced with these conflicting pressures, policymakers both in the White House and in Congress needed to think about how they wanted to reshape the offshore oil industry.46

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

70

BP’s Macondo: Spill and Response 711-021

13

Exhibit 1 Remarks by President Barack Obama on the BP Oil Spill, June 15, 2010

On April 20, an explosion ripped through BP Deepwater Horizon drilling rig, about 40 miles off the coast of Louisiana. Eleven workers lost their lives. Seventeen others were injured. And soon, nearly a mile beneath the surface of the ocean, oil began spewing into the water. Because there has never been a leak this size at this depth, stopping it has tested the limits of human technology. That’s why just after the rig sank, I assembled a team of our nation’s best scientists and engineers to tackle this challenge—a team led by Dr. Steven Chu, a Nobel Prize–winning physicist and our nation’s secretary of energy. Scientists at our national labs and experts from academia and other oil companies have also provided ideas and advice. As a result of these efforts, we’ve directed BP to mobilize additional equipment and technology. And in the coming weeks and days, these efforts should capture up to 90 percent of the oil leaking out of the well. This is until the company finishes drilling a relief well later in the summer that’s expected to stop the leak completely. Already, this oil spill is the worst environmental disaster America has ever faced. And unlike an earthquake or a hurricane, it’s not a single event that does its damage in a matter of minutes or days. The millions of gallons of oil that have spilled into the Gulf of Mexico are more like an epidemic, one that we will be fighting for months and even years. But make no mistake: We will fight this spill with everything we’ve got for as long as it takes. We will make BP pay for the damage their company has caused. And we will do whatever’s necessary to help the Gulf Coast and its people recover from this tragedy. Tonight I’d like to lay out for you what our battle plan is going forward: what we’re doing to clean up the oil, what we’re doing to help our neighbors in the Gulf, and what we’re doing to make sure that a catastrophe like this never happens again. First, the cleanup. From the very beginning of this crisis, the federal government has been in charge of the largest environmental cleanup effort in our nation’s history—an effort led by Admiral Thad Allen, who has almost 40 years of experience responding to disasters. We now have nearly 30,000 personnel who are working across four states to contain and clean up the oil. Thousands of ships and other vessels are responding in the Gulf. And I’ve authorized the deployment of over 17,000 National Guard members along the coast. These servicemen and women are ready to help stop the oil from coming ashore, they’re ready to help clean the beaches, train response workers, or even help with processing claims—and I urge the governors in the affected states to activate these troops as soon as possible. Because of our efforts, millions of gallons of oil have already been removed from the water through burning, skimming, and other collection methods. Over five and a half million feet of boom has been laid across the water to block and absorb the approaching oil. We’ve approved the construction of new barrier islands in Louisiana to try to stop the oil before it reaches the shore, and we’re working with Alabama, Mississippi, and Florida to implement creative approaches to their unique coastlines. As the cleanup continues, we will offer whatever additional resources and assistance our coastal states may need. Now, a mobilization of this speed and magnitude will never be perfect, and new

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

71

711-021 BP’s Macondo: Spill and Response

14

challenges will always arise. I saw and heard evidence of that during this trip. So if something isn’t working, we want to hear about it. If there are problems in the operation, we will fix them. . . . The third part of our response plan is the steps we’re taking to ensure that a disaster like this does not happen again. A few months ago, I approved a proposal to consider new, limited offshore drilling under the assurance that it would be absolutely safe—that the proper technology would be in place and the necessary precautions would be taken. That obviously was not the case in the Deepwater Horizon rig, and I want to know why. The American people deserve to know why. The families I met with last week who lost their loved ones in the explosion—these families deserve to know why. And so I’ve established a national commission to understand the causes of this disaster and offer recommendations on what additional safety and environmental standards we need to put in place. Already, I’ve issued a six-month moratorium on deepwater drilling. I know this creates difficulty for the people who work on these rigs, but for the sake of their safety, and for the sake of the entire region, we need to know the facts before we allow deepwater drilling to continue. And while I urge the commission to complete its work as quickly as possible, I expect them to do that work thoroughly and impartially. One place we’ve already begun to take action is at the agency in charge of regulating drilling, and issuing permits, known as the Minerals Management Service. Over the last decade, this agency has become emblematic of a failed philosophy that views all regulation with hostility—a philosophy that says corporations should be allowed to play by their own rules and police themselves. At this agency, industry insiders were put in charge of industry oversight. Oil companies showered regulators with gifts and favors, and were essentially allowed to conduct their own safety inspections and write their own regulations. When Ken Salazar became my secretary of the interior, one of his very first acts was to clean up the worst of the corruption at this agency. But it’s now clear that the problem there ran much deeper, and the pace of reform was just too slow. And so Secretary Salazar and I are bringing in new leadership at the agency—Michael Bromwich, who was a tough federal prosecutor and inspector general. And his charge over the next few months is to build an organization that acts as the oil industry’s watchdog— not its partner. So one of the lessons we’ve learned from this spill is that we need better regulations, better safety standards, and better enforcement when it comes to offshore drilling. But a larger lesson is that no matter how much we improve our regulation of the industry, drilling for oil these days entails greater risk. After all, oil is a finite resource. We consume more than 20 percent of the world’s oil, but have less than 2 percent of the world’s oil reserves. And that’s part of the reason oil companies are drilling a mile beneath the surface of the ocean—because we’re running out of places to drill on land and in shallow water. For decades, we have known the days of cheap and easily accessible oil were numbered. For decades, we’ve talked and talked about the need to end America’s century-long addiction to fossil fuels. And for decades, we have failed to act with the sense of urgency that this challenge requires. Time and again, the path forward has been blocked—not only by oil industry lobbyists, but also by a lack of political courage and candor.

Source: Excerpts from President Obama’s First Oval Office Address, June 15, 2010.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

72

BP’s Macondo: Spill and Response 711-021

15

Exhibit 2 Simplified Oil Well Diagram

Source: Casewriter.

Exhibit 3 BP Stock Price (Daily Close), April 17 to September 9, 2010

Source: Adapted with data from Bloomberg LP, accessed September 2010.

0

10

20

30

40

50

60

70

4 /1

7 /2

0 1

0

4 /2

2 /2

0 1

0

4 /2

7 /2

0 1

0

5 /2

/2 0

1 0

5 /7

/2 0

1 0

5 /1

2 /2

0 1

0

5 /1

7 /2

0 1

0

5 /2

2 /2

0 1

0

5 /2

7 /2

0 1

0

6 /1

/2 0

1 0

6 /6

/2 0

1 0

6 /1

1 /2

0 1

0

6 /1

6 /2

0 1

0

6 /2

1 /2

0 1

0

6 /2

6 /2

0 1

0

7 /1

/2 0

1 0

7 /6

/2 0

1 0

7 /1

1 /2

0 1

0

7 /1

6 /2

0 1

0

7 /2

1 /2

0 1

0

7 /2

6 /2

0 1

0

7 /3

1 /2

0 1

0

8 /5

/2 0

1 0

8 /1

0 /2

0 1

0

8 /1

5 /2

0 1

0

8 /2

0 /2

0 1

0

8 /2

5 /2

0 1

0

8 /3

0 /2

0 1

0

9 /4

/2 0

1 0

9 /9

/2 0

1 0

S

t

o

c

k

P

r

i

c

e

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

73

711-021 BP’s Macondo: Spill and Response

16

Exhibit 4 Leading Oil Producers and Consumers in 2009

Source: Adapted from CIA World Factbook.

Production Rank

Country

Oil production

(millions barrels/day)

Consumption Rank

Country

Oil Consumption

(millions

barrels/day)

1 Russia 9.9 1 United States 18.7

2 Saudi Arabia 9.8 2 China 8.2

3 United States 9.1 3 Japan 4.4

4 Iran 4.2 4 India 3.0

5 China 4.0 5 Russia 2.9

6 Canada 3.3 6 Brazil 2.5

7 Mexico 3.0 7 Germany 2.4

8 United Arab Emirates 2.8 8 Saudi Arabia 2.4

9 Brazil 2.6 9 Korea South 2.2

10 Kuwait 2.5 10 Canada 2.2

11 Venezuela 2.5 11 Mexico 2.1

12 Iraq 2.4 12 France 1.9

13 Norway 2.4 13 Iran 1.8

14 Nigeria 2.2 14 United Kingdom 1.7

15 Algeria 2.1 15 Italy 1.5

16 Angola 1.9 16 Spain 1.5

17 Libya 1.8 17 Indonesia 1.1

18 Kazakhstan 1.5 18 Australia 0.9

19 United Kingdom 1.5 19 Thailand 0.9

20 Qatar 1.2 20 Netherlands 0.9

21 Indonesia 1.0 21 Taiwan 0.9

22 Azerbaijan 1.0 22 Singapore 0.9

23 India 0.9 23 Venezuela 0.7

24 Oman 0.8 24 Iraq 0.7

25 Argentina 0.8 25 Egypt 0.7

26 Malaysia 0.7 26 Argentina 0.6

27 Colombia 0.7 27 Belgium 0.6

28 Egypt 0.7 28 Turkey 0.6

29 Australia 0.6 29 South Africa 0.6

30 Sudan 0.5 30 Poland 0.5

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

74

BP’s Macondo: Spill and Response 711-021

17

Exhibit 5 Government Take of Oil Production Revenues, 2002

Country Take

Algeria 71.72

Angola (deepwater) 59.93

Angola (shelf) 74.11

Argentina 46.93

Australia (offshore) 45.51

Azerbaijan 61.54

Brazil (deepwater) 60.19

Brazil (shelf) 47.88

Canada (East Coast) 35.17

Egypt (offshore) 73.04

Egypt (onshore) 74.27

India 66.82

Indonesia (offshore) 71.01

Indonesia (onshore) 80.13

Kazakhstan 51.88

Libya 78.73

Malaysia 81.24

Mexico 30.00–32.00*

Nigeria (deepwater) 64.62

Nigeria (onshore) 87.21

Norway 74.74

Oman 83.19

Qatar 79.09

Sudan 76.96

United Kingdom ( shallow water) 40.77

United States (Alaska) 64.24 United States (Gulf of Mexico deepwater) 42.10

Venezuela 49.56

* From a different, 1997, consulting study.

Source: U.S. Government Accountability Office, GAO-07-676R, Oil and Gas Royalties, May 1, 2007.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

75

711-021 BP’s Macondo: Spill and Response

18

Exhibit 6 Offshore Activity and Accidents (Total), 2003–2005

Manhours (millions)

Fatalities (per

million manhours)

Medical Treatment Incidents

(per million manhours)

Lost Time Incidents

(per million

manhours)

Africa 139.3 0.065 2.44 1.60

Asia/Pacific 169.8 0.047 2.24 1.46

Canada 9.5 0.105 5.26 1.79 Central/South America 118.4 0.076 3.58 1.81

Europe 176.3 0.011 2.57 1.91

Middle East 119.7 0.058 2.12 0.82

United States 231.7 0.056 3.16 1.57

Source: Compiled with data from International Association of Drilling Contractors (data submitted voluntarily and unaudited).

Exhibit 7 Percentage of Americans Who Favored Increased Offshore Oil and Gas Drilling in U.S. Waters, September 2008–October 2010

Source: Adapted using data from the Pew Research Center.

67 68

63

54

44

51

0

10

20

30

40

50

60

70

80

9 /2

0 0

8

1 0

/2 0

0 8

1 1

/2 0

0 8

1 2

/2 0

0 8

1 /2

0 0

9

2 /2

0 0

9

3 /2

0 0

9

4 /2

0 0

9

5 /2

0 0

9

6 /2

0 0

9

7 /2

0 0

9

8 /2

0 0

9

9 /2

0 0

9

1 0

/2 0

0 9

1 1

/2 0

0 9

1 2

/2 0

0 9

1 /2

0 1

0

2 /2

0 1

0

3 /2

0 1

0

4 /2

0 1

0

5 /2

0 1

0

6 /2

0 1

0

7 /2

0 1

0

8 /2

0 1

0

9 /2

0 1

0

1 0

/2 0

1 0

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

76

BP’s Macondo: Spill and Response 711-021

19

Exhibit 8 Operators Affected by Gulf Deepwater Moratorium, 2010

Company Number of Affected

Rigs

Royal Dutch Shell Plc 5

Anadarko Petroleum Corp. 3

Eni SpA 3

Marathon Oil Corp. 3

BHP Billiton Ltd. 2

BP Plc 2

Chevron Corp. 2

Devon Energy Corp. 2

Noble Corp. 2

Statoil ASA 2

ATP Oil & Gas Corp. 1

Cobalt International Energy Inc. 1

Hess Corp. 1

LLOG Exploration Co. 1

Murphy Oil Corporation 1

Newfield Exploration Co. 1

Nexen Inc. 1

Petroleo Brasileiro SA 1

Walter Energy Inc. 1

Source: Adapted by casewriter using data from IHS Global Insight Daily Analysis, June 23, 2010.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

77

711-021 BP’s Macondo: Spill and Response

20

Endnotes

1 “U.S. News: Engineer Warned BP of Seal Danger,” Wall Street Journal, August 25, 2010.

2 “Deeper Trouble: On Doomed Rig’s Last Day, A Divisive Change of Plan,” Wall Street Journal, August 26, 2010.

3 Per Holand, “Reliability of Subsea BOP Systems for Deepwater Application,” SintefRreport, November 7, 1999; “How the Minerals Management Service’s Partnership with Industry Led to Failure,” Washington Post, August 24, 2010.

4 “BP Scrambles to Contain Oil Spill,” Wall Street Journal Europe, April 26, 2010.

5 National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, Report to the President, January 2011, p. 146.

6 “White House Keeps ‘Boot’ on BP’s Throat,” Agence France Presse, May 3, 2010.

7 “Slippery Start: U.S. Spill Response,” Wall Street Journal, June 17, 2010.

8 “Obama Extends Moratorium,” New York Times, May 28, 2010.

9 “BP Says It Won’t Issue Further Dividends This Year; Agrees to $20 Billion Fund,” Dow Jones Business News, June 16, 2010.

10 “BP Top Exec Faces U.S. Lawmakers’ Wrath,” Reuters, June 17, 2010; “BP Apology Dogs Barton Campaign,” Houston Chronicle, July 16, 2010.

11 “Analysis: Experts Question Why BP Delayed Cap,” Wall Street Journal, July 22, 2010.

12 “BP Puts American Face on Crucial U.S. Market,” Wall Street Journal, July 26, 2010.

13 “BP Says Limits on Drilling Imperil Oil Spill Payouts,” New York Times, September 2, 2010.

14 BP 2009 Annual Report.

15 U.S. patent 7,706,980, B2, Blowout Preventer Testing System and Method.

16 “BP Amoco Workers Question Safety of Drilling,” Wall Street Journal, April 13, 2001; “Fueling Controversy: How Many Inspectors Make Safety Checks in Alaska’s Oil Fields?,” Wall Street Journal, July 10, 2001; “BP Gives Details of Problems at Prudhoe Bay,” Wall Street Journal, November 9, 2001.

17 U.S. Chemical Safety and Hazard Investigation Board, Report No. 2005-04-I-TX, March 2007.

18 “BP Texas City Meets Post-Accident Mandate,” Platts Oilgram News, August 15, 2008; “05 Texas City Refinery Blast Still Dogs,” Houston Chronicle, August 13, 2010.

19 “IHS CERA: The Role of Deepwater Production in Global Oil Supply,” press release, June 30, 2010, http://press.ihs.com/press-release/energy-power/ihs-cera-role-deepwater-production-global-oil-supply, accessed February 24, 2011.

20 Ruth Seydlit et al., Characteristics and Possible Impacts of a Restructured OCS Oil and Gas Industry in the Gulf of Mexico (Washington, DC: U.S. Department of the Interior, Minerals Management Service, November 1995), http://www.gomr.boemre.gov/PI/PDFImages/ESPIS/3/3428.pdf, accessed February 24, 2011; “11 Missing as Oil Rig Inferno Rages the Blaze,” Houston Chronicle, April 22, 2010.

21 Transocean, Fleet Directory, December 2009; “Rig Owner Had Rising Tally of Accidents,” Wall Street Journal, May 10, 2010.

22 “Reaction Mixed to Idea of East Coast Drilling,” Associated Press Newswires, April 1, 2010.

23 U.S. Department of Interior Outer Continental Shelf Safety Oversight Board, Report to the Secretary of the Interior, September 1, 2010.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

78

BP’s Macondo: Spill and Response 711-021

21

24 U.S. Government Accountability Office, “The Federal System for Collecting Oil and Gas Revenues Needs Comprehensive Reassessment,” September 2008; Erling Kvadsheim, “The Norwegian Petroleum Tax and Government Take, 1965–2002,” seminar presentation, 2002.

25 Philip Haile, Kenneth Hendricks, and Robert Porter, Recent U.S. Offshore Oil and Gas Lease Bidding: A Progress Report, February 2010, http://www.econ.yale.edu/~pah29/ijio.pdf, accessed February 24, 2011.

26 MMS Final Notice of Sale 206; Government Accountability Office, Federal Oil and Gas Resource Management and Revenue Collection in Need of Stronger Oversight and Comprehensive Reassessment, testimony of Frank Rusco, April 2009; R. Preston McAfee and John McMillan, “Auctions and Bidding,” Journal of Economic Literature, June 1987.

27 “BP, Oil Industry Take Fire at Hearing,” Wall Street Journal, June 16, 2010.

28 Senate Committee on Energy and Natural Resources, Full Committee Hearing: To Receive Testimony on Environmental Stewardship Policies Related to Offshore Energy Production, 111th Congress, 1st sess., November 19, 2009.

29 Moving Beyond Conflict to Consensus, report of the OCS Policy Committee’s Subcommittee on OCS Legislation, October 1993, http://www.boemre.gov/mmab/policycommittee/subcommitteereports/Moving BeyondConflictToConsensus 10-1993.pdf, accessed February 24, 2011.

30 Investigative Report, MMS Oil Marketing Group—Lakewood, U.S. Department of Interior, Office of Inspector General, August 19, 2008;

31 Investigative Report—Island Operating Company, U.S. Department of Interior, Office of Inspector General, March 31, 2010; “Interior Probe Finds Fraternizing, Porn and Drugs at MMS Office in La.,” New York Times, May 25, 2010.

32 “Safety and Environmental Management Systems for Outer Continental Shelf Oil and Gas Operations,” Federal Register, June 17, 2009.

33 “Hazelwood Cleared on Most Counts, Tanker Captain Guilty of One Misdemeanor,” Washington Post, March 23, 1990; “Damages Cut Against Exxon in Valdez Case,” New York Times, June 26, 2008.

34 Hearings before the Subcommittee on Environmental Pollution of the Committee on Environment and Public Works, U.S. Senate, April–May 1978.

35 Beard Stacey & Jacobsen, LLP, “Deep Water Horizon Oil Rig Disaster Focuses Need to Repeal Limitation of Liability Act,” June 23, 2010, http://www.hg.org/article.asp?id=19168, accessed February 24, 2011.

36 “Oil Self-Regulation Happens All Around the Globe,” Huffington Post, May 20, 2010.

37 Petroleum Safety Authority Norway, “Regulations Relating to Health, Environment and Safety in the Petroleum Activities,” August 31, 2001.

38 “Leaking Oil Well Lacked Safeguard Device,” Wall Street Journal, April 28, 2010.

39 Oystein Noreng, “The Macondo Accident: Lessons from Norway,” Energy Compass, July 16, 2010.

40 “Taking Stock of Deepwater Disaster,” Toronto Star, August 8, 2010; “Gulf May Avoid Direst Predictions After Oil Spill,” New York Times, September 13, 2010.

41 “Oil-Fund Czar Vows Ample Payouts,” Wall Street Journal, August 23, 2010.

42 “Spill Damage Claims Absent the Spill,” Wall Street Journal, August 27, 2010.

43 “The World Drills On,” Wall Street Journal, August 7, 2010.

44 “Curbs on Deepwater Drilling Lifted Early,” Financial Times, October 12, 2010.

45 Bureau of Ocean Energy Management, Regulation and Enforcement, Increased Safety Measures for Energy Development on the Outer Continental Shelf, final rule, October 14, 2010.

46 “BP Says Limits on Drilling Imperil Spill Payouts,” New York Times, September 2, 2010.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

79

6.

Dr. Claudia H. L. Woo prepared this case under the supervision of Prof. Zhigang Tao for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes.

© 2015 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise (including the internet)—without the permission of The University of Hong Kong.

Ref. 14/550C

1

ZHIGANG TAO

MCDONALD’S CHINA: THE EXPIRED MEAT SCANDAL

China is no stranger to food scares. Just when the 2012 scandal involving Kentucky Fried Chicken (KFC) “instant chicken” had begun to fade, two years later another food safety scare hit Chinese fast food chains. In July 2014, a Shanghai television station revealed that Shanghai Husi, a Chinese subsidiary of a reputable US-owned food supplier, was producing substandard meat products. McDonald’s was one of its biggest fast-food clients and had been sourcing from the supplier for more than two decades. The scare affected not just a large number of McDonald’s outlets in China but also in Hong Kong and Japan, which had also sourced meat and other food items from Shanghai Husi and other Chinese-based Husi factories. As part of their investigation, Chinese health authorities forced Shanghai Husi to shut down. Having relied on this supplier for over two decades, McDonald’s suddenly faced a severe shortage as well as declining stock prices and dropping revenue in the Asia-Pacific region. What would McDonald’s do to improve its product safety and supply chain management in China, when it seemed that even a large, foreign-owned supplier no longer guarantees reliability?

Quality Control in Chinese Food Processing and the Fast-Food Industry

Since China’s market reforms in 1978, its fast-growing economy and rapid urbanization had contributed to higher disposable income and increased demand for high-quality food products, boosting the country’s agribusiness and food processing sectors. [See Exhibit 1.] The Asia- Pacific region was the world’s biggest and fastest-growing with respect to consumption of processed meat, accounting for 63% by volume of the growth generated from 2009 to 2014. 1 [See Exhibit 2.] China accounted for the largest share of sales within the region, with retail sales of six billion tons in 2014. It was expected to surpass the US by 2015 to become the biggest processed-meat market in the world. Despite being a strongly growing and profitable industry, there was little government supervision of the industry and no regular inspections of

1 Hosafci, P (18 August 2014) “Processed Meat – What is the New Euromonitor Data Telling Us?”, Euromonitor International,

http://www.globalmeatnews.com/Industry-Markets/Processed-meat-what-is-the-new-Euromonitor-data-telling-us (accessed 23 September 2014).

HK1055

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

81

14/550C McDonald’s China: The Expired Meat Scandal

2

meat-processing plants. For example, using expired meat in food-processing facilities, according to industry insiders, was not uncommon in China.2 The industry usually relied on the public and media for scrutiny.3 Although food producers in China were encouraged by the Chinese government to adopt international compliance standards, this was not mandatory. The nation’s food-safety regulations had improved since 2008, after the melamine tainted- milk scandal hit the country, at which time the Food Safety Law was introduced to replace the outdated Food Hygiene Act. In some respects, food safety standards in China were arguably stricter on paper than in many developed countries.4 However, the country’s enforcement of food safety standards was always questionable. One of the problems was a shortage of food- safety inspectors. According to market researchers the Mintel Group, there were about 500,000 food-production and processing companies in China and only one inspector for every 420 of them.5 Of these 500,000 companies, 70% had less than 10 employees. Given their size, they tended to be less structured in terms of quality control and lacked the capital and technology for improvement. In contrast, most foreign-owned companies in China had more stringent in-house food-safety control measures. Nevertheless, many of them were staffed by local employees and run by local management, who, while familiar with the Chinese market, might have little concern about food quality and were willing to cut corners to save costs.6 With respect to third-party inspections, industry insiders noted that it was common for Chinese food suppliers to know about audits in advance, making inspection findings highly biased, as plant operators could window-dress conditions on the day of the audit. 7 Even though heavier penalties for food-safety violations had been introduced over the years in China due to frequent food scandals, many expected still tougher punishments to be instituted. For instance, prior to July 2014, selling expired food would be fined up to Rmb50,000 (equivalent to US$8000) if the food products’ value was less than Rmb10,000. Otherwise, the penalty would increase to 10 times the product value. The draft of a new amendment to the law suggested raising the penalty to 30 times the food’s value.8 Food scares implicating top foreign fast-food restaurants in China were frequent in recent years. In 2005, KFC China had taken its chicken products from the menu after a cancer- causing food dye, “Sudan Red,” was found in the seasoning. The chain was accused in 2007 of re-using frying oil for up to ten days by adding magnesium trisilicate to extend usage.9 In 2012, a McDonald’s outlet in Beijing had reportedly altered expiration dates on some dessert products and used meat patties that had been dropped on the floor. At the end of the same year, both KFC and McDonald’s were under fire as Chinese national television found that

2 Sina Finance (26 July 2014) “The Expired Meat Scandal; Losing Control Over Sourcing Management of Fast Food Giants”,

http://finance.sina.com.cn/chanjing/gsnews/20140726/013119824489.shtml (accessed 5 October 2014). 3 Burkitt, L (27 July 2014) “McDonald’s Meat Supplier Pulls Chinese Plant’s Products”,

http://online.wsj.com/articles/mcdonalds-meat-supplier-pulling-all-products-made-by-shanghai-husi-unit-1406445545 (accessed 20 September 2014).

4 For example, nearly a decade earlier, China banned clenbuterol and all beta-agonists in its class (i.e., growth-enhancing chemicals), which were used to make hog grow faster and leaner. However, in the United States, certain types of beta-agonists used in animal feed claimed to be less threatening than clenbuterol were still allowed. See Philpott, T (3 June 2013) “China Could Actually Improve US Pork. Here’s How”, Mother Jones, http://www.motherjones.com/tom-philpott/2013/05/why- chinas-smithfield-buy-could-slightly-clean-us-pork (accessed 23 September 2014).

5 Bloomberg News (25 July 2014) “China Meat Scare Add Foreign Suppliers to Food Worried”, http://www.bloomberg.com/news/2014-07-24/china-meat-scare-adds-foreign-suppliers-to-food-worries.html (accessed 22 September 2014).

6 Ibid. 7 Reuters (2 September 2014) “McDonald’s to Boost China Audits After Food Safety Scandal”,

http://www.reuters.com/article/2014/09/02/mcdonalds-china-idUSL3N0R32HO20140902 (accessed 15 October 2014). 8 Global Times Published (22 July 2014) “Confidence in US Fast Food Dented After Meat Scandal”

http://www.globaltimes.cn/content/871870.shtml (accessed 24 September 2014). 9 CRIENGLISH.com (13 march 2007) “KFC Reusing Oil Could be Dangerous”,

http://english.cri.cn/4026/2007/03/13/[email protected] http://www.cbsnews.com/news/officials-say-okay-to-processed- chicken-from-china/ (accessed 16 September 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

82

14/550C McDonald’s China: The Expired Meat Scandal

3

their local suppliers had used illegal amounts of antibiotics to boost chicken growth. Less than a year later, both fast food giants were accused of using contaminated ice cubes that contained considerably more bacteria than the water from local toilets. In the past, products sold by foreign chains were perceived to be safer than those from local Chinese stores, and in many food scandals, locally-owned suppliers were usually put on the spot. With more cases implicating foreign companies coming to light, Chinese food-chain problems became more alarming.

McDonald’s in China

McDonald’s, the famous American fast-food chain, entered China in 1990, during a period when “franchising” was still a very new concept in the country. Instead of relying on the franchise model to expand its outlets in China, McDonald’s restaurants were initially run either under wholly foreign-owned enterprises (“WFOEs”) established in the country or joint ventures with local firms.10 In 2004, as the nation’s regulatory and investment environment became more developed, McDonald’s China began franchising. However, a rather slow and cautious approach was still taken in order to maintain brand quality and management control. Even though McDonald’s restaurants outnumbered KFCs globally, the latter was more open to the franchising model and had many more outlets in the Chinese market. Between 1990 and 2010, McDonald’s restaurants in China expanded at an annual rate of 17% — much more slowly than in certain other markets in the Asia-Pacific region, such as Japan.11 . By 2013, China had become McDonald’s third-largest market in the world, although only 12% of its restaurants in China were franchised. At the end of April 2014, McDonald’s China had launched 2000 restaurants in the country. It expected to increase the ratio of its franchised restaurants in China to about 25% by 2015. 12 [See Exhibit 3 for McDonald’s Consolidated Revenues by Region and Operating Mode.] By focusing on operating efficiency and standardization to minimize operating costs, McDonald’s global competitive strategy was oriented towards cost leadership. However, in China, McDonald’s was initially perceived as pursuing a differentiation approach, as it sourced most of its raw ingredients outside China at higher costs to assure quality. Chinese consumers also tended to regard foreign fast food as higher in quality and were willing to pay more to multinational companies than to local eateries. McDonald’s Chinese supply chain had a single meat-production plant in the country when it opened its first outlet. The rest of the ingredients were imported. It was not until 1999 that it managed to serve french fries made from Chinese-grown potatoes in all its restaurants in the country—after 14 years of joint investment between McDonald’s and its primary US-based french-fry supplier pioneering the development of industrial potato-farming in China.13 As market competition intensified in China, with the entry of more foreign and local fast-food companies, cost-reduction became a must for McDonald’s China. To cut down operating costs and leverage China’s abundant labor and agricultural resources, McDonald’s invested heavily in creating a large supply chain in the country to furnish locally produced food to

10 Vedder, T. (19 August 2007) “Fast Food Domination”, China International Business,

http://www.cibmagazine.com.cn/Features/Industry.asp?id=85&fast_food_domination.html (accessed 9 October 2008). 11 Worldcrunch (12 March 2014) “Supersize the Franchise: McDonald’s New China Strategy”,

http://www.worldcrunch.com/business-finance/supersize-the-franchise-mcdonald-039-s-new-china-strategy/kfc-fast-food- rivalry-catering-restaurant-franchisee/c2s15258/#.VGMl7jSUdX4 (accessed 11 November 2014).

12 ChinaRetailNews (21 April 2014) “Fast Growth Equals More Fast Food For McDonald’s in China”, http://www.chinaretailnews.com/2014/04/21/7055-fast-growth-equals-more-fast-food-for-mcdonalds-in-china/ (accessed 21 September 2014).

13 Groom, N (10 November 2006) “McDonald’s Look to China to Supply Restaurants”, Reuters, http://www.reuters.com/article/2006/11/10/businesspro-leisure-mcdonalds-china-dc-idUSN1047786220061110 (accessed 21 September 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

83

14/550C McDonald’s China: The Expired Meat Scandal

4

more of its restaurants in China and other parts of the world. Over the years, McDonald’s had created a solid network of farmers, food processors, and other direct and indirect suppliers in China. By 2006, more than 95% of the ingredients used by McDonald’s China (e.g., potatoes, meat patties, vegetables, milk) originated from within the country.14 Meanwhile, McDonald’s suppliers in China also exported products such as chicken, beef, lettuce and apple pies to the chain’s other Asian markets. Much of the packaging used in McDonald’s restaurants around the world was also produced in the country’s factories. Globally, McDonald’s claimed to approach its supply chain through the three E’s—ethics, environment, and economics—from raw material production through processing and distribution. According to the company, this meant “working with suppliers to innovate and implement best practices for sustainable ingredients, requiring that McDonald’s suppliers protect human rights in the workplace, and safeguarding food quality and safety through best practices in animal health and welfare.” 15 With respect to food safety management, McDonald’s applied the internationally recognised Hazard Analysis and Critical Control Point (HACCP) 16 program globally at its suppliers’ plants and its own restaurants to track food-production safety risks and put preventive measures in place.

McDonald’s Long-Term Meat Supplier

McDonalds’s China tended to work with big-name suppliers. Its largest meat supplier was the OSI Group (“OSI”).17 Founded in 1909, OSI was a global food processor headquartered in Aurora, Illinois, supplying top fast-food chains around the world. OSI first started supplying beef patties to McDonald’s in Illinois in 1955. It entered the Chinese market in 1991, beginning with processing chicken, beef, fish and pork. With the growing demand for western fast food in China, OSI expanded into processing vegetables. OSI’s decentralized business model allowed its Chinese managers great decision-making autonomy and this strategy had helped OSI to expand quickly in China beginning in the early 1990s.18 OSI established a wholly-owned subsidiary, Shanghai Husi, in China in 1996, which built five production lines for pork, beef, chicken, vegetables and noodles. There were other Husi plants in China, in Hebei, Guangzhou, Kunming and Shandong. It was one of the few Chinese poultry suppliers with nationwide recognition. Some of Shanghai Husi’s Chinese clients in China included Burger King, Yum! Brands (owner of KFC and Pizza Hut), Dicos, Papa John’s, Subway, Starbucks, etc. By the end of 2013, OSI had successfully established its tenth facility in China and spent at least US$750 million on three vertically integrated poultry processing plants.19 All three vertically integrated operations used entirely company-owned

14 Cheung, A. (11 December 2006) “An Exclusive Interview with Gary Rosen, McDonald’s Chief Marketing Officer in China”,

The China Perspective: Consumer and Retail, http://thechinaperspective.com/articles/anexclusiveinterviewwithgaryrosenMcDonald’s039schiefmarketingofficerinchina1751/ index.html (accessed 29 August 2008).

15 McDonald’s (2013) “Our Journey Together For Good- McDonald’s Corporate Social Responsibility & Sustainability Report 2012-2014”, pg. 25, http://www.aboutmcdonalds.com/content/dam/AboutMcDonalds/2.0/pdfs/2012_2013_csr_report.pdf (accessed 21 September 2014).

16 For more details of the HACCP Program, see the official website of Standards.Org: http://www.standards.org/standards/listing/haccp (accessed 3 October 2014) ,

17 Cendrowski, S (2 September 2014) “Why McDonald’s Supplier Failed in China”, Fortune.com, http://fortune.com/2014/09/02/why-mcdonalds-supplier-failed-in-china/ (accessed5 October 2014).

18 Ibid. 19 Forbes (21 July 2014) “U.S. Firm at Center of Reported China Meat Scandal Had Earlier Success”,

http://www.forbes.com/sites/russellflannery/2014/07/21/u-s-firm-at-center-of-reported-china-meat-scandal-had-earlier- success/ (accessed 13 October 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

84

14/550C McDonald’s China: The Expired Meat Scandal

5

farms, aiming to improve food-safety and traceability control throughout its supply chain. With this investment, OSI was able to process more than 300 million birds annually.20 Back in 2004 and 2010, the US Department of Agriculture (USDA) had conducted on-site audits of the Shanghai Husi plant in an effort to clear the way for exporting Chinese poultry to the US. The company was issued a clean bill of health.21 However, some food-safety experts criticized the effectiveness of the USDA’s Foreign Establishment Audit Checklist form’s one- page format. In 2013, a former employee of the Shanghai quality-control team brought a lawsuit against Shanghai Husi for running an unsafe workplace and faking food-production dates.22 However, a local court dismissed the case due to lack of evidence and Shanghai Husi managed to defend itself with records of health and safety procedures implemented in the plant.

The Expired Meat Scandal

On July 20, 2014, a Chinese state-owned media outlet, Dragon TV ( ), broadcast an undercover video of the Shanghai Husi operation. The video showed workers in the plant picking up meat dropped on the floor and taking it back to the processing machine, repacking old meat and extending expiration dates, and mixing expired with fresh meat. A worker told the undercover reporter that each division only did what it was told to do from the top and did not care about what upstream or downstream divisions did. Workers would be informed by the management in advance if external inspections or audits were to be carried out so that they would have enough time to cover up, for example, by hiding piles of blue plastic bags filled with expired meat that were stacked around the factory floor on normal days. Such instructions were written by the management in Chinese. In the video, the staff of Shanghai Husi said the company kept two set of records related to food products, one of which was doctored for auditors visiting the plant.23 Immediately following this video broadcast, Shanghai Husi became the subject of an investigation by Chinese authorities, which later shut the plant down. The Shanghai Municipal Food and Drug Administration (SFDA) discovered that expired chicken and beef items had indeed been reprocessed and repackaged with new expiration dates. Amongst the substandard products, over 4,300 cases of smoked beef patties were found to have forged production dates, with more than 3,000 cases already sold. 24 The SFDA officials also confirmed that Shanghai Husi kept different sets of records to enable the resale of out-of-date meat.25 On 23 July 2014, six executives of Shanghai Husi were arrested by the Shanghai branch of the Public Security Bureau on suspicion of producing and selling fake and inferior products. 20 The National Provisioner (13 November 2013) “OSI’s Vertically Integrated Poultry Investment in China Exceeds USD $750

Million”, http://www.provisioneronline.com/articles/99810-osis-vertically-integrated-poultry-investment-in-china-exceeds- usd-750-million (accessed 6 November 2014).

21 China Daily (31 July 2014) “Food Inspectors Face Challenges”, http://www.chinadaily.com.cn/china/2014- 07/31/content_18220261.htm (accessed 6 October 2014).

22 Judicial Options of China (13 February 2014), “Wang Donglai v. Shanghai Husi”, Jiading District People’s Court Decision, Case Reference no. 1074, dated 6 January 2014, http://www.court.gov.cn/zgcpwsw/sh/shsdezjrmfy/shsjdqrmfy/ms/201402/t20140213_336719.htm (accessed 5 October 2014).

23 Takada, K. (24 July 2014) “Exclusive: China Meat Supplier Faced Claims Over Unethical Work Practices”, Reuters, http://www.reuters.com/article/2014/07/25/us-china-food-dispute-idUSKBN0FU05Y20140725 (accessed 13 October 2014).

24 Li, Z (30 July 2014) “China Tainted Meat Scandal Explained”, CNN, http://edition.cnn.com/2014/07/29/world/asia/explainer- china-meat-scandal/ (accessed 7 October 2014).

25 Burkitt, L. and Bunge, J. (23 July 2014) “Meat Supplier’s CEO Apologizes for China Unit”, The Wall Street Journal, http://online.wsj.com/articles/chinese-authorities-say-shanghai-husi-food-violations-company-led-1406081978 (accessed 8 October 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

85

14/550C McDonald’s China: The Expired Meat Scandal

6

The local authorities urged several leading global fast-food companies to publish the names of their suppliers on their Chinese websites in order to strengthen oversight. By the end of September 2014, 214 food producers and 22 fast-food companies had been examined by local food inspectors, who seized 18 tons of Chicken McNuggets, 78.1 tons of smoked beef patties and 48 tons of beefsteak for investigation.26 Starbucks, Burger King and 7-Eleven convenience stores immediately halted sales of products from Shanghai Husi. McDonald’s key competitor, Yum! Brands, also cut all ties with Husi, which Yum! claimed was not a significant supplier. The scandal further prompted Yum to cease all purchases from Illinois-based OSI. Shanghai Husi was licensed to export to Japan. The Japanese government stopped all imports from its plants after FamilyMart Co. withdrew the supplier’s products from its Japanese outlets. After the scandal erupted, OSI recalled all products manufactured by Shanghai Husi. OSI apologized to its customers worldwide and called the case an isolated incident, claiming that Chinese inspectors had found no issue with its other facilities in the country.27 Media also reported that while some former workers at Shanghai Husi criticized lax quality control at the plant, workers at another Husi plant in northern China defended their management’s strict safety rules.28 It was speculated that OSI had not conducted enough audits to ensure all its Chinese plants complied with the global standards developed by OSI headquarters in the US.29 Further, documents used in the Chinese plants were reportedly written in Chinese, making it difficult for English-speaking staff to understand data or operations. Apart from conducting internal investigations into current and former Chinese senior management, OSI brought a new management team, under direct US control, to lead its China operation. It also planned to rotate global experts to examine and audit its Chinese units. However, in early September, news circulated that OSI might withdraw from the China market even though its executives had tried to rescue its business there. 30 This was because OSI’s partner found it risky to continue the partnership.

Impacts on McDonald’s

McDonald’s claimed itself a victim in the scandal and its Chief Executive, Don Thompson, said that the company felt “a bit deceived” by the Shanghai Husi audit results it had received. It was reported that McDonald's and many other restaurant operators relied on third parties to conduct audits of compliance with food safety rules and other regulations at their suppliers’ facilities.31 The scandal impacted McDonald’s restaurants not just in mainland China, but also in Hong Kong, Japan and certain other Asian markets, with some outlets forced to pull suspect items from their menus. McDonald's shares on the New York Stock Exchange dropped 4.7 percent 26 Yan, A. (23 September 2014) “Rotten-Food-Scandal-Hit Factory Shanghai Husi Sacked 340 Workers”, China Morning Post,

http://www.scmp.com/news/china/article/1598010/rotten-food-scandal-hit-factory-shanghai-husi-sacks-340-workers (accessed7 October 2014).

27 Burkitt, L. and Bunge, J. (23 July 2014) “Meat Supplier’s CEO Apologizes for China Unit”, The Wall Street Journal, http://online.wsj.com/articles/chinese-authorities-say-shanghai-husi-food-violations-company-led-1406081978 (accessed 8 October 2014).

28 Takada, K. (24 July 2014) “Exclusive: China Meat Supplier Faced Claims Over Unethical Work Practices”, Reuters, http://www.reuters.com/article/2014/07/25/us-china-food-dispute-idUSKBN0FU05Y20140725 (accessed 13 October 2014).

29 Cendrowski, S (2 September 2014) “Why McDonald’s Supplier Failed in China”, Fortune.com, http://fortune.com/2014/09/02/why-mcdonalds-supplier-failed-in-china/ (accessed5 October 2014).

30 WantChinaTimes (4 September 2014) “McDonald’s Meat Supplier Might Quit China After Scandal”, http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20140904000140&cid=1206 (accessed 14 October 2014).

31 Baertlein, L. (23 July 2014) “Corrected-McDonald's Feels "Bit Deceived" by Audit Results from China Plant”, Reuters, http://www.reuters.com/article/2014/07/24/china-food-mcdonalds-idUSL2N0PX13920140724 (accessed 16 October 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

86

14/550C McDonald’s China: The Expired Meat Scandal

7

following the Shanghai Husi investigation. [See Exhibit 4.] Its global sales growth plummeted to a decade-worst low of 3.7 percent in August 2014. In the same month, sales in its home market, the US, and in Europe had respectively dipped by 2.8 and 0.7 percent. 32 [See Exhibits 5 and 6.] While McDonald’s does not break Chinese sales out publicly, the company earned 23.6 percent of its revenue and 16.8 percent of its operating profit from the Asia-Pacific, Middle East and Africa (APMEA) region in the first six months of 2014.33 McDonald’s believed the expired meat scandal had caused the company’s same-store sales in the APMEA region to tumble 9.9% in the quarter ending September 2014.34

McDonald’s China: Standing by OSI? McDonald’s pulled beef, pork and chicken products from its Chinese outlets after the scandal broke. In cities like Beijing and Shanghai, fish burgers were the only sandwiches available.35 Instead of completely cutting ties with Shanghai Husi and its parent company OSI, as its competitors did, the Golden Arches initially told the media at the end of July that it would stand by its long-time supplier. Even though it would no longer receive supplies from the Shanghai facility, it would continue sourcing from Husi’s other operations in China. 36 Reportedly, McDonald’s planned to shift its sourcing to OSI’s new processing plant in Henan province, which in August 2014 became the first LEED-certified plant in China and among the few meat-processing plants in the world to obtain a green building certification.37 After stopping sourcing from its main supplier, McDonald’s China ran into severe shortages. The chain had to turn to other existing suppliers, urging them to increase capacity. Even so, many food items could not be sold in restaurants due to lack of ingredients. There was a mix of responses from Chinese consumers to the scandal. Some of them criticized the lack of oversight by McDonald’s China or even suspected that McDonald’s China might have been aware of the situation but chose to keep silent. McDonald’s China low-cost strategy was also blamed for squeezing supplier profits, forcing them to provide substandard products to cut costs. On the other hand, some Chinese consumers believed that McDonald’s was still better than local fast-food chains, which might use gutter oil in its products. The scandal also gave rise to conspiracy theories from the foreign media, which reported that the Chinese government was trying to undermine foreign brands and business in the country. 38 It was speculated that the Chinese government had lately been putting the spotlight on large multinationals like KFC, McDonald’s, Microsoft and GSK, undercutting their reputations to help Chinese companies compete with them. At the same time, officials were said to be trying to get public recognition for being serious in addressing significant issues such as food safety without harming the Chinese interests. Such speculation was strongly 32 Sharma, B. (10 September 2014) “McDonald’s Sales Continue Decline After Being Hit by China Meat Scandal”, International

Business Times, http://www.ibtimes.co.in/mcdonalds-sales-continue-decline-after-being-hit-by-china-meat-scandal-608777 (accessed 11 October 2014).

33 Wahba, P (4 August 2014) “China Meat Supplier Prove Taking Big Bite Out of McDonald’s Sales”, Fortune, http://fortune.com/2014/08/04/mcdonalds-china-meat-sales/ (accessed 14 November 2014).

34 Gu, W (6 November 2014) “China’s Economic Slowdown Reflected by Multinationals”, The Wall Street Journal, http://online.wsj.com/articles/chinas-economic-slowdown-reflected-by-multinationals-1415304851 (accessed 14 November 2014).

35 Bloomberg News (29 July 2014) “McDonald’s Pulls Meat From China Restaurants”, http://www.bloomberg.com/news/2014- 07-28/mcdonald-s-supplier-recalls-meat-in-expired-food-scandal.html (accessed 12 October 2014).

36 Jargon, J. and Bunge, J. (24 July 2014) “McDonald’s Stands By Meat Supplier in Crisis”, The Wall Street Journal, http://online.wsj.com/articles/mcdonalds-stands-by-meat-supplier-in-crisis-1406244870?mod=WSJ_hpp_sections_business (accessed 6 October 2014).

37 Higgins, K. (2014) “One-Two Punch: Inspections and Audits”, Food Processing.com, http://www.foodprocessing.com/articles/2014/one-two-punch-inspections-and-audits/ (accessed 8 October 2014).

38 Schuman, M. (23 July 2014) “The Factory in the China Food Scandal Is Foreign-Owned. That Could Have Made It a Target”, Time, http://time.com/3021854/china-mcdonalds-kfc-pizza-hut-osi-yum-starbucks-food-safety-foreign-investment/ (accessed 11 November 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

87

14/550C McDonald’s China: The Expired Meat Scandal

8

opposed by some Chinese netizens, who urged foreign companies to be more responsible for quality, rather than shying away from the issue.39

McDonald’s Hong Kong: Poor Crisis Management Practice As soon as all imports from Shanghai Husi were suspended by the Hong Kong food safety regulator, McDonald's Hong Kong stopped selling products the processor supplied. A range of items was taken off the menu, including Chicken McNuggets, McChicken sandwiches, Big Macs and products such as green salads, fresh corn cups and lemon tea, which were made with items previously sourced from Husi units in Hebei and Guangzhou. It was not until early August 2014 that McDonald's outlets in Hong Kong resumed serving burgers such as the Big Mac and McChicken with vegetable ingredients such as onion and lettuce sourced from the US and Taiwan. When the scandal first went public, McDonald’s Hong Kong denied having imported any food products from Shanghai Husi. However, the Hong Kong SAR government’s Environmental Hygiene Department blew the lid off the denial. According to the authorities, McDonald's Hong Kong had imported pork and chicken from Shanghai Husi. It was revealed that all of the chicken imported by McDonald’s Hong Kong from Shanghai Husi two months before the scandal broke had already been sold to customers. No Shanghai Husi products remained in stock. It was also discovered that from July to December 2013, McDonald's Hong Kong had imported 10 batches of frozen pork from Shanghai Husi. McDonald’s Hong Kong later apologized to its consumers for releasing what it called “confusing information” and explained the denial was made because the chain held no more stock supplied by Shanghai Husi in its warehouses or restaurants. 40 It further posted information on its website about ingredients that had been imported from all Husi facilities in China and products that would be temporarily suspended from the menu. [See Exhibit 7].The chain also reiterated that its products conformed to food and safety standards. Despite the apology, McDonald’s Hong Kong was criticized by local legislators and media for attempting to mislead the public over the scandal, given its initial denials. A Hong Kong spokesperson also refused to take questions regarding the scandal in a press briefing. Considered a victim at the beginning of the incident, McDonald’s mishandling of the Hong Kong situation made the public view the company in a different light.

McDonald’s Japan: Marking the Worst Monthly Same-Store Sales Since 2002 In contrast to the controversial response of McDonald’s Hong Kong, McDonald's Japan admitted that the company had sourced about 20 percent of its Chicken McNuggets from the Shanghai plant and said it would stop selling product from Husi facilities. It also announced two days after the news hit that it had found alternative chicken suppliers from Thailand to replace Shanghai Husi. McDonald’s shares traded in Japan fell by 2.8 percent by the end of July as a result of the scandal.41 [See Exhibit 8]. Its same-store sales in July dropped by 17.4 percent compared to a

39LegalDaily (2014), “US Media Being Criticised for Defending Husi Scandal”, Vol 2045-August. (2014),

” http://m.183read.com/magazine/article/article_id/262431 (accessed 6 November 2014). 40 Chan, K (25 July 2014) “McNuggets Taken Off McDonald’s Menu”, China Daily Asia,

http://www.chinadailyasia.com/hknews/2014-07/25/content_15151939.html (accessed 10 October 2014) 41 Yan, S (30 July 2014) “Meat Scandal Takes a Bites out of McDonald’s Sales in Japan”, CNN,

money.cnn.com/2014/07/30/news/mcdonalds-japan-meat-scandal/index.html?hpt=hp_t3 (accessed 12 October 2014)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

88

14/550C McDonald’s China: The Expired Meat Scandal

9

year earlier, making this the largest monthly fall-off since July 2002.42 Sales further plunged 25.1 percent in August, while the number of visitors to its Japanese outlets fell 16.9% that same month [See Exhibit 9].43

Rebuilding Brand and Reassessing McDonald’s Chinese Suppliers

Amidst the scandal, McDonald’s launched an 18-month global rebranding campaign at the end of July 2014. The fast-food operator had in fact suffered from various criticisms in recent years regarding its service quality, dietary concerns about the food it served and employee pay issues. The campaign was aimed to transform McDonald’s into a more trusted and respected brand by focusing its efforts on reshaping its business value, marketing and operations excellence.44 In early September 2014, McDonald’s China officially terminated its relationship with Husi and confirmed a new list of five meat suppliers in China, including foreign-owned McKey, Cargill, Hormel and Trident, and a large local chicken supplier, Sunner, which owned some of the largest vertically integrated chicken farms, feed mills and processing plants in China. McDonald’s China sought new vegetable, as well as meat, suppliers within China, including a European-owned vegetable producer, The Creative Food Group. It also assessed another US- owned vegetable and fruit vendor in China, Golden State Food, one of the world’s largest diversified fast-food suppliers. McDonald's announced it would strengthen its Chinese supplier-assessment process by increasing the number of its China-based supplier audits, including ad-hoc plant visits by both internal and external parties. 45 As part of its preventive measures, the company would enhance video monitoring of its Chinese supply facilities and create a whistle-blower hotline enabling its office and restaurant employees to report misconduct. A new position of “food safety governance head” would also be created, reporting directly to the country’s chief executive.46 The food scare had disrupted the general belief that food produced by foreign brands was better than Chinese counterparts’. When large, foreign-owned suppliers in China, like OSI, could not be trusted, would McDonald’s China’s new preventive measures be adequate and what more could McDonald’s China do to strengthen its supply-chain management and facilitate its rebranding campaign? In view of the ever-increasing competition in the fast-food industry, would it be better for McDonald’s China to run its own food processing plants in China and to change its positioning strategy to one of differentiation?

42 The Japan Times (5 August 2014) “China Meat Supplier Probe Hurting McDonald’s Sales”, Bloomberg,

http://www.japantimes.co.jp/news/2014/08/05/business/china-meat-supplier-probe-hurting-sales-mcdonalds/#.VDka2GeSxX4 (accessed 12 October 2014).

43 Fujikawa, M. (10 September 2014) “McDonald’s Japan Gets Burned by Chicken Scandal”, The Wall Street Journal, Japan, http://blogs.wsj.com/japanrealtime/2014/09/10/mcdonalds-japan-gets-burned-by-chicken-scandal/ (accessed 10 October 2014).

44 Lam, A. and Chan, J. (28 July 2014) “Will McDonald’s Rebranding Plan be Good Enough?”, Marketing Interactive, http://www.marketing-interactive.com/mcdonalds-rebranding-plan-good-enough/ (accessed 10 October 2014).

45 Reuters (2 September 2014) “McDonald’s to Boost China Supplier Audits After Food Safety Scandal, http://www.reuters.com/article/2014/09/02/mcdonalds-china-idUSL3N0R32HO20140902 (accessed 13 October 2014).

46 BIDNESSETC (2 September 2014) “McDonald’s To Improve Food-Safety Control in China”, http://www.bidnessetc.com/24956-mcdonalds-to-improve-foodsafety-controls-in-china/1/ (accessed 18 October 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

89

14/550C McDonald’s China: The Expired Meat Scandal

10

EXHIBIT 1: ANNUAL PER CAPITA SPENDING OF CHINESE URBAN HOUSEHOLDS ON MEAT AND VEGETABLE PRODUCTS

Note: CNY1 equivalent to USD0.16, as at 12 November 2014

Source: Adapted from China City Statistical Yearbook 2013, 2011, and China Urban Life and Price Yearbook 2012, China Statistics Press

EXHIBIT 2: PROCESSED MEAT RETAIL VOLUME SALES BY REGION

Source: Hosafci, P (18 August 2014) “Processed Meat – What is the New Euromonitor Data Telling Us?”, Euromonitor International, http://www.globalmeatnews.com/Industry- Markets/Processed-meat-what-is-the-new-Euromonitor-data-telling-us (accessed 23 September 2014)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

90

14/550C McDonald’s China: The Expired Meat Scandal

11

EXHIBIT 3: MCDONALD’S CONSOLIDATED REVENUES BY REGION AND OPERATING MODE, 2005-2013

*APMEA= Asia Pacific, Middle East and Africa region (Note: McDonald’s did not break out China revenue separately, but included it in total APMEA revenue)

Source: Adapted from McDonald’s Annual Reports, 2013, 2010, 2007

Franchised revenues (Dollars in millions)

Company-operated revenues (Dollars in millions)

Total revenue (Dollars in millions)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

91

14/550C McDonald’s China: The Expired Meat Scandal

12

EXHIBIT 4: MCDONALD’S NEW YORK STOCK EXCHANGE PERFORMANCE BETWEEN JUNE 2014-NOVEMBER 2014

Source: Reuters Finance, as at 6 November 2014 http://www.reuters.com/finance/stocks/chart?symbol=MCD.N (accessed 6 November 2014)

USD

Month, 2014

The expose of expired meat scandal

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

92

14/550C McDonald’s China: The Expired Meat Scandal

13

EXHIBIT 5: MCDONALD’S GLOBAL COMPARABLE SALES BY MONTH AND YEAR ENDING JULY 31, 2013 AND 2014

Notes:

� APMEA= Asia Pacific, Middle East and Africa region � Comparable Sales represents sales at all restaurants, whether operated by McDonald’s or by

franchisees, in operation for at least 13 months, including those temporarily closed. Comparable sales exclude the impact of currency translation.

� Systemwide Sales includes sales at all restaurants, whether operated by McDonald’s or by franchisees.

� Information in constant currency was calculated by translating current year results at prior year average exchange rates.

Source: McDonald’s Newsroom (8 August 2014) “McDonald's Reports Global Comparable Sales for July” http://news.mcdonalds.com/Corporate/Press-Releases/Financial-Release?xmlreleaseid=123054 (accessed 6 November 2014)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

93

14/550C McDonald’s China: The Expired Meat Scandal

14

EXHIBIT 6: MCDONALD’S GLOBAL COMPARABLE SALES BY MONTH AND YEAR ENDING AUGUST 31, 2014 AND 2013

Refer to notes in Exhibit 5.

Source: McDonald’s Newsroom (9 September 2014) “McDonald's Reports Global Comparable Sales for August” http://news.mcdonalds.com/Corporate/Press-Releases/Financial-Release?xmlreleaseid=123055 (accessed 6 November 2014)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

94

14/550C McDonald’s China: The Expired Meat Scandal

15

EXHIBIT 7: MCDONALD’S HONG KONG WEBSITE

Source: Extracted from Lam, A. and Chan, J. (28 July 2014) “Will McDonald’s Rebranding Plan be Good Enough?”, Marketing Interactive, http://www.marketing-interactive.com/mcdonalds- rebranding-plan-good-enough/ (accessed10 October 2014)

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

95

14/550C McDonald’s China: The Expired Meat Scandal

16

EXHIBIT 8: MCDONALD’S TOKYO STOCK EXCHANGE PERFORMANCE BETWEEN JUNE 2014 AND NOVEMBER 2014

Source: Reuters Finance, as at 6 November 2014 http://www.reuters.com/finance/stocks/chart?symbol=2702.T (accessed 6 November 2014)

EXHIBIT 9: MCDONALD’S JAPAN SAME-STORE SALES AND NUMBER OF VISITORS BETWEEN AUGUST 2013 AND AUGUST 2014

Source: Extracted from Fujikawa, M. (10 September 2014) “McDonald’s Japan Gets Burned by Chicken Scandal”, The Wall Street Journal, Japan, http://blogs.wsj.com/japanrealtime/2014/09/10/mcdonalds-japan-gets-burned-by-chicken-scandal/ (accessed 10 October 2014).

Japanese Yen

Month, 2014

The expose of expired meat scandal

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

96

7.

©2015 by the Kellogg School of Management at Northwestern University. This case was prepared by Professor Russell Walker and Rafique Jiwani ’14. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 847.491.5400 or e-mail [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Kellogg Case Publishing.

RUSSELL WALKER AND RAFIQUE JIWANI ’14 5-315-501

Reinventing E-Commerce: Amazon’s Bet on Unmanned Vehicle Delivery

I would define Amazon by our big ideas, which are customer centricity, putting the customer at the center of everything we do, [and] invention. We like to pioneer; we like to explore; we like to go down dark alleys and see what’s on the other side . . . I know [drone technology] look[s] like science fiction—it’s not. It will work and it will happen. It’s going to be a lot of fun.1

—Jeff Bezos, CEO and founder, Amazon.com

In a December 1, 2013, interview on American television program 60 Minutes, Amazon CEO Jeff Bezos announced that Amazon would soon change the future of online shopping by enabling customers to receive items within thirty minutes of ordering. This delivery service, Bezos said, would be powered by unmanned autonomous drones and could be offered as soon as 2015. The market reaction was instantaneous and positive.

Still, Amazon needed some answers before it could launch autonomous delivery services: Were customers ready to embrace and pay for this type of delivery service? Would regulators allow it? Should Amazon make or buy its drones? Would it be too risky for Amazon to wait to launch this service? If it decided to go ahead, how should it launch, and to whom?

The U.S. E-Commerce Industry

The Early Days

An English inventor named Michael Aldrich began developing the precursor to online shopping in 1979. Aldrich, frustrated with how long it took to shop for groceries (driving to the store, looking for items, waiting in line, and driving back home), tested a device that used videotex* to connect a television set to a transaction-processing computer with a telephone line. He decided to commercialize his concept in 1980, just when VCRs were beginning to gain mass- market traction in the United States. Aldrich envisioned that his product, coined the Teleputer, would enable a new form of information exchange between businesses and consumers;

* Videotex, developed in the mid- to late 1970s, was a technology that incorporated a television with a computer interface, allowing users to send messages and content to each other.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

97

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

2 KELLOGG SCHOOL OF MANAGEMENT

additionally, he felt that firms could gain competitive advantages by externalizing labor costs and serving customers more efficiently.2

While finding short-lived success with B2B-focused customers (e.g., General Motors tested the system to sell spare truck parts), Aldrich was unable to make headway in the minds of consumers. They had just woken up to the idea of the VCR in their homes and the costs were extremely high, and there was no real online marketplace in use or laws regulating how firms could conduct business online.* Further, consumers were wary that these systems had no way of transacting orders securely. Aldrich later commented on his release of the Teleputer:

It is also clear that moving a company [or consumer], for strategic reasons, from a low technology profile to a higher technology profile is not an overnight activity. Before using information technology strategically the goals, capabilities, positioning, and constraints on the enterprise must be established . . . If the first step in our guide was the management of change, the second step must be the business implications of change.3

Aldrich’s insight, though ahead of its time, gave way to evolving technologies such as the ATM, electronic payment through credit cards, and telephone banking during the 1980s. However, it was nearly fifteen years before his work would be remodeled for a consumer willing to accept the risk of shopping online.

1994 Resurgence

As the 1980s continued, little notable advancement occurred in the online shopping industry, though there were signs of potential. The first mass-market online services, Prodigy and AOL, began advertising flowers on their welcome pages in the late 1980s, but the attempt was more of an advertisement than a platform to complete a transaction. Security was still seen as the major impediment to consumer adoption. It wasn’t until 1994, four years after the invention of the World Wide Web, that security protocols (SSL) and high-speed connections (DSL) were established, allowing users to confidently purchase goods online securely and quickly. The withdrawal of entry barriers enabled the emergence of hundreds of online retailers by 1995, including Amazon, eBay, and Dell. Offering goods at prices 10 to 20 percent below those at brick-and-mortar retail locations allowed online retailers to grow substantially through the latter part of the decade. By 1999, the U.S. online retail market reached over $15 billion in annual sales.4

Along with the exponential rise of Internet retail companies came a substantial amount of venture capital (VC) funding. VCs believed that the success of an online retailer would come after realizing net losses in order to gain market share, and were willing to back startup dot-coms based simply on an idea. Within a year, the NASDAQ fell 78 percent from its high in March 2000, and 52 percent of dot-com companies established between 1995 and 2000 disappeared. This left only a few pure-play online retailers, including Amazon, eBay, and Priceline.

* By 1984, California was the only U.S. state that had passed an electronics commerce act that defined corporate and consumer rights online.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

98

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 3

2001–2013 Boom

Continuous revitalization of goals, identification of “white space,”* and diversification of risk became a major theme for dot-com companies that survived the bubble and the subsequent decade. Amazon explored interests in B2B, reseller, and hardware operations; Priceline shifted its product focus from air travel to hotel and rental car travel; and eBay drastically expanded its product lines. By 2013, Amazon was the clear and dominant leader in online retail. With over $74 billion in revenue, it outpaced eBay, Priceline, and all other online retailers many times over.5

Amazon.com

History

The story of Amazon is widely known. Founded in Jeff Bezos’s garage in 1995 as a reseller of books, the company took advantage of the rapidly growing e-commerce space that followed the increased security measures enacted by Netscape founders. Attempting to carry “every product from A to Z,” Bezos enacted an unusual business plan (though not uncommon to Internet startups at the time) that focused on customer and revenue growth rather than profit. He also emphasized the need for Amazon to pursue areas within and outside online shopping from the beginning of its existence as a public company. In a 1997 letter to shareholders, Bezos contended:

Our goal is to move quickly to solidify and extend our current position while we begin to pursue opportunities in other areas. We see substantial opportunity in the markets we are targeting. This strategy is not without risk: it requires serious investment and crisp execution.6

By 1997, the company—now public—had greatly expanded its reach. Employee headcount grew from 185 to 614; distribution center capacity grew from 50,000 to 285,000 square feet; and book inventories surpassed 200,000 titles. Amazon soon found itself competing less on price with incumbent retailers and more on convenience and time to delivery.7 Throughout the next fifteen years, Amazon’s focus on winning with time and price in every aspect of its business was crucial. Retail competitors had a difficult time transitioning from brick-and-mortar operations to e- commerce platforms. Even the ones who experienced some online success still had trouble competing with Amazon because of its sheer range of product offerings and logistical capabilities. By the end of 2013, Amazon had $74 billion in sales and had turned a profit for five consecutive years. (See Exhibits 1A, 1B, and 1C for Amazon financials.) It occupied nearly 50 million square feet of distribution centers around the country and employed more workers than Google and Microsoft (Exhibit 2).

* White space is a management term coined in 1991 by Geary Rummier and Alan Brache to identify areas of an organization where no one is in charge. Mark Johnson redefined the term in 2010 as an area in which businesses can create new business models.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

99

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

4 KELLOGG SCHOOL OF MANAGEMENT

Growth Strategies and Amazon Prime

Though making every effort to grow Amazon organically, Bezos acquired a diverse group of companies beginning in 1998. (See Exhibit 3 for a complete list of Amazon acquisitions through 2009.) Economist Mark W. Johnson elaborated:

Amazon at its roots is built to transform. When it finds opportunities to serve new customers, or existing customers in new ways, it conceives and builds new business models to exploit them. Amazon has the unique ability to launch and run entirely new types of businesses while simultaneously extracting value from existing businesses. Amazon’s journey forward will likely be marked by a series of transformations, as it continues to pursue its vision unafraid of white space, business model innovation, or renewal.8

As Amazon grew over the next decade, it leveraged the Amazon brand as it introduced cloud computing services (Amazon Web Services) and its first hardware product, the Amazon Kindle. In an article in the Harvard Business Review, Accenture partners Larry Downes and Paul Nunes described the Amazon Kindle:

Amazon’s real innovation was waiting just until the right combination of technologies was ready for mainstream use and then leveraging its powerful brand and customer network to launch Kindle with easy access to a huge catalog of books on day one . . . along the way, they scrambled every link in the supply chain.9

While the Kindle grew, Amazon invested heavily again in serving customers as quickly as possible with Amazon Prime, a service guaranteeing two-day shipping for certain products. Initially, 1 million products were targeted for Prime at its launch in 2004. By 2014, 120 million products in Amazon’s catalog qualified for Prime. The $79-per-year subscription service became a huge profit machine for Amazon, and the company soon began adding digital services for Prime members, including Prime Instant Video. Many Prime members claimed they would pay over $100 for annual services, and they spent nearly double at Amazon than regular customers ($1,200 per year versus $600 per year). Instant access became a major competitive advantage for Amazon. Customers saved time on everything from watching movies to downloading books to ordering groceries, and viewed Amazon as their premier online shopping destination. Reports indicated that the number of Amazon Prime members could reach 25 million by 2017.10

Fulfillment and Distribution

Amazon’s efficiencies in fulfillment and distribution were critical to its success, particularly its ability to serve online customers more quickly than its competitors. Its heavy investment in more than sixty distribution centers (compared to two or three for the average retailer) across the United States paid off annually as more and more products that consumers traditionally bought in-store were being purchased online.11 (See Exhibit 4 for a map of Amazon’s fulfillment centers.) Customers expected to receive products as soon as possible; the closer a supplier was to the customer, the quicker it could ship the product. (See Exhibit 5 for a diagram of Amazon’s shipping and receiving process.)

Amazon’s reliance on shipping companies increased in tandem with its expansion in fulfillment centers and need to rapidly service its customers. The costs associated with its

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

100

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 5

arrangements with these companies were beginning to become a major concern for Bezos and Amazon. In a 2013 statement to shareholders, Bezos discussed the necessity to reduce fulfillment and delivery service costs in order to maintain the health of Amazon’s business:

We rely on a limited number of shipping companies to deliver inventory to us and completed orders to our customers. If we are not able to negotiate acceptable terms with these companies or they experience performance problems or other difficulties, it could negatively impact our operating results and customer experience.12

Amazon heavily relied on delivery services such as UPS and FedEx. Both UPS and FedEx announced in 2014 average price increases of 4.9 percent and 3.9 percent, respectively, on delivery costs due to increased fuel prices. It was estimated that fuel for the long-haul fleets that UPS and FedEx employed accounted for nearly 40 percent of their operating expenses.13 (See Exhibit 6 for financial highlights for UPS and FedEx.)

Lobbying

Amazon began heavily lobbying the U.S. government in 2010 on issues such as taxes on online sales, transportation safety, data protection, and intellectual property. In addition, the company fought hard at the state level to ensure that it could retain multiple competitive advantages, such as tax breaks on large distribution centers and of course the ability to sell without charging customers sales tax. (Amazon threatened to leave the state of Texas when it asked to collect taxes from the company’s shipments.14) Amazon spent $3.4 million on lobbying in 2013, its highest spending year since its inception, and over $200,000 on political donations. It partnered with the CIA in a $600 million cloud-computing contract in 2012. In his 60 Minutes interview, Bezos claimed that Amazon conducted a significant amount of lobbying in 2013 for the legalization of unmanned autonomous drones. (See Exhibit 7 for Amazon lobbying spending.)

Customer Data

Amazon considered the data it captured from its customers one of its most important assets. The data allowed the company to foster a relationship with customers that it claimed is superior to that of a traditional retailer. Aside from promising its customers that their data was kept secret, however, Amazon rarely discussed how much it did or did not use it, though customers highly valued the product recommendations that Amazon provided based on the customer data. A special report in Time magazine investigated the data that Amazon collected:

While brick-and-mortar stores are black boxes—customer behavior inside the store is effectively invisible to managers—Amazon is able to collect endlessly useful information about shoppers and use it to sell more stuff by targeting customers through e-mail and the website itself. Whenever a customer buys something from Amazon or logs in without buying something, Amazon is collecting all kinds of information about that person. There’s a lot of data that can be mined about how they peruse the website, what they put in the cart, what they abandon, and how the customer actually goes about searching for a product.15

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

101

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

6 KELLOGG SCHOOL OF MANAGEMENT

By 2014, Amazon enjoyed tremendous customer trust in the management and use of customer data, providing it a clear advantage over other leading digital firms.16 Shoppers trusted Amazon more than Google, Facebook, Twitter, and Apple when it came to consumer privacy. In fact, only 7 percent of American consumers viewed Amazon as a threat.17

Autonomous Vehicles

Background

By 2014, the development of autonomous vehicles (AVs) had been underway for quite some time. In his 60 Minutes interview, Bezos suggested that Amazon would deliver goods by drones, or flying AVs. At the same time, however, advances in autonomous cars and trucks were being made, allowing for the possibility that retailers could use a fleet of both drones and autonomous cars and trucks. By that time, the National Highway Traffic Safety Administration (NHTSA) had classified “autonomy” into five different levels when associated with a land- or air-based vehicle:

Level 0: No features of autonomy; full control by driver.

Level 1: Individual features of autonomy, such as automatic braking.

Level 2: Different controls of a vehicle working together autonomously.

Level 3: Near autonomy; a driver is present only for critical control of the vehicle.

Level 4: Full autonomy; a driver is not needed to be present for control of the vehicle and it runs solely on data it collects from surrounding vehicles. (Amazon focused on using this level of autonomy.)

(See Exhibit 8 for a detailed description of the NHTSA classification schedule.)

At the highest level of autonomy, there were clear benefits for corporations that delivered goods within an industry’s value chain,* particularly for those involving freight activity. (See Exhibit 9 for a breakdown of the value of commercial freight activity and predicted savings.) Trucks could complete overnight deliveries (those that took longer than twelve hours) without having to take rest breaks due to driver fatigue. Drivers might not even be needed on a large scale, as robotic functions in the vehicle could theoretically perform automotive tasks in a safer, more consistent manner than a human could, thereby virtually eliminating a portion of labor costs and insurance claims associated with on-the-job accidents.† With advanced convergence technologies, vehicles could travel at higher speeds by communicating with each other, mimicking a human’s processing of information when driving their vehicles. Velocity, location, direction, and status would be communicated between vehicles so that each could operate more

* In 2014, Peloton Technology, an autonomous trucking company, estimated that AVs could save $6 billion per year for the trucking industry. † The cost for a vehicle crash on the job can cost an employer up to $74,000. See OSHA, “Guidelines for Employers to Reduce Motor Vehicle Crashes,” https://www.osha.gov/Publications/motor_vehicle_guide.pdf (accessed September 14, 2015).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

102

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 7

efficiently and without the error introduced by drivers. Without drivers, AVs could use less fuel and become more efficient in operation and ownership.

But there were concerns with investing in AV technology as well. First, a major impediment for the mainstream introduction of AVs would eventually be consumer adoption for the emerging technology. Without adoption, there is no convergence, and without convergence the limitations for scale are real.18 Scale was important, particularly because of the reliance of AVs on big data. In fact, it was the large amounts of consumer data that vehicles could collect and use that would make them truly valuable. Once customers could hail a driverless car to go where they needed, the data collected about the trip would not only provide operational efficiencies, such as which route to take, but would also provide a view on what individuals elected to do and where they went. Wide-scale use of AVs in society would provide data that could be used to determine not only how customers travel and where they shop, but also when and where they work and other elements of their lives. For critical adoption, consumers would need assurance that data would be secure in the hands of whichever company controlled it.

Second, although consumers were excited about the prospect of autonomous features in their vehicles, only 12 percent claimed they would actually feel safe purchasing an AV or being on the road with one (though this number was highly skewed toward urban dwellers). Predictions about when consumers would embrace the new technology widely varied. (See Exhibit 10 for predictions of full Level 4 AV adoption.) Political support for Level 4 autonomy would also be crucial for consumer adoption. Following on the heels of advancement in AV technology was a rise in legislation associated with it. (See Exhibit 11 for a timeline of recent U.S. state legislation involving AVs.)

Competitive Landscape

The 2010s saw many different parties investing meaningful capital in the production of AVs. (See Exhibit 12 for renderings of AVs for some of these firms.)

G O O G L E ’ S S E L F - D R I V I N G P R O J E C T

Google seemed to be the most aggressive proponent of commercializing AVs. Promoted as its “self-driving project,” Google’s autonomous cars had logged over 700,000 miles in testing by May 2014 and were designed to take humans completely out of the transportation equation, though humans would still be expected to ride in the initial test models using a stop/go emergency button, if necessary. Partnering with automobile manufacturer Lexus, Google focused more on the technology behind the vehicles than the vehicle itself. Chris Urmson, director of the Google Self-Driving Project, elaborated on the progress of the project:

As it turns out, what looks chaotic and random on a city street to the human eye is actually fairly predictable to a computer. As we’ve encountered thousands of situations, we’ve built software models of what to expect, from the likely (car stopping at a red light), to the unlikely (blowing through it). We still have lots of problems to solve and we are still waiting for some follow up regulation in California . . . but thousands of situations on city streets that would have stumped us two years ago can now be navigated autonomously.19

Google did not plan to sell the car but the technology behind it; its commercialization plan involved partnering with retailers, who could use the autonomous technology to serve customers

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

103

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

8 KELLOGG SCHOOL OF MANAGEMENT

quickly, and car service companies, such as UberRush, in densely populated areas. Additionally, the vehicles could be given routes via mobile devices, which would allow for greater fuel efficiencies.

C A T E R P I L L A R A N D T H E R O B O T I C S I N S T I T U T E

In 2010 Carnegie Mellon University’s Robotics Institute conducted a study with Caterpillar to develop an autonomous truck to be tested in a barren terrain of Central Australia. By 2013, the self-driving truck had been developed and tested, demonstrating the ability to carry 240 tons of iron ore in a single trip. By 2014, Caterpillar had six fully functional mining trucks. Each truck had 2,650 horsepower from combustible engines and was “driven” by over 25 million lines of software code. These trucks operated without drivers and could work day and night. The automation replaced four drivers per truck per 24-hour period.20 Ted Scott, director of engineering and safety policy for the American Trucking Association, which sponsored the study, said:

Ubiquitous, autonomous trucks are close to inevitable. Eventually we are going to have wireless, self-driving trucks because there will be money in it. Safety features like automatic braking will be commercially available over the next decade, but they will be quickly superseded by autonomous trucks after that.21

Caterpillar’s trucks were considered connected vehicles (at Level 3 autonomy), as they still needed technicians to monitor and sometimes guide several trucks at once, similar to advancements developed by Peloton Technology.* Most experts believed that even at its near- term technological peak, full Level 4 autonomy might not be a realistic goal.

U P S A N D F E D E X

UPS and FedEx had kept fairly quiet about their potential use of AVs until Bezos’s appearance on 60 Minutes, though both had expressed a desire to significantly decrease labor costs. After the interview aired, a UPS spokesman mentioned that the company might have many uses for drones. Particularly, UPS trucks could bring packages quickly from an airport to a major distribution center in more remote locations, speeding up the delivery process from business to customer. The spokesman said, “UPS invests more in technology than any other company in the delivery business, and we’re always planning for the future.”22

FedEx founder Fred Smith spoke more about his eager desire to get into the “unmanned aerial vehicle game” than UPS. FedEx’s goal was to have an aircraft that had no one on board and that could carry a significant amount of cargo. Smith continued:

A modern 777 is already capable of being an unmanned vehicle. They let the pilots touch the controls for about 20 seconds, to advance throttles, and then the plane takes over. Today, pilots drive the planes on the ground, but there’s no reason a computer can’t do that. It’s just a matter of getting the laws into place so companies can begin building to those specifications and doing some real field testing.23

* Peloton Technology was at the forefront of Level 3 autonomous innovation. Its driver-assisted truck platooning (DATP) model was working with the Federal Aviation Administration for a 2015 launch. Exhibit 13 shows an illustration of the technology.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

104

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 9

A M A Z O N P R I M E A I R

Focusing on its major competitive advantage of speedy delivery to customers, Amazon decided to pursue an aerial approach to autonomy. By the end of 2013, the Amazon Prime Air team was in its sixth generation of drone testing. The team planned to start aerial-drone delivery service to areas in the immediate vicinity of Amazon’s many U.S. fulfillment centers. Prime Air promised to deliver packages of up to five pounds—which comprised 86 percent of Amazon shipments—to any address within ten miles of its fulfillment centers.

Bezos told 60 Minutes he hoped that Prime Air would be ready for launch by 2015, but in addition to perfecting the technology, he also needed to consider how to use the data collected from customers to better serve them through autonomous delivery. He also needed to wait for official approval from the Federal Aviation Administration (FAA) to begin the service. Senator Ed Markey (D-Mass) commented on the FAA approval with regard to Amazon’s press event on 60 Minutes:

Before drones start delivering packages, we need the FAA to provide privacy protections for the American public. Convenience should never trump constitutional protections. My Drone Aircraft Privacy Act requires transparency on the domestic use of drones and adds privacy protections that ensure that this technology cannot and will not be used to spy on Americans.24

Although Amazon did not release figures for the portion of R&D spent on Prime Air, in 2013 total R&D expenses reached $1.73 billion, an all-time high. Estimates put the cost of owning and operating air drones at $20,000–$30,000.

Conclusion

Though Prime Air would not be ready for deployment for at least another year, Bezos had many questions before it could launch. He knew that Amazon needed to continuously innovate to provide the level of service its customers were accustomed to having. But what risks would be associated with venturing into autonomous delivery before consumers fully adopted the technology? Moreover, what risks would Amazon take on if it waited for another competitor to enter the market first? How would the retail landscape change and could Amazon change with it? The problem was, the information he needed to answer these questions would not be available for months—or even years.

F

o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

105

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

10 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 1A: Amazon.com Consolidated Statement of Operations

Source: Amazon 2013 Annual Report.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

106

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 11

Exhibit 1B: Amazon.com Consolidated Balance Sheet

Source: Amazon 2013 Annual Report.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

107

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

12 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 1C: Amazon.com Consolidated Statement of Cash Flows

Source: Amazon 2013 Annual Report.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

108

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 13

Exhibit 2: Amazon, Microsoft, and Google Labor Comparisons

Source: Blair Hanley Frank, “Amazon Soars to Nearly 110,000 Employees, Surpasses Microsoft for First Time,” GeekWire, October 24, 2013.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

109

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

14 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 3: Visual Breakout of Acquisitions by Amazon, 1998–2009

Source: Nicholas Carlson, “Visualizing Amazon’s Acquisition History,” Business Insider, July 27, 2009.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

110

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 15

Exhibit 4: Map of Amazon’s Fulfillment Centers

Source: “Amazon Fulfillment and Distribution Center Locations Map,” E-Commerce and Auction Site News, January 26, 2014, http://auctionsitenews.com/amazon-fulfillment-center-locations.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

111

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

16 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 5: Amazon’s Fulfillment Process

Source: Company documents.

F

o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

112

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 17

Exhibit 6: Financial Highlights for UPS and FedEx

U P S ( $ I N M I L L I O N S ) :

2013 2012

Revenues 55,438 54,127

Operating expenses 48,404 52,784

Net income 4,372 807

F E D E X ( $ I N M I L L I O N S ) :

2013 2012

Revenues 44,287 42,680

Operating expenses 41,736 39,494

Net income 1,561 2,032

Source: UPS and FedEx company documents.

Exhibit 7: Amazon’s Annual Spend on Lobbying

Source: Center for Responsive Politics, http://www.opensecrets.org/lobby/clientsum.php?id=D000023883 (accessed May 1, 2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

113

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

18 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 8: Detailed AV Definitions from the National Highway Traffic Safety Administration

NHTSA defines vehicle automation as having five levels:

 No Automation (Level 0): The driver is in complete and sole control of the primary vehicle controls—brake, steering, throttle, and motive power—at all times.

 Function-Specific Automation (Level 1): Automation at this level involves one or more specific control functions. Examples include electronic stability control or pre-charged brakes, where the vehicle automatically assists with braking to enable the driver to regain control of the vehicle or stop faster than possible by acting alone.

 Combined Function Automation (Level 2): This level involves automation of at least two primary control functions designed to work in unison to relieve the driver of control of those functions. An example of combined functions enabling a Level 2 system is adaptive cruise control in combination with lane centering.

 Limited Self-Driving Automation (Level 3): Vehicles at this level of automation enable the driver to cede full control of all safety-critical functions under certain traffic or environmental conditions and in those conditions to rely heavily on the vehicle to monitor for changes in those conditions requiring transition back to driver control. The driver is expected to be available for occasional control, but with sufficiently comfortable transition time. The Google car is an example of limited self-driving automation.

 Full Self-Driving Automation (Level 4): The vehicle is designed to perform all safety- critical driving functions and monitor roadway conditions for an entire trip. Such a design anticipates that the driver will provide destination or navigation input, but is not expected to be available for control at any time during the trip. This includes both occupied and unoccupied vehicles.

Source: “U.S. Department of Transportation Releases Policy on Automated Vehicle Development,” NHTSA 14-13, press release, May 30, 2013.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

114

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 19

Exhibit 9: Estimate of Average Trucking Operating Costs and AV Savings

Component Per Mile

($) Percentage of

Total (%) Annual Total ($) AV Savings

(%)

Fuel 0.540 39 70,200 20

Truck cab and trailer depreciation (based on 5-year straight line)

0.240 17 30,600 25

Driver’s salary 0.360 26 46,800 90

Repairs and maintenance 0.120 10 15,000 —

Insurance 0.050 4 6,500 80

Tires 0.030 3 4,000 —

Permit, licenses 0.020 2 3,600 —

Coffee 0.004 — 600 —

Total 1.380 180,000 39

Source: “The Real Cost of Trucking—Per Mile Operating Cost of a Commercial Truck,” KPMG Trucker’s Report, http://www.thetruckersreport.com/infographics/cost-of-trucking (accessed May 1, 2014).

Exhibit 10: Predictions of Introduction of AVs to the Mass Consumer Source Year Summary

Google 2016–2018 Plans to release Google-car technology

Nissan 2020 Available in showrooms

GM 2020 Fully autonomous cars available

BMW 2025 Fully autonomous cars available

Ford 2025 AVs will be “a common sight” on roads in the United States

McKinsey 2025 10–20% of 1.2 billion private cars on the road will be autonomous

IDC 2040 Too many regulatory/trust barriers to be mainstream before 2040

IEEE 2040 75% of cars on the road will be autonomous by 2040

Source: Company documents for all above.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

115

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

20 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 11: Milestones in U.S. State AV Regulation

June 2011: The Nevada legislature passes a law authorizing the use of AVs.

May 2012: The Nevada Department of Motor Vehicles issues the first license to a self- driven car to a Toyota Prius using Google’s technology.

July 2012: Florida becomes the second state to authorize AVs.

September 2012: California signs a law allowing the legalization of driverless cars in the state. A mandate for the California Department of Motor Vehicles to draft full regulations by 2015 is issued.

January 2014: Michigan allows the testing of AVs with a human being inside the vehicle.

Source: Bryant Walker Smith, “Automated Vehicles Are Probably Legal in the United States,” Texas A&M Law Review 1, no. 411 (2014).

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

116

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 21

Exhibit 12: Images of Autonomous Vehicles

G O O G L E

C A T E R P I L L A R

A M A Z O N

Source: Company documents.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

117

AMAZON’S UNMANNED VEHICLE DELIVERY 5-315-501

22 KELLOGG SCHOOL OF MANAGEMENT

Exhibit 13: Peloton Technology Level 3 Autonomous DATP Model

Source: Company documents.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

118

5-315-501 AMAZON’S UNMANNED VEHICLE DELIVERY

KELLOGG SCHOOL OF MANAGEMENT 23

Endnotes

1 Jeff Bezos, in interview with 60 Minutes, December 1, 2013. 2 Michael Aldrich, “Management Guide to IT,” white paper, January 1982. 3 Ibid. 4 U.S. Department of Commerce, “E-Stats Report on E-Commerce for 1999,” March 7, 2001. 5 Revenue data from Amazon 2013 Annual Report, eBay 2013 Annual Report, and Priceline Group 2013 Annual Report. 6 Amazon 2013 Annual Report. 7 Brian Fung, “Everything You Need to Know about Amazon’s Delivery Drones,” Washington Post, December 2, 2013. 8 Mark W. Johnson, “Amazon’s Smart Innovation Strategy,” Bloomberg BusinessWeek, April 12, 2010. 9 Larry Downes and Paul F. Nunes, “Big Bang Disruption,” Harvard Business Review, March 2013. 10 Brad Tuttle, “Amazon Prime: Bigger, More Powerful, More Profitable Than Anyone Imagined,” Time, March 18, 2013. 11 Nitin Chaturverdi et al., “The Future of Retail Supply Chains,” McKinsey Quarterly, Spring 2012. 12 Amazon 2012 Annual Report. 13 David J. Donatelli, “Evolution of US Air Cargo Productivity ” (master’s thesis, Massachusetts Institute of Technology, September 2012). 14 Brad Plumer, “Here’s What Amazon Lobbies for in D.C.,” Washington Post, August 6, 2013. 15 Christopher Matthews, “Will Amazon Take Over the World?” Time, July 16, 2012. 16 Timothy Morey, Theodore “Theo” Forbath, and Allison Schoop, “Customer Data: Designing for Transparency and Trust,” Harvard Business Review, May 2015. 17 Nadia Tuma and Laura Simpson, “Why Amazon’s Data Store Doesn’t Scare People—But Facebook’s Does,” Advertising Age, January 23, 2014. 18 KPMG and Center for Automotive Research, “Self-Driving Cars: The Next Revolution,” 2012. 19 Chris Urmson, “The Latest Chapter for the Self-Driving Car: Mastering City Street Driving,” Google blog, April 28, 2014, http://googleblog.blogspot.com/2014/04/the-latest-chapter-for-self-driving-car.html. 20 Dennis K. Berman, “Daddy, What Was a Truck Driver?” Wall Street Journal, July 12, 2013. 21 Ibid. 22 Christina Chaey, “UPS Is Researching Drone Deliveries, Too,” Fast Company, December 3, 2013. 23 Chris Anderson, “Fred Smith: FedEx Wants UAV’s,” DIY Drones, February 12, 2009. 24 “Americans Debate Amazon’s Intent to Deliver Packages by Drones,” Business Standard, December 3, 2013.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

119

8.

H

9B04C001 ENRON — WHAT WENT WRONG1 Professor Bert Spector prepared this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services is the exclusive representative of the copyright holder and prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661- 3208; fax (519) 661-3882; e-mail [email protected]. Copyright © 2004, Northeastern University, College of Business Administration Version: (A) 2009-10-06 On December 14, 2000, Houston-based Enron Corporation seemed to stand at the peak of its meteoric rise to prominence. Chief Executive Officer (CEO) Kenneth Lay announced that he would soon turn over the reins to Jeffrey Skilling. Lay and Skilling exuded both pride in the past achievements of its company and confidence in their future. Most observers agreed. At the time of the transition from Lay to Skilling, the company reported $15 billion in assets, $100 billion in revenues and 20,000 employees. Such impressive achievements told only part of the story. Enron had done more than just succeed within the parameters of the energy industry; it had virtually redefined that industry. Embracing deregulation and free markets, adopting new technology with remarkable quickness and radically reinventing its own business model several times over, Enron seemed to stand as a paradigm of successful innovation. In 2000, Fortune named Enron as the “Most Innovative Company” for the fifth year in a row, and the magazine’s praise did not stop there. Enron was also rated 24th on its list of “Best Companies to Work For,” 29th on “America’s Fastest Growing Companies,” second on “Reputation of Employee Talent,” and first — just ahead of General Electric — on “Reputation of Quality of Management.”2 Almost precisely one year later, on December 2, 2001, Enron declared bankruptcy. The stunning swiftness with which Enron tumbled from one of the New Economy’s most admired companies to the largest bankruptcy ever in U.S. history up to that point, led to debates as to what had caused the collapse. Multiple theories abounded, and they all had one core idea in common: the roots of the collapse spread both deep and wide through the company’s history.

1This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Enron Corporation or any of its employees. 2See Fortune, Jan. 10, 2000, p. 88; Feb. 21, 2000, p. 110; Sept. 4, 2000, p. 146.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

121

Page 2 9B04C001 ENRON CORPORATION Enron Reshapes the Energy Industry and Itself Kenneth Lay headed Enron since its creation from a 1985 merger between InterNorth, Inc. and Houston Natural Gas Corporation. “Spend long enough around top Enron people and you feel you are in the midst of some sort of evangelical culture,” observed The Economist. “In a sense, you are. Mr. Lay, with his ‘passions for markets,’ is the cult’s guru.” Enron employees came to view Lay as a father figure in whom they could place complete trust. Said one executive, “The employees loved him. He walked the floors . . . . He was this warm, fatherly figure . . . . They trusted him.”3 As Lay worked to build the biggest pipeline system in the country, he focused his time and company resources on lobbying governments, especially state governments, to deregulate the energy industry.

Early on when other natural gas companies were attempting to hold onto a regulated market, we were pushing hard to move our business upstream into unregulated businesses. We thought there’d be more opportunity here to differentiate ourselves on products and services and make a profit at it.

To achieve that goal, Enron needed deregulated energy markets, so Lay became heavily involved in state- level political campaigns, spending more than $1.9 million of Enron’s money on 700 candidates in 28 states. Between 1997 and 2000, 24 states moved toward greater energy market deregulation. Up-ending the industry was an accomplishment that Lay himself viewed with pride:

In this new world, the public utility industry will fade into memory. Competition and technological change is turning the gas and electric industry into yet another mass- marketing segment of the U.S. and global economy.4

Lay also focused his energies on the promulgation of four core Enron values: communication, respect, integrity and excellence (a statement of those values can be found in Exhibit 1). He had banners hung in the company’s corporate lobby proclaiming those values. “I was always in the forefront of trying to make sure that our people did in fact live and honor those values . . . .” recalled Lay. “Integrity and character are incredibly important to me.”5 Becoming a Trader A free market for natural gas allowed Enron the opportunity for its first major innovation: a “gas bank.” In the late 1980s, gas prices entered a period of instability, and Enron found itself with a vast inventory of natural gas and uncertain future prices. To turn this apparent disadvantage into an opportunity, Jeffrey Skilling, who, at that time, was a McKinsey & Co. consultant working with Enron, proposed the idea of selling gas futures to customers at agreed-upon prices or price ranges. Natural gas customers, seeking a 3The Economist.com, June 1, 2000, p. 2; Laura Goldberg and Mary Flood, “The Rise of Ken Lay As Dramatic As His Fall,” HoustonChronicle.com, Feb. 3, 2002, p. 1, John Schwartz, “As Enron Purged Its Ranks, Dissent Was Swept Away,” New York Times, Feb. 3, 2002, p. C1. 4Lay is quoted in Fortune, June 23, 1997, p. 87; and Kenneth L. Lay, “Coming Soon To Your Home and Business: The New Energy Majors,” in G. William Dauphinais and Colin Price, eds., Straight From the CEO: The World’s Top Business Leaders Reveal Ideas That Every Manager Can Use (New York: Simon & Schuster, 2000), p. 255. See also New York Times, March 27, 2002, p. A20; Kurt Eichenwald, “Audacious Climb to Success Ended in a Dizzying Plunge,” New York Times On the Web, Jan. 13, 2002, p. 7; Greg Farrell and Chris Woodyard, “Three Powerful Men Forged Enron’s Path,” p. 2B. 5Gruley and Smith, “Keys to Success Left Kenneth Lay Open to Disaster,” p. A5.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

122

Page 3 9B04C001 hedge against the future fluctuation of prices, could enter into a contract with Enron. They would be able to withdraw gas from the bank in the future according to the provisions set forth in a current contract. Fortune magazine described the trading process:

A utility wanted gas for 30 days at a fixed price? Floating prices, but with a maximum and minimum price? A guaranteed supply of gas whenever the temperature went over 95 degrees? No problem: Enron could slice and dice the gas to a customer’s specifications — and, in return, of course, could charge a little extra.

It was this notion of a gas bank that would, according to Skilling, provide Enron with the “huge breakthrough” that would allow the company to “conquer the world because we had a better idea.”6 When Skilling left McKinsey to join Enron in 1990 as CEO of the company’s gas bank division, he moved the company more decisively into trading gas futures, seeking contracts of 15 years and longer. Given the volatility of gas prices, such long-term arrangements were not without risks, so the company needed to create an ability to manage that uncertainty. Enron’s risk management centered on “two simple rules: all trades must be balanced with an offsetting trade to minimize unhedged risks and each trader must report a daily profit-and-loss statement.”7 When wholesale electricity was deregulated in 1992, Enron leaped into the market. By 1994, it was selling $10 million worth of electricity, very little of which Enron generated itself. Instead, it relied on “the arts of swaps, collars, caps, floors, and hybrids.” Three years later, Enron reported revenues in electricity sales to be $4 billion, and by 2000, 95 per cent of its revenues came from wholesaling energy and services.8 “WALL STREET IN HOUSTON” Jeffery Skilling saw the gas bank as a model for ever-greater growth. Why not enter other non-energy markets that had never been traded before as commodities? If Enron had made money from gas and electricity futures, why could it not do the same for fiber-optic bandwidth, pollution-emission credits, even weather derivatives? Enron could move even farther afield with its trading and risk management competency, trading wood pulp, steel and television advertising. “The application [of the trading model] is almost limitless because every single business has, at its heart, markets,” Skilling explained. “Enron is an incumbent player’s worst nightmare.”9 As Enron moved more decisively into the trading business, it could shed physical assets and become highly flexible and adaptive. “Jeff’s theory,” said a senior Enron executive “was assets were bad, intellectual capital was good.” Skilling himself disdained what he called “old economy” companies that were burdened with assets. “These big companies will topple over from their own weight,” he warned.10 Enron’s transition to pure trader was widely noted by business analysts; typically with admiration for Enron’s ability to, once again, reinvent itself. CIO Magazine called the transformation “Enron’s boldest move to date,” which involved “its own version of Wall Street in Houston . . . .” The Economist agreed: 6Brian O’Reilly, “The Power Merchant,” Fortune (April 2000), p. 154. Skilling is quoted in USA Today, Jan. 28, 2002, p. 3B and Gary Hamel, Leading the Revolution, (Boston: Harvard Business School Press, 2000), p. 221. 7Kathleen M. Eisenhardt and Donald N. Sull, “Strategy As Simple Rules,” Harvard Business Review (January 2001), p. 114. 8Economist.com, Feb. 26, 1998, pp. 1-2; Fortune, April 17, 2000, p. 156; Fortune.com, March 5, 2001, p. 2. 9Skilling is quoted in The Industry Standard.com, Aug. 14, 2001, p. 2. 10The Enron executive is quoted in Business Week Online, Dec. 17, 2001, p. 1. Skilling is quoted in Bethany McLean, “Why Enron Went Bust,” Fortune.com, Dec. 24, 2001, p. 2.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

123

Page 4 9B04C001 “Enron, in effect, was abandoning its roots as an energy provider in favor of becoming a Wall Street trader that just happened to be based in Houston, Texas.” A stock analyst suggested that Enron had become “a company that traded for trading’s sake.”11 Jeffrey Skilling and Andrew Fastow Skilling, the man behind Enron’s transformation, had joined McKinsey in 1979 after receiving an undergraduate degree from Southern Methodist University and an MBA from the Harvard Business School. At Harvard he was a Baker Scholar and, according to one professor, “may have been the single best student I ever had, and he did not suffer fools.” Another professor found him to be passionate and relentless, adding that all the professors who had dealings with Skilling remembered him and “I don’t think anybody remembered an unpleasant thing about him.”12 When Skilling began working with Enron in 1988 — this was the point at which he introduced the gas bank idea — he was a senior partner in McKinsey’s Houston-based North American Energy and Chemical Practices division. Within two years, he was CEO of the Enron Finance Corporation. “I’ve never not been successful in business or work,” Skilling told a reporter, “Ever.” Ken Lay recognized and rewarded Skilling’s success by naming him president and chief operating officer (COO) (Lay retained the positions of chairman and CEO) in 1996.13 Over the next three-and-a-half years, Enron’s stock soared 350 per cent to a high of $90 a share. Skilling himself claimed General Electric’s transformational leader Jack Welch as his personal role model and extolled the organizational virtues of flexibility and innovation. “You should always value the ability to move and change, because that creates options.” In order to create an appropriate environment for innovation, he said, “You wanted to have an environment that weird people liked operating in. It’s the weird ideas that create new businesses.” 14 Skilling took pride in surrounding himself with talent, tough-minded individuals, and none played a more important role in determining the way Enron reported its financial performance than Andrew Fastow. A graduate of Tuffs University and the Kellogg School of Management at Northwestern University, Fastow joined Enron in 1990 at age 29. Eight years later, he was chief financial officer (CFO). Said a colleague of Fastow’s: “What the guy knew was numbers and finance. He knew how to close a deal. No one did that better than Andy.” USA Today noted the similarity between Fastow and Skilling: “Skilling could be cold and impersonal, but Fastow took it further — when he wasn’t secluded in his office, he was arrogant and abrasive, capable of pounding his fist on the table and dressing down colleagues in front of their peers.” Others talked about a kind of split personality. Said a former executive, “He was very smart and very good at what he did. He could be nice, but he could also be quite volatile and short-tempered. He didn’t have a lot of patience with people who weren’t as smart as him.”

11 Koch, “Reinvent Now: 100 Leaders For the Next Millennium,” p. 2. The analyst is quoted in McLean, “Why Enron Went Bust,” p. 3. See also the Economist.com, Nov. 29, 2001, p. 2. 12 Quoted in Marie Brenner, “The Enron Wars,” Vanity Fair, April 2002, p. 190 and John Schwartz, “As Enron Purged Its Ranks, Dissent Was Swept Away,” New York Times, Feb. 3, 2002, p. C1. 13Skilling is quoted in John Schwartz, “Darth Vader. Machiavelli. Skilling Set Intense Pace,” New York Times On the Web, Feb. 7, 2002, pp. 2-3. 14 Farrell and Woodyard, “Three Powerful Men Forged Enron’s Path,” p. 3B; Thomas A. Stewart, “Taking Risk to the Marketplace,” Fortune.com, March 6, 2000, p. 1; Schwartz, “As Enron Purged Its Ranks, Dissent Was Swept Away,” p. C1.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

124

Page 5 9B04C001 Skilling and Fastow helped drive Enron’s performance in the 1990s, and in December 2000, Ken Lay recognized Skilling’s contribution by naming him president and CEO, effective the following February. Said Lay:

The best time for succession is when the successor is ready and when the company is well- positioned for the future. Jeff is a big part of Enron’s success and is clearly ready to lead the company. With Jeff’s promotion, succession is clear, our deep pool of management talent remains intact, and no other organizational changes need to be made to take the company to new levels of growth.

Ken Lay had hung a banner in Enron’s corporate lobby proclaiming “The world’s leading energy company.” Skilling replaced that with a new banner: “The world’s leading company.”15 During his tenure as CEO, Skilling’s brash style often rubbed people the wrong way, including a number of Wall Street analysts. Said one, Skilling “was famously boastful . . . and thin-skinned, declaring on a conference call that a money manager who dared ask for a balance sheet was an ‘asshole.’” A colleague of Skilling offered this view: “He was always saying people don’t get it.”16 Building Businesses “To get ahead here,” said Skilling, “you have to be a business builder.” Human resource executive Cindy Olson agreed. “Entrepreneurs can build something of their own . . . with the luxury of a stable organization.” Enron supported the idea of “cellular division” wherein entrepreneurial new businesses, especially ones that challenged established business models, would become separate divisions. Executive Lou Pai explained the reasons for this differentiation:

A lot of times you’re off running an existing business and are responsible for new business as well, you’re not really as accountable for the success of the new business as long as your old business continues to do well. We want everyone building the new business to be involved 100 per cent.

To enhance that sense of involvement, Enron offered “phantom equity” to the start-up teams of these new businesses. At the point where the business began to show a profit, that phantom equity could be swapped for real Enron shares. Once businesses were up and running, they became highly autonomous, selecting their own infrastructure and often raiding other units for employees.17 Company executives could point to a number of examples of bottom-up generators of new business ideas, including the 1999 genesis of Enron Online. “We didn’t start it because the chairman said we need an e- commerce strategy,” said Executive Vice-president Steve Kean. Louise Kitchen drove the initiative while heading Enron’s gas trading operation in Europe. Based on previous experience with Internet trading (while she was working in Enron’s Scandinavian office), she began to work on an ad hoc basis, pulling together an informal coalition of commercial, legal and technical people. She informed her immediate supervisor, John Sheriff. Chief Operating Officer Skilling remained out of the loop until the ad hoc group, 15Ken Lay is quoted in “Skilling Named Enron CEO,” FinancialTimes.com, Dec. 14, 2000, p. 1. The banner change is reported in the Economist.com, June 28, 2001, p. 2. 16 Bethany McLean, “Enron’s Power Crisis,” Fortune.com, Sept. 17, 2001, p. 1; John Schwartz, “Darth Vader. Machiavelli. Skilling Set the Pace,” New York Times On the Web, Feb. 7, 2002, p. 2. 17 Skilling and Olson quoted in Nicholas Stein, “Winning the War To Keep Top Talent,” Fortune.com, May 29, 2000, p. 4. Pai quoted in Hamel, Leading the Revolution, p. 271.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

125

Page 6 9B04C001 which grew to 250 people, were ready to launch the online business. Sheriff finally approached Skilling in November 1999, and the COO was unenthusiastic but willing to explore the idea. Recalled Skilling:

So John says to me, “Actually, we’re almost done.” I was never asked for any capital. I was never asked for any people. They had already purchased the servers. They had already started ripping apart the building. They had already started legal reviews in 22 countries by the time I heard about it.

Skilling approved, and Enron Online was up and running in less than a year. Enron’s head of information technology (IT), Michael McConnell, said that online trading was revolutionary for the company, not so much because of the technology, but because of the impact it had on Enron traders: “Since Enron Online has reduced our transaction time to less than a second, our guys have to manage their businesses by the second — not just by the day as in the past.”18 Building a Trading Culture An Enron executive said a key to the company’s culture was “an overweening pride, which led people to believe they could handle increasingly exotic risks without danger.” The apparent success Enron enjoyed led to increasing pressure for ever-improving performance. “The driver was this unbelievable pressure to keep portraying Enron as something very, very different,” said another executive, “and keep the track record going and going.” The deal-makers at Enron, said a former deal maker, “thought they were so brilliant they could overcome any obstacle.” Added an employee, “We were doing deals that no one had done before. We were taking risks that no one else had taken before.”19 Lay and Skilling recognized that in order to fuel this trading culture, they would have to attract to Enron a different breed of employee from those who might otherwise find their way to Texas-based energy firms.

We not only had to attract talent from investment banking houses, commercial banks and elsewhere, but we also had to compete against them. We also had to go up against the big consulting firms for some of the new MBAs coming out of graduate schools.

The head of an executive search firm that worked for Enron talked about this “new” type of recruit: “Enron was a real pioneer in bringing a new type of executive to the energy business. They started a trend in the energy business of attracting executives who otherwise would have gone into investment and commercial banking.” What attracted these new recruits, in part, was their view of Enron “as a hip, dynamic, New Age, blue-chip company that you could join and have a good time of it.”20 Following the vision of Lay and Skilling, these new recruits recreated the Enron culture. In Enron’s world, the engineers have been replaced by theoretical physicists trained in portfolio analysis; the reliability is engineered on the trading floor, where young traders price and strike deals with customers in something like 90 seconds.

18 Skilling is quoted in Hamel, Leading the Revolution, p. 216. McConnell is quoted in Economist.com, June 28, 2001, p. 4. On Enron Online, see also Economist.com, June 28, 2001, p. 2 and Nicholas Stein, “The World’s Most Admired Companies,” Fortune.com, Oct. 2, 2000, p. 2. 19Economist.com, June 1, 2000, p. 1; McLean, “Why Enron Went Bust,” p. 2; Washington Post, Jan. 27, 2002, p. A1; “Enron’s Aggressive Risk-Taking Culture That Eventually Led to Its Demise, National Public Radio’s All Things Considered, Feb. 6, 2002. 20 Lay is quoted in Fortune, June 23, 1997, p. 87. Ron Lumbra of Russell Reynolds Associates is quoted in Houston Chronicle, Dec. 9, 2001, p. A1.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

126

Page 7 9B04C001 These new traders, according to Gary Hamel, “were bold, hungry, and creative. They were assigned to a territory and/or a specialty, but their real assignment was simply to find ways to make money.” There were occasional examples of traders overstepping the boundaries: between 1985 and 1987, two Enron oil traders defrauded the company out of $136 million. These two employees, viewed by the company as “rogue traders” and “expensive embarrassments” to the otherwise positive culture, were promptly fired.21 Global Expansion As a counter-trend to Skilling’s preference for pure trading, in the early 1990s, Enron began buying energy-related assets overseas. “We have created a new model based on an at-risk, entrepreneurial culture; we look for opportunity in chaos,” said an Enron executive explaining the company’s approach to global expansion.22 Under the leadership of Rebecca Mark, Enron aimed first at Europe, South America and Russia, and later focused on China and India. Newsweek wrote of Mark:

When she entered the utility business in the early ’80s, it was populated with frumpy males in baggy suits and short-sleeved shirts with pocket protectors. Mark was a builder . . . . By the mid-’90s, she had constructed or acquired five plants in the United States and was on her way to buying or building well in excess of 15 in Europe, Asia, South America and the Middle East.23

Like Skilling, Mark had graduated from the Harvard Business School. Unlike Skilling, however, Mark believed in building hard assets. In the late 1990s, Enron engaged in two large-scale overseas ventures. Azurix, Enron’s subsidiary, which held its water-related assets, purchased the U.K.’s Wessex Water for $1.9 billion. Mark brought what she referred to herself as a “missionary zeal” to her overseas expansion:

. . . we are bringing a market mentality and spreading the privatization gospel in countries that desperately need this kind of thinking. We are in the business of doing deals. This deal mentality is central to what we do. It’s never a question of finding deals but of finding the kind of deals we like to do. We like to be pioneers.

Enron also moved to build a power plant in Dabhol, in the state of Maharashtra, India. Despite a World Bank warning that such an investment in India was not viable, Enron partnered with General Electric and Bechtel to contribute $1.2 billion of the total $2.9 billion project. (“We make our own rules,” said an Enron executive explaining this decision. “Most people look at the world and think too small; when we went to India, the majors said we were crazy.”) The effort generated little revenue, however. A major shift in local political alignments accompanied by accusations of corruption and illegality on the part of Enron officials led the plant’s sole customer, the Maharashtra State Electricity Board, to stop purchasing power. They also declined to pay past bills. Enron and its partners shut down the project in June 2001.24 21 Economist.com, Feb. 26, 1998, p. 1; Hamel, Leading the Revolution, p. 213; Corey Kilgannon, “Coincidences From a Case 15 Years Old,” New York Times On the Web, March 5, 2002, pp. 2-3. 22Quoted in Andrew Inkpan, Enron and the Dabhol Power Company (American Graduate School of International Management/Thunderbird, 2002), p. 2. 23Johnnie L. Roberts and Evan Thomas, “Enron’s Dirty Laundry,” Newsweek, March 11, 2002, p. 25. 24New York Times, March 7, 2002, p. C7. Mark is quoted in V. Kasturi and Krishna G. Palepu, Enron Development Corporation: The Dabhol Power Project in Maharashtra, India (A). (Boston: Harvard Business School Publishing, 1997), p. 1. The Enron executive is quoted in Inkpen, Enron and the Dabhol Power Company, p. 2.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

127

Page 8 9B04C001 By that time, Skilling was moving to unload Enron’s international assets. In August 2000, Rebecca Mark left Enron. Skilling placed virtually the entire global holdings on the market, hoping to recover as much as possible of the $7.5 billion Enron had invested. No buyers, however, were found.25 Employee Development “I prefer a smart person to an asset,” said Jeffrey Skilling, referring to his belief that intelligent, flexible, performance-oriented employees would provide Enron with a competitive advantage, especially when compared to asset-heavy traditional companies. Enron’s human resources department sought to take advantage of that flexibility and knowledge by creating an open market for internal labor. “We have so many business units,” said Executive Vice-president Cindy Olson, that “the opportunities are limitless.”26 To maximize mobility, Enron sought to allow seamless movement across businesses and units. Common compensation and evaluation systems removed potential barriers, as did policies that allowed employees to transfer their titles as they moved. An emphasis on stock options was meant, at least in part, to keep employees focused on the overall performance of the company.27 In Skilling’s view, knowledge had to be balanced with an emphasis on individual performance. To ensure such an emphasis, Enron employed a fixed-curve rating system. Employees were evaluated not by supervisors alone, but by a group of employees called a Performance Review Committee. Each year, units were required to identify the bottom 15 per cent of their performers, and, in a system nicknamed “rank- and-yank,” fire those on the bottom.28 Observers found both plusses and minuses in Enron’s employee development system. A Fortune survey found Enron to be one of the most successful companies at attracting and retaining top talent in a highly competitive labor market:

Employees are encouraged to be risk-taking career builders. College recruits spend time in several business units to see which is the best fit. As employees progress, they are pushed to manage their careers by moving around within the firm and acquiring new skills. In fact, 85 per cent of the people in Enron’s core business units have held at least two positions within the company. Enron also keeps a database of online resumes — updated regularly by employees — so that managers can recruit from within. As result, the company’s annual turnover is a minuscule three per cent, even though it hired nearly 5,000 people last year [1999].

Much internal criticism, however, was aimed at the ranking-by-committee approach. “Everyone was in it for themselves,” said an executive. “People stabbed you in the back.” Another complained that the review process focused entirely on the amount of revenue generated by the employee: “I never once heard a discussion about a person’s teamwork or integrity or respect.” Aware of such concerns, Skilling expressed support for changing the committee aspect of the ranking system.29

25 Laura Goldberg and Tom Fowler, “The Myth of Enron,” Houston Chronicle.com, Jan. 26, 2002, p. 2; New York Times, March 9, 2002, p. B3. 26Skilling is quoted in Thomas A. Stewart, “Taking Risk to the Marketplace,” Fortune.com, March 6, 2000, p. 1; Olson is quoted in Nicholas Stein, “Winning the War To Keep Talent,” Fortune.com, May 29, 2000, p. 2. 27Stewart, “Taking Risk to the Marketplace,” p. 2. 28Matthew Boyle, “Performance Reviews: Perilous Curves Ahead,” Fortune.com, May 28, 2001, p. 1. 29 Stein, “Winning the War To Keep Talent,” p. 4; Houston Chronicle, Dec. 9, 2001, p. A1; Joshua Chaffin and Stephen Fidler, “The Enron Collapse,” Financial Times, April 9, 2002, p. 30.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

128

Page 9 9B04C001 Compensation Lay and Skilling recognized that if they were going to compete with investment houses and consulting firms for talent, they would have to offer competitive compensation packages. “Young traders just out of school were tantalized with promises of $500,000 within a year,” said one observer. High salaries were matched by lavish perks: $1.5 million company parties (at one, Rebecca Mark rode in on the back of an elephant); $100 bills left on each employee’s desk when the stock price reached $50. Employees felt they earned such lavishness because of their long hours and frequently gruelling travel schedules. The environment, said one executive, was, “Get it done. Get it done now. Reap the rewards.” The extravagance, said another, “is what made it great to work” for Enron. Lay himself maintained that corporate spending could have a desirable motivational impact. “All these planes,” he said, referring to Enron’s fleet of corporate jets, “give my CEOs something to aspire to.”30 Skilling was keen on moving Enron’s compensation plan to be more rewarding of entrepreneurial behavior. “If we’ve broken a paradigm,” an executive said, “it’s the compensation paradigm. We pay people like entrepreneurs.” High bonuses were paid, based on deals completed and revenue booked. Said one employee:

The bonuses led employees to focus on pushing deals through the system, even if the deal was a bad deal. The people working on Dabhol power plant in India did very well in bonus time because they worked on a deal and got it done. Two years later, the deal went into the tank, but the system was not good at differentiating between temporary value and long-term value.

Top executives could receive sizable bonuses based on a calculated combination of dividends paid to shareholders plus improvements in the stock price. On January 11, 2001, for example, CFO Andrew Fastow received a bonus check of $350,000; on February 5, he received a check for $1.3 million and then on February 7, he received a bonus payment of $1.4 million. Sizable bonuses were not the exclusive domain of corporate officers, though. In 2001, a 27-year-old energy trader earned an $8 million bonus on reported profits of $750 million in natural gas contracts.31 Increasingly, as Enron’s stock price rose, the company came to rely on stock options — granting employees the right to buy shares in the future at a fixed price, typically the price of the share at the time the option is granted — as a way of rewarding executives. Skilling pointed to the reliance on stock options as a practice “used by every corporation in the world.” In addition to basing rewards on company performance, stock options allowed companies to look more profitable than if they had paid executives with a salary. Granting stock options is the only form of compensation that is not reported as an expense.32 Skilling made clear that top Enron executives were quite conscious of that advantage. “Essentially what

30 Brenner, “The Enron Wars,” p. 196; Schwartz, “As Enron Purged Its Ranks, Dissent Was Swept Away,” p. C1; Neela Banerjee, “At Enron, Lavish excess Often Came Before Success,” New York Times, Feb. 26, 2002, p. C1. Lay is quoted in Brenner, “The Enron Wars,” p. 195. 31 The executive is quoted in Hamel, Leading the Revolution, p. 271; Houston Chronicle, Dec. 9, 2001, p. A1. Information on Fastow’s bonuses as documented by company records, is reported in Kurt Eichenwald, “Enron Paid Huge Bonuses in ’01; Experts See a Motive for Cheating,” New York Times on the Web, March 1, 2002, p. 2. On John Arnold’s bonus, see David Barboza, “Enron Trader Had a Year to Boast of, Even If . . .” New York Times, July 9, 2002, p. C1. 32 If stock options were counted as an expense, profitability of many large corporations would be reduced substantially. A study by the Federal Reserve estimated that between 1995 and 2000, the average earnings growth rate for S&P 500 companies would have been reduced by 25 percent if stock options had been reported as expenses. When the option is exercised, the issuing company declares a tax deduction based on the difference between the option price and the exercise price. The exercise of stock options by all Enron executives in 2000 accounted for a $390 million tax break for the company.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

129

Page 10 9B04C001 you do is you issue stock options to reduce compensation expense,” he explained, “and therefore increase your profitability.” In 2000, Skilling exercised options that netted him $62.5 million.33 Culture of Confidence A sense of confidence and pride infused Enron’s culture in a way that could be, and often was, experienced as arrogance. “The Enron way was to be brash,” said an executive, “and there was an arrogance about it.” Said another, “Anyone who criticized Enron — internally or externally — was taken out and flogged.” If you were an Enron employee, “you thought you were better. You were smarter than everyone else.”34 Ken Lay dismissed charges of corporate or even personal arrogance. In a June 2000 interview with The Economist, he compared himself and his company to Michael Milikin and Drexel Burnham Lambert. Milikin and Lambert had likewise been accused of arrogance. (Milikin had also been accused and convicted of securities fraud.) Like Enron, Lay insisted to the reporter, they were really being “very innovative and very aggressive.”35 Aggressive Accounting Enron followed the “mark to market” rule for recognizing revenues. The fully legal practice allowed the company to book as revenue the entire projected downstream value of a deal at the time the deal was made. Thus, a deal to provide $500,000 a year in natural gas to a customer for five years would be recognized as $2.5 million at the inception of the deal. Of course, most of Enron’s trading deals were far more uncertain and ambiguous that that example. Prices and needs varied in the complex agreements struck with customers. Additionally, many of the agreements stretched out for 10 to 15 years; or, in the case of the New York State Power Authority, 33 years.36 Would a customer exist in 10 to 15 years, let alone be willing and able to pay? Enron had just such an example of that uncertainty when the Maharashtra State Electricity Board, the sole customer of Enron’s multibillion- dollar investment in India, canceled all future contracts with the Dabhol power plant and refused to pay past bills. Rather than projecting revenue streams cautiously, Enron tended to be aggressively optimistic. For instance, in a state where power had not yet been deregulated, Enron based its projections on the assumption that power would soon be deregulated, allowing the company to raise the price. It was this aggressiveness that, while approved by Arthur Andersen, Enron’s accounting firm, led to the designation of “cutting edge.” Enron executive Gary Foster said that even at the time it was reporting these revenues, “we knew that we pushed the limit in our accounting practices, and that people would come in with their numbers whether we really did [achieve them] or not.”37 Many analysts, both critics and supporters, acknowledged that openness concerning performance numbers was never Enron’s strong suit. Writing in Fortune, Bethany McLean noted: 33 Skilling is quoted in “Transcript of Senate Commerce Committee Hearing on Enron,” p. 41. On his 2000 stock option income, see “Stock Option Excess,” New York Times, March 31, 2002, Section 4, p. 8. 34 All quotes are from the Houston Chronicle, Dec. 9, 2001, p. A1. 35Lay is quoted in The Economist.com, June 1, 2000, p. 2. 36Hamel, Leading the Revolution, p. 214. 37Gruley and Smith, “Keys to Success Left Kenneth Lay Open to Disaster,” p. A5.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

130

Page 11 9B04C001

. . . the company remains largely impenetrable to outsiders, as even some of its admirers are quick to admit. Start with a pretty straightforward question: how does Enron makes its money? Details are hard to come by because Enron keeps many of the specifics confidential for what it terms “competitive reasons.”38

When Azurix, an Enron subsidiary, was trying to win a contract from the Houston Area Water Corporation to build a purification plan, the negotiations fell through because the Water Corporation’s board was uneasy about Azurix’s financial status. “We could never flush out of Azurix the financial documents we wanted,” explained the board’s chairman. “The first tell-tale sign of something being amiss is the refusal to turn over documents.”39 When doubts were expressed about the validity of Enron’s high-performance claims, company executives responded aggressively. On August 21, 2001, for example, broker Chung Wu of PaineWebber’s Houston office sent a pre-dawn e-mail to clients warning about the performance of Enron’s stock. Clients, Wu suggested, should “take some money off the table.” Aaron Brown, Enron’s manager of employee stock option plans, fired off his own e-mail to PaineWebber executives saying that he found Wu’s advisory to be “extremely disturbing” and asking them to “Please handle the situation.” By that evening, PaineWebber executives had fired Wu and issued a retraction, assuring clients that Enron’s stock was “likely heading higher than lower from here on out. All this occurred on the same day that Ken Lay sold $4 million worth of his own personal Enron holdings.40 In 2000, Carl Bass, a partner at Houston office of Enron’s accounting firm, Arthur Andersen, sent an e- mail to partners in the accounting firm’s Chicago headquarters expressing concern over various accounting practices — how the company recognized revenues, its dealings with various off-balance sheet partnerships — and the fact that these practices had been “sustained” by the local Andersen office. Executives within Enron got wind of these concerns and lobbied, unsuccessfully on this occasion, for Andersen to “replace Carl.”41 The Collapse It was possible to trace the collapse of Enron — at least the public manifestation of that collapse — to a Tuesday afternoon in the summer of 2001. At the close of the markets on August 14, Jeffrey Skilling who had served as Enron CEO since the previous February, unexpectedly announced his resignation. Chairman Kenneth Lay offered reassuring words: “The company is probably in the strongest and best shape it has ever been in.”42 Lay would assume the day-to-day leadership of Enron. The financial markets, however, were not reassured. The stock price, which had been as high as 90 a year earlier, now tumbled through the 30s. Troubled by Skilling’s sudden resignation and the investor scrutiny that the bombshell announcement was sure to attract, an Enron vice-president, Sherron Watkins, wrote a memo to Ken Lay expressing her concern that Enron would “implode in a wave of accounting scandals.”43 At the heart of Watkins’ expressed concern was her belief that the many complex deals that Enron had constructed with off-balance 38 Bethany McLean, “Is Enron Overpriced?” Fortune.com, March 5, 2001, p. 1. 39Quoted in Houston Chronicle, Dec. 9, 2001, p. A1. 40Quotes from Richard A. Oppel, Jr., “The Man Who Paid the Price For Sizing Up Enron,” New York Times, March 27, 2002, pp. C1, C4. 41 42“Enron CEO Jeffrey Skilling Unexpectedly Resigns,” FinancialTimes.com, Aug. 14, 2001, p. 1. 43The full text of this memo is provided in Fortune.com, Jan. 16, 2001, pp. 1-6.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

131

Page 12 9B04C001 sheet entities had obfuscated the true financial picture of the company. From 1999 to 2000, a period of explosive growth in Enron’s stock price, CFO Andrew Fastow created hundreds of off-balance sheet partnerships. Known collectively as LJM2 and run by Fastow and fellow executive Michael Kopper, these partnerships could be used to hide debt and inflate revenues. But they rested on stock issuance, cross- collateralization and stock “trigger points.” As Enron’s stock price plunged, Enron faced losses in the hundreds of millions of dollars.44 The following week, Watkins met face-to-face with Lay. The CEO assured Watkins that he would investigate the matter, and he did in fact contact both the company’s law firm as well as David B. Duncan, the senior partner of Enron’s accounting firm, Arthur Andersen, in charge of the Enron account. The law firm conducted a month-long investigation and concluded there was nothing to be concerned about. Duncan pulled together an unofficial committee within Andersen to review past practices.45 On October 16, Enron released its third-quarter results, showing a loss of $1 billion in bad investments. And the bad news was just beginning. In a conference call with analysts the following day, Lay mentioned, in a fleeting way, an additional $1.2 billion in capital reduction stemming from unspecified problems arising from off-book partnerships run by CFO Andrew Fastow. This write-down resulted from the review conducted by Duncan, although none of these specifics was enunciated in the call. Lay was so off-handed in his handling of the announcement, in fact, that participants in the call were not sure until days later that this charge was in addition to the $1 billion loss announced in the quarterly report. “They were trying to sneak it by,” recalled one participant.46 To calm investors, Lay removed Fastow as CFO, but the stock price took another hit on October 22 with an announcement by the Securities and Exchange Commission (SEC) that it had opened an investigation into certain accounting practices relating to the off-balance sheet partnerships. The stock fell to $21. On October 30, Moody’s downgraded Enron’s bonds to “junk” status, and the stock price plunged again. Enron employees who might have wanted to sell stock from their retirement package were prevented from doing so; the company was shifting plan administrators, and retirement accounts were temporarily frozen. The news went from bad to worse. In the first week in November, with the stock price now in the single digits, Enron announced that it was reducing its earnings over the past four years by almost $600 million, due to the manner in which three “unconsolidated entities” had been accounted for in past financial statements (more fallout from Duncan’s review of past practices) and warned that additional reductions might be forthcoming. Although Enron had borrowed $6 billion in the six weeks after the October announcement of third-quarter results, it still faced more than $31 billion in combined debt. With the stock price now below a dollar a share, with debt spiraling out of control and with no further access to capital markets, Enron filed for Chapter 11 bankruptcy on December 2, 2001.

44In August 2002 Michael Kopper pleased guilty to charges of conspiring to commit fraud and money laundering in connection to these partnerships. Federal investigators made clear that the Kopper plea bargain was only the beginning in the prosecution of other Enron executives. 45It is this committee that, on October 23 — a day after the S.E.C. announced that they had opened an investigation into “certain related party transactions” — commenced the destruction of thousands of Enron-related documents. That destruction led, eight months later, to the conviction of Andersen on federal charges of obstruction of justice. 46“Analysts Vent Anger at ‘Hidden’ Enron Charge,” FinancialTimes.com, Oct. 18, 2001, p. 1.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

132

Page 13 9B04C001

Exhibit 1

ENRON CORPORATE VALUES Communication We have an obligation to communicate. Here, we take the time to talk with one another . . . and to listen. We believe that information is meant to move and that information moves people. Respect We treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment. Integrity We work with customers and prospects openly, honestly and sincerely. When we say we will do something, we will do it; when we say we cannot or will not do something, then we won’t do it. Excellence We are satisfied with nothing less than the very best in everything we do. We will continue to raise the bar for everyone. The great fun here will be for all of us to discover just how good we can really be. Source: Company files.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

133

9.

9B14D005

APPLE INC.: MANAGING A GLOBAL SUPPLY CHAIN1 Ken Mark wrote this case under the supervision of Professor P. Fraser Johnson solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) [email protected]; www.iveycases.com. Copyright © 2014, Richard Ivey School of Business Foundation Version: 2014-06-12

INTRODUCTION Jessica Grant was an analyst with BXE Capital (BXE), a money management firm based in Toronto.2 It was February 28, 2014, and Grant was discussing her U.S. equity mandate with BXE’s vice president, Phillip Duchene. Both Grant and Duchene were trying to identify what changes, if any, they should make to BXE’s portfolio. “Apple is investing in its next generation of products, potentially the first new major product lines since Tim Cook took over from Steve Jobs,” she said. Apple Inc., the world’s largest company by market capitalization, had introduced a series of consumer products during the past dozen years that had transformed it into the industry leader in consumer devices. Apple managed a global supply chain with creative development in the United States, outsourced manufacturing in Asia and components sourced from suppliers around the world. Apple was in the centre of a complex ecosystem that produced market-leading consumer devices. With $160 billion3 in cash in February 2014, the company was well-capitalized. Despite its commercial success, Apple’s stock was at $524.47 on February 28, 2014, 25 per cent below the $700 level it had reached in 2012. Cook reassured investors that the firm was focused on the future, and it had a solid pipeline of new products. This was his way of signalling to stakeholders that he would be able to run the firm following the death of Steve Jobs, one of Apple’s co-founders and the man responsible for rebuilding the firm. “We’re working on some things that are extensions of things you can see and some that you can't see,” Cook said at Apple’s annual shareholders' meeting on February 28, 2014.4 Industry observers were skeptical that the company could deliver new product successes:

It is unclear whether the spread-sheeting-loving, consensus-oriented, even-keeled Cook can successfully reshape the cult-like culture that Jobs built. Though Cook has deftly managed the iPhone and iPad product lines, which continue to deliver enormous profits, Apple has yet to launch a major new product under Cook; talk of watches and televisions remains just that . . . in the day-to-day at Apple, Cook has established a methodical, no-nonsense style, one that’s as different as could be from that of his predecessor. Job’s bi-monthly iPhone software meeting, in which he would go through every planned feature of the company’s flagship product, is gone. “That’s not Tim’s style at all,” said one person familiar with those meetings. ‘He delegates.’5

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

135

Page 2 9B14D005 Nevertheless, it was clear to Jessica that Apple’s product range would get more complex in the next few years. As part of her analysis of Apple’s stock, she wanted to take a look at the company’s supply chain to see if she could gain some insight into whether to continue with Apple as a key holding in BXE’s fund. APPLE INC. Apple Computer was founded on April 1, 1976, by Steve Jobs, Steve Wozniak and Mike Markkula to manufacture and distribute desktop computers. Both Jobs and Wozniak started tinkering with computing devices in a time when enthusiasts who wanted a fully functioning computer had to assemble the parts by themselves from individual components. They struck a deal to sell an initial order of 50 units of their “Apple I” computer to a local computer shop, and negotiated a 30-day credit term to pay for the parts, effectively using their suppliers to fund the startup. After selling 200 units of the Apple I, Wozniak improved the design and showcased the Apple II in April 1977. Needing capital for the next phase of their company, they brought on Markkula, a marketing manager at Intel who had retired after making millions on his stock options. The company became the largest private manufacturer of personal computers in the United States and held its initial public offering in December 1980, thereby creating 300 millionaires. Although it had a great product, the team at Apple soon found that IBM’s entry into the market in 1981 would change the industry. By 1983, IBM’s personal computer (PC) became the best-selling computer in the United States, heralding the beginning of its domination of the PC market. Even Apple’s popular 1984 Superbowl commercial,6 combined with a heavy marketing campaign, was not enough to stop IBM’s growth. Jobs left Apple in 1985. The company stumbled along for the next decade, and even though it launched a line of Macintosh computers such as Quadra, Centris and Performa, it failed to gain traction in the marketplace. Worse, its retail partners such as CompUSA and Sears did not devote resources to displaying its products properly. Apple also suffered from a perception that its machines were more expensive than comparable Windows PCs. The company had poor operating controls and inventory management, failing to properly estimate demand for its products and leading to both stock-outs and excess inventory.7 Apple squandered its goodwill from the 1980s Macintosh era. In 1996, Microsoft was one year into the launch of Windows 95, which was turning out to be a very popular operating system. Apple’s sales of Macintosh computers fell dramatically and Apple, in an attempt to reverse the trend, began licensing the Mac operating systems to third-party manufacturers. From 1993 to 1996, Apple went through three CEOs: John Sculley, Michael Spindler and Gil Amelio.8 In 1996, Jobs returned to the company as CEO at a time when Apple’s future was in question. Apple’s market capitalization had fallen from $11.6 billion in 1987 to $3.1 billion at the end of 1996. In 1996, sales were $9.8 billion. In the early 1990s, Apple had begun licensing its Mac operating system to third- party manufacturers who would produce their own lines of devices powered by Mac’s operating system. Its licensing model was similar to that employed by Microsoft, allowing the operating system producer to earn additional revenues by selling copies to generic computer manufacturers. With the objective of reasserting control over its product, one of Jobs’ first decisions was to stop licensing Apple’s Mac operating system. This resulted in a fall in computer unit market share from 10 per cent to 3 per cent. Throughout this time, Apple continued to manufacture its own devices. In 1997, Jobs announced a partnership with Microsoft that would see the latter invest $150 million in Apple and release the dominant office software — Microsoft Office — for Macintosh. At the time of the announcement, Apple’s market capitalization had continued to fall to $2.5 billion.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

136

Page 3 9B14D005 Between 1998 and 2001, Apple launched iMac computers as a line of revamped PCs that focused on design. The computer body was made from bright colours such as green, blue and purple. The line sold well and provided the spark for Apple’s return to prominence. In May 2001, Apple announced that it would be opening its own retail stores to enable it to educate consumers and to grow its market share. In October 2001, it introduced the iPod portable digital audio player. Supporting the iPod was the iTunes music store, which was stocked with downloadable songs. At a time when the biggest record labels were worried about pirated songs being downloaded to MP3 players, Apple negotiated a deal with the five largest labels to be part of iTunes. The success of the iPod helped to revitalize Apple’s prospects, building a strong financial base from which the firm could grow. By 2004, Apple was able to gain better control over its supply chain by working with new suppliers on proprietary parts for which Apple would provide upfront capital in return for volume commitments and a lower overall price per unit. Apple’s growing clout allowed it to work with its suppliers to launch a series of new products containing significant technological advancements, such as iPod Video, iPod Touch and, by 2007, the iPhone. Concurrently, Apple expanded its retail store base beyond the United States, opening its first Japanese store in 2003. From 2007 to 2013, Apple’s success with its music players allowed it to upgrade its iPhone and iPod line- up, introduce new Mac computers and other products such as Apple TV, and develop its application (app) store, where third party developers listed their apps for consumers to download. In April 2010, Apple reinvented the tablet computer market by launching its iPad. With its slim design, multi-touch screen and touch-sensitive keyboard, the iPad was an instant commercial success. For consumers, the iPad was a portable computer and entertainment device, allowing them to respond to emails, watch videos, play games, and browse the Internet, among other things. While Apple still used retail partners to distribute its products, it sold 70 per cent of its products and services directly to consumers and businesses (see Exhibit 1). Jessica had seen many reviews stating that Apple’s success was due to a combination of design, functionality, marketing and an ability to modify production to meet spikes in demand. She read an article about Apple’s launch of its iPhone 5 in September of 2012, including a demonstration of the new phone by the vice president of marketing for Apple, Phil Shiller. Nine days away from that product’s official launch, Apple was confident enough in its just-in-time supply chain that it had not yet begun to ramp up production. The company had an aggressive schedule to meet as the iPhone 5 eventually sold at a rate of 3.7 million units per week for the first three months. In addition, it was available in 100 countries from 240 mobile phone carriers. 9 Intrigued by Apple’s ability to coordinate its supply chain on a real-time basis, Jessica started to dig further for details of the firm’s operations. She decided to focus on one product, the iPhone, and understand how Apple managed to bring that product to market. The iPhone’s Supply Chain Apple’s iPhone supply chain was global, tying together a research and development base in the United States, 156 suppliers, assembly operations in China and retail stores, some of which were its own Apple- branded stores. Jessica began to trace the path of Apple’s iPhone from inception to delivery to customer.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

137

Page 4 9B14D005 New Product Development Apple’s management team kept a short new product development cycle. Whereas a traditional product lifecycle – for a new car model, for example – might span four to five years, Apple’s iPhone lifecycle was closer to one year. Exhibit 2 provides a list of iPhone models since the first version was launched in June 2007, and Exhibit 3 shows iPhone unit sales by the quarter. The new product development department coordinated a wide variety of stakeholders, including internal groups such as hardware, software and production. For example, the industrial design team headed by senior vice president, Jony Ive, worked with the production team to ensure that products could be built in large volumes. Instead of outsourcing its manufacturing to third-party service providers — as in the case of Samsung10 — Apple preferred to control the entire supply chain internally. 11 Unlike other electronics manufacturers that might outsource the entire production — and management — of their supply chain to a third-party service provider such as Solectron or Flextronics, Apple designers worked in close proximity with suppliers. Quite literally, the designers would often spend “months living out of hotel rooms in order to be close to suppliers and manufacturers, helping to tweak the industrial processes that translate prototypes into mass-produced devices.”12 Creative design and engineering was managed in California, where Apple developed new technologies, acquired licenses for intellectual property and made bolt-on acquisitions of technology firms whose products could be used in Apple’s ecosystem of products and services. Concurrently, Apple conducted market research and product-testing to refine the upgrade being considered. Cost data were put together, including a list of parts and suppliers, and an estimate of what it would cost to assemble the iPhone. Potential quality defects were identified and plans were drawn up to mitigate risk. In 2013, Apple continued to invest heavily in research and development (R&D) to ensure that it would have innovative products in its pipeline. R&D spending was $4.5 billion in 2013, up from $3.4 billion in 2012 and $2.4 billion in 2011. Apple’s devices — unlike Dell’s — were available in a limited number of configurations, a deliberate product strategy that allowed its supply chain processes to be streamlined. Apple’s technology competitors typically had separate R&D departments and separate profit and loss accountability for each product segment. In contrast, Apple was highly integrated, with centralized R&D and accounting for the entire company.13 Procurement Apple products contained key components that were often sourced from a single manufacturer. Because the different mobile phone firms often used the same components, key parts from a single, popular supplier were regularly out of stock due to overwhelming demand. To counteract this supply issue, part of Apple’s procurement strategy was to purchase suppliers’ production capacity in advance in order to ensure the steady supply of key parts (see Exhibits 4 and 5). In addition, Apple had a program that allowed it to buy capital equipment for suppliers in exchange for both supply assurance and achieving cost targets.14 As a percentage of the selling price of an iPhone, Apple captured approximately 60 per cent as gross margin, and suppliers such as LG and Samsung captured another 5 per cent to 7 per cent as revenues (see Exhibit 6 for a breakdown of the distribution of value from the sale of an iPhone). Product demand was forecast 150 days in advance and updates were continually sent to suppliers to allow adjustments in

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

138

Page 5 9B14D005 production schedules. Apple’s procurement team used sales targets to manage production ramp-up issues and place material purchase commitments, making pre-payments if necessary.15 It reacted to changes in sales forecasts by altering the orders, often at a moment’s notice. Depending on forecast demand, Foxconn was known to wake up its workers – even at midnight – to meet sudden spikes in orders from Apple:

One former executive described how the company relied upon a Chinese factory to revamp iPhone manufacturing just weeks before the device was due on shelves. Apple had redesigned the iPhone’s screen at the last minute, forcing an assembly line overhaul. New screens began arriving at the plant near midnight. A foreman immediately roused 8,000 workers inside the company’s dormitories, according to the executive. Each employee was given a biscuit and a cup of tea, guided to a workstation and within half an hour started a 12-hour shift fitting glass screens into beveled frames. Within 96 hours, the plant was producing over 10,000 iPhones a day. “The speed and flexibility is breathtaking,” the executive said. “There’s no American plant that can match that.”16

These alterations had an impact on both components and assembly labour requirements. Every quarter, for its current slate of products, Apple reviewed its inventory levels, adjusted its demand forecast, and monitored its cost of components. New products in the development pipeline were added to the review as well. An analyst estimated that the bill of materials for the iPhone 5 ranged from $199 to $230 for sub-models that retailed for $649 to $849 (see Exhibit 7). The production of the iPhone began with orders placed to 156 component suppliers around the world. It was normal for Apple to sign exclusivity agreements with key suppliers. For example, when Ive found a U.S. laser equipment supplier that made $250,000 machines to cut precision holes, an agreement was signed to secure hundreds of the machines for manufacturing Apple’s products. According to observers, maintaining control over suppliers was important. Apple’s decision to manage a “closed ecosystem” enabled it to negotiate large discounts on components. This gave the company access to flexible manufacturing volume in the event demand was high, and savings on other supply chain costs such as air-freight.17 Apple engineers worked closely with suppliers to update manufacturing processes and technology. For example, new tooling equipment was designed to cut the MacBook’s unibody shell. Apple’s insistence on exclusivity and its high volume of purchases meant that competitors often had to wait for key components, such as screens. “To manufacture the iPad 2,” for example, “Apple bought so many high- end drills to make the device’s internal casing that other companies’ wait time for the machines stretched from six weeks to six months, according to a manager at the drillmaker.”18 These delays had a material impact on competitors. In May 2005, news about Apple ordering DRAM chips sent Samsung’s stock price tumbling in one day, erasing a staggering $10 billion of the electronics giant’s market cap.19 For suppliers, Apple’s high-volume orders and offers to invest in capital equipment had both benefits and drawbacks. While suppliers enjoyed profits due to the high volumes ordered by Apple, the latter expected detailed breakdowns of suppliers’ costs for manufacturing labour, materials and even projected profit. Suppliers were also expected to keep two weeks of parts inventory in close proximity to assembly plants. In addition, the cost to carry parts was borne by suppliers as Apple stretched out its payables to as long as 90 days after the parts were used. 20 Apple’s offer to pay for machinery and its firm commitments to future supplier volume were not typical for the electronics industry, which traditionally preferred to negotiate the lowest possible combination of

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

139

Page 6 9B14D005 price and volume commitments per order. The following is an example of a deal negotiated by Apple with a key supplier:

Apple struck a deal with GT Advanced Technologies Inc., a maker of furnace equipment that is used to produce sapphire materials that cover smartphone lenses and home buttons. Apple received an exclusivity agreement from GT Advanced for the furnaces in exchange for making a prepayment of $578 million. GT Advanced said it would pay Apple back over five years starting in 2015. The deal has “limited our ability to take additional” business, Thomas Gutierrez, GT Advanced’s CEO, said in a conference call with analysts. GT Advanced said in its announcement that revenue from the division that includes the kinds of machines Apple is buying will increase to 80 per cent of the company’s total business, predicted to be $600 million to $800 million, up from 31 per cent previously.21

To maintain their independence, some suppliers chose to decline Apple’s orders and capital, realizing that Apple’s negotiating tactics would leave them with slim profits. A major parts manufacturer declined to commit its manufacturing capacity to Apple’s products, even refusing a $1 billion upfront payment from Apple. The manufacturer was worried that Apple’s insistence on committed capacity and low prices would have an impact on sales to its other customers. 22 Product Assembly Final assembly of the iPhone 5 occurred in China, at Apple subcontractor Hon Hai Precision Industry Co., better known as Foxconn, at a cost to Apple of $8 per unit. Foxconn, founded in 1974, was an original design manufacturer for clients such as Apple, Sony, Nintendo, and BlackBerry. Based in Taiwan, it was the world’s largest electronics manufacturer with 1.23 million workers in 2012. In 2012, Foxconn generated $2.7 billion in net income from $4.2 billion in revenues. Foxconn had factories in Asia, Europe, Mexico and South America. Apple’s competitors, in contrast, tended to outsource production of their smartphones: • In June 2011, it was reported that Nokia outsourced its Windows Phone handset production to

Compal Electronics.1 • In December 2013, BlackBerry, in an attempt to turn around its business, outsourced its hardware

production to Foxconn,2 • Even Samsung, a large conglomerate, announced in December 2013 that it would be outsourcing the

production of its low-end smartphones.3 Several iPhone components required labour-intensive assembly operations with complex quality control processes. For example, Apple had run each iPhone camera module through a battery of tests before it could be inserted into an iPhone. One of the key tasks for subcontractors was coordinating the sourcing and hiring of the temporary labour used in testing and assembling individual components. For example, for a group of 24 companies with 28 plants in Malaysia that were supplying assembly services to Apple’s component suppliers, receiving assembly orders meant that they had to focus efforts on hiring thousands

1 www.slashgear.com/nokia-outsources-windows-phone-production-to-compal-tip-insiders-24161238/; accessed June 4, 2014. 2 Will Connors, “At BlackBerry, Stock Jumps Despite Big Loss”, The Wall Street Journal Online, December 20, 2013, http://online.wsj.com/news/articles/SB10001424052702303773704579269901455159052; accessed June 4, 2014. 3 www.sammobile.com/2013/11/13/samsung-to-outsource-production-of-low-end-devices-focus-its-own-manufacturing- plants-on-premium-models/; accessed June 4, 2014.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

140

Page 7 9B14D005 of temporary workers. These firms looked to draw workers from developing Southeast Asian countries such as Indonesia, Cambodia, Mynamar, Vietnam and Nepal. When the iPhone 5 forecasts were developed, one of Apple’s top component manufacturers, Flextronics, put out a call for 1,500 additional temporary workers to assemble a camera component. Labour was hired via a network of recruiters and subagents, all of which were tasked with finding people on short notice. For a job that paid approximately $178 per month, temporary workers paid as much as $1,000 in fees — to recruiters. Flextronics arranged for workers to board scheduled flights from their home countries to Malaysia, where they were transported to the company compound. Housing was provided, and workers were expected to work 12-hour shifts per day. Flextronics accounted for the fluctuations in orders by hiring or terminating temporary workers as needed. In the example cited above, 4,500 temporary workers began assembling iPhone 5 camera components in October 2012. But the workers were laid off in mid-January 2013, eliciting comments from the public that they had been unfairly treated. In response, Apple pointed to its supplier code of conduct, which had clear policies governing abusive practices such as harassment, involuntary labour and human trafficking.23 Due to Apple’s just-in-time supply chain, which placed significant responsibility on the shoulders of suppliers, component delays had an impact on Apple’s inventory projections. Sharp Corp, a supplier of iPhone displays, notified Apple that its output had fallen behind schedule as it struggled with high costs and debt servicing obligations.24 Finished components were consolidated at Foxconn’s China factories, where thousands of workers assembled the components into iPhones. Aside from the general labour required to test components and assemble devices, another critical advantage for Apple was that global suppliers provided engineers at a scale that its U.S. suppliers could not match. Apple’s executives had estimated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers eventually involved in manufacturing iPhones. The company’s analysts forecasted that it would take as long as nine months to find that many qualified engineers in the United States. In China, it took 15 days. On the assembly side, managing a huge workforce and keeping to tight schedules was difficult. A Foxconn factory was closed in Taiyuan, China in September 2012, following a riot among its 2,000 employees. In the summer of 2013, Foxconn began restricting workers to nine hours of overtime per week.25 To ensure that secrecy was maintained throughout the assembly process, Apple placed electronic monitors in select boxes of parts and followed the components remotely — from Cupertino — in case there were leaks. Logistics In 1997, Jobs’ return brought Apple a renewed focus on revamping its supply chain management capabilities. That year, Apple was facing a $1 billion backlog of orders that frustrated the management team. The firm looked at innovative ways to speed up the supply chain, even using expensive air-freight when most computer firms were relying exclusively on shipments by sea. In 1998, Jobs even pre- purchased all available holiday air-freight, paying $50 million to ensure that Apple’s new iMacs could be delivered to stores for the holiday sales rush. The move had the added benefit of shutting out rivals — such as Compaq Computer — from using air-freight as a transportation option. In fact, when it came time to ship its new iPod products in 2001, Apple discovered it was cheaper to ship them directly to consumers from its suppliers’ assembly plants in China. 26

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

141

Page 8 9B14D005 Apple relied on intermediate warehouses at UPS and Fedex and had its own warehouses in Elk Grove, California. It had to ensure that its many sales outlets — online stores, retail stores, direct sales force, wholesalers and retail network — had the product stock they needed according to the demand forecast. In addition, the company had a reverse logistics system as well, encompassing the management of warranty claims, trade-ins and Apple’s recycle and reuse program. Managing reverse logistics effectively contributed to Apple’s success, both on a cost level and on a customer service experience level. Traditionally, when a customer sought to return an electronic product, he or she would have to bring it back to the store with a receipt, and the store would take the item back, issue a refund, then hold the presumably defective item until it could be delivered back to the manufacturer. In contrast, Apple allowed consumers to enter data about the defect on the Apple website, adding the unit’s serial number to identify purchase details (including date of purchase, location and information about the customer). Within half a day, Apple would send the customer an email indicating if the product was still under warranty and providing details about how it would be returned. Within 48 hours, a pre-addressed, pre- stamped box would arrive at the customer’s door-step, sent by express parcel service. A shipping label and a receipt for the return were both included in the box, along with secure foam packaging and even packaging tape. By calling a central dispatch number, Apple’s assigned courier — UPS, FedEx or DHL — would come and pick up the item directly from the customer’s house or office.27 By providing rapid service through its reverse logistics function, Apple improved customer satisfaction, lowered the number of calls to its technical support services and eliminated the likelihood of customer error when processing a return (by using an incorrect address, for example). Getting the electronic product back into Apple’s service depots allowed them to diagnose and return the item to the customer rapidly, or fix the issue and sell the refurbished product as an “Apple Certified. Good as New” product in its Apple Store.28 Apple’s close management of its logistics system extended to packaging devices in plain boxes to “avoid detection,” and monitoring “every handoff point — loading dock, airport, truck depot and distribution center — to make sure each unit was accounted for.”29 Retail Experience Apple had 424 retail stores in 16 countries around the world. In addition, its online Apple Store was available in 39 countries. The company’s retail stores were typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores in desirable high-traffic locations, Apple was positioned to ensure a high-quality buying experience and attract new customers. The stores were designed to simplify and enhance the presentation and marketing of the company’s products and related solutions. The retail stores employed experienced and knowledgeable personnel who provided product advice, service and training and offered a wide selection of third-party hardware, software, other accessories and peripherals that complemented Apple’s products. Apple could monitor product sales by store by the hour and it relied on this information to tweak its production forecasts on a daily basis. According to one article: “If it becomes clear a given part will run out, teams are deployed and given approval to spend millions of dollars on extra equipment to get around the bottleneck.”30

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

142

Page 9 9B14D005 The company also invested in programs to enhance reseller sales by placing high-quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focused on the Apple platform by providing a high level of product expertise, integration and support services. A side-by-side comparison of Apple’s iPhone 5 with devices from key competitors can be found in Exhibit 8. Looking Forward At the end of fiscal year 2013, Apple had $171 billion in sales, with market capitalization of $457 billion.31 There were rumours that Apple was going to announce a stock split, something it had only done three times in its history: on June 15, 1987, on June 21, 2000 and on February 28, 2005.32 Jessica noticed that Apple continued to invest in its supply chain. At the end of 2013, Apple was investing $10.5 billion in new technology — including assembly robots and milling machines — to ensure that its products could be made more quickly and more cost effectively. In fact, Apple’s supply chain was ranked number one in a list prepared by Gartner Group, an analytics firm (see Exhibit 9). Selected financial information from three competitors – Samsung, BlackBerry and Nokia - is shown in Exhibit 10. One observer noted that:

Apple is increasingly striking exclusive machinery deals . . . outspending peers on the tools that it then places in the factories of its suppliers, many of which are in Asia. ‘Their designs are so unique that you have to have a very unique manufacturing process to make it,’ said Muthuraman Ramasamy, an analyst with consulting firm Frost & Sullivan, who has studied the use of the machinery. ‘Apple has so much cash that they can invest in cutting-edge, world-class machinery that is typically used for aerospace and defense.’33

Finally, Jessica pored over financial information from 1996 to 2013, as well as important segment information (see Exhibits 11 and 12), before summarizing her notes on Apple’s supply chain. Then she started to prepare a one-page outline of the pros and cons for her presentation to Phillip Duchene.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

143

Page 10 9B14D005

EXHIBIT 1: APPLE’S PRODUCTS iPhone The iPhone, with the iPhone 5s and 5c as the latest versions, combined a phone, photo and video camera, music player and Internet-accessible device. Apple’s iPhone segment generated $91.3 billion in sales in 2013, up 16 per cent from 2012. The iPhone had been launched as a high-end product and was available at a premium price. Apple’s iPhone 5c, however, was the first version of the iPhone targeted at the entry- level market. In 2013, Apple sold 150.3 million iPhones, up from 125 million units in 2012. iPad The iPad was Apple’s tablet computer, with the fifth generation iPad Air launched in October 2013. While many competitors had launched tablet computers in the past decade, Apple’s iPad, featuring a touch-screen interface, was the first tablet computer to gain traction in the market. Apple’s iPad segment generated $32 billion in sales in 2013, up 3 per cent from 2012. The number of iPad units sold rose 22 per cent from 58.3 million to 71 million, yet this segment’s revenues were stagnating due to Apple’s launch of smaller, less expensive iPad models over the years. Mac Apple’s Mac computers had Intel microprocessors and their own OS X operating system. Apple produced both desktop and laptop computers. Mac revenues fell 7 per cent to $21.5 billion in 2013. Unit sales fell 10 per cent to 16.3 million in 2013 from 18.2 million in 2012. iPod The firm’s portable digital music players combined a flash-memory player with features such as a photo and video camera, and allowed consumers to purchase content from its iTunes store. Sales of the iPod had been declining for the past few years, with segment revenues down 21 per cent in 2013 to $4.4 billion, and unit sales down 25 per cent to 26.4 million devices. iTunes and the iTunes Store Consumers could purchase and download apps, music and TV shows from the iTunes store. The iTunes store was integrated with Apple’s App Store and iBooks Store, which featured eBook downloads. The iTunes software and services segment generated revenues of $16.1 billion in 2013, up 25 per cent from 2012. By January 2013, Apple customers had downloaded 40 billion apps and Apple had made $7 billion in payments to third-party developers.34 Mac App Store and iCloud Computer users could download Mac apps from the Mac App store and iCloud was Apple’s cloud service, where users could keep their personal information online. Source: Apple annual reports and SEC filings.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

144

Page 11 9B14D005

EXHIBIT 2: IPHONE VERSIONS AND FEATURES

Source: Apple annual reports and SEC filings.

iPhone (1st ge ne ration)

iPhone 3G iPhone 3GS iPhone 4 iPhone 4S iPhone 5 iPhone 5C iPhone 5S

iOS 4.0 (GSM) iOS 4.2.5 (CDMA)

In addition to prior, features a fingerprint- resistant oleophobic coating,[242] and 262,144-color (18-bit) TN LCD with hardware spatial dithering[9]

4, 8 or 16 GB 8 or 16 GB 8, 16, 32 or 64 GB

16, 32 or 64 GB 16 or 32 GB 16, 32 or 64 GB

833 MHz (underclocked to 600 MHz) ARM Cortex-A8[11][245]

Samsung S5PC100[11][246] (64 KB L1 + 256 KB L2) 256 MB LPDDR DRAM[11][245] (200 MHz)

1 GB LPDDR3 DRAM[260]

Back 3 MP photos, VGA (480p) video at 30 fps, macro focus

5 MP photos, f/2.8, 720p HD video (30 fps), Back- illuminated sensor, LED flash

8 MP photos, f/2.4, 1080p HD video (30 fps), Back-illuminated sensor, face detection, video stabilization, panorama

8 MP photos with 1.5µ pixels, f/2.2 aperture, 1080p HD video (30 fps) or 720 HD video slo-mo video at 120 fps, improved video stabilization, True Tone flash, Infrared cut-off filter, Back- illuminated sensor, face detection, panorama, ability to take photos while shooting videos and Burst mode

Front

1.2 MP photos with 1.75µ pixels, 720p HD video (30 fps), Back- illuminated sensor

4, 8 GB: June 29, 2007

16, 32 GB: June 19, 2009

16, 32 GB: June 24, 2010

16, 32, 64 GB: October 14, 2011

16 GB: February 5, 2008

8 GB black: June 24, 2010

CDMA: February 10, 2011

8 GB: September 20, 2013

White: April 28, 2011 8 GB: October 14, 2011

4 GB: September 5, 2007

16 GB: June 8, 2009

16, 32 GB: June 24, 2010

16, 32 GB: October 4, 2011

32, 64 GB: September 12, 2012

8, 16 GB: July 11, 2008

8 GB black: June 7, 2010

8 GB black: September 12, 2012

8 GB: September 10, 2013

16 GB: September 10, 2013 8 GB: In Production

M ode l

Initial ope rating syste m

iPhone OS 1.0 iPhone OS 2.0 iPhone OS 3.0 iOS 5.0

Storage 8, 16 or 32 GB

Proce ssor 620 MHz (underclocked to 412 MHz) Samsung 32-bit RISC ARM (32 KB L1) 1176JZ(F)-S v1.0[243][244]

1 GHz (underclocked to 800 MHz) ARM Cortex-A8 Apple A4 (SoC)[247]

1 GHz (underclocked to 800 MHz) dual- core ARM Cortex- A9 Apple A5 (SoC)[248]

iOS 6.0 iOS 7.0

Display

3.5 in (89 mm), 3:2 aspect ratio, scratch-resistant[7] glossy glass covered screen, 262,144-color (18- bit) TN LCD, 480 × 320 px (HVGA) at 163 ppi, 200:1 contrast ratio

3.5 in (89 mm), 3:2 aspect ratio, aluminosilicate glass covered 16,777,216-color (24-bit) IPS LCD screen, 960 × 640 px at 326 ppi, 800:1 contrast ratio, 500 cd⁄m² max brightness

4 in (100 mm), 71:40 aspect ratio, 1136 x 640 px screen resolution at 326 ppi

1.3 GHz dual-core Apple-designed ARMv7s Apple A6[249]

1.3 GHz dual-core Apple-designed ARMv8-A 64-bit Apple A7 with M7 motion coprocessor[250]

M e mory 128 MB LPDDR DRAM[252] (137 MHz) 512 MB LPDDR2 DRAM[253][254][255][256][257] (200 MHz)

1 GB LPDDR2 DRAM[258][259]

Came ras

2 MP f/2.8

8 MP photos with 1.4µ pixels, f/2.4, 1080p HD video (30 fps), Infrared cut-off filter, Back- illuminated sensor, face detection, video stabilization, panorama and ability to take photos while shooting videos

No VGA (0.3 MP) photos and videos (30 fps)

1.2 MP photos with 1.9µ pixels, 720p HD video (30 fps), Back- illuminated sensor

M ate rials Aluminum, glass, steel, and black plastic

Glass, plastic, and steel; black or white

(white not available for 8 GB models) Black or white aluminosilicate glass and stainless steel

Black with anodized aluminium "Slate" metal or white with

White, pink, yellow, blue or green polycarbonate

Silver (white front with "Silver" aluminium metal back), Space Gray (Black front with anodized aluminium

All models: September 20, 2013

Discontinue d All models: September 10, 2013

In Production

Re le ase d All models: July 11, 2008

All models: September 21, 2012

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

145

Page 12 9B14D005

EXHIBIT 3: IPHONE SALES BY QUARTER

Source: Apple annual reports and SEC filings.

Global iPhone Sale s by FY Quarte r (in M M s)

Q3 2007 0.270 Q4 2007 1.190 Q1 2008 2.315 Q2 2008 1.703 Q3 2008 0.717 Q4 2008 6.890 Q1 2009 4.363 Q2 2009 3.793 Q3 2009 5.208 Q4 2009 7.367 Q1 2010 8.737 Q2 2010 8.752 Q3 2010 8.398 Q4 2010 14.102 Q1 2011 16.240 Q2 2011 18.650 Q3 2011 20.340 Q4 2011 17.070 Q1 2012 37.040 Q2 2012 35.100 Q3 2012 26.000 Q4 2012 26.900 Q1 2013 47.800 Q2 2013 37.400 Q3 2013 31.200 Q4 2013 33.800 Q1 2014 51.000

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

146

Page 13 9B14D005

EXHIBIT 4: IPHONE SUPPLIERS OF 97 PER CENT OF APPLE’S IPHONE PRODUCT MATERIALS

Source: Apple Inc., www.apple.com/supplier-responsibility/, accessed October 4, 2013.

Apple Suppliers 2011 1 AACTechnologies Holdings Inc. 53 Daishinku Corporation (KDS) 105 Interflex Co.,Ltd. 2 AcBel Polytech Inc. 54 Darfon Electronics Corporation 106 International Rectifier Corporation 3 Acument GlobalTechnologies 55 Delta Electronics Inc. 107 Intersil Corporation 4 Advanced Micro Devices,Inc. 56 Diodes Inc. 108 Inventec Appliances Corporation 5 AmperexTechnology Ltd. 57 Dynapack InternationalTechnology 109 Jabil Circuit,Inc. 6 Amphenol Corporation 58 Elpida Memory,Inc. 110 Japan Aviation Electronics Industry,Ltd. 7 Analog Devices,Inc. 59 Emerson Electric Co. 111 Jin Li Mould Manufacturing Pte Ltd. 8 Anjie Insulating Material Co.,Ltd. 60 ES Power Co.,Ltd. 112 Kaily Packaging Pte Ltd. 9 Asahi Kasei Corporation 61 Fairchild Semiconductor International 113 Kenseisha Sdn.Bhd.

10 AU Optronics Corporation 62 FasteningTechnology Pte Ltd. 114 Knowles Electronics 11 AustriaTechnologie & Systemtechnik AG 63 FLEXium Interconnect,Inc. 115 Kunshan Changyun Electronic Industry 12 austriamicrosystems 64 Flextronics International Ltd. 116 LairdTechnologies 13 AvagoTechnologies Ltd. 65 Fortune Grand Enterprise Co.,Ltd. 117 Lateral Solutions Pte Ltd. 14 Brady Corporation 66 Foster Electric Co.,Ltd. 118 Lens OneTechnology (Shenzhen) Co.,Ltd. 15 Brilliant International Group Ltd. 67 Fuji Crystal Manufactory Ltd. 119 Lg Chem,Ltd. 16 Broadcom Corporation 68 Fujikura Ltd. 120 Lg Display Co.,Ltd. 17 Broadway Industrial Group Ltd. 69 Grand UprightTechnology Ltd. 121 Lg Innotek Co.,Ltd. 18 Byd Company Ltd. 70 Gruppo Dani S.p.A. 122 LinearTechnology Corporation 19 CareerTechnology (MFG.) Co.,Ltd. 71 Gruppo Peretti 123 Lite-OnTechnology Corporation 20 CatcherTechnology Co.,Ltd. 72 Hama Naka Shoukin Industry Co.,Ltd. 124 Longwell Company 21 Cheng Loong Corporation 73 Hanson Metal Factory Ltd. 125 LSI Corporation 22 Cheng Uei Precision Industry Co.,Ltd.(Foxlink) 74 Heptagon Advanced Micro-Optics Pte Ltd. 126 Luen Fung Commercial Holdings Ltd. 23 Chimei Innolux Corporation 75 Hi-P International Ltd. 127 Macronix International Co.,Ltd. 24 Coilcraft,Inc. 76 Hitachi-LG Data Storage 128 Marian,Inc. 25 Compeq Manufacturing Co.,Ltd. 77 Hon Hai Precision Industry Co.,Ltd.(Foxconn) 129 MarvellTechnology Group Ltd. 26 Cosmosupplylab Ltd. 78 Hynix Semiconductor Inc. 130 Maxim Integrated Products,Inc. 27 CymMetrik (Shenzhen) Printing Co. 79 Ibiden Co.,Ltd. 131 Meiko Electronics Co.,Ltd. 28 Cyntec Co.,Ltd. 80 InfineonTechnologies AG 132 MicrochipTechnology Inc. 29 Cypress Semiconductor Corporation 81 Intel Corporation 133 MicronTechnology,Inc. 30 Mitsumi Electric Co.,Ltd. 82 Ri-Teng Computer Accessory Co.,Ltd. 134 Suzhou Panel Electronic Co.,Ltd. 31 Molex Inc. 83 ROHM Co.,Ltd. 135 Taiyi PrecisionTech Corporation 32 Multek Corporation 84 Rubycon Corporation 136 TaiyoYuden Co.,Ltd. 33 Multi-Fineline Electronix,Inc. 85 Samsung Electro-Mechanics Co.,Ltd. 137 TDK Corporation 34 Murata Manufacturing Co.,Ltd. 86 Samsung Electronics Co.,Ltd. 138 Texas Instruments Inc. 35 NanYa Printed Circuit Board Corporation 87 SanDisk Corporation 139 Tianjin Lishen Battery Joint-Stock Co.,Ltd. 36 NEC Corporation 88 SANYO Electric Co.,Ltd. 140 Toshiba Corporation 37 Nippon Mektron,Ltd. 89 SDI Corporation 141 Toshiba Mobile Display Co.,Ltd. 38 NishokuTechnology Inc. 90 SeagateTechnologies 142 Toyo Rikagaku Kenkyusho Co.,Ltd. 39 NVIDIA Corporation 91 Seiko Epson Corporation 143 TPK Holding Co.,Ltd. 40 NXP Semiconductor N.V. 92 Seiko Group 144 TripodTechnology Corporation 41 ON Semiconductor Corporation 93 Sharp Corporation 145 TriQuint Semiconductor 42 Optrex Corporation 94 Shimano Inc. 146 Triumph Lead ElectronicTech Co. 43 Oriental Printed Circuits Ltd. 95 Shin Zu Shing Co.,Ltd. 147 TXC Corporation 44 Panasonic Corporation 96 SilegoTechnology Inc. 148 Unimicron Corporation 45 PCH International 97 SimploTechnology Co.,Ltd. 149 UnisteelTechnology Ltd. 46 Pegatron Corporation 98 Skyworks Solutions Inc. 150 Universal Scientific Industrial Co.,Ltd. 47 Pioneer Material PrecisionTech 99 Sony Corporation 151 Vishay Intertechnology 48 Prent Corporation 100 Standard Microsystems Corporation 152 Volex plc 49 Primax Electronics Ltd. 101 STMicroelectronics 153 Western Digital Corporation 50 Qualcomm Incorporated 102 Sumida Corporation 154 Wintek Corporation 51 Quanta Computer Inc. 103 Sumitomo Electric Industries,Ltd. 155 Yageo Corporation 52 Renesas Electronics Corporation 104 SunrexTechnology Corporation 156 Zeniya Aluminum Engineering,Ltd.

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

147

Page 14 9B14D005

EXHIBIT 5: LIST OF APPLE’S KEY SUPPLIERS

Firm Location Part or service supplied Samsung Singapore CPU and Video Chips Infineon Singapore Baseband Communications Primax Electronics Taiwan Digital Camera Modules Foxconn International Taiwan Internal Circuitry Entery Industrial Taiwan Connectors Cambridge Silicon Taiwan Bluetooth Umicron Technology Taiwan Circuit Board Catcher Technology Taiwan Casings Broadcomm U.S. Touch Screen Controls Marvell U.S. 802.11 Specific Parts Foxconn China Assembly and Inventory

EXHIBIT 6: DISTRIBUTION OF VALUE FOR IPHONE, 2010

Source: Kenneth L. Kraemer, Greg Linden and Jason Dedrick, “Capturing Value in Global Networks: Apple’s iPad and iPhone”, July 2011, page 5. From “pcic.merage.uci.edu/papers/2011/Value_iPad_iPhone.pdf. ” Note that “Apple Profits” are gross margins to Apple and suppliers’ “profits” are revenues to that supplier. Amounts do not add up to 100 per cent due to rounding.

Cost of inputs: China labor 1.8% Cost of inputs: Non-China labor 3.5% Cost of inputs: materials 21.9% Unidentified profits: 5.3% South Korea profits 4.7% Japan profits 0.5% Taiwan profits 0.5% E.U. profits 1.1% Non-Apple U.S. profits 2.4% Apple profits 58.5%

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

148

Page 15 9B14D005

EXHIBIT 7: IPHONE 5 – ESTIMATED BILL OF MATERIALS (2012)

Source: HIS iSuppli Research, September 2012. https://technology.ihs.com/410378/iphone-5-carries-199-bom-virtual- teardown-reveals, accessed January 3, 2014.

Components/Hardware Elements 16 GB 32 GB 64 GB Pricing without Contract 649$ 749$ 849$ Total Bill of Materials Cost 199$ 209$ 230$ Manufacturing Cost 8.00$ 8.00$ 8.00$ Bill of Materials and Manufacturing 207$ 217$ 238$ M ajor Cost Driv e rs Memory NAND Flash 10.40$ 20.80$ 41.60$ DRAM 10.45$ 10.45$ 10.45$ Display and Touchscreen 44.00$ 44.00$ 44.00$ Processor 17.50$ 17.50$ 17.50$ Camera(s) 18.00$ 18.00$ 18.00$ Wireless Section - BB/RF/PA 34.00$ 34.00$ 34.00$ User Interface and sensors 6.50$ 6.50$ 6.50$ Bluetooth/WLAN 5.00$ 5.00$ 5.00$ Power Management 8.50$ 8.50$ 8.50$ Battery 4.50$ 4.50$ 4.50$ Mechanical/Electro-Mechanical 33.00$ 33.00$ 33.00$ Box Contents 7.00$ 7.00$ 7.00$

iPhone 5 M ode l

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

149

Page 16 9B14D005

EXHIBIT 8: IPHONE AND COMPETITORS

Source: http://mashable.com/2012/09/12/iphone-5-compared/, accessed April 3, 2014.

iPhone 5 Samsung

Galaxiy S III Droid RAZR

HD Nokia Lumia

920

Screen Size 4 inches 4.8 inches 4.7 inches 4.5 inches

Resolution 1,136 x 640 1,280 x 720 1,280 x 720 1,280 x 768

Weight 3.9 oz 4.7 oz 5.1 oz 6.5 oz

CPU Dual-core Apple A6

Dual-core 1.5GHz Snapdragon S4 (in the U.S.)

Dual-core 1.5GHz Snapdragon S4

Dual-core 1.5 GHz Snapdragon S4

Storage 16GB, 32GB or 64GB, no card slot

16GB, 32GB or 64GB +microSD slot

12GB+microSD slot

32GB, no card slot

Connectors Apple Lightning

microUSB microUSB microUSB

Operating System iOS 6 Android 4.0.4 (Ice Cream Sandwich)

Android 4.0.4 (Ice Cream Sandwich)

Microsoft Windows Phone 8

Battery

225 hours standby, 8 hours talk time (3G)

790 hours standby, 11:40 hours talk time (3G)

TBA

300 hours standby, 10 hours talk time (3G)

Camera

8MP, 3264x2448 pixels, autofocus, LED flash

8MP, 3264x2448 pixels, autofocus, LED flash

8MP, 3264x2448 pixels, autofocus, LED flash

8MP, 3264x2448 pixels, optical image stabilization, autofocus, dual- LED flash

Networking Wi-Fi, 2G, 3G, 4G LTE

Wi-Fi, 2G, 3G, 4G LTE

Wi-Fi, 2G, 3G, 4G LTE

Wi-Fi, 2G, 3G, 4G LTE

Price

$199 for 16GB, $299 for 32GB, $399 for 64GB; avail. Sept. 21

$199.99 + $35 carrier fee

$199 (estimated, launch end of 2012)

TBA, launch Q4 2012

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz

a tio

n a l P

o lic

y a t T

e xa

s S

o u th

e rn

U n iv

e rs

ity t a u g h t b y

R a yn

a rd

P o rt

e r

fr o m

J a n u a ry

1 6 , 2 0 1 7 t o M

a y

0 5 , 2 0 1 7 .

U se

o u ts

id e t h e se

p a ra

m e te

rs is

a c

o p yr

ig h t vi

o la

tio n .

150

Page 17 9B14D005

EXHIBIT 9: SUPPLY CHAIN RANKINGS BY GARTNER GROUP

Notes: 1. Gartner Opinion and Peer Opinion: Based on each panel's forced-rank ordering against the definition of “DDVN orchestrator” 2. ROA: ((2012 net income / 2012 total assets) × 50%) + ((2011 net income / 2011 total assets) × 30%) + ((2010 net income / 2010 total assets) × 20%) 3. Inventory Turns: 2012 cost of goods sold / 2012 quarterly average inventory 4. Revenue Growth: ((change in revenue 2012-2011) * 50%) + ((change in revenue 2011-2010) * 30%) + ((change in revenue 2010-2009) × 20%) 5. Composite Score: (Peer Opinion * 25%) + (Gartner Research Opinion * 25%) + (ROA * 25%) + (Inventory Turns × 15%) + (Revenue Growth × 10%) 6. 2012 data used where available. Where unavailable, latest available full-year data used. All raw data normalized to a 10- point scale prior to composite calculation. “Ranks” for tied composite scores are determined using next decimal point comparison. Source: Debra Hofman, Stan Aronow, Kimberly Niles, “The Gartner Supply Chain Top 25 for 2013”, The Gartner Group, 22 May 2013, pages 5-6.

Rank Company

Peer Opinion1

(172 voters) (25%)

Gartner Opinion1

(33 voters) (25%)

Three-Year Weighted

ROA2 (25%)

Inventory Turns3

(15%)

Three-Year Weighted Revenue

Growth4 (10%) Composite

Score5

1 Apple 3,203 470 22.3% 82.7 52.5% 9.51 2 McDonald's 1,197 353 15.8% 147.5 5.9% 5.87 3 Amazon.com 3,115 475 1.9% 9.3 33.6% 5.86 4 Unilever 1,469 522 10.5% 6.5 9.0% 5.04 5 Intel 756 515 15.6% 4.2 11.4% 4.97 6 P&G 1,901 493 8.6% 5.8 3.6% 4.91 7 Cisco Systems 1,167 517 8.5% 11.2 7.8% 4.67 8 Samsung Electronics 1,264 298 11.6% 18.5 15.7% 4.35 9 The Coca-Cola Co. 1,779 278 11.7% 5.5 14.0% 4.33

10 Colgate-Palmolive 794 324 18.9% 5.2 3.6% 4.27 11 Dell 1,409 342 6.2% 30.7 -0.6% 4.05 12 Inditex 745 221 18.0% 4.2 13.4% 3.85 13 Wal-Mart Stores 1,629 282 8.8% 8.1 4.9% 3.79 14 Nike 955 236 14.1% 4.2 10.6% 3.62 15 Starbucks 808 159 16.5% 4.8 11.5% 3.41 16 PepsiCo 810 314 8.6% 7.8 10.5% 3.41 17 H&M 399 41 28.2% 3.7 6.7% 3.22 18 Caterpillar 714 247 5.8% 2.8 23.4% 2.91 19 3M 999 105 13.3% 4.2 6.9% 2.87 20 Lenovo Group 397 211 2.5% 22.2 29.8% 2.75 21 Nestlé 679 112 13.3% 5.1 -0.6% 2.51 22 Ford Motor 552 231 5.7% 15.1 3.1% 2.51 23 Cummins 74 139 13.3% 5.3 13.5% 2.48 24 Qualcomm 122 45 12.7% 8.5 25.9% 2.37 25 Johnson & Johnson 730 144 9.6% 2.9 3.3% 2.35

F o r

u se

o n ly

in t h e c

o u rs

e O

rg a n iz