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05/04/2011

BP’s Failure to Debias: Underscoring the Importance of Behavioral Corporate Finance


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“BP has a systemic problem with its culture that runs deep.”

Ending the Management Illusion, Shefrin (2008), p. 95.

“In the view of the Commission, these findings highlight the importance of organizational culture and a consistent commitment to safety by industry, from the highest management levels on down.”

Report to the President, National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, (2011), p. ix.

1. INTRODUCTION

In this paper, we apply key concepts from behavioral finance to document how psychological biases and framing effects impacted corporate culture and management decisions at energy firm BP. On April 20, 2010, an accident drilling BP’s Macondo well in the Gulf of Mexico produced the worst environmental disaster in US history, an event which dominated the daily news during the spring and summer of 2010. In itself, this event makes for the study of BP’s decision making of interest, prompting the question of whether the April 20 accident was simply an unfavorable chance event or instead the result of biased decision making.

The discussion of BP’s decisions provides a vehicle for discussing more general issues about how corporate managers, analysts, investors, regulators, and academics can apply insights from behavioral corporate finance. In the last decade a literature has emerged documenting the impact of psychological traits such as excessive optimism and overconfidence on the decisions of corporate managers: See Shefrin (2001, 2006, 2008, 2010c), Baker et al. (2007), and Ben-David et al. (2010).

The degree to which firms deal with vulnerability to psychological pitfalls varies, and in this regard firms occupy a spectrum from low to high. Using a framework developed in Shefrin (2008), our discussion locates BP within this spectrum. The framework identifies process loci for vulnerability to psychological pitfalls, and offers a series of examples of firms that occupy different portions of the spectrum. In applying the pitfall-process framework, we conclude that capital budgeting pitfalls were a major factor in the April

20 accident, and offer suggestions about how BP can use behavioral techniques to debias, improve its decisions going forward, and achieve a stronger corporate culture.

Assessing vulnerability to psychological pitfalls is not just an issue for corporate managers. In respect to BP, investors, analysts, regulators, and the media generally missed the warning signals. Consider a contrast between the characterization of BP by Shefrin (2008) and the community focusing on corporate social responsibility. Shefrin (2008) profiled BP as an organization possessing many of the psychological weaknesses of high risk firms. He specifically singled out BP because those weaknesses led it to engage in excessive cost cutting and to take excessive risks in respect to the environment, worker safety, national security, and its own profitability. He wrote at the time that BP’s rhetoric about social and environmental responsibility was diametrically opposed to its deeds. And he pointed out that these inclinations were imbedded within its corporate culture (Shefrin, 2010b).

Shefrin wrote his analysis of BP in 2007. In contrast, Sverjensky (2010) points out that in the annual ranking of the world’s most responsible companies for 2007, both Fortune and AccountAbility bestowed on BP a top ranking. Statman (2010) points out that just prior to the Gulf disaster, the Dow Jones Sustainability Indexes (DJSI) identified BP as a “Sustainability Leader,” writing that “BP is leading its peers in corporate sustainability and is committed to shaping the oil and gas industry in the social and environmental aspects of business.”

Both Sverjensky and Statman ask how the financial community’s judgments about BP were so mistaken, effectively slamming the barn door after the horse had bolted. In this paper, we provide answers rooted in behavioral corporate finance, identifying psychological phenomena which affected the judgments of the financial community and BP alike. We argue that the financial community exhibited confirmation bias, in that it underweighted publicly available information indicating that BP displayed some of the key features characterizing firms with problematic corporate cultures.


Webinar with Hersh Shefrin


As we complete this article, the estimated cost to BP from the 2010 explosion in the Gulf of Mexico is US$40 billion. This figure, along with the events surrounding BP’s decisions, vividly illustrates the importance of behavioral corporate finance, and underscores the importance of diagnosing and treating psychological vulnerabilities. The need for diagnosis and treatment comprises the main lesson of the paper. We suggest that this lesson applies across the board, to corporate managers, to security analysts, and to investors. We also suggest that academics have a special responsibility to incorporate the behavioral dimension into their research, and to teach future managers how to run organizations that are less susceptible to psychological pitfalls.

A word of caution about the devil being in the details: we describe BP’s activities in considerable detail. We do so for at least two reasons. The first reason is to convey, as best as we can, the psychological context in which BP made its choices. Some of the underlying issues are subtle, and not always salient in media coverage.1 The second reason is that we have been unable to detect very few of these details mentioned in analysts’ reports, leading us to believe that analysts and investors were either unaware or chose to ignore critical issues associated with BP’s risk management practices. The description we provide of decisions and events involving BP underscores what analysts failed to highlight.

The remainder of the paper is organized as follows. Section 2 focuses on events involving BP at Texas City and Alaska, which were documented in Shefrin (2008). Section 3 introduces the pitfall-process behavioral framework and briefly applies it to analyze BP’s decisions at Texas City and Alaska. Section 4 describes the events surrounding the explosion of Deepwater Horizon, with a behavioral analysis of BP’s standards for risk management. Section 5 deals with the judgments of legislators, analysts, investors, and regulators. Section 6 focuses on steps firms in general and BP in particular can take to improve their cultures to mitigate biases using cognitive repairs. The paper ends with concluding remarks.

2. MAJOR PROBLEMS IN TEXAS AND ALASKA: HISTORY

Shefrin (2008) described problematic issues which arose at BP’s operations in Texas and Alaska. In this section, we describe conditions and events at those operations2 which led him to conclude that the firm’s culture left its management prone to excessive cost cutting, and to taking excessive risks in respect to the environment, worker safety, national security, and the company’s profitability.

2.1 Texas City

In 2005, the failure of an emergency warning system at a BP refinery in Texas City, Texas caused an explosion that killed fifteen people. The Texas City facility was the second largest refinery in the US, but it had been built in 1934, and was poorly maintained.3 The investigation that followed the 2005 accident, conducted by a panel of independent experts led by former US secretary of state James Baker, found significant process safety issues not only at the Texas City, but also in the other five BP US refineries.4 In respect to the Texas City accident, the investigating panel found that the explosion occurred when a tower was being filled with liquid hydrocarbons, with nobody noticing that it was being overfilled. The panel noted that workers were discouraged from talking with each other about potential safety issues, and that several workers had been on 12-hour shifts for more than a month (Lyall, 2010).5

In evaluating conditions at BP’s Texas City facility, the Occupational Safety and Health Administration (OSHA) found more than 300 safety violations,6 and BP agreed to pay US$21 million, the largest fine in OSHA history at the time (Lyall, 2010). In subsequent years, a series of investigations by inspectors from OSHA found more than 700 safety violations. In 2009, OSHA proposed to sanction BP with a record fine of US$87 million for failing to make safety upgrades at that Texas City refinery.7 The greatest part of the fine was due to the company failing to respect the previous settlement in full.

2.2 Alaska

In March 2006, corrosion caused a leak in BP’s Alaskan oil pipeline, resulting in a 267,000-gallon spill, which was the largest ever on Alaska’s North Slope. The spill forced BP to shut down half of its output from its Prudhoe Bay operations. An investigative panel subsequently attributed the incident to the firm’s poor maintenance practices.

Over time, pipelines build up sediment through time that can eventually corrode the pipes, causing leaks and spills. Oil companies check pipelines using a technique called “pigging” that involves the injection of a cylindrical droid (the “pig”) into the line. Even though BP pledged to improve its safety and maintenance programs, there were complaints by employees claiming that the company was letting equipment and critical safety systems languish at Prudhoe Bay.

As a response, the company hired a panel of independent experts to examine the allegations. In their October 2001 report, the experts found systemic problems in BP’s maintenance and inspection programs. According to the report, it seems that BP was trying to sustain profits in the aging drilling field, even though production was declining. To achieve this goal, the only way seemed to be to cut costs, with resulting maintenance backlogs.To achieve this goal, the only way seemed to be to cut costs, with resulting maintenance backlogs.8 To achieve this goal, the only way seemed to be to cut costs, with resulting maintenance backlogs. Notably, the panel’s report states that there was “a disconnect between GPB (Great Prudhoe Bay) management’s stated commitment to safety and the perception of that commitment” (Lustgarten, 2010).

The panel experts claimed that solving these problems was necessary to ensure mechanical integrity and operational efficiency in the long run. They warned the management of the company that those issues could have a potential immediate safety impact or pose an environmental threat. Without a systemic effort to address them, single actions could only provide temporary relief, and not be a solution in the long run. Alaska state regulators underscored the experts’ findings, claiming that BP failed to properly maintain its pipelines.

During 2002, the Alaskan Department of Environmental Conservation had a dispute with BP, and to resolve it, the department asked the oil company to use intelligent pigs9 to probe its pipelines for leaks, along with a list of other tasks, and to pay a fine of US$150,000.

BP responded that there was no evidence to suggest that its pipelines had anything more than minimal sediment buildup, thus asserting there was no need to use intelligent pigs.10 Five days after receiving this communication, the department withdrew its requirement that BP pig its lines.

In the following two years, Alaska pressured BP to comply with state laws and check its pipelines. At the same time, the company received from workers several warning regarding the danger of failing to use intelligent pigs.

Eventually, BP asked another team of outside investigators to check the warnings raised by local workers. The resulting 2004 inquiry found that pipeline corrosion and the age of the field endangered operations at Prudhoe Bay. It highlighted health, safety and environment concerns raised by employees who accused BP of allowing “pencil whipping” (falsifying inspection data), and of pressuring workers to skip key diagnostics to cut costs. BP management was cutting maintenance costs with a “run to failure” strategy, meaning that aging equipment was used for as long as possible.

BP eventually ran an intelligent pig through its lines in August 2006, only after the March spill, four years after the department asked it to do so, and fourteen years after the last probe, in 1992. The severe pipeline corrosion and leak caused BP to shut down half of its output from Prudhoe Bay.

BP’s problems in Alaska continued. In September 2008, a section of a high pressure gas line on the Slope blew apart. A 28-foot-long section of steel flew nearly 1,000 feet through the air before landing on the Alaskan tundra. Had the release caught a spark, the explosion could have been very significant. In 2009, three more accidents occurred on the same system of pipelines and gas compressor stations, including a near explosion that had the potential to destroy the entire facility. See Lustgarten (2010). On May 25, 2010 a power failure led to a leak that overwhelmed a storage tank, resulting in the spillage of 200,000 gallons of oil. See Lyall (2010).

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Hersh Shefrin and Enrico Maria Cervellati


1. In addition, there are issues involving the establishment of legal liability which is yet to be determined, thereby inducing some information spinning by affected parties. We have made a concerted effort to achieve balance in our presentation of the facts.

2. This section augments the discussion in Shefrin (2008).

3. Two months before the accident, a consulting firm hired to examine conditions at the refinery stated “We have never seen a site where the notion ’I could die today’ was so real” (Rowell, 2010).

4. In 2002, California officials discovered that BP falsified inspections of fuel tanks at a refinery in the Los Angeles area. They also found that more than 80 percent of the facilities did not meet the requirements needed to properly maintain storage tanks. BP settled a civil lawsuit brought by the South Coast Air Quality Management District for more than US$100 million (Lustgarten, 2010).

5. Jeanne Pascal, a former EPA attorney who investigated the Texas City explosion, referring to BP, once affirmed “They are a recurring environmental criminal and they do not follow US health safety and environmental policy”. He also added that none of the other big oil companies had an environmental record of violations like the one held by BP (Lustgarten, 2010).

6. Even if BP owns only six of the 150 refineries in the US, 97 percent of the most dangerous violations found by the Occupational Safety and Health Administration (OSHA) were on BP facilities, as reported by the Center for Public Integrity (Morris and Pell, 2010).

7. On August 10, 2010, BP agreed to pay US$ 50 million as part of this fine (that eventually was reduced to US$ 80 million). BP, however, did not plead guilty.

8. The company had not checked pressure valves, emergency safety shutoff valves, automatic emergency shutdown mechanisms, and gas and fire detectors essential to preventing explosions. These key equipments for emergency shutdown were similar to those that could have prevented the fire and the subsequent explosion on the Deepwater Horizon rig in the Gulf of Mexico (Lustgarten, 2010).

9. Intelligent pigs are droids loaded with sensors used for maintenance tests in the oil industry. A cheaper and more convenient-to-use alternative is using external devices such as ultrasound that however are not as effective as intelligent pigs.

10. The use of pigs is standard in the oil industry. For example, the company that operates and maintains Trans Alaska Pipeline System, Alyeska Pipeline Service, checks its pipelines with intelligent pigs every three years, and it also uses cleaning pigs at least twice a month (Shefrin, 2008).

 

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