DEA BEST PRACTICE ASSESSES RELATIVE EFFICIENCY, PROFITABILITY
D. Thomas Taylor
Palladian Analysis & Consulting
Houston
Russell G. ThompsonThe U.S. Federal Energy Regulatory Commission (FERC), in its Order 636 of Apr. 8, 1992, stated, "All natural gas suppliers, including pipelines, will compete for gas purchases on an equal footing."
University of Houston
This FERC order changed the economic environment in the natural gas pipeline industry. Now, gas pipeline companies must know their market position, since rate of return regulation is no longer relevant. They must be managed more than before as compa- nies have been in less-regulated parts of the oil and gas business. How they adapt to the new environment, therefore, can be instructive to companies throughout the energy industry.
Several fundamental questions must be faced by top managers of gas pipeline companies:
- How do we stand, relative to our market peers?
- Is our production side aligned with the market?
- How do we move from where we are to where we need to be?
- What will be the costs of making 'such moves?
- How much will we gain in profits?
Bedrock measures of relative efficiency and profit potential are necessary to answer these questions.
Industry observers, noting the turbulence of the gas industry, have called for changes to meet the challenge. S.L. Hamilton said, "We must develop a clear, simple model of what is happening in the utility business."' Her model focused on efficiency, liberty, equality, and community.
Our model, in the spirit of Hamilton, focuses on only two dimensions directly: relative efficiency and profit potential. However, indirectly her dimensions of community, liberty, and equality are not necessarily ignored.
Tradeoffs between the values of labor, capital, and profit are taken into account in finding the best-in-class performers and the profit potentials. This tradeoff evaluation looks not just at one set of value ratios but at wide ranges of value ratios. Thus, commonality between the consumer and the producer is sought in finding the best guidelines for management decisions.
Simply stated, our study is directed to providing balanced, objective guide-lines to help managers implement informed change. No prespecified weights are applied; also, no preconceived behavioral assumptions are applied.
Here, we look at annual report data of 18 gas pipeline companies for two periods: Period 1, 1990-92, and Period 2, 1993- 94 (Table 1)(26790 bytes). These 18 companies, a sample of leading gas pipeline companies in the United States, ranged in total asset size from relatively small to relatively large: $1 billion to $28 billion averages in 1993-94. Alternative samples of these companies may be similarly analyzed.
We let these data reveal the best-practice frontier of the 18 firms studied. That is, the tradeoff weights between labor, capital, and profits are derived from the publicly reported data, not assumed. This enveloping boundary,which is called the efficient frontier, shows who is doing the best job in production and by how much; it provides a norm to benchmark all of the other firms against.
Within observed ranges of price ratio bounds, the best-in- class positions on that frontier are identified. All other firms are referenced against these role models. Interpretations of the results are made in accordance with longstanding economic principles.
The method of analysis applied is known as DEA Best Practice, with the acronym DEA standing for "Data Envelopment Analysis" (Fig. 1)(24178 bytes). Notably, the concepts involved - especially the need for separate analysis of efficiency and profitability - are relevant to management throughout the oil and gas industry. 234567 In fact, they apply generally to any set of firms in an industry (see box). pIn this study, the DEA best-practice modeling results show significant opportunities exist to improve efficiency and increase profit potentials across the 18 gas pipeline companies in both periods analyzed. Nearly all of them could make much more efficient use of their capital and labor and enhance profitability. Several large, prominent pipeline companies must change a lot to be competitive in a market arena.
CONCEPTUAL EXAMPLE
If one pipeline's work, applied to its capital stock, results in more product - i.e., gas sales - than any other pipeline's (everything else equal), then this pipeline is the most productive; its efficiency rating is one. Conversely, if a pipeline is not efficient, then some other pipeline is obtaining the same level of product with less work relative to its capital stock; its efficiency rating is less than one.
Efficiency, while necessary, is not sufficient when it comes to making profits. History has provided many terrifying examples: oil in 1986, gas in 1971, and cotton in 1932. In each case, the product price was less than per-unit production costs; efficiency did not matter. Nobody made a profit then, since the maximum profit ratio (MPR) was less than one.
FRAMEWORK FOR ANALYSIS
In this article, DEA best-practice methods measure relative efficiency and profitability potential. This measurement reflects fundamental economic relationships. The operational efficiency model analyzed is as follows: Y1 = f(x1, x2), where Y1 is gross profits,
x1 is total assets (capital employed), and
x2 is total employees (labor employed).
Y1 is a comprehensive indicator of a pipeline's output, whereas x1 represents the pipeline's total capital employed, and x2 represents the pipeline's total labor employed. This model reflects principles long studied in economics. 8 9
OBJECTIVES AND PROCEDURES
As stated above, DEA best practice was used to analyze publicly reported data for the 5 years 1990-94. By company, the first 3 years of data were averaged for the 1990-92 period, and the last 2 years of data were averaged for the 1993-94 period. The 1990-92 period represents the time period largely before FERC Order 636 became policy; the 1993-94 period represents the time period after this order became policy.
The DEA best-practice firms at the vertices of the enveloping boundary define the efficiency frontier. Each of these firms is radially (or technically) efficient in making product, here gross profits. However, being technically efficient does not imply profitability because the consumer calls the tune in determining tradeoff values.
One way of considering the consumer's value choices is to use ranges of market data in the DEA best-practice analysis to bound the modeled prices (multipliers). Then the modeling results identify the best-positioned firms on the efficiency frontier - i.e., economically efficient. Separately analyzing the price ratio bounds shows which pipeline company has the greatest operational potential to transform its input effort into profits.
Each set of price ratios reflects the relative tradeoffs made by supply-demand forces in the market. Instead of choosing a single price scenario and then evaluating results based on it, DEA best practice evaluates reasonable ranges of price ratio bounds across all inputs and also across all outputs.
Initially, the efficiency measures below reflect constant returns to scale (RTS). Later on, increasing and decreasing RTS are considered.
OPERATIONAL MODEL RESULTS
Plotting labor employed per unit of gross profit (x2/y) against capital employed per unit of gross profit (x1/y) provides a visual perspective for the efficiency analysis in both periods (Figs. 2(25049 bytes)and 3).(25097 bytes) This presentation allows us to focus on the production tradeoffs between labor and capital given gross profits.
In Fig. 2,(25049 bytes) ANR Pipeline Co. (ANR) employs less capital than any other pipeline company. Texas Eastern Transmission Corp. (TEst) employs more capital but less labor than ANR. Together, these two companies determined the best-practice frontier closest to the origin in 1990-92. ANR and TEst are said to be technically efficient. The frontier consists of all the points on the line connecting them (technically efficient frontier), plus the vertical portion extending upward from ANR's point and the horizontal portion extending rightward from TEst's point (extended frontier).
Efficiency in DEA best practice is defined relative to the radial distance from the origin to the frontier. Any company on the frontier is at maximum relative efficiency and is given the efficiency rating of 1. Radial efficiency for nonfrontier companies is measured relative to this frontier and is less than 1.
The radial efficiency of Southern Natural Gas Co. (SnNG), for example, is found by taking the radial line out of the origin to the plotted point for SnNG. The length of the line from the origin to the frontier relative to the length of the line from the origin to SnNG's point is its radial efficiency, which is less than 1.
A similar line of reasoning is followed for the 1993-94 period (Fig. 3).(25097 bytes) The frontier in Period 2 is determined by ANR and Panhandle Eastern Pipeline (PhEP).
In specifying the market price bounds, the capital prices were based on our inspection of industry financial records, particularly pretax income to total assets. They were specified to vary from 4%/year to 10%/year in Period 1 and from 6%/year to 12%/year in Period 2.
The labor compensation levels were based largely on the Survey of Current Business. They were specified to vary from $38,930/employee in 1990 to $43,030/employee in 1992 and also from $44,930/employee in 1993 to $47,200/employee in 1994.
One key analysis point is the change in labor intensity relative to the change in capital intensity. Technically, econo- mists call this ratio the marginal rate of labor substitution for capital. It is found simply by computing [- ^(x2/y)/^(x1/y)] from publicly available data. DEA best practice routinely calculates these marginal rates of substitution internally in the software and relates them to the price ratio bounds in the analysis.
ECONOMICALLY EFFICIENT FIRM
In Period 1, matching the marginal substitution rates in production (along the efficiency frontier) to the price ratio bounds from the "market" observations provides the economically efficient firm, which is ANR. Similarly, in Period 2, the range of price ratio bounds in conjunction with the marginal substitution rates in production (along the efficiency frontier) show ANR again to be economically efficient (Table 2).(41415 bytes)
The best-in-class performer was ANR in both periods. However, if a smaller lower bound for the capital price of 4%, instead of 6%, had been considered in Period 2, then both ANR and PhEP would have been economically efficient.
Projection of some inefficient gas pipeline companies to the DEA efficient frontier may result in nonproportional adjustments in resource use - or slacks. Some slacks are identified in both periods in Table 2;(41415 bytes) as indicated, they were in the labor input except for some slack in TEst's capital in Period 2.
Some inefficient companies stand to gain handsomely by adjusting optimal]y to the frontier. For example, the Williams Cos.' (WilC) costs of capital and labor at the margin were 1.4%/S/year and $508/employee/year too high, respectively, in Period 2.
The MPRs indicate where an entrepreneur may invest money to make the largest returns under favorable conditions. In Period 2, the best-in-class performer was ANR. The second best-in-class performer was PhEP. Notably, the minimum profit ratio (mPR) of Colorado Interstate Gas Co. (CIG), which was technically inefficient, was greater than the mPR of PhEP, which was tech- nically efficient. This verifies the need for separate treatment of profitability and efficiency.
Table 3 (63384 bytes) shows values for the variables used in these calculations.
RTS ADJUSTMENTS
Several more pipeline companies might also be regarded as economically efficient if they made adjustments to reach their most productive scale size. In 1993-94, those pipelines were CIG, Consolidated Natural Gas (CNG), Pacific Gas & Electric Co. (PG&E), SnNG, Tennessee Gas Pipeline (Tenn), and TEst.
CIG and SnNG exhibited increasing RTS (IRTS). Both need to expand their scale of operations to achieve their most productive scale size and minimize average costs.
CNG, PG&E, Tenn, and TEst exhibited decreasing RTS (DRTS). These four pipeline companies need to decrease their scale of operations to achieve their most productive scale size and minimize average cost.
IMPROVING POSITIONS
Transco Energy Co. (Tsco) was recently acquired by WilC. In this transaction, WilC acquired another inefficient organization, which was positioned better than itself. In particular, Tsco had more profit potential than WilC, which alone was assured of loss- es. Accordingly, WilC can expect a better bottom line. This pattern of acquisition has been noted previously in other industries, such as banking.
A second common observation deals with the use of employees relative to capital. Some companies make efficient use of employees but inefficient use of capital. Usually in this situ- ation, the company finds itself burdened with too much fixed plant and equipment, especially in previously regulated industries, and overcompensates by laying off far too many employees. This may well exasperate the company's economic plight rather than improve it.
Most notably, PhEP made major adjustments in both capital and labor, relative to gross profit, from Period 1 to Period 2. It adjusted from an inefficient position in the 1990-92 period to a technically efficient position in the 1993-94 period; also, its profit potential improved considerably. It replaced TEst on the efficiency frontier, which more or less stood pat.
SITUATION MATRIX
Relative to results of this study, the 18 gas pipeline companies fell into four classes, as shown in Fig. 4.(30221 bytes) The eco- nomically efficient company, ANR, stood out as the best-in-class performer. PhEp, CIG, and El Paso Natural Gas Co. (EIPN) followed close behind in very good cost and revenue management positions.
Nearly completing the top 50% in cost and revenue management were CNG, National Fuel Gas Co. (NFGC), PG&E, and Tsco. The remaining firms were Arkla Inc. (ARKL), which needs to do a better job of revenue management, followed by Texas Gas Transmis- sion Corp. (TGas), TEst, SnNG, Enron Corp. (Eron), Enserch Corp. (Esch), KN Energy Inc. (KNE), and Western Resources Inc. (WRI), which need to improve both their cost and revenue management positions.
The remaining two gas pipeline companies, Tenn and WilC, seem to have formidable adjustment problems. WilC has recently made one major adjustment to improve its position in acquiring Tsco, as discussed above.
OPPORTUNITIES
DEA best-practice analysis of 18 gas pipeline companies in the U.S. showed significant opportunities exist to improve efficiency and to attain larger profits. Enterprising entrepreneurs have an attractive, perhaps unique, opportunity to cut costs and increase profits in most of the market areas for these companies.
Managers of gas pipeline companies must recognize the need to be both efficient in production and aligned with the market. Also, they must recognize the need to evaluate both maximum and minimum profit potentials.
DEA best practice provides a method for defining a new paradigm and developing competitive strategies to compete in a market arena.
