Question

John Miller, a research associate at Applegate State University, has discovered a novel process of extracting bio diesel out of genetically modified corn. The bio diesel may be burned in regular diesel engines like normal mineral diesel, and its use does not pollute the atmosphere nor add to the causes of global warming. The process is rather complicated, and currently John’s bio diesel is about 50% more expensive than the regular diesel. John Miller estimates that if the process is adopted commercially the (current) costs may easily go down by at least 40 per cent.

Global Petroleum (GP), one of the world’s largest petroleum companies, has learned about John Miller’s discovery. GP has been very concerned lately with rising oil prices, pollution, and possible exhaustion of the world’s oil reserves. Among other alternatives, GP’s management team is considering diversifying into fuel cell business and John Miller’s bio diesel.

What value-creating and value-neutral reasons might GP have for such diversification?

GP has made a decision to diversify into bio fuel and needs to select the means for such diversification. In particular, it considers (1) in-house development of their own technology, (2) establishing some form of cooperative arrangement with John or Applegate State University, and (3) outright acquisition of the technology.

Discuss the benefits and drawbacks of each choice
Explain your recommendation of the means of diversification

Answer 1

The value creating reasons for diversification are as follows

1. The oil reserves of the world face the threat of exhaustion due to use of the same being increasing at a rapid rate. If GP continues to stay only in petroleum business and not diversify into anything else, then eventually one day it there wont be any petroleum left in the world and the company will cease to exist.

2. If GP becomes an early entrant in the fuel cell and bio diesel business, it will gain the first mover advantage and thus establish a strong foothold in the same before the competitors enter this segment of the market. Conversly if its competitors are already in the business of fuel cell and bio diesel, this diversification will give and opportunity to GP to reduce the gap with its competitors.

3. As GP is already into fuel business, it would already resources with vast and expansive knowledge and competencies in fuel business, with which it would be able to identify synergies and reduce costs in the manufacture of fuel cells and biodiesel and achieve competitive advantage and economies of scope.

The value neutral reasons for diversification are as follows.

1. Petroleum products cause pollution and also add to the phenomenon of global warming. Due to this there is an increased efforts both from governmental and non-governmental agencies to reduce the use of petroleum based products. There may come a time when laws will be formulated to reduce or ban the use of petroleum products and hence GP has to be prepared for this eventuality.

2. As petroleum industry is a highly mature industry, the product line is already matured and there is little scope for any innovation which may endanger the future cash flows. Hence GP needs to identify newer avenues for generating and increasing the cash flows.

Coming to the decision of diversfying into biofuel, each choice and its associated benefits and drawbacks are discussed below.

1. In-house development of their own technology - Clearly the most important benefit of this would be that GP would have complete autonomy in the entire process and the product. If the process by which GP develops the technology is a significantly new process, then it can patent the process and thus setup entry barriers for its competitors. The drawbacks of these method of diversification would be that GP would have to incur significant costs to develop the technology from the scratch. Also, the development of any new technology takes time and it will hold true in this case as well. Additionally, its competitors may acquire the technology from John Miller and launch its bio-diesel and related products in the market thus acquiring the first move advantage. This may cause significant shareholder unrest especially if it becomes known that the technology was already developed and available in the market.

2. Establishing some form of cooperative arrangement with John or Applegate State University : If GP goes ahead with this method, the immediate advantage would be that the technology would be available to GP in a very short time. It would also be able to use the knowledge and expertise of Miller and the University in further refining the process as part of this cooperative arrangement. However on the flipside, the drawbacks in this method can be that Miller and the Applegate University can have more say in how the technology is used and GP would not have complete autonomy on the same. GP may also have to offer financial incentives to them (like seat on board etc.) as part of this cooperative arrangment which will cost GP. Thirdly and most importantly, Miller and Applegate university will demand a share in the revenue from bio-diesel which will significantly reduce the profit which GP can make with this product.

3. Outright acquisition of the technology : In GP goes ahead with this route, the advantage would be that once bought by it, GP will again have complete autonomy over the way the product is used. It wont have to share revenue with or offer financial incentive to either Miller and the Applegate University thus saving a lot of cost. It also would not have to incur significant time and expenses on hiring new resources to develop the technology as they would get the entire knowhow of the technology as part of the purchase. The drawback of this method would be that if there is another competitor who is planning to buy this technology, then GP will have fight it out with that competitor before it can acquire the technology.

The recommendation would be to go-ahead with the outright acquisition of the technology as GP would be able to procure the technology within the least possible time frame, outrightly block its competitors from acquiring this technology and have a first mover advantage and have complete autonomy over the way this tehcnology is put to use without having any profit sharing arrangement with Miller and the Applegate University.