05 Feb Blockchain – Facing Up to the Risks for Oil and Gas
Blockchain looks like it will have lots of potential in oil and gas but what risks and barriers need to be surmounted to move from hype to reality?
This article is a collaboration with my good friend and colleague Arthur Kramer, a specialist in oil and gas risk management.
We recently spent a week meeting with some of Europe’s leading oil and gas companies on blockchain applications in the industry.
What can possibly go wrong?
Oil and gas industry professionals tend to equate blockchain with bitcoin, which is thoroughly understandable given how much conventional and business press has been given over to the stellar rise and collapse in bitcoin value. However, after a few minutes of discovery and exploration of the possibilities of blockchain technology, distinct from the single use case of bitcoin, oil and gas audiences surface plenty of intriguing potential. They also surface the risks.
The fun (and challenging) part of working with big oil on any change initiative, particularly one that is based on a new technology, is that industry professionals want to know what could go wrong. This isn’t meant to be critical – frankly, a bit more of that kind of thing could have helped out in the Gulf of Mexico a few years ago. Here’s a few of the risk questions posed to us and our responses.
Oil and gas companies don’t like arbitrary and unexpected changes to technologies, regulations, business terms, contracts, and so on. Change creates risk for an industry that can’t react quickly. The industry worries about who controls change to blockchain protocols, such as the number of transactions in a block, or the mining time cycle, or the compensation model for miners.
For the most part, blockchain governance is still either opaque, immature, or subject to the whims of founders. The bun fight within the bitcoin community over block size (bitcoin purists want to stay with the smaller block size, whereas some innovators seek a larger block size), reflected poorly on the maturity of governance over bitcoin and raised questions about governance over other blockchain innovations, which causes alarm in the cautious world of oil and gas.
We didn’t have a good answer to this challenge, so let us put that back to blockchain app and protocol founders – you need to think about how you will manage change to your protocol, app, crypto currency and business. Take a page from the technology industry, provide plenty of notice and engage with those reliant on your technology solution.
The industry worries about technology scalability. The media reports that there are sometimes 10 – 20 minute delays to process transactions on some blockchain implementations, and that the response time can degrade with greater volume. The playful crypto kitties project on Ethereum is one such red flag – performance of the Ethereum system slowed precipitously with the added volume on the network. For comparison, the bitcoin system processes 2000 transactions every 10 minutes, or 3 transactions a second, compared to 750 transactions a second at Western Union, and 250,000 transactions a second on the Visa network. Being used to running at their own pace and using their own systems, oil and gas gets fidgety about scalability issues.
Blockchain developers are acutely aware of these performance worries, and are actively experimenting with newer protocols that are rapidly improving transaction throughput. Over time, we should see the same kind of exponential improvement that characterises other digital technologies. In any case, business solutions on blockchain, such as smart contracts, will likely not need the same throughput as the large global payment systems like Visa.
Oil and gas capital lasts 20-40 years. A quick visit to Investing.com and their crypto page shows some 1400 crypto currencies, or tokens. It’s not clear how many will be around that long, but some will merge, others will decline in use, and some will ultimately go under. Recovery of one’s investment, not just in lost token value, but in any installed blockchain applications, is uncertain, but with so many crypto currencies in circulation, it’s clear that someone is going to lose their shirt when these coins fail to make a return or go bust.
The mooted Petro, a crypto currency that Venezuela thinks it can launch to circumvent US sanctions and currency controls, falls into this bucket of crypto with an uncertain future. In our view, the spread of crypto currencies is not a good reason to ignore blockchain. Companies should still carry out small trials to learn how blockchain behaves, which will help to minimise any regret capital in apps and crypto currency.
Oil and gas companies are very sensitive to their carbon footprint, and getting involved in a technology with an energy profile that potentially shows unlimited carbon growth is counter to a low carbon agenda.
Bitcoin and similar variations are well known to be energy intense, and the bitcoin world has come under an alarmist press scrutiny about the amount of energy being used to mine bitcoin. A few analysts think a simple linear growth progression from today points to bitcoin mining eventually becoming the single largest energy use in the world. However, the bitcoin design anticipated that the supply and demand for mining would temper the number of miners, and there would potentially be a consolidation in the number of miners.
Fortunately, oil and gas companies will be happy to learn that other blockchain designs and protocols aside from bitcoin are dramatically less energy intense.
Indeed, an interesting study someone may wish to carry out is to baseline the carbon intensity of an existing industry process and what the intensity would be under blockchain. We may be pleasantly surprised by the result.
Oil and gas risk professionals are alarmed about a distributed ledger that has data from multiple oil companies on it. This has the whiff of collusion and anti-trust behaviour that distresses oil and gas executives. If the data on a blockchain can be hacked or privacy can be compromised, then blockchain for the industry is a non-starter. The number of thefts of bitcoin, and the value of the thefts, is also troubling because it implies that privacy can be compromised.
Then again, blockchain is based on the strongest known encryption technologies. While it is theoretically possible to hack into the encryption algorithms, the thefts of bitcoin are actually due to hackers breaking into exchanges where people keep their private keys for their bitcoin holdings. Hackers use classic phishing and spoofing attacks to steal personal identifiers and encryption keys.
Business use of blockchain for things like smart contracts will likely be on private blockchains that will be both encrypted and not publicly accessible, which will help make them considerably less vulnerable to attack.
It doesn’t take long for oil and gas to conclude that they will likely be in a world of multiple blockchain players (ripple, hyperledger, ethereum), and multiple configurations (private, hybrid, public), for many different purposes (contracts, assets, property), and so will their suppliers and stakeholders. Right away, they can anticipate that their suppliers will have to deal with multiple blockchain solutions. Therefore, how blockchains will work together becomes important. A smart contract on hyper ledger may trigger a clause for an asset transfer that takes place on another blockchain ledger, on a different protocol, and payment on a third, meaning three blockchain solutions will need to interact with each other.
As with scalability, the blockchain developer community is very aware of the need to resolve interoperability, and have several committees, projects and new solutions at work on this problem, under such names as the Blockchain Interoperability Alliance, COSMOS and Polkadot.
Oil and gas companies have a difficult enough time managing the volatility of fiat currencies and oil prices, and adding new crypto currencies with a lot more volatility than normal, and that lacks transparent markets, hedging instruments, futures and derivatives does not inspire confidence.
It’s inevitable, and probably a certainty, that someone somewhere is already transacting for oil and gas using crypto currency. It sidesteps currency controls, masks the buyers and sellers, and gets around sanctions. While it is a matter of company policy if a crypto currency is accepted as tender, oil and gas companies should anticipate that sometime soon, a reputable player will ask to settle in a crypto currency. It is probably time to get familiar with crypto behaviour and learn to manage its risks.
Oil and gas is possibly the most regulated industry on earth, but governments are still trying to find their way in regulating bitcoin. Countries are banning bitcoin and exchanges, banning mining activity, limiting funding to mining companies, and so forth. Regulations are fluid. Know your customer rules, and anti-money laundering rules, are becoming more common. Most if not all of this activity is focused on the role of bitcoin as a replacement for a fiat currency.
The great bulk of beneficial blockchain applications in oil and gas, involving assets, trust, ownership, contracts and identities, need not incorporate money at all, and may not necessitate much regulatory oversight. For example, a blockchain solution aimed at tracking critical spares across multiple oil companies in a single basin will not likely trigger any additional regulatory issues.
What if poor quality data was encoded to a blockchain? Oil and gas companies were quick to point out that once on the chain, forever on the chain. Blockchain is just another kind of database, so business still needs to govern the accuracy of initially entered data, as making changes to the blockchain is not possible.
Technically, this is true – data cannot be overwritten, unlike in a traditional database. But a second data record that supersedes the first could be added to the chain, effectively correcting the data. Similarly, incorrect data could be put on the blockchain that supersedes original data.
The difference between a traditional database and a distributed database is that all parties need to agree the change, which reduces the probability that poor data gets on the chain in the first place. Still, business needs to put in place good controls around blockchain systems to minimize data issues.
The Bottom Line
Blockchain technology is not without its risks. We suggest you give your blockchain innovation a road test with auditors and risk management professionals. They’re the best at asking those awkward questions about what could possibly go wrong and how to protect yourself from any downside.
Special thanks to Arthur Kramer, a specialist in oil and gas risk management, who co-authored this article on risk.