Wednesday, April 10, 2013


It seems like there's bad news for the gaming industry almost every day now.

Electronic Arts. Square Enix. LucasArts. The number of studios who have either been shut down outright or seriously downsized in the last year would fill half of this screen.

I've been thinking about this for weeks, trying to find a simple description for what's happening. I think I may have found it this morning.


Let's look at the evolution of gaming, from a business perspective, using oil.

What does oil represent? Us. Gamers.

In the beginning, computer games are created with one or two-man teams. Costs are almost zero. So are returns, because a computer game might only sell a few hundred copies.

I don't know what the first hugely successful computer game was, but let's use the Ultima series. Consider that Spindletop.

Now, people understand that gaming could be very lucrative in a commercial sense. More people start making games. Most of them are still one or two-man teams (like wildcatters, trying to find new wells), but larger companies start to form, trying to develop production on a more significant scale.

This works out well, because there is plenty of oil out there. Lots of people realize that they enjoyed playing games, so there are plenty of untapped deposits, and you can drill in plenty of different places and strike oil.

More drillers get in the game, and more companies form. The existing companies buy some of the wildcatters who found big deposits, and so they get bigger.

The oil companies start buying equipment. They build infrastructure.

Now, fixed costs are creeping up. Whether that equipment is being used or not, it has to be stored and maintained.

No problem, though. There's plenty of oil out there.

Fixed costs continue to creep up. A new piece of equipment comes out that can pump much more oil out of a well, but it's 10X more expensive than the old equipment. Most of the rest of the equipment gets replaced in a similar fashion.

There's so much expensive equipment and infrastructure in place that drilling a new well, unless it's a huge, known reserve, just doesn't make sense anymore. Wildcatting a well for a low cost isn't even possible anymore, because these big oil companies only have incredibly expensive equipment tailored to pump out massive amounts of oil. Plus, they need so much revenue that the little wells are just a waste of time.

This is a critical mistake, because geologic reports can be inaccurate. Sometimes, huge reserves can still be found in places where the big oil companies aren't surveying.

The oil companies look at their business, which is suddenly struggling, and realize that they can make plenty of revenue to support operations if they just focus on proven reserves. It's efficient, it matches the scale of their infrastructure, and it's focused.

This goes well, at least at first. Then a proven reserve is discovered to be smaller--quite a bit smaller--than what was previously projected. Then another.

How does this oil company adapt? It can't. It has no new wells that could have larger reserves than estimated. It's fixed costs are enormous. As soon as the proven reserves have dried up, they have nothing left.

What about an existing well, though? Could it turn out to be much larger than estimated? It could, except the reserve was probably over-estimated to begin with. No one makes money under-estimating reserves.

There's still plenty of oil, but the economics of production for the large companies has made that oil unavailable to them. So they  have no choice but to scale down. That will work, right? Just cut costs until they match revenue, then go forward.

Dismantling infrastructure to reduce costs is incredibly difficult, though, because infrastructure never operates the way it looks on an organizational chart. It's a complex web of dependencies and relationships that have developed over time. Dismantling it always causes unexpected, collateral damage.

Still, they try to survive. They buy wildcatters who have substantial proven reserves. Buy success instead of doing the heavy lifting themselves. The problem with buying proven reserves, though, is that the bidding is highly competitive, and to secure a reserve, they have to overpay.

Some of these wildcatter's wells pay off. Many more, though, turn out to never be profitable, because the oil company overpaid to such a degree to acquire the well that it never paid back the original investment.

It's a vicious, downward spiral.

Meanwhile, far away, the wildcatters have a bonanza of opportunity, because the big oil companies have abandoned plenty of smaller and even medium-sized pockets of oil. With extremely low costs to drill, if they find even a small amount of oil, they can make money. And if they keep costs low, they can do this again and again with every little risk.

The wildcatters are in position to drill for the rest of their lives, if they want to.

What should the big oil companies do? They don't know. Neither does anyone else.

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