The Wall Street Journal: Losing Reserve: At Shell, Strategy and Structure Fueled Troubles 

Oil Giant Relied on Its Prowess for Finding
Fresh Oil -- And Fell Behind Rivals

By CHIP CUMMINS, SUSAN WARREN, ALEXEI BARRIONUEVO and BHUSHAN BAHREE
Staff Reporters of THE WALL STREET JOURNAL
March 12, 2004 12:07 a.m.; Page A1

In July of 2001, Royal Dutch/Shell Group tapped Philip Watts to pep up a century-old oil giant that had grown lethargic. The gruff British seismologist was coming off what appeared to be an extremely successful run as head of the division that finds and produces oil for Shell. And he was pumped.

"Exploration and production is in very good shape," he said at the time in an interview with this newspaper, reeling off a record that helped earn him a knighthood: big progress in projects in Oman, Nigeria, the U.S., Sakhalin Island in Russia and Egypt. "We have a very robust portfolio."

But within months of taking the chairman's job, it became increasingly clear behind the scenes that the picture wasn't as bright as Sir Philip had painted. Internal correspondence indicates Sir Philip and his successor as head of exploration -- and possibly their subordinates and other senior executives -- knew as far back as February 2002 that Shell may have greatly overstated its reserves of oil and natural gas, according to a person familiar with the situation. And much of that overstatement came on Sir Philip's watch as head of exploration.

Now Securities and Exchange Commission investigators and Shell auditors are sifting through the trail of correspondence and other company documents. Whatever the outcome of the probe, the big forces that helped humble Shell are already clear. The oil giant has been plagued by what was once a source of strength: a quirky, loose corporate structure bestriding its twin bases in England and the Netherlands. And it erred in overrelying for growth on its traditional prowess for finding oil, as new discoveries have grown harder to eke out. The revision has also painted a starkly different picture of the company's recent performance, showing Shell lagging behind competitors in key performance measures instead of just keeping up.

The company has replaced reserves at a much lower rate than originally thought, and its costs are significantly higher.

Only in January of this year did Sir Philip inform the joint boards of Shell's English and Dutch holding companies about the mounting questions. On Jan. 9, Shell came clean to investors, saying it would slash its reserve holdings by 20%. Last week, after the boards reviewed the early results from an internal probe of what went wrong, Sir Philip and his successor as head of exploration, Walter van de Vijver, were forced to resign.

The controversy has rocked the $1 trillion-a-year global oil industry. Rivals are reassessing their own reserve tallies, and engineers are clamoring for clearer guidance from the SEC about reserve accounting, which has always been more art than science. Reserves are a key measure of an oil company's recent performance and longer-term value for investors.

A number of mysteries remain unanswered. How did Shell misjudge its reserve so badly? Why didn't anybody catch the mistakes before now? Why didn't Sir Philip disclose them sooner? Did Shell actively try to hide the problem? The company's current top executives -- including Shell's chief financial officer and the man who replaced Sir Philip as chairman -- are under pressure to disclose what they knew about the reserve problems and when. Shell's board signaled in a statement Tuesday that it is standing by them.

The group audit committee recommended that board members and external auditors "feel confident in relying on the representations of the group's current senior management," said A.G. Jacobs, a board member and chairman of the committee, in a statement.

The roots of Shell's unusual corporate structure date back to 1907, when 60% owner Royal Dutch, an oil-production company in the Dutch East Indies, came together with 40% owner Shell Transport & Trading, a London-based kerosene merchant.

The company went on to become a vast empire of independent operating units -- from oil-sales businesses in the U.S. to a production and refining company in Venezuela. Shell became one of the world's most flexible companies. To this date, both holding companies maintain separate boards and separate headquarters in The Hague, Netherlands, and London. A "committee of managing directors" acts as the company's top management body.

Shell erred in the 1990s in overrelying on its other great tradition: big oil strikes. In recent decades, new oil has become harder to find, as Middle Eastern countries expelled foreign oil companies and fields in the West matured. BP PLC and Exxon Corp., later Exxon Mobil Corp., responded by buying up their rivals and selling off poor-performing fields. Shell largely stuck to organic growth through hunting for discoveries.

But Shell was also lagging in that area. In the late 1990s, Shell fell behind its two closest rivals, Exxon Mobil and BP, in reserve replacement, or the rate at which a company finds new oil to replace the oil it produces. The entire industry was struggling to find big new discoveries, but Shell's shortfall became a target of investor and analyst criticism.

Between 1997 and 2002, Wood Mackenzie, an Edinburgh energy consultancy, figures BP replaced 152% of the oil it pumped, not counting acquisitions and divestitures of oil fields. Shell's reserve-replacement rate was 105% -- but after its recent reserve downgrade, the number falls to just 57%.

The difficulty in finding new reserves translated into higher costs, another key measure for investors. Between 1997 and 2002, Wood Mackenzie estimates Shell's cost of finding and developing oil at $4.27 a barrel, behind Exxon Mobil's $3.93 and BP's $3.73. After its revisions, Shell's costs soar to $7.90 per barrel.

Hot Commodity.

Shell's rise began in the late 1800s, when a Dutch tobacco merchant visiting a Sumatra plantation stumbled on large deposits of kerosene, a hot global commodity at the time. He won a royal charter for his venture from Dutch King William III and launched Royal Dutch in 1890, according to an account in Daniel Yergin's "The Prize."

Meanwhile, Briton Marcus Samuels had built a world-class kerosene-trading operation atop his father's modest business buying and selling curios, including popular seashell-covered boxes. Mr. Samuels merged his business with Royal Dutch, which had been taken over by Dutch oil titan Henri Deterding. Together they took on Standard Oil -- the U.S. petroleum giant that eventually spawned the company that became Exxon.

By the second half of the 20th century, Shell executives -- many of them hailing from Cambridge and Oxford -- had jumped into new growth areas in Africa and Asia. That masterstroke helped Shell weather the devastating nationalizations in the 1970s in the Middle East, which robbed competitors such as BP of key oil concessions.

By the late 1980s, "the Group," now referred to simply as Shell, had become the world's largest oil company in terms of revenue and production, for a time displacing Exxon. But the elites who ran Shell sniffed at profits. "It would be very nice to be No. 1" in profitability, Shell chief Peter Holmes told the Journal in 1987. He added: "That isn't our prime objective." Size was all.

Unlike its rivals, Shell was run through individual companies that enjoyed generous autonomy. Shell's Nigeria subsidiary was considered a Nigerian company by officials there, not a foreign affiliate. Shell's affiliate in Venezuela operated for years as a stand-alone company with its own budget and board.

The U.S. operation also had its own board, and top executives had little contact with London or The Hague.

In the late 1990s, rivals BP and Exxon launched industry-changing megamergers, setting off an acquisition binge among almost every major oil company. Shell, with its twin boards and sometimes slow decision-making, was left behind.

Mark Moody-Stuart, a geologist and keen sailor, became chairman of Shell in 1998 amid the merger mania. Profit was plunging and investors deserting in droves. Sir Mark initiated a major centralization effort shortly after coming to power, attempting to bring together Shell's operations.

Much hinged on the performance of the head of exploration: Philip Watts. As a young man, he taught physics and math in a government-run secondary school in Sierra Leone. He returned to Britain and joined Shell as a seismologist in 1969. His posting took him to top exploration and production jobs in Asia, the North Sea and Nigeria. At the home he keeps outside of London, Mr. Watts is building a two-acre Japanese-style garden.

Sir Philip led Shell's Nigerian operations from 1991 to 1994 and took the top exploration and production job in 1997. By 2000, Sir Philip was racking up impressive gains in production, and profits swelled amid high oil prices. He took over as chairman in July 2001.

Shell's overbooking troubles appear to have started as far back as 1990, according to one person familiar with the situation. But the lion's share of the overstatements happened on Sir Philip's watch as head of exploration and production.

There are rigorous U.S. guidelines for booking reserves, but in the end accounting rules require a company only to be reasonably certain it can commercially extract the oil or gas. That leaves companies with leeway to use their own geological and financial assumptions and models for things such as the price of oil and the technological challenge of getting the oil to the surface.

Companies usually don't break out reserve totals for specific projects, so it's difficult to compare Shell's individual reserve bookings with those of other companies in similar projects. But in some projects where comparisons are available, Shell was more aggressive than its peers. In the Gorgon natural-gas field off the northwest coast of Australia, Shell started booking the equivalent of 557 million barrels of oil in 1997. Partners on the same project -- including Exxon Mobil and ChevronTexaco -- have said they never booked any reserves there.

Off the coast of Norway, in a field called Ormen Lange, Shell booked gas reserves to the tune of some 109 million barrels of oil equivalent, as early as 1999. Though there is little doubt the gas is there, Shell didn't make a final investment decision about developing the field until 2003, according to an explanation by Shell executives in London last month. That had analysts wondering how Shell could have been reasonably certain it would extract the resources. Shell executives said the Gorgon misbooking was due to a mix-up between local and headquarters accounts.

By 1999, concerns were rising over a push by U.S. oil companies into overseas projects and a boom in joint ventures, trends that made it more difficult to get a clear picture of reserves.

That year, the SEC hired two engineers dedicated to reviewing reserve estimates for oil and gas companies, Jim Murphy and Ron Winfrey. They soon put the industry under greater scrutiny. In letters to oil companies in 2002, the SEC chastised companies for not obeying reserves rules, demanding explanations on how calculations were made.

"This is confusing and incomplete disclosure," the two engineers complained in a letter to one U.S. company, one of dozens made public by the SEC. They slapped the company for listing wells as successful even when output had been suspended. "If they were successful, why are they suspended? What do you mean by successful?"

Despite its European headquarters, Shell is required to file annual reserves statements with the SEC because its shares are traded in the U.S.

Open Secret

There was also growing unease in the industry about an open secret: a widespread tendency to overbook reserves. In a 2001 report, Houston consultants Rose & Associates noted the pressure on managers at publicly traded energy companies "to push the envelope of credibility in efforts to buoy investor confidence and thus increase stock value." Among other things, the consultants pegged the overbooking to incentive programs that offered bonuses for big reserve estimates.

The internal Shell review has unearthed correspondence from this time that indicate a dialogue between Sir Philip and Mr. van de Vijver -- and between the two men and their subordinates -- about the reserve-booking problems, according to a person familiar with the situation. The review also found correspondence between the two men and their subordinates.

One memo circulated between senior executives was dated Feb. 11, 2002. It warned that the company may have overstated reserves by one billion barrels of oil because of apparent inconsistencies between Shell booking guidelines and current SEC guidelines, according to two people familiar with the document who described it to The Wall Street Journal.

In later correspondence, Mr. van de Vijver at times appears to be frustrated by booking problems in the exploration and production unit and eager to correct them, one of these people says. Reserve-booking issues were raised again by Mr. van de Vijver in reports in July 2002, January 2003 and July 2003, according to a person familiar with the situation. It's unclear which senior Shell executives had access to these reports.

By the fourth quarter of 2003, Shell executives had commissioned a series of in-depth internal reserve-booking reviews and audits, which ultimately resulted in the Jan. 9 disclosure. It isn't clear what prompted Shell to undertake these audits.

"In finding out what had happened, in fact, it was clear that the top man [Sir Philip] had been juggling in these matters, and had not been completely forthcoming," says a person familiar with the matter.

Though Mr. van de Vijver, the exploration chief, appears in the correspondence to have tried to point out and fix the problems, he failed to take the matter to the right people, including board members, says the person familiar with the situation.

Repeated attempts to reach Sir Philip and Mr. van de Vijver since their ouster haven't been successful. Senior Shell executives -- including current Chairman Jeroen van der Veer and Judy Boynton, Shell's chief financial officer -- have declined to be interviewed.

Shell officials have declined repeated requests for comment about whether other senior executives had knowledge of the potential reserves shortfall. The company also has refused repeated requests to make senior executives available for interviews.

Few at Shell headquarters seem to have caught the overbooking. Technical experts at each of Shell's three dozen exploration and production units around the world forwarded their reserve tallies to Shell's exploration headquarters, located just outside The Hague. Those bookings were blessed by a group of senior executives -- including Shell's top technical expert and its senior reserve auditor -- and were sent up to be included in the company's annual SEC filings.

In October 2003, the combined audit committee of the two Shell boards asked for and received a routine briefing on reserve issues. But the committee wasn't notified of any major problems with the company's bookings, according to a person familiar with the situation. Board members learned there was a problem only after Shell managers placed a round of phone calls in late December, asking them to attend an emergency board meeting for an unspecified reserve issue, this person says.

The boards met in early January. Senior managers dropped a bombshell: Shell needed to slash its estimate of oil and gas reserves. Board members were stunned and immediately ordered an inquiry into how the overstatements happened. Shell quickly put together a conference call for analysts and reporters on Jan. 9. Sir Philip didn't show up, leaving an investor-relations executive to break the bad news, angering analysts. Shares in both Royal Dutch Petroleum Co. and Shell Transport & Trading Co. fell sharply.

On Feb. 5, a daylong presentation about the reserves issue to analysts did little to clear the air. Sir Philip apologized for his absence on the conference call, but said he had the full support of both boards and intended to stay on to fix the problem. Then, on Monday of last week, Shell's audit committee -- comprising independent directors from both boards -- huddled at Shell's headquarters in The Hague ahead of a regularly scheduled board meeting that week. They heard initial reports from the internal investigation team and briefed board colleagues about the preliminary findings of the review.

Briefed on the correspondence, directors decided unanimously that they had lost confidence in Sir Philip and Mr. van de Vijver. A delegation of board members broke the news to the two in private meetings Wednesday and asked for their resignations. Both boards convened separate, formal meetings and appointed Mr. van der Veer chairman. Malcolm Brinded, a long-serving Shell executive, would take over as exploration and production chief for Mr. van de Vijver.

The SEC and Shell's internal investigators are looking into whether the company's bonus system provided financial incentives to employees to overstate reserves, according to people familiar with both probes. Shell has acknowledged shortfalls in its reserve oversight and auditing processes, and has restructured its auditing process.

--Thaddeus Herrick in Houston and Michael Schroeder in Washington contributed to this article.