The Economist: Royal Dutch/Shell - Another Enron?
Mar 11th 2004
Assessing the seriousness of Shell's crisis
ROYAL DUTCH/SHELL, one of the world's largest oil companies, “recklessly violated accounting rules and guidelines, which resulted in an enormous and shocking overstatement of oil and gas reserves.” So claims Berger & Montague, an American law firm now suing Shell on the grounds that this “enormous” deception has harmed shareholders and “severely overstated” the firm's market value. Berger is but one of a number of law firms now preparing class-action lawsuits against the oil major for purported malfeasance. Listen to such voices, and you might think that venerable old Shell has cooked up a scam of Enron proportions.
Just consider the mess. In January, Shell shocked the energy world by reducing its “proven” reserves of oil and gas by a whopping one-fifth, amounting to nearly four billion barrels of oil. Shortly thereafter, Sir Philip Watts, its aloof chairman, brushed off accusations of wrongdoing or incompetence. Even as the firm launched an internal investigation, he vowed to stay at the helm. Last week, the company's board sacked him and appointed a new boss, Jeroen van der Veer. This week, an explanation for the board's surprise decision seemed to turn up: memos leaked to American newspapers suggested that Sir Philip had known as far back as 2002 about the reserves problem.
There may be worse to come. The knives are out for Judy Boynton, Shell's American chief financial officer. In addition to the internal investigation, America's Securities and Exchange Commission (SEC) is now looking at the firm. Alas, the leaked memos suggest that Mr van der Veer may also have known about the miscategorisation. And even if he survives the scandal, he may yet (thanks to a court case in New Jersey) have to fend off class-action lawsuits. Glen Abramson of Berger & Montague gleefully declares that the memos surfacing this week strengthen his firm's case. More law firms seem certain to join the scrum before the filing deadline on March 26th.
Despite all this, there are some reasons to think that the current crisis at Shell may not in the end amount to another Enron. At the defunct energy trader, the bosses made a long habit of enriching themselves at the expense of the company's ordinary employees and shareholders. In contrast, whatever his other errors, Sir Philip was not lavishly paid. His total compensation was much smaller than that of his rivals at BP and Exxon Mobil. The incentive to cheat by fiddling the books seems (at least on current evidence) not to have been as strong as at Enron either: it is reported that only a tiny fraction of the relevant Shell managers' pay depended on the booking of oil and gas reserves, although the SEC may now examine this.
Not quite a shell game
More importantly, Shell's shifting of reserves (from “proven” to “probable”) simply cannot be compared with the phantom profits and bogus assets booked by Enron. That is because the oil and gas actually still exists, and Shell still owns them as real, usable assets. The shift in category means that they are not close enough to commercialisation for Shell to consider them, under SEC rules, as “proven.” However, experts say that “probable” assets are also very likely to get to market—just not as quickly as proven ones. Derek Butter of Wood Mackenzie, an industry consultancy, goes further: the firm's bungled recategorisation, he insists, in “no way changed our view of Shell's commercial reserve potential”. Most investors seem to be taking the same view. After an initial drop of 8% on the news of the restatement of reserves in January, Shell's shares have fared rather well (see chart).
How could that possibly be, given the SEC's definition? Mr Butter thinks that the narrow focus of the SEC and some investors on proven reserves may be misleading He describes the “2P” measure (proven plus probable) as “the company's best guess on what will be produced”. It is, he insists, a better indicator of a firm's underlying valuation than proven reserves alone. On that argument, Shell's “recategorised” reserve position still looks decent (see chart). Wood Mackenzie points approvingly to Canada and Australia, where firms typically disclose the 2P measure.
Even critics think that the current media frenzy over reserves may miss the mark. Eric Knight of Knight Vinke Institutional Partners, an investment fund (partly owned by the CalPERS pension fund) that holds Shell shares, has been pushing the firm hard to reform its corporate governance. Still, he thinks today's focus on proven reserves that can get to market quickly reflects a short-termism among investors that is inappropriate for a sector that is more akin to slow-and-steady utilities than to “growth” stocks.
Even if there has not been an Enron-style looting of Shell, there are two important lessons already from this affair. The first is that Shell needs to do much better in the future at finding new hydrocarbons. Though its 2P figure is decent, the firm still lags its chief competitors—and risks falling further behind them. As one rival oil and gas executive put it, “The problem is not the downward revision—we all ‘debook' every year, but we just book even more in new reserves. The fundamental problem at Shell is that it isn't replacing reserves.” For this, analysts blame a combination of bad luck, under-spending and outmanoeuvring by BP and Exxon for Shell's poor upstream performance.
The second lesson is that the company must become much more transparent. This is a general problem for the entire oil industry, which rarely discloses its accounts in any detail. Such habits are now likely to change. Oilmen are talking of embracing independent audits of reserves and other voluntary measures designed to head off onerous new regulations.
The firm with the greatest need for reform at the top, however, is Shell. As the scale of any misstatement or deception becomes clear, further heads may roll. More important will be structural reforms to the unwieldy ways in which the company's two parts—Royal Dutch and Shell—are cobbled together. This awkward structure weakens the chief executive, argues Mr Knight, and “fosters a lack of accountability.” Mr Knight says that he was lecturing Sir Philip on precisely this topic just days before Sir Philip got the sack.
Yet even Mr Knight, a crusader for corporate governance, defends Shell thus: “There's no black hole, assets haven't disappeared or been misappropriated.” The real damage, he says, may be to the firm's once-stellar reputation. Whether or not Shell's bosses made an honest mistake in booking those four billion barrels of oil now matters less than how they handle what has happened.