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The Economist: Shell shock

Jan 15th 2004


A dramatic cut in Shell's reserves has the oil world buzzing


HOW on earth can an oil company lose a fifth of its reserves overnight? And not any old oil company, but that very model of a modern oil major, Royal Dutch/Shell, which has long boasted of the excellence of its management.


Shell announces the downgrading. The SEC outlines its classification of “proven reserves”.


On January 9th, Shell said that it was downgrading nearly four billion barrels of oil and gas—a whopping fifth of its total reserves—from “proven” reserves to “probable” or other, even less-certain, categories. As proven reserves are one of the main metrics used by analysts to value oil firms, investors were not pleased. Shares in the world's third-biggest oil firm promptly fell by 7%, amid fears of worse to come.


In some respects, Shell's shock news is not as bad as it seems. The firm has not actually lost any oil. Michael Lynch of Strategic Energy & Economic Research, an industry consultancy, explains that, under the oil industry's murky accounting practices, “shifting a project from proven to probable is like moving it out of a cash account to accounts receivable. It is still an asset, but not as valuable because of the lower certainty.” Shell still expects to bring most of the reclassified oil and gas to market eventually. It stresses that there has been no restatement of financial results, like at Enron or WorldCom—though it is surely undeniable that the firm has restated data of great importance to investors.


Still, this fiasco could yet lead to big changes, both at Shell and in the industry as a whole. The firm's boss, Sir Philip Watts, was never a favourite of investors, but now he faces intense pressure to go. He has long been seen as aloof and uncommunicative—an impression he reinforced this week by going to ground and leaving other executives to manage the bad news.


Now investors are questioning his competence. The revised figures suggest that, on Sir Philip's watch, Shell has performed far worse than previously thought on several important measures. Wood Mackenzie, a consultancy, calculates that in 1997-2002, the firm's rate of replacement of reserves—which are inevitably depleted as firms pump hydrocarbons out of the ground—was not 105% as previously thought, but an abysmal 57%, significantly below that of both BP and Exxon Mobil (see chart). Recalculated, Shell's “finding and development” costs in that period jump from an already relatively high $4.27 per barrel to $7.90 per barrel. 


There is no evidence of criminal wrongdoing. And there is no precise legal standard or industry agreement on how to classify reserves. Under guidelines on what firms can call “proven reserves” issued by America's Securities and Exchange Commission (SEC), managerial discretion is allowed and reclassifications tolerated. Indeed, revisions—both up and down—are fairly common. What is uncommon is the breathtaking size of this reduction in reserves, the largest ever.


As has been widely noted, Sir Philip was previously in charge of Shell's exploration and production. That means that he knew, or should have known, how accurately the firm was booking new oil and gas discoveries. All eyes will be on him at Shell's fourth-quarter results presentation, due on February 5th—if he is there.


Shell's error may prompt an industry-wide move towards standardisation, and perhaps firmer regulation, of the booking of reserves, even though Shell's rivals are standing by their own numbers. Chevron Texaco and Exxon Mobil, for example, are Shell's partners in Australia's giant Gorgon gas project, which accounted for a big part of Shell's recent reclassification. But, unlike Shell, both firms say that they did not book Gorgon's reserves as proven.


The rewriting of Shell's history is so dramatic that the SEC is likely to investigate. It already has a small enquiry under way, triggered by questions about how firms were booking reserves in the deep waters of America's Gulf of Mexico.


Investors, too, may demand greater transparency. After all, if they can't be sure of trusty old Shell, how can they believe smaller, perhaps shadier, operators?


The most ironic suggestion now making the rounds is that the world's biggest oil companies should permit independent verification of reserves by outside consultants. Russian oil firms, with a well-deserved reputation for dodgy dealings, were forced to adopt that sensible if ego-deflating measure in order to satisfy the demands of western investors. How embarrassing it will be if the industry's proudest names are now put to the same test of transparency.


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