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The New York Times: Shell Pays a Price for Overstating Reserves



Published: April 18, 2004




INVESTORS are punishing the Royal Dutch/Shell Group for making the worst of a good situation. Oil prices have jumped toward their highest level in a decade, but shares in the company, the world's third-largest energy concern, have been struggling to recover from a steep fall after several managerial faux pas.


A reduction of 20 percent, or four billion barrels, in its stated oil and gas reserves in January forced the departure of two top executives, including the chairman, Sir Philip Watts. It has also led to shareholder lawsuits, investigations by the Securities and Exchange Commission, the Justice Department and European regulators of the way Shell accounts for reserves, and a decision by the company to delay publishing its 2003 report until late May.


The Dutch and British parent companies, which trade on the New York Stock Exchange, fell by as much as 15 percent over six trading days after the reserve cut was announced. They later edged higher, then fell again this month after Shell announced another, though much smaller, downward revision of reserves.


Royal Dutch Petroleum, which owns 60 percent of the Shell operating company, closed Friday at $50, and Shell Transport and Trading, the British parent, ended the week at $42.88. This year, the two New York-listed stocks are down more than 2 percent, while the Standard & Poor's 500-stock index is up about 2 percent. Other major oil companies have outperformed the index by a few percentage points this year because of a rally in the sector in the last month.


Some analysts argue that Shell's difficulties are a serious but short-term problem for an otherwise sound business, and that the drop in the shares renders them a good value. Others worry that a longer decline is possible for Shell and that stronger investment alternatives exist, especially among European oil producers. Those often mentioned include BP of Britain, Total of France and ENI of Italy. All trade in New York.


Shell's reserve revisions represent "a very big issue on sentiment and trust,'' said Jonathan Wright, an oil analyst in London for Citigroup. The problem, he said, is that "we have to take what these companies tell us because we can't clarify it one way or the other.'' But such a substantial cut in stated reserves, he said, "puts a very big question mark over anything they tell us.''


Because Mr. Wright regards Shell's share price as cheap, he still makes a case for investing, especially if you want to take a defensive stand on the oil industry.


"I'm somewhat nervous we're going to see a correction in the oil price in the second quarter,'' he said. "There's a safe haven in Shell, dare I say it, because the valuation is so depressed.'' He described the dividend yield as ''pretty solid.''


Prices of crude oil tend to fall as winter gives way to spring and heaters across the Northern Hemisphere are switched off. But several factors have kept prices up, including a decision by the Organization of the Petroleum Exporting Countries to proceed with production cuts. Mr. Wright also cited political instability in Venezuela - a large OPEC producer - as well as weakness in the dollar and persistent concerns about terrorism.


Mr. Wright has a hold rating on Shell Transport and Trading and recommends a ''defensive stance'' toward oil stocks in general. Citigroup has a buy rating on Total and a hold on ENI. In the United States, Citigroup advises holding ChevronTexaco and recommends selling Exxon Mobil and ConocoPhillips.


Some analysts argue that because many investors are shifting their stock portfolios into more conservative holdings, oil stocks are a good buy. "Overall stock market strength may have peaked, and we are now beginning to see funds flowing out of the more highly rated sectors back into better-value, defensive areas such as oils,'' a report by oil analysts at Morgan Stanley said.


Morgan Stanley has a neutral rating on Shell. Analysts are wary of the uncertainty that will linger until investigations of the reserve revisions are complete. Morgan Stanley has a positive rating on BP, Exxon Mobil and ENI and is neutral on ChevronTexaco.


The analysts said production problems in the industry -related to the rising expense and difficulty of extracting oil from the earth - have largely been factored into share prices. Shell's reserve revisions exemplify the problems, the report said, but Gordon Gray, a J. P. Morgan oil analyst, noted that Shell's rivals were quick to report that they stood by their reserve estimates.


"The evidence we've seen so far points to it being a company-specific issue,'' Mr. Gray said. Morgan recommends an overweight position in oil stocks, and he said he recently upgraded Shell, albeit only to neutral.


"We were underweight the stock for most of last year, mainly on concerns for the quality of its opportunities upstream,'' he said, referring to Shell's ability to find and produce oil and gas. "We had been concerned that the level of overall growth prospects was weaker than the competition and that capital-expenditure numbers looked low.''


THE upgrade was "a valuation call and an expectation call,'' Mr. Gray said. After the company reported its bad news, the sell-off made the shares cheap, he said, and this also served to "manage expectations down.''


BP has done the opposite, sending expectations - and its stock - higher by announcing recently that its reserve estimates were solid and that it planned to buy up to $33 billion of its stock. But while Shell's bad news may have made its stock cheap, BP's good news does not make its shares expensive, Mr. Gray said.


BP, which he called "our top pick among the supermajors,'' has hit a sweet spot in which costs are falling and oil and gas production is accelerating. Heavy investment has started to pay off, he said, and problems involving large, expensive projects in Russia have abated. Both factors depressed the company's stock over the last two years.


HSBC, like J. P. Morgan, is overweight in oil shares, with Shell as its top pick. Jason James, a global equity strategist for HSBC, said the reserve cut "does not translate in a straightforward way into a diminution of the value of the oil reserves controlled by the company.'' He said Shell's valuation was also appealing.


Shell's competitors are eager to show that their reserves have been classified correctly, but Mr. James says that if they all ultimately have less oil than they think, their prospects may actually improve.


"The bears typically argue that companies like Shell are spending more and more money to find less and less oil, but I think this bearish argument misses the wood for the trees,'' he said. "For any one company, a failure to replace reserves is a problem, but if the industry as a whole fails to replace reserves, then oil prices will tend to rise. This, of course, would be a bullish scenario for the industry. The last time we worried about oil running out, in the 1970's, the sector had a bonanza.''

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