The Observer: Shareholders want to know where Shell's reserves went
Sunday January 18, 2004
A week later and even the most basic questions remain unanswered after the shock confession by the Anglo-Dutch giant that its oil and gas reserves are not as plentiful as they seemed. Oliver Morgan reports
Shell is living in the Twilight Zone. Some would say that is the natural habitat of the oil giant, whose history of cumbersome bureaucracy, opaque governance, lacklustre financial performance and prickliness to outsiders has suggested it occupies a world of its own.
Its investors had hoped attempts in the decade since the Brent Spar debacle to transform this aloof, quasi-imperial Anglo-Dutch behemoth into a more open, entrepreneurial (yet prudent) oil and gas major were succeeding. Now the investors are in limbo, too.
Following the announcement a week ago that 3.9 billion barrels of oil and gas, or 20 per cent of its reserves, were no longer 'proved' - meaning they would not be retrieved as quickly as thought - they must wait until a results presentation on 5 February for an explanation by chairman Sir Philip Watts.
They are furious, and feel fobbed off by the one-page press release and conference call, in which neither Watts nor finance director Judy Boynton, the other executive director on the board of the UK side of the company, took part. In the resulting information vacuum, the shares have gyrated from 401p to 359p.
Investors are still asking the basic questions. What has happened? How did it happen? Why? What will it mean for returns on our investments?
As one fund manager said last week: 'Have circumstances changed vis à vis the oil price? It doesn't appear so. Have they simply taken a different view on the probability of these reserves being commercial? If so, why? And why, on an issue of this importance, don't the most important people turn out?
'We don't know any of the answers, but our corporate governance people are looking at it all very carefully. The National Association of Pension Funds is now involved. If they don't get satisfactory answers, we will be forced to write demanding explanations.'
So, what happened? Shell's announcement moved the 3.9 billion barrels from the 'proved' category - which indicates commitment to extracting oil and gas commercially - to 'scope for recovery', a lower category in which the commitment is weaker and extraction further away.
Critically, it means that regulators, particularly the US Securities and Exchange Commission (SEC), do not recognise the barrels as reserves. Shell does not book the reserves as financial assets, but they are an indication of future growth prospects, and so the numbers are crucial.
It was a disaster for Shell, and for Watts, who is already at the bottom of the FTSE 100 chief executive popularity league thanks to his waspish manner and a couple of hiccups since his appointment in 2001, including allegedly overpaying for Enterprise oil and missing production targets.
How did it happen? Robert Plummer of consultancy Wood Mackenzie identifies five stages from discovering oil, through appraisal of the find, engineering work, making commercial arrangements such as project finance and negotiating contracts for output to the final investment decision (FID), when a company commits to recovering the oil and/or gas.
Plummer says: 'What appears to have happened is that the 3.9 billion barrels was booked before FID.' This is 'surprising', particularly in the case of the biggest examples, the Gorgon liquified natural gas project in Australia and Shell's Nigerian operations, which together account for 50 per cent of the total.
With Gorgon, Shell had letters of intent from Korean and Japanese customers to buy the output when it booked the project in 1997. But, Plummer says, there is a long way between these and commitment. Nigeria has vast potential reserves. But development is dependent on Shell gaining a larger proportion of Nigeria's Opec quota.
The Gorgon case is difficult for Shell because its partners, Exxon Mobil and Chevron Texaco, did not book reserves as proved. Both are difficult for Watts, who was head of exploration and production from 1997 to 2001.
Despite refusing to put up senior executives, Shell was last week desperate to limit the damage. It claims that the oil hasn't gone away, the reserves are still there, and it expects to get them out, re-listing them proven 'over time'. There is little disagreement among experts over this, just concern about what 'over time' means.
Second, Shell says the classification of reserves is a 'very grey area'. Last year, because of concerns over lack of consistency in booking standards, the SEC issued guidance, underlining that, to be proved, there must be 'reasonable certainty' of recovery, and urging conservatism.
Even this is not clear. Deutsche Bank analyst JJ Traynor points out that booking is still governed by guidelines, not rules. Most companies only book as proved those reserves with a 90 per cent or more chance of recovery on current capital spending plans. Most only ink them in after FID. Shell (and in some circumstances BP) are less conservative.
And the SEC demands that only reserves retrievable during the license period allowed by local authorities be booked, while UK companies have traditionally booked those over the life of the field. BP (currently enjoying Shell's discomfort) faced concerns over this in Russia last year, although they came to nothing.
Apart from the SEC's guidelines, the Society of Petroleum Engineers has produced definition of reserves, with nine categories. The SEC is interested only in the first. Shell says it has moved the relevant reserves only from the first to the second of these categories.
Then there are the companies. Ultimately it is subjective - Traynor points out that the rules 'leave it to the companies to exercise proper judgment about when a reserve becomes commercial and is thus likely enough to be developed that it should be considered so certain as to be classified as proven'. Therefore, technically, Shell was not breaking rules.
Third, Shell argues that its review was discovered during a routine review of reserves started a year ago, so it is virtuously 'fessing up. Fourth, it argues its immediate financial performance has not been harmed.
Investors are taking all this with a pinch of salt. That the reserves are still in the ground is not the point. When will they come out? As Commerzbank analyst Clay Smith says: 'The issue for investors is: how much more will it cost Shell to bring these reserves back?'
In the data vacuum since 9 January, analysts are finding that tough to work out. The company points to a 10 per cent reduction in future cashflow from the affected reserves. Without detailed knowledge of planned investment, analysts are guesstimating; one back-of-the-envelope sum indicated Shell's value had slumped by $2.4bn.
In the absence of harder data, the City has looked at how Shell compares with its rivals in terms of booked reserves before and after 9 January.
Wood Mackenzie calculates that before the revision Shell was replacing the oil it was extracting at a rate of 105 per cent - its future stocks were increasing. But even then it was behind ExxonMobil (116 per cent) and BP (152 per cent). After 9 January Shell's figure fell to 57 per cent - its reserves are contracting.
Before, it had 13.6 years of proved reserves. After, it had 10.9. BP has 12.9, Exxon 13.3. And as economies of scale evaporate, its finding and development costs rise from $4.27 to $7.9 per barrel, or around 25 per cent of sale price, compared with BP's $3.73 and Exxon's $3.93.
It is these benchmarks on which oil majors are valued against each other. That is why Shell is being hit.
BP and Exxon have ruled out similar downgrades and are enjoying Shell's problems. BP says it books reserves after FID, except in cases where it is certain FID is imminent. Exxon gloats that it has a high threshold for reserves to be proved. 'Shell... had booked Gorgon reserves while Exxon had not.'
Plummer says: 'Reserves are the future of a company. The data shows that Shell is less efficient at replacing its reserves than competitors. While there may be no impact on immediate earnings, it is the sustainability of production you have to ask about.'
It is a disaster. So why did it happen?
Analysts point back 10 years. Shell's then chairman, Cornelius Herkstroter, resolved to bridge the gap between Shell's return on capital - 7.9 per cent - and the industry average of 9.3 per cent. Efforts were re-doubled under Mark Moody Stuart. Smith says: 'I remember him sitting on the edge of a desk in 1997 and vowing to us that Shell would never again sacrifice return on capital for growth.'
As the company became obsessed with returns it attempted to break up the Byzantine 'matrix' management structure recommended by McKinsey in 1959, subordinating more than 100 regional chief executives to a central committee of managing directors composed from the UK's Shell Transport and Trading Company (which owns 40 per cent of the group) and Royal Dutch, the Netherlands part, which has 60 per cent.
One Shell watcher says: 'The old set-up created regional fiefdoms, which bid for budgets from the centre, and had an incentive to bump up reserves, and to talk up their own province at the expense of others. Australia and Nigeria were traditionally key "baronies".'
Plummer says: 'There are two things. First, as it has modernised, Shell has moved bookings, along with many other things, from being devolved to being much more centralised, and that may have prompted this. At the same time, whatever Shell says, the SEC has been asking some probing questions of the companies.'
For example, in last year's guidance, the SEC indicated that: 'An inordinately long delay in the schedule of development may introduce doubt sufficient to preclude the attribution of proved reserves.'
This meant, in the case of Gorgon, that the fact that letters of intent had not been converted into firm commitments - thanks to the 1998 Asian crisis and the slump in regional demand for natural gas - meant there were questions.
Shell argues it booked the reserves in good faith. 'They were booked according to our best interpretations of reasonable certainty,' said a spokesman last week.
Good faith may not be enough. Many Investors want explanations; some want Watts' head. But non-executives are said to be on his side, and, thanks to the arcane board structure, some investors are unsure of how to unseat him. Perhaps it is another example of the different worlds occupied by those who run the company and those who own it.
We will know what Watts thinks of the prospects of the company, and of himself, only when they return from the Twilight Zone in February.
Only then will investors get an idea if the company wants to re-join the real world.
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