The Scotsman: A Shell of a crisis
ANDRE MURRAY WATSON and RICHARD ORANGE
Sun 25 Apr 2004
IT WAS Benjamin Disraeli who first coined the famous phrase "There are three kinds of lies: lies, damned lies and statistics". But the mantra did not become part of the popular lexicon until American author Mark Twain got hold of it. He used it to sum up the persuasive power of authoritatively made numeric presentations to a largely innumerate public.
If the whole Shell debacle has taught us anything, it could be that the power of the glib over the gullible still holds sway a century later. First off, Shell’s lies. There are any number to choose from, but consider one contained in Shell Transport and Trading’s 2002 annual report and accounts by former chairman Sir Philip Watts.
"In times of uncertainty, what counts is being trusted to deliver. As the long-standing slogan said, we want people to know they ‘can be sure of Shell’. I believe that our performance last year helps us earn and keep that trust."
Now for the damned lies, one handily provided by a Shell press officer following a shattering downgrade of the company’s proven oil and gas reserves. "No one is going to lose their jobs and there is no need to panic."
And finally the statistics. In its 2002 annual report and accounts, Shell stated it had 19.4 billion barrels of proven oil and gas reserves. In the same year, Sir Philip took home £1.79m, of which £874,000 was ‘performance-related’. Following a devastating series of downgrades, reserves now stand at closer to 15 billion barrels; Sir Philip along with chief financial officer Judy Boynton has been kicked out of the company, and Shell is facing numerous lawsuits from outraged US investors.
The UK’s financial Services Authority got into the act on Friday.
The watchdog said it is formally investigating oil giant Shell following the shock downgrade of its reserves.
Simon Culhane, the new head of the Securities Institute, the City’s leading organisation to promote ethical behaviour, has also criticised Shell's cover-up of its oil reserves shortfall and claimed it could be a "watershed" in British corporate ethics.
The company has lost the trust of shareholders and the fallout has sent the oil and gas industry reeling. The price of crude is edging ever higher beyond the symbolic $30 per barrel mark and the reputation of the UK and Dutch business has taken a kicking.
The executive summary of Shell’s internal investigation revealed the full extent of the concerted attempts by senior management to hide the reality of the company’s reserves. The most damning aspect of the report is that the cover up has been going on for years. Watts emerges as villain-in-chief, with then exploration head Walter van de Vijver as his unwilling accomplice, desperate to come clean about the problem but somehow held back - either by fear of Watts himself or by his ambition to one day replace him.
In one e-mail Van de Vijver told his boss: "I am becoming sick and tired about lying about the extent of our reserves issue and the downgrade revisions that need to be done because of far too aggressive/optimistic bookings."
But much of the original report, drawn up by US law firm Davis Polk and Wardwell with the help of Shell staff, was suppressed at the bequest of US investigators. The full report will show that the nightmare foisted upon the company by Watts could still have some way to run.
Although the bulk of the blame for Shell’s current problems is laid at the door of its old management, the new band of executives do not escape censure. New group chairman Jeroen van der Veer, and the company’s new exploration head, Malcolm Brinded, were both aware of the reserves issue for a considerable time. As early as February 2002, Van der Veer was sent a note saying 2.3 billion barrels of the company’s reserves might have been booked in breach of US securities law. But it didn’t stop him, as chairman of the Dutch half of Shell, signing off the accounts for that year.
According to the published report, in July of the same year, Brinded, in a meeting with Shell’s committee of managing directors, outlined a strategy to manage the problem of over-booked reserves.
Despite the obvious failings of the command chain, there still appears to be reluctance at the top to alter the company’s management structure. Lord Oxburgh, the chairman of Shell Transport and Trading, told analysts last week it was due to "human failings, not structural deficiencies". Unfortunately for Shell, nobody believes him.
Ratings agencies Moody’s, Standard & Poor’s and Fitch have all kicked the company down a notch, depriving it of its treasured AAA credentials.
Analysts critical of Shell’s bloated management structure highlight comments made by Van de Vijver in the DPW report. He claimed he couldn’t blow the whistle because of an "unspoken rule within the company that you are not supposed to go directly to board members or to the group audit committee".
It also transpired that the group’s reserves auditors answered to the head of exploration and not Shell’s group chief financial officer - the director responsible for the company’s regulatory filings. To muddy the waters further, the un-named individual employed to check the company’s reserves was a part-time retired employee who checked each field only once every four years. In the report he claims he would have been sacked if he had raised the importance of complying with US securities guidelines.
The pressure Shell evidently felt to massage its reserve figures stemmed from before Watts was appointed. Peter Nicol, an analyst at ABN Amro in London, said: "They made a hell of a lot of poor decisions in the early-1990s."
While BP, Total and others were opening new offshore areas, Shell was focusing more on finding smaller fields near existing ones. It missed out on the mega-mergers of the 2000-2001, meaning it dropped from first to third place among the super-majors.
Analysts point to other ways Shell was also failing to react to a changing global market. For example, it started developing an alliance with Russian gas giant Gazprom seven years ago. The two are still talking. BP, meanwhile, has done two Russian deals.
Watts was supposed to streamline Shell’s decision-making process. The company’s directors had gone out on a limb to appoint him in 2001. Watts had made his name in the company ruthlessly driving down costs of the exploration arm while still getting the exploration results. Jon Rigby, an analyst at Commerzbank, said: "He was punchy and I think a lot of people were fairly relaxed about him as the new chairman."
But within months, the holes started to show, both internally and externally. Shell missed a string of targets for oil and gas production, then continued to underperform its peers in the upstream.
Soon after Watts took the top job, new exploration head Van de Vijver realised he had been passed a poisoned chalice. By late 2003 he was lambasting Watts for his "far too aggressive/optimistic booking", which made it impossible to match the upstream performance of its peers, and forced him to lie to investors about the reasons behind it. Analysts were in the dark. "The truth is disclosure was so poor that we didn’t suspect anything," said JJ Traynor at Deutsche Bank. "We knew something was wrong," argued Fadel Gheit at the Oppenheimer brokerage in New York, "but we didn’t think the numbers were exaggerated, embellished or overstated."
Shell’s non-executive directors fared little better at unravelling the web of deceit spun by the executive management.
Lord Oxburgh said: "The audit committee was indeed seeking to probe the question of reserves. I’m sorry to say it seems to have been given incomplete answers by the executives." Investors are unlikely to accept that as a decent excuse.
Even with Shell’s new levels of disclosure, the company will have to work hard to win back investors’ trust, whether with regard to future performance, governance or its corporate structure.
In terms of performance, Brinded has a long road ahead to bring the exploration and production department up to the standard of its peers. "Disclosing the facts and circumstances behind the disaster and the reserve problem doesn’t solve it," said Irene Himona, an analyst at Morgan Stanley. "The operational problem is very serious. To stay still they have to replace 100% of production. Over the past five years their average has been 60%."
It’s easy to overestimate the company’s problems. As Shell’s first quarter results next week should demonstrate, it is still capable of generating cash on a vast scale - somewhere between $3-$4bn this quarter, according to analysts.
Production levels are set to be flat this year, sinking into a decline in 2005, but Brinded said he was confident the company had set up long-term projects, such as Russia’s Sakhalin, that were as good as any in the industry.
Even if performance does start to improve, investors will still try and force through major structural change at Shell. But the company is already implementing change. Van der Veer has rolled out a long list of reforms designed to improve the way it assesses reserves, and tighten up its reporting lines to prevent a similar scandal occurring again.
Reserves auditors will be independent of the exploration company’s management, reporting instead through the group CFO to the audit committee. Internal guidelines for reserves bookings have been brought into line with those of the SEC and staff will be trained in the new rules.
In addition, more resources will be employed for evaluating reserves. Each field will now be assessed every other year, major ones annually, and external experts will double-check decisions. But so far there are few signs that Shell’s dual board structure will be reformed and investors will have to wait until the company’s AGM on June 28 for further proposals.
Institutions want to abolish the firm’s dual listing, the collegiate nature of the CMD, where the chairman is only first among equals, and the semi-independence of different divisions within the group. But the noises coming from the company suggest it is unlikely to follow its Anglo-Dutch peer Unilever and unify its two boards.
If Shell turns down investors’ ideas, it won’t be the first time. When the management consultancy McKinsey recommended in 1959 that two parent companies should share one chief executive and one chairman, Shell turned it down in favour of keeping the CMD. Whether it can afford to ignore advice this time, is much less certain.
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