The Sunday Times: A broken Shell
Dominic O’Connell and Lucinda Kemeny report
January 11, 2004
Shell’s shares slumped last week after it revealed its reserves had been wildly overstated. Now its boss, Sir Philip Watts, has just four weeks to rectify matters.
THE alarm bells started ringing at the Shell Centre on Thursday afternoon. As London commuters scurried through the rain outside, senior executives of Royal Dutch Shell, one of the world’s largest oil companies, listened in stunned silence to some devastating news.
The company had been living a lie. The group’s reserves — its bank of future assets, and the bedrock of its £36 billion stock-market value — were not all there. An exuberant assessment of a field in Australia seven years earlier meant that Shell’s reserves had been overstated by one-fifth. Properly counted, Shell’s store of future production was four billion barrels of oil and gas less than everyone had thought.
Aghast at the mistake, Shell’s top brass hastily consulted their advisers. Since Enron and more recently Parmalat, equity markets were extremely sensitive to any suggestion of lax accounting or the mis-statement of assets. This bombshell called for some nimble footwork if the company’s reputation and value was not to be seriously damaged.
But the Australian field — Gorgon — was aptly named. Rather than fronting up to investors, analysts and the media, Shell chairman Sir Philip Watts and finance director Judy Boynton were turned to stone. Neither took part in a conference call to explain the debacle, to the anger and puzzlement of institutional investors.
The style of the announcement was similarly detached. The news was announced to the market at 7am on Friday under the arcane heading “proved reserve recategorisation”.
Shell stressed that the change in the reserves figures would not affect financial statements. “The recategorisation ... does not materially change the estimated total volume of hydrocarbons in place, nor the volumes that are expected ultimately to be recovered. It is anticipated that most of these reserves will be rebooked in the proved category over time.”
The markets were not fooled for a moment. Shell shares slid by 7.5% on the day, analysts slashed their recommendations, and the all-important credit- rating agencies, which decide how much big companies have to pay to borrow money, signalled that they were poised to lower their opinion of Shell’s credit worthiness.
But the damage was not limited to Shell. Jitters over the categorisation of reserves spread to the rest of the sector, with Chevron Texaco and Exxon Mobil both stumbling.
Analysts who had followed Shell, and had praised what was regarded as conservative reserves accounting, were stunned. “This reduces the value of the company by 10% on a discounted cashflow basis,” said Kempen & Co analyst Richard Brakenhoff. “Investors will be shocked because Shell was usually known for its conservative accounting policy.”
Goldman Sachs said that the affair raised “significant concerns with respect to the credibility of the company’s underlying operational performance”. The bank retained its “outperform” rating, but said the share would remain in the doldrums until “management can repair the reputational damage caused”. Goldman warned that the Securities and Exchange Commission might tighten disclosure rules on oil companies by requiring audits by independent reserve engineers.
Watts’s handling of the debacle has not endeared him to shareholders or his fellow board members, and many oil-industry executives believe that unless he has a transforming deal for the company up his sleeve, he is living on borrowed time. Insiders said two company executives have been lined up as possible replacements: Walter van der Vijver, chief executive of exploration and production, and Malcolm Brinded, chief executive of Shell Gas and Power.
IT was hardly Watts’s first managerial faux pas. Since he succeeded Sir Mark Moody-Stuart as chairman of Shell nearly three years ago, his reign has been characterised by a series of bungled announcements.
Only a month after taking the job, he reduced oil-production growth targets set by his predecessor, cutting them from 5% to 3.5%. The market was not impressed with the performance of the 58-year-old Leicestershire physicist, who had at a stroke knocked £4 billion off the group’s market value.
It was a punishing debut, and Watts knew he had much to learn. But after three decades at the company he found it hard to change his ways. He remains an intensely private man who is uncomfortable in the media spotlight. Analysts say Shell is stuffy, collegiate and not given to accepting outsiders. His unhappiness with the job’s public role is made even more obvious by the ease with which Lord Browne, his counterpart at BP, handles the media and the international stage.
But for a short while it looked as if Watts was going to waste no time in stamping a lasting imprint on the Anglo-Dutch group. In the space of a few days in April 2002, he paid £2.2 billion (including debt) for Pennzoil-Quaker State, the American lubricants business. This was followed by the £4.3 billion takeover of Enterprise Oil, then Britain’s biggest independent exploration and production company. It sent out a clear signal that Watts did not want Shell to lose ground to Exxon-Mobil and BP.
The honeymoon did not last long, particularly for Shells’ institutional shareholders, who found Watts’s barely concealed disdain for their opinions hard to swallow.
Their anger surfaced in a front-page story in the Financial Times in August 2002, barely a year after he took the top job. Fund managers were trenchant in their criticism of his approach to the City. “I would like to be generous to (Watts) as he is relatively new in the job, but our meetings with him have been poor and unsatisfactory — among the poorest we have had with a FTSE 100 company management,” said Steve Thornber, head of the global oil team at Threadneedle Investments. At the time, Threadneedle was Shell’s eighth-largest shareholder with 1.5% of the equity.
Watts professed himself “perplexed” at the criticisms, rather than angry — another sign, his critics said, of his detachment from shareholders. Although Watts said he was ready to learn from the charges levelled by the City grandees, there were few changes to the company’s top management or the investor and media-relations strategy.
THE reserves shambles may prove the final straw. Yesterday Shell was blaming the cock-up on local managers, saying that when the gaffe was made in 1996 Shell was run on a much more decentralised basis, with each region having some say in how reserves were categorised, and that Watts and the head office could not be blamed for the mistake.
But Watts’s history in the company indicates that he should have had reasonable knowledge of the $8 billion (£4.3 billion) Gorgon field. The mistake was made for reserves booked in 1996, and Watts was head of exploration for Shell from 1997 to 2001.
Analysts agree that Shell’s fundamentals remain sound, and that the one saving grace is that there does not appear to have been any deliberate attempt to mislead. Watts must first explain why the mistakes occurred and how management weakness will be tackled — then he must find a way to secure the extra reserves the company desperately needs.
At BP, Browne won this battle with a highly risky, but potentially lucrative $7 billion deal to form a joint venture with Russian oil giant TNK. This secured BP an almost unassailable position in Russia, one of the world’s last great undeveloped oil provinces.
Watts needs to summon up an equally bold stroke by February 5. Over the next few days he will carefully weigh up Shell’s potential targets.
Late last year Shell was tipped to be taking a close interest in Anadarko, one of America’s biggest independent exploration and production companies, but the trail went cold.
A genuine blockbuster would be a swoop on BG, the oil and gas exploration company created from the break-up of British Gas. With a market value of £9.7 billion, BG would be easily affordable for the oil giant. Yet the rumour mill has swirled around the pair for so long that BG’s share price has been pushed to levels that Shell’s board may feel uncomfortable paying.
BG has also had a fantastic share-price run, and was downgraded earlier this month by Deutsche Bank to “sell” — so a deal with a hefty premium would probably not be the soothing balm that shareholders would want to see.
Whatever happens, Watts will not be able to stick his head in the sand. He will have to come out fighting, either by promising a deal, an internal review, or his head on a block.
On Friday, investors learnt they can no longer be so sure of Shell.
SHORTCOMINGS OF A COMPANY LIFER
AMONG the personal interests listed in the biography of Sir Philip Watts, chairman of Shell, is the fact that he likes to relax by converting two acres of field into a garden — a project he now realises is likely to take 20 years, writes Lucinda Kemeny.
This sort of detail says a lot about the man who heads one of the world’s biggest companies.
Despite running a huge enterprise, Watts has been uncomfortable in the spotlight ever since he took the top job in July 2001 and would prefer the quiet solitude of his back garden. He has been labelled one of the poorest communicators to head a FTSE 100 company.
As long ago as August, shareholders took the unprecedented step of publicly lambasting the chairman for his failure to deal with the investment community.
Angus McPhail, at ING Markets, said at the time: “Mr Watts still has to prove that he can turn around the $7 billion of assets over the next two years, otherwise his position could look vulnerable.” Another big shareholder said that Watts seemed to show “complete disdain for communication with the City”.
But is it all his fault? Watts is a Shell lifer. He started as a seismologist in Indonesia before spending time in Malaysia and Singapore and becoming exploration director of Shell UK. Working his way up the ladder, he was made managing director of Shell’s interests in Nigeria before becoming chief executive officer of exploration and production — his last job before chairman.
He could be a product of his surroundings, mimicking the character of the comp- any he runs — bureaucratic, shunning the public eye and behaving almost like a national government, where nothing is agreed without everyone’s support.
Yet Watts has alienated the City at his peril. He may find that shareholders are too burnt from his management style to grant him time to recover.
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