The Sunday Times: Shell board on trial as report on reserves throws group into turmoil

By Paul Durman and Lucinda Kemeny

April 25, 2004

A shake-up of the oil giant's management structure seems inevitable after an investigation revealed a host of failures

NINE days ago the boards of Royal Dutch and Shell Transport & Trading met to consider an explosive report drawn up by Davis Polk & Wardwell, a firm of American lawyers.

Even before it was finished, the document had cost the oil giant's two most senior executives their jobs. Now the report - or at least a summary of it - was ready for publication, complete with lurid e-mails from Walter van de Vijver, Shell's former head of exploration and production (E&P), to Sir Philip Watts, the sacked chairman.

Shell's directors knew they were in for another week of disastrous headlines, worrying the group's 118,000 employees around the globe. Judy Boynton, its chief financial officer, would have to follow Watts and Van de Vijver out of the door for her part in failing to prevent the reserves fiasco that has shaken the company over the past four months.

Some directors were unhappy with parts of the report, commissioned by the group audit committee in early February. Despite its seemingly dry topic - the "reclassification" of 3.9 billion barrels of oil reserves - the Davis Polk report made a gripping read. The copious use of Van de Vijver's e-mails and notes gave it 'colour' that would capture the imagination of newspapers.

Far from displaying any lawyerly caution, Davis Polk's findings couldn't have been more categorically brutal. Shell's two most senior executives had been at war over the true level of the reserves for almost two years. Worse, Shell had hidden these very serious doubts from shareholders - tantamount to misleading the stock market, or worse.

The report left little room for doubt about the principal culprit. In one bitter e-mail to Watts, Van de Vijver said: "I am becoming sick and tired about lying about the extent of our reserves issues and the downward revisions that need to be done because of far too aggressive/optimistic bookings."

Watts appears doubly culpable - both for resisting disclosure of the "true" numbers and for being responsible for the over-aggressive booking of reserves in the first place, when he ran the E&P business.

Unhappy with the report's unflattering impression, the directors wondered whether there was any chance of dissenting with Davis Polk's findings.

Could the company agree to implement the recommendations for remedial action, without accepting the full report, warts and all?

Shell's senior advisers were firm. The company's reputation had been so tarnished by the events of the past few months that it had no option. Shell had to accept the report in its entirety. Any other response would only increase investor criticism of the company.

After some debate, the Shell and Royal Dutch boards decided to follow this advice. When the report was published on Monday, Lord Oxburgh, the geologist who has become chairman of Shell Transport & Trading, said the company accepted the findings "unreservedly".

Yet this is far from the end of the matter. Shell has chosen to interpret the Davis Polk report as it sees fit. Ignoring evidence of an endemic, cultural problem, Oxburgh blamed the reserves controversy on "personal failings" rather than any structural deficiencies - firmly pointing the finger of blame in Watts's direction.

It appears that Shell may seek to undermine the status of the Davis Polk report in its dealings with the regulators who are investigating the company's mis-reporting of reserves. The Sunday Times has established that company executives remain unhappy with elements of the report.

One complaint is that the quotes from Van de Vijver "light up the page" and do more to blind readers to the truth than illuminate it.

Shell faces months, perhaps years, of investigations by the Financial Services Authority in the UK, the Dutch regulators and America's Securities and Exchange Commission (SEC) and Department of Justice.

The Davis Polk report is being keenly studied by all of them.

The group's directors would like to draw a line under the reserves debacle. But rather than marking the end of the story, the Davis Polk report has only opened another chapter.

SHELL's problems crashed into the open in early January, when the company announced that it was re-classifying 3.9 billion barrels of proven oil reserves - 20% of its total. In effect, Shell was no longer sure that it would be able to produce as much oil as expected from some of its largest fields, including those in Australia, Nigeria, Oman and Brunei.

Extraordinarily, Watts failed to appear at a teleconference called to explain this worrying news to investors, leaving this job to junior officials. It was this, as much as anything else, that compounded Shell's reputation for being insular, arrogant and poor at communication.

It seemed at first that Watts had failed to grasp the significance of the "loss" of a fifth of the group's reserves. After a ferocious backlash from investors, he begged forgiveness, but claimed he had the full support of the group's directors.

This lasted only until the beginning of March, when the report's preliminary findings were made known to the boards.

Far from overlooking the importance of the reserves announcement, Watts had been keenly aware of the doubts for at least two years. It was his failure to acknowledge the seriousness of the problem that condemned him to oblivion.

THE Davis Polk report laid the blame full square on Watts's shoulders. Shell, often accused of lacking savvy in its dealings with the media and the outside world, must have known how the report would come across.

Van de Vijver's now infamous quote about "lying" was perfect fodder for the following day's newspaper reports. "Bosses lied to investors", read a front-page headline in The Daily Telegraph.

Despite the forceful nature of the summary produced by Davis Polk's Tom Reid, the findings are hedged with caveats: "These interviews were not conducted under oath and Davis Polk was unable to subpoena or otherwise compel the attendance of former employees. Because of the time pressures and the disparate geographical regions at issue, some interviews were conducted by phone and not all could be conducted with the benefit of review of all relevant documentation."

This weekend sources said the nature of the problems at Shell was much less black and white than the report makes out.

Take, for example, Van de Vijver's apparently explosive response to members of his E&P staff who prepared a report on the reserves last December. He was told that 2.3 billion barrels of proven reserves could not be included because of SEC rules. The reserves as reported in Shell's filings in America were "materially wrong . . . not to disclose it would constitute a violation of US securities law".

According to Davis Polk, Van de Vijver sent this swift response: "This is absolute dynamite, not at all what I expected and needs to be destroyed."

On the face of it, the tall Dutchman was suggesting the destruction of documents to keep these details from the board and the market - a serious abuse of the market.

This is the most grave allegation made against Van de Vijver, who could otherwise have been seen as a half-hearted whistle-blower.

But those familiar with the full details say that Davis Polk has taken the e-mail out of context. These sources say that what Van de Vijver actually intended was that Frank Coopman, then chief financial officer of E&P, should go back to the drawing board and prepare a paper that could be presented to the committee of managing directors - the central decision-making board of executives at Royal Dutch/Shell.

Davis Polk declined to discuss its report.

One Dutch acquaintance of Van de Vijver said: "It's because he respected the company so much that he didn't want to blow the whistle, but instead ordered the investigation and tried to remedy the problem through the company.

"He is a man who has invested his entire life in Shell and believed in its ethos of looking after its employees fairly and for life. He was the archetypal company man who was on course to take over the reins."

Shell's attempts to make a lone scapegoat of Watts do not stand up to scrutiny. The reserves issue was extensively debated within the E&P division, where it was known as the "caught in the box" problem. Van de Vijver had also repeatedly raised his concerns with the committee of managing directors. As early as February 2002 he had warned that 2.3 billion barrels might need to be re-classified because of the SEC regulations.

As the report stated: "Executives and employees had, over time, varying degrees of exposure to the debate and, in various strata of management at Shell's central offices and in the field, involvement in the operations that were the subject of the bookings."

Despite the huge amount of oil involved, and the wide knowledge of the problem, Shell's board failed to address the issue seriously until late last year. "It finally got through to the top that the figures just didn't hang together," said a source from E&P.

That Shell failed to provide accurate figures to the market seems beyond question. The bigger issue is this: did Shell's executives perpetrate a deliberate fraud, or was the company simply paralysed by its own internal civil service?

IN A COMPANY with such an entrenched hierarchy, change will be difficult.

While its executives argue that Shell's culture is not a problem, most outsiders believe that only a wholesale shake-up will ensure that the company survives.

Eric Knight of Knight Vinke, a representative of Calpers, the giant American pension fund, has been in close touch with other shareholders. He said there was now widespread agreement between Dutch and British fund managers over the need for change.

Shareholders have said they want an independent chairman and finance director to inject some much-needed new blood.

But this is only the start. Oxburgh and Aad Jacobs, chairman of Royal Dutch, are under severe pressure to unite the two companies properly. Jacobs said the situation was under review, but his lack of enthusiasm was palpable.

Shell's biggest problem is finding oil. A legacy of scattergun investing in small fields has left it badly exposed. Oil production will be flat this year, and may even fall next year. This is not a sustainable situation for a company of Shell's scale and history.

After writing down its reserves, Shell is replacing only between 50% and 60% of the oil it produces. BP and other big rivals manage 100% to 150%.

Irene Himona, an analyst with Morgan Stanley, said: "They are apologising but it does not offer a solution. It is very basic. They need to start spending more money and start finding more oil."

Resolving its current regulatory and legal battles may be the least of Shell's problems.

Additional reporting by Justin Sparks and Daniel Box