Australian Financial Review: Shell shocked: the tank's empty

By Chip Cummins, Susan Warren and Bhushan Bahree   |   Wall St Journal

16 Mar 04

In July 2001, Royal Dutch/Shell Group tapped Philip Watts to pep up a century-old oil giant that had grown lethargic. The gruff British seismologist was coming off what appeared to be an extremely successful run as head of the division that finds and produces oil for Shell. And he was pumped.

"Exploration and production is in very good shape," he said at the time, reeling off a record that helped earn him a knighthood: big progress in projects in Oman, Nigeria, the United States, Sakhalin Island in Russia and Egypt.

But within months of taking the chairman's job, it became clear that the picture wasn't as bright as Watts had painted.

Internal correspondence indicates Sir Philip and his successor as head of exploration - and possibly their subordinates and other senior executives - knew as far back as February 2002 that Shell may have greatly overstated its reserves of oil and natural gas, according to a source. And much of that overstatement came on Watts's watch as head of exploration.

Now Securities and Exchange Commission investigators and Shell auditors are sifting through the trail of correspondence and other company documents. Whatever the outcome of the probe, the big forces that helped humble Shell are already clear.

The oil giant has been plagued by what was once a source of strength: a quirky, loose corporate structure bestriding its twin bases in England and the Netherlands. And it erred in over-relying for growth on its traditional prowess for finding oil, as new discoveries have grown harder to eke out.

The revision has also painted a starkly different picture of the company's recent performance, showing Shell lagging behind competitors in key performance measures instead of just keeping up.

Only in January of this year did Watts inform the joint boards of Shell's English and Dutch holding companies about the mounting questions. On January 9, Shell came clean to investors, saying it would slash its reserve holdings by 20 per cent.

Last week, after the boards reviewed the early results from an internal probe of what went wrong, Watts and his successor as head of exploration, Walter van de Vijver, were forced to resign.

The controversy has rocked the $US1trillion-a-year ($1.36 trillion) global oil industry. Rivals are reassessing their own reserve tallies, and engineers are clamouring for clearer guidance about reserve accounting, which has always been more art than science. Reserves are a key measure of an oil company's recent performance and longer-term value for investors.

A number of mysteries remain unanswered. How did Shell misjudge its reserve so badly? Why didn't anybody catch the mistakes? Why didn't Watts disclose them sooner? Did Shell actively try to hide the problem?

The company's current top executives - including Shell's chief financial officer and the man who replaced Watts as chairman - are under pressure to disclose what they knew about the reserve problems and when. Shell's board signalled in a statement last Tuesday that it is standing by them.

The group audit committee recommends that board members and external auditors "feel confident in relying on the representations of the group's current senior management," says A.G. Jacobs, a board member and chairman of the committee.

The roots of Shell's unusual corporate structure date back to 1907, when 60 per cent owner Royal Dutch, an oil-production company in the Dutch East Indies, came together with 40 per cent owner Shell Transport & Trading, a London-based kerosene merchant.

The company went on to become a vast empire of independent operating units - from oil-sales businesses in the US to a production and refining company in Venezuela. Shell became one of the world's most flexible companies. To this date, both holding companies maintain separate boards and separate headquarters in The Hague, Netherlands, and London. A "committee of managing directors" acts as the company's top management body.

Shell erred in the 1990s in relying too much on its other great tradition: big oil strikes. In recent decades, new oil has become harder to find, as Middle Eastern countries expelled foreign oil companies and fields in the West matured.

BP and Exxon Corp, later Exxon Mobil Corp, responded by buying up their rivals and selling off poor-performing fields. Shell largely stuck to organic growth through hunting for discoveries. But Shell was also lagging in that area. In the late 1990s, Shell fell behind its two closest rivals, Exxon Mobil and BP, in reserve replacement, or the rate at which a company finds new oil to replace the oil it produces.

Between 1997 and 2002, Wood Mackenzie, an Edinburgh energy consultancy, figures BP replaced 152 per cent of the oil it pumped, not counting acquisitions and divestitures of oil fields. Shell's reserve-replacement rate was 105 per cent - but after its recent reserve downgrade, the number falls to just 57 per cent.

The difficulty in finding new reserves translate into higher costs, another key measure for investors. Between 1997 and 2002, Wood Mackenzie estimates Shell's cost of finding and developing oil at $US4.27 a barrel, behind Exxon Mobil's $US3.93 and BP's $US3.73. After its revisions, Shell's costs soar to $US7.90 per barrel.

In the late 1990s, rivals BP and Exxon launched industry-changing megamergers, setting off an acquisition binge among almost every major oil company. Shell, with its twin boards and sometimes slow decision-making, was left behind.

Mark Moody-Stuart, a geologist and keen sailor, became chairman of Shell in 1998 amid the merger mania. Profit was plunging and investors were deserting in droves.

Much hinged on the performance of the head of exploration: Philip Watts. As a young man, he taught physics and mathematics in a government-run secondary school in Sierra Leone. He returned to Britain and joined Shell as a seismologist in 1969.

Watts led Shell's Nigerian operations from 1991 to 1994 and took the top exploration and production job in 1997. By 2000, Watts was racking up impressive gains in production, and profits swelled amid high oil prices. He took over as chairman in July 2001.

Shell's overbooking troubles appear to have started as far back as 1990, according to one source.

There are rigorous US guidelines for booking reserves, but in the end accounting rules require a company only to be reasonably certain it can commercially extract the oil or gas. That leaves companies with leeway to use their own geological and financial assumptions and models for things such as the price of oil and the technological challenge of getting the oil to the surface.

Companies usually don't break out reserve totals for specific projects, so it's difficult to compare Shell's individual reserve bookings with those of other companies in similar projects. But in some projects where comparisons are available, Shell was more aggressive than its peers.

In the Gorgon natural-gas field off the north-west coast of Australia, Shell started booking the equivalent of 557 million barrels of oil in 1997. Partners on the same project - including Exxon Mobil and ChevronTexaco - have said they never booked any reserves there.

Off the coast of Norway, in a field called Ormen Lange, Shell booked gas reserves to the tune of some 109 million barrels of oil equivalent as early as 1999. Though there is little doubt the gas is there, Shell didn't make a final investment decision about developing the field until 2003.

By 1999, concerns were rising over a push by US oil companies into overseas projects and a boom in joint ventures, trends that made it more difficult to get a clear picture of reserves. That year, the SEC hired two engineers dedicated to reviewing reserve estimates for oil and gas companies, Jim Murphy and Ron Winfrey.

They soon put the industry under greater scrutiny. In letters to oil companies in 2002, the SEC chastised companies for not obeying reserves rules, demanding explanations on how calculations were made.

There was also growing unease in the industry about an open secret: a widespread tendency to overbook reserves. In a 2001 report, Houston consultants Rose & Associates noted the pressure on managers at publicly traded energy companies "to push the envelope of credibility in efforts to buoy investor confidence and thus increase stock value". Among other things, the consultants pegged the overbooking to incentive programs that offered bonuses for big reserve estimates.

The internal Shell review has unearthed correspondence from this time that indicate a dialogue between Watts and van de Vijver - and between the two men and their subordinates - about the reserve-booking problems, according to a source.

One memo circulated between senior executives was dated February 11, 2002. It warned that the company may have overstated reserves by 1 billion barrels of oil because of apparent inconsistencies between Shell booking guidelines and current SEC guidelines.

Reserve-booking issues were raised again by van de Vijver in reports in July 2002, January 2003 and July 2003, according to a source. It's unclear which senior Shell executives had access to these reports.

By the fourth quarter of 2003, Shell executives had commissioned a series of in-depth internal reserve-booking reviews and audits, which ultimately resulted in the January 9 disclosure.

In October 2003, the combined audit committee of the two Shell boards asked for and received a routine briefing on reserve issues.

But the committee wasn't notified of any major problems with the bookings.

Board members learned there was a problem only after Shell managers asked them to attend an emergency board meeting for an unspecified reserve issue.

The boards met in early January. Senior managers dropped a bombshell: Shell needed to slash its estimate of oil and gas reserves. Board members were stunned and immediately ordered an inquiry into how the overstatements happened. Shell quickly put together a conference call for analysts and reporters on January 9.

Watts didn't show up, leaving an investor-relations executive to break the bad news, angering analysts. Shares in both Royal Dutch Petroleum and Shell Transport & Trading fell sharply.

On February 5, a day-long presentation about the reserves issue to analysts did little to clear the air.

Then, on Monday of last week, Shell's audit committee - comprising independent directors from both boards - huddled at Shell's headquarters in The Hague ahead of a regularly scheduled board meeting that week. They heard initial reports from the internal investigation team and briefed board colleagues about the preliminary findings of the review.

Briefed on the correspondence, directors decided unanimously that they had lost confidence in Watts and van de Vijver. A delegation of board members broke the news to the two in private meetings and asked for their resignations.

http://afr.com/articles/2004/03/15/1079199159189.html