Royal Dutch Shell Group .com

The New York Times: At Shell, New Accounting and Rosier Oil Outlook

 

By STEPHEN LABATON and JEFF GERTH

Published: March 12, 2004

 

Arriving on stage in a spaceship and an astronaut suit, Philip Watts, then the senior executive in charge of exploration and production for the Royal Dutch/Shell Group, glowed as he delivered a message of optimism to a conference of 600 company executives in the Dutch city of Maastricht in June 1998.

 

"I have seen the future and it was great," he declared.

 

He was talking about the success of a special management program that had recently addressed a fundamental problem at the company — that it was pumping oil and gas out of the ground faster than it was finding new supplies. Internal documents show, however, that the program allowed Royal Dutch/Shell to increase its oil and gas reserves not by discovering major new sources, but by changing its accounting to add reserves that it was not sure could ever be tapped.

 

At the conference, executives wore yellow T-shirts that said "15 percent growth" and affirmed their faith in Shell's "transformation process" by singing "Ode to Joy," according to a company employee and a brief account in The Times of London.

 

Royal Dutch/Shell's future does not look as great now as it did then. The company, a storied oil giant that traces its roots to a Dutch oil company and an English seashell importer in the 1890's, ousted Sir Philip as chairman last week. He had risen to the top of the company three years ago in part because of his ability to increase reported reserves and had been knighted by Queen Elizabeth in 2003 for his service to Britain.

 

His departure followed almost two months of investor unrest over the company's decision to cut estimates of its proven reserves by 20 percent, or 3.9 billion barrels. The Securities and Exchange Commission, seeking to protect American investors who bought Royal Dutch/Shell stock and bonds, is now investigating whether he or the company broke the law with the way they accounted for reserves.

 

Internal corporate documents and interviews with oil executives and industry analysts describe a company that in the go-go 1990's tried to manage its reserve figures much the way other companies managed their earnings — to satisfy investors.

 

The documents show that worried executives felt compelled to increase the reserves, which throughout the first half of the 1990's were declining because discoveries did not keep pace with production.

 

The fall in the so-called reserve replacement ratio troubled analysts and investors because it is an important measure of an oil company's prospects.

 

"Following a sustained period of proven reserves decline in the early 1990's, there was considerable pressure, both external and internal, to correct performance," according to a confidential internal review code-named Project Rockford. The origin of the name is not clear.

 

Along with other company documents, that review, which was completed in December in anticipation of the restatement of reserves on Jan. 9, shows that senior company executives ignored warnings over several years of the possible inflation of reserves.

 

Most of the misstated reserves were recorded from 1997 to 2000, when Sir Philip was in charge of exploration and production. He could not be reached for comment. His home phone number in a suburb of London is not listed and a spokesman for Shell said the company could not reach him. "As he is no longer an employee, we do not have a way to reach him," said the spokesman, Andy Corrigan.

 

The misstated reserves came during a decade of significant upheaval for Royal Dutch/Shell, at a time when low oil prices were increasing competitive pressures throughout the industry. And the unwieldy corporate structure of the oil conglomerate may have made the problems worse, some large institutional investors said.

 

Since the merger that created it nearly a century ago, Royal Dutch/Shell has been overseen by separate Dutch and English boards, though decisions are made by a third group, made up of executives from the boards and known informally as "the conference." Investors and others criticize the structure as too cumbersome.

 

"The conference has no formal decision-making power and is currently made up of some 20-odd people," said Robert Talbut, chief investment officer with Isis Asset Management. "Our view is that with any organization with 20 people, it doesn't take a genius to tell you that that is considerably suboptimal."

 

The structural weaknesses in the boards made it even harder for them to watch over company executives in Europe who were also struggling to control a sprawling global conglomerate that consisted largely of separate fiefs. The company merged its four European headquarters into one in the mid-1990's but until the end of the decade it also continued to give significant authority to its operating units.

 

"They set clearly defined targets, and created motivational schemes," said Colin Allcard, who retired in 1999 and was a senior manager in the Ethiopian oil products division. "Your performance was measured and rewarded."

 

The company came under greater competitive pressure from its larger rivals, BP Amoco and Exxon Mobil, which were building their reserves with discoveries, mergers and strategic alliances.

 

The problems at Royal Dutch/Shell can be traced to the first half of the 1990's, when executives and investors began to grow concerned that the group's reserves were not keeping pace with production. Their concern led them in 1997 to instruct the leadership and performance group, known within the company as LEAP, to "create value through entrepreneurial management of hydrocarbon resource volumes," according to one company document.

 

Royal Dutch/Shell created the LEAP program in the mid-1990's to find ways to improve business practices, reduce expenses and increase income by intensively studying particular issues and by consulting experts inside and outside the company. Other companies have used similar management programs, but industry executives say they do not know of any instances of such a program's being used to overhaul a company's accounting guidelines.

 

The team proposed, and the company approved, a simple way to increase reserves: relax the accounting guidelines that it uses to book them.

 

But the new guidelines wound up significantly inflating the group's reserves, one of the most important assets of the company and a barometer of its financial health, an internal review recently concluded.

 

The calculation of reserves, which can be done in a variety of ways, is as much art as science. Because the oil or natural gas being measured is often deep below the earth's surface, estimates of reserves involve imprecise engineering and geological calculations.

 

"Industry executives, regulators and investors have all been reminded that, although science and regulations are well established, the error band around a company's proved reserves estimate can grow to be uncomfortably wide," said a research report last month by Simmons & Company International, an investment bank that specializes in the energy industry.

 

The first standards were published by the American Petroleum Institute in 1936, and the Securities and Exchange Commission applied its first rules in the area in 1978. In the last few years, the commission's staff has tightened its interpretation of its rules on reserves, after the collapse of Enron and the disclosure of other corporate scandals.

 

One of the most important principles of the current rules is that companies cannot book "proven developed" reserves for any oil and natural gas fields for which they have not already allocated the money to do the drilling.

 

But the changes in Royal Dutch/Shell's guidelines — abandoning a more rigorous standard for a looser one — enabled the company to book reserves in fields years before making significant investments to get the oil and gas out of the ground. The guidelines permitted the company to inflate the amount of "proven developed" reserves, which the S.E.C. defines as reserves for which the data indicates there is a "reasonable certainty" that oil or natural gas could be recovered through existing wells and equipment.

 

The changes "corrected the group's under-reporting of mature reserve fields" relative to competitors', the December review concluded. "But with the benefit of hindsight it left the group vulnerable to net over-reporting of immature field reserves, brought about, for example, by registering reserves well in advance of the commitment to develop and including reserves outside the proven area as it would be defined by the S.E.C."

 

Because of the changes, the company was able to reverse the trend of declining reserves over the next few years — and, more important, it was able to report that it was replacing reserves far faster than it was pumping them dry. In the late 1990's, after the accounting changes, reported proven reserves increased about four billion barrels, according to publicly available documents. Those increases improved the reported assets of the company by tens of billions of dollars.

 

The inflated reserves did not occur throughout the group. The United States units of the company generally appeared to continue a more conservative accounting approach to reserves, as they had through much of the previous few decades. Still, the internal documents show that the overseas units generally used less rigorous standards than the American units, although the Royal Dutch/Shell Group is required to follow the S.E.C. rules because the company has sold stock and bonds in the United States.

 

Still, company executives at the European headquarters of the group appeared to push aside warnings of possible reserve problems.

 

The warnings included a complaint at the end of 2002 by outside auditors that the company was overstating its part of a giant gas field, called Gorgon, off the coast of Australia. Despite that red flag, the company concluded at the time that the overstatements might not be significant enough. (When it ultimately revised its reserves, Gorgon accounted for the second-largest individual change.)

 

Gorgon was not an isolated problem. Internal documents show that some fields, including those in Nigeria and Oman, had not been audited for four years, in spite of the practice at other companies to perform annual audits. The December review found that in many areas in those countries, the accounting of reserves did not comply with S.E.C. regulations. In some instances, reserves were booked even though executives knew the oil could not be extracted before the expiration of licenses the company had bought from those countries.

 

In 2002, as S.E.C. officials were beginning to offer tougher interpretations of the accounting rules for reserves, executives at Royal Dutch/Shell developed a Potential Reserves Exposure Catalog, which listed the major concerns of the current inventory. Modest reductions in the volume of booked reserves were made, but most were retained.

 

"The view was taken that the exposures should indeed be highlighted and addressed as a matter of priority, but that no corrective action was warranted in the meantime in relation to external disclosures" the December review said.

 

The review also suggested that there may have been financial incentives for some executives to overstate reserves, although it provided few details.

 

"Through the linkage of proven reserves additions to business and individual score cards, it is possible that situations occurred in which staff involved with reserves estimation were subjected to pressure to propose proved reserves changes that might not have been fully compliant," the review found.

 

Company officials have said in recent days that there is a minimal connection between increasing reserves and performance-related pay.

 

Last year, executives began to grow increasingly concerned about the way the company was accounting for its reserves, and they commissioned a review that led to the revisions made in January.

 

But until last week, the company continued to express its support of Sir Philip, and even in the days leading up to his departure, he publicly seemed to convey no sense that he was about to be dismissed.

 

Early last week, three days before he was ousted, Sir Philip was meeting with investors, assuring them he was not leaving, and sharing the theme of the annual meeting in May at which he was planning to speak about the problem of AIDS in Africa.

 

(A July 2002 memorandum to the Royal Dutch/Shell Group's committee of managing directors from Walter van de Vijver, the head of exploration and production at the time. It indicates that the company's senior executives had concerns about shortfalls in its proven reserves of oil and natural gas, referred to here as RRR, for reserves replacement ratio, well before the company disclosed a shortfall two months ago).    

 

http://www.nytimes.com/2004/03/12/business/12OIL.html?ex=1079672400&en=fbe334dc28f1d8c7&ei=5062&partner=GOOGLE


Click here to return to Royal Dutch Shell Group .com