The Observer: City claims its biggest trophy yet

Its chairman has gone, but Shell's problems have deep roots, says Oliver Morgan

Sunday March 7, 2004

On the face of it, the City's corporate assassins last week got their biggest scalp - and in double-quick time. A mere 54 days separated the catastrophic announcement that Anglo-Dutch group Shell's proven oil reserves had been depleted by 20 per cent and the resignation on Wednesday of chairman Sir Philip Watts. His unseating is spectacular because of Shell's reputation for haughty disdain towards outside pressure.

But, Shell being Shell - notoriously clandestine - the story is not quite as simple as it seems. The campaign against Watts dates back to 2001, when he took over as chairman.

He got off to a bad start, forced to say the company would not meet its 5 per cent a year production growth target. Then he had to explain to investors why Shell did not overpay for Enterprise Oil. And he did it all in the Shell house style, aloof, and seasoned with his own renowned grit.

As one shareholder remarked last week: 'He got off on the wrong foot because of his communications. I remember saying in 2002, "I'm not sure you can judge a chairman purely on his communication skills". But it seems rather like that is what got him in the end.'

This is a reference to Watts's decision not to take the conference call on 9 January explaining the downgrade. Investors were angered by this. At the time, Standard Life's David Cumming said: 'I am surprised Phil Watts is not present to explain, given his direct responsibility for the upstream business.' For a fund manager, that's fighting talk.

Off the record, investors were even less dilatory. That weekend's headlines pointed to pressure on Watts to resign. Watts took to a bunker, claiming 'closed season' immunity prior to Shell's fourth-quarter results on 5 February. His absence intensified the assault. Shell bowed to pressure and arranged a meeting between investors and Lord Oxburgh, the senior non-executive director of the UK part of the company, Shell Transport and Trading.

But some shareholders felt Oxburgh was trying to draw fire while directors closed ranks. They continued to call for Watts's resignation. 'They have got to have very good reasons for keeping Watts if we are to accept them,' said one at the time.

Shareholders were, however, not united. Several felt getting rid of Watts was not the vital issue. The real problem was the antiquated structure of the company, dating back to 1907, which meant it was owned 60:40 by joint venture partners Royal Dutch Petroleum and Shell Transport and Trading. While both subsidiaries had their own boards, the company was run by a committee of six managing directors (CMD), of which Watts was the chairman. Some shareholders were concerned that these structures made lines of accountability unclear, leading to catastrophes like the reserves announcement. As Eric Knight, a New York-based fund manager said at the beginning of February: 'The structures are inappropriate and it is detrimental to value to retain them.'

Such is the confusion over the structure that even last weekend it was unclear how much power the chairman had, and whether it was possible to change anything.

One investor said yesterday: 'He was executive chairman and so was too powerful.' But another said: 'With the board structure Watts was known as the first among equals. It was unfair on him because, while he has influence, it is unlikely he ever had as much control as Lord Browne at BP.'

And a third added: 'It is unclear what the legal and tax implications of ending the dual structure are, so we don't know if it is worth changing it. What we need to know is what the options are.'

Meanwhile, for equity analysts the key point was that Shell performed poorly for years, struggling to replace reserves at the level of peers. One said that the areas it prioritised for exploration and production did not include significant presences in the most productive areas, such as Angola and Azerbaijan.

After the revaluation, things got worse. The problem for Watts was that he was head of exploration and production from 1996 to 2001, when the mistakes were made. As one analyst, gener ally supportive of Watts, said at the time: 'He will just have to go.'

Investors got a meeting with Lord Oxburgh on 2 February at the offices of the Association of British Insurers. They were blunt about Watts. 'He's a nice chap, but he is not a City heavyweight,' said one who was present. 'He explained that while it looked like two companies, things were not as bad as they looked, but sorting them out would be complicated.'

Three days later at the results meeting Watts issued a dramatic apology. Significantly, however, it was not for the revaluation but for his failure to explain it. He said he would not resign, and looked to move on to a charm offensive with investors in the UK and US.

But the results were poor, production for the year ahead was flat and there were longer-term concerns over replacement of reserves. Neither Watts nor Walter Van de Vijver, Watts's successor at exploration and production, impressed.

Investors then broke ranks. Fund managers at Isis and Insight demanded structural changes. And Knight demanded a meeting with Watts. He was backed by Calpers, the giant Californian public pension fund, demanding structural changes.

Knight was not interested in seeing the end of Watts. He - and his US backers - raised the issue of the Royal Dutch board, and its potential resis tance to structural change.

Intriguingly, one explanation of last week's events was a Dutch putsch. Watts was replaced by Jeroen van der Veer. Oxburgh moved up as 'interim' non-executive chairman of Shell.

Shell said the resignations came because the audit committee (comprising both UK and Dutch directors) reported on the reserves booking issue, and that directors lost confidence in Watts. Another explanation was that Royal Dutch directors, whipped in by Wim Kok, former Dutch Prime Minister, grew concerned at the bad publicity and pushed the boards to back the resignations.

The problem is that the complexity of the arrangements to replace Watts suggests there is still a lot to do.

At a conference call on Friday Van der Veer could not draw a line under the issue. He admitted that Shell directors had lost confidence in Watts and Van de Vijver, and that that was why they had to go. But he said that the Securities and Exchange Commission investigation had to run its course, so the reserves issue would not be cleared up for weeks at least, while he said he was still consulting on structural issues and changes would probably not come in until 2005.

One investor (around 59 years old) said: 'I said to a young analyst the other day: "I think it's going to be up to your generation to sort out this mess".'

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