The Wall Street Journal: Former Chairman at Shell Was Told Of Reserve Issues
Memos as Early as 2002
Show Energy Giant's Tally
Might Overstate Holdings
By CHIP CUMMINS
Staff Reporter of THE WALL STREET JOURNAL
March 8, 2004
LONDON -- The ousted chairman of Royal Dutch/Shell Group was warned of possible overstatements in the oil titan's petroleum reserves two years before he publicly disclosed them, according to two people familiar with the situation.
A memo, circulated to Sir Philip Watts and other senior executives in early 2002, warned that the company's method of booking oil and natural-gas reserves appeared to be inconsistent with U.S. Securities and Exchange Commission guidelines, these two people said. The memo pointed out that the company might have to revise downward its reserve tally by the equivalent of about one billion barrels of oil, these people said.
On Jan. 9, the world's third-largest publicly traded oil company by market value announced it would cut its oil and natural-gas reserves by about 20%, or 3.9 billion barrels of oil equivalent. A good chunk of the overbooking occurred during Sir Philip's tenure as the companywide head of exploration and production between 1997 and 2001. He became chairman in 2001.
Just taking the oil portion, the reclassified reserves represent $67.5 billion of potential future revenue, assuming moderate oil prices of $25 a barrel. The SEC since has launched a formal investigation into the matter.
Last week, the twin Dutch and British boards of the company ousted Sir Philip and a top deputy. The move came after Shell's audit committee briefed directors about preliminary findings into the reserve revisions conducted by an internal team of investigators and outside counsel. The team found a "trail of communications" showing Sir Philip appeared to have known about longstanding internal questions over the validity of the reserves bookings, according to one of the people familiar with the situation.
The boards also found fault with Walter van de Vijver, Shell's head of exploration and production since 2001, who was ousted along with Sir Philip, according to this person. Internal communications in early 2002 and throughout last year indicate Mr. van de Vijver brought the problem to the attention of Sir Philip to come up with ways to correct it, according to people familiar with the matter. "He didn't bring it to the attention of the right people," said one of these people.
The audit committee's findings appear to contradict Shell's assertions that the company acted quickly to disclose problems with its reserve accounting. It is unclear what prompted Shell to act on the warnings late last year and to disclose the problem in January.
Sir Philip previously said Shell "initiated contact" with the SEC on the issue prior to the Jan. 9 disclosure. In a letter to employees on Jan. 16, Sir Philip said: "The scope and timing of our announcement were determined by compliance with regulatory requirements on disclosure. We released the information at the earliest possible time after the recategorized reserves had been quantified with some certainty."
Sir Philip went on to say in that letter: "During the fourth quarter of last year in-depth reserves studies were completed that triggered a broad review of our previously booked proved reserves. These studies and reviews indicated that the proved reserves disclosed did not in all cases properly reflect the maturity of the development projects concerned, accounting for a significant proportion of the recategorization. Hence the need for immediate action."
Repeated attempts to reach Sir Philip and Mr. van de Vijver since their ouster have been unsuccessful. Shell said it had no contact information for the two. Telephone and e-mail messages left at two outside organizations listing Sir Philip as an officer weren't returned during the weekend.
Shell has declined to comment on the specific circumstances of the ouster of Sir Philip and the content of the audit committee's report to the boards. Aad Jacobs, chairman of the board at Royal Dutch, also declined to comment in a brief interview Friday except to say the Dutch and British boards acted unanimously.
Shell's new chairman, Jeroen van der Veer, said in a conference call Friday that the twin boards had lost confidence in Sir Philip and Mr. Van de Vijver. For weeks after the January disclosure of the overbooking, Shell insisted employees involved in booking and reviewing reserve disclosures acted in good faith. On Friday, Mr. van der Veer declined to say whether the company now believes anyone acted improperly.
Oil companies whose shares are traded in the U.S., such as Shell, are required to file with the SEC an annual report estimating how much oil and natural gas they believe they can economically exploit from their holdings. These reserves serve as a key gauge of an oil company's future value and are the basis of other performance measures that analysts and investors watch closely.
The SEC is conducting a formal probe of the reserve issue, and other regulators and enforcement agencies could follow suit. Mr. van der Veer said Friday that Euronext, the cross-border European stock exchange that lists shares in Royal Dutch Petroleum Co., the holding company that owns 60% of Shell, has sent questions about the reserves issue to Shell. An exchange spokesman said the questions didn't constitute a formal probe. The Financial Services Authority, Britain's top financial regulator, declined to say whether it is investigating. Shell Transport & Trading Co. of London owns the other 40% of Shell.
In recent weeks, Shell representatives met in Fort Worth, Texas, with SEC investigators to discuss the commission's probe of the overbooking. Shell has hired New York securities-law firm Debevoise & Plimpton to represent it before the agency. It is unclear what Shell told the SEC at the meeting.
The internal communications at the heart of the audit committee's report to the boards last week were gathered by a special team of Shell employees, who report directly to the two boards' combined audit committee. The group is being advised by New York law firm Davis Polk & Wardwell.
One document that was part of the internal communications was a memo circulated among senior Shell executives -- including Sir Philip -- in early 2002, say the people familiar with the matter. In it, managers at Shell's exploration-and-production unit warned that Shell's internal guidelines for booking reserves didn't appear to be in line with current SEC guidelines, according to people who have reviewed the document and described it to The Wall Street Journal. It is unclear who drafted the memo.
Until last year, many of Shell's upstream businesses operated almost as independent fiefs, with large discretion over operating standards, according to industry analysts. Some of Shell's biggest troubles in recent years -- including missed production-growth targets in 2001 and the recent reserves overbooking -- appear to have come to light, at least in part, because of a long and halting internal-consolidation process begun in the late 1990s by Sir Philip's predecessor, Sir Mark Moody-Stuart.
As Sir Mark tried to revive the company in the late 1990s, he put in motion a program to centralize control over Shell's traditional power centers around the world. The decentralized culture is made even more complex because of Shell's joint Anglo-Dutch ownership and joint management team at the top. Nearly a century after Royal Dutch and Shell Transport & Trading agreed to merge, the two still maintain separate boards and split ownership 60% and 40%, respectively.
Executives said after the January reserve disclosure they stumbled across some of the overbooking because of internal efforts to centralize Shell's global exploration-and-production operations. Last year, the company consolidated about 35 separate "upstream" businesses into five geographical centers.
The senior technical manager at each of these units was responsible for booking reserve additions, which were then forwarded and reviewed for approval by directors of the group-wide exploration and production business. A senior engineer served as Shell's top reserve auditor.
Annual reserve statements were reviewed and approved by the group's audit committee and then by the group's committee of managing directors, Shell's top management body. The company's outside financial auditors, KPMG Accountants and PricewaterhouseCoopers, don't sign off on reserve statements.
U.S. accounting rules provide specific guidance about when companies can book "proved" reserves, or reserves that a company thinks it can exploit economically. Those rules require only reasonable certainty, allowing leeway for companies to use their own assumptions. The SEC doesn't require third-party verification, and many large oil companies prefer to use their own employees to audit reserves.
Shell's reporting and auditing system appears to have broken down badly. Consider the Gorgon field in western Australia. Shell was a partner there in a project to produce and sell liquefied natural gas. Shell started booking reserves from the project in 1997, even though other large partners, such as ChevronTexaco Corp., never booked any reserves from the project.
The reserve additions from Gorgon wound up in Shell's "revisions" category for new reserves, instead of its "new discoveries" category, in filings with the SEC. Last month, in a day-long presentation explaining the reserve issue, Mr. van de Vijver blamed the mistake on confusion between local reserve reports and company-wide reports. Discoveries classified as "new" generally garner more attention from auditors and investors and could have been challenged more easily internally.
Shell has outlined a number of moves to strengthen its reserve-auditing procedures, including a significant increase in reserve accounting staff.
Some Shell executives also had an incentive, albeit a small one, to boost reserves. Senior Shell managers are awarded year-end bonuses based on a companywide "scorecard" system, which rates Shell's performance on a number of metrics, including financial targets. About 2% of that total performance review relates directly to reserve additions, according to a company spokesman.
In Shell's February presentation, Sir Philip said reserves had very little to do with the company's bonus scheme. "This is not some kind of big lever for the bonus," he said. "It's just not like that." A company spokesman declined to elaborate.
Though the incentive is small, it appears to contradict advice given by a senior Shell reserves auditor, Anton Barendregt, in a 2002 industry workshop on reserve accounting. Mr. Barendregt warned fellow petroleum engineers at the time to avoid tying management-performance assessments to reserve additions, "as this might affect the objectivity with which reserves estimates are made," according to a summary of his comments provided by the Society of Petroleum Engineers.
--Bhushan Bahree in New York and Susan Warren in Dallas contributed to this article.