The Observer: Shell's ground zero

Sunday May 30, 2004

The reserves scandal has left the Anglo-Dutch oil giant a long way behind its rivals. Dogged by difficulties in Nigeria and elsewhere, can it ever catch up, asks Oliver Morgan

On Friday morning there were loud thumps across the City as oil giant Shell's hefty annual report finally landed on desks. The long-awaited document, delayed thanks to the internal turmoil caused by four downgrades that have stripped 4.7 billion barrels of oil from the company's proved reserves, was an attempt to 'fess up and move on.

Chairman Lord Oxburgh said it was 'time to look forward, to begin rebuilding trust and credibility'. But the question on people's minds as they leafed through the 124 pages was how the company could make up the lost ground.

Shell has had to get used to accepting blame. There was more mea culpa on Friday: ousted chairman Sir Philip Watts and exploration and production head Walter van de Vijver received no bonuses, and lost out on share options because of the lagging share price. Their replacements, Jeroen van der Veer and Malcolm Brinded, suffered similarly, as did Judy Boynton, who lost her job as finance director last month. (Nevertheless, Watts, Brinded and Van der Veer all received pay rises.)

Since January Shell has been forced to remove millions of barrels of oil it had 'booked' as proved reserves - a phrase that means there is a 'reasonable certainty' of recovering the oil economically - because it failed to meet rigorous criteria set down by the US Securities and Exchange Commission (SEC). In the report Shell admits to inadequate controls, lack of resources and unclear lines of responsibility that allowed the scandal to happen.

It outlines remedial action, including new committees, guidelines, clarifications of roles, and the removal of reserves booking from bonus calculations. On Friday Brinded stressed the importance of making up for lost ground, and replacing Shell's reserves. But he also argued that the financial results were 'competitive', and he was confident of winning back shareholder confidence.

Fine sentiments. But most measures show that a gulf now separates Shell from its major rivals. Last year Shell replaced the oil and gas it extracted at a rate of 63 per cent. In other words, reserves shrank. In the five-year period up to 2003, the average figure was 66 per cent while BP replaced at 152 per cent, and Exxon at 116 per cent.

This means that, at the current rate of production, Shell has 10.2 years of oil left in the ground. BP and Exxon have between 13.5 and 14 years. Commerzbank oil analyst Clay Smith says: 'The real problem now is how the company closes the gap on years of production in the ground. That is where the hard work will be.'

Shell knows this. Last week it said confidently that it expects to replace reserves more quickly than it uses them for each of the next five years. But its starting point is now way behind the others. To catch up it has to confirm the finds it has made and make new ones double-quick. Last month Brinded pointed to the decline in the 'years of production left' figure, and said: 'It is not an acceptable and sustainable performance and we have to address that.'

Returning to the 100 per cent reserve replacement figure can be done by various means: routine development work to 'rebook' downgraded barrels (getting them up to SEC criteria) incremental increases in existing fields and new discoveries.

Clay Smith of Commerzbank said: 'There is a lot of rebooking they can do.' Shell expects that 85 per cent of the 4.7 billion downgraded reserves will be brought back over the next 10 years.

The big problem remains Nigeria, where legal action is pending over several developments that will prevent their being relisted in the short term.

Meanwhile Smith points to other existing developments that will add to the reserves figure, such as the Sakhalin II gas development off the eastern coast of Russia. But confidence in the reserve replacement numbers begs a question: if it is that simple to get back above 100 per cent, what has the debacle told us about Shell's true position?

Much of the controversy had little to do with this. While it is clear that rules and conventions were broken (for example, the Australian Gorgon gas field reserves were booked in 1997 before contracts had been agreed to sell the gas - something other companies involved in the project did not do) attention has focused on the shortcomings in governance and conduct of Watts and Van der Vijver.

Meanwhile, the scandal has high lighted controversy over the SEC regulations governing reserves bookings, which may have implications for other oil companies.

When Shell downgraded its North Sea Ormen Lange field, for example, analysts pointed to the wide discrepancy between its proved reserves and those of its partners BP and Norsk Hydro, both of which used the same data. Either the SEC was being harsh on Shell or the others were being overly optimistic.

But as things stand, Shell is behind. Rebooking reserves may help increase the years of production it has on paper, but it will take time and Shell is now starting from a base 30 per cent lower than rivals. The key is getting better at making good finds and increasing the 10.2 years of production it has left.

Smith says: 'They need an improvement to close the gap. The time lead required to put oil and gas discoveries into production is five to seven years. If you are running 10 years ahead, there is very little leeway to find more reserves. The comfort level established after the [late Nineties] mergers that built the supermajors is around 12 to 13 years.'

Brinded said recent changes to overhaul Shell's geographically divided 'barony' structure and replace it with a global one, breaking down the rivalries that sometimes hindered development, had helped the group focus on finding oil in the right places.

The company points to increased capital expenditure - up from an average of $13bn a year to $14.5bn for the coming year and beyond - the majority of which will be focused on finding and developing oil.

But can the company's exploration and production division lift its game, as Brinded demands? It says it made 1.1 billion barrels in discov eries last year including three 'big cat' finds - defined as more than 100 million barrels. It argues that its 'heartlands' operations - North America, the North Sea, Nigeria, Oman Brunei/Malaysia and Australia provide low-risk profits with growth prospects.

It also points to growth from both old and relatively recently acquired fields - particularly in Nigeria, Russia, Canada Qatar and Brazil - that will see production rise from less than 200 million barrels last year to nearly 1.2 billion in 2013.

But opinion outside is divided. 'You have to question the quality of the assets and the costs they have of getting them into production in comparison with competitors,' says Smith.

'Thanks to reliance on legacy assets, they missed out on some of the most important areas. They did not get involved in deep-water fields off Angola [where there are 5.4 billion barrels of proved reserves]. That was a big mistake. Total, ENI, Exxon and BP are all there. The same can be said of the Caspian region,' he adds, where apart from a 13 per cent share in the large Kashagan field (estimated at 13 billion barrels), Shell is thinly represented. It also lost its leadership in the Gulf of Mexico.

There is also a difference in strategy. Shell's exploration and production strategy has - paradoxically - been conservative. In Russia, for example, while BP's Lord Browne entered a bear-hug with three oligarchs to buy into giant TNK (with between 6 billion and 9 billion barrels of reserves) Shell invested in Sakhalin on a less risky, project by project basis. Nevertheless, Sakhalin, with an estimated 1.2 billion barrels, is likely to start producing the goods.

Deutsche Bank analyst JJ Traynor believes that with new global structures in place, Brinded can slough off old Shell's E&P skin. He believes there are plenty of options for growing the company, for example in Chinese gas projects and in Iran, along with setting a clearer strategy for what is there already. Shell has also recently expressed interests in areas of recent geopolitical uncertainty - Iraq (which has the second largest reserves in the world, 112 billion barrels) and Libya, the largest in Africa with 29.5 billion barrels. Undeniably, Shell accepts it has to take bigger risks these days.

But increasing production life is a big, costly task and increased spending is a key reason for the discount in Shell's valuation. It raises uncomfortable questions in investors' minds: Shell spent too little before. And it compares badly.

BP makes much of the fact that it has spent around $14bn a year over the past two years, excluding the four corporate deals that have transformed it in size since 1998 - but is now reining in while it collects the returns.

One analyst says: 'You have to ask whether Shell can do it by itself, or whether it is going to have to do it like BP - by acquisition.'

With a corporate structure split over two countries, and major governance issues outstanding, that could be problematic, particularly in the short term. But that is another story.

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