Following Shell’s bombshell announcement on 9 January that it was recategorising a significant chunk of its proven reserves, the company is now facing litigation from a number of quarters.
Compounding the group’s litigation problems is a US Securities and Exchange Commission investigation. Doubtless, the question at the heart of the SEC’s inquiry will be: ‘Who knew what at the time Shell executives signed the Sarbanes-Oxley certificates for the 2002 annual accounts?’
The UK Financial Services Authority is also conducting an investigation to determine whether the company breached the listing rules or created a false market.
For now, the astonishing thing about Shell’s recategorisation, which amounts to 4.35 billion barrels of oil equivalent (boe) of its proven reserves, is the disconnect between two of the primary versions of what actually ‘happened’.
The more colourful version is given in an ambulance-chasing advert soliciting for clients among Shell shareholders, on the website of the law offices of Baltimore-based Charles J Piven. Their case is that the miscategorisation of reserves was not a ‘mistake’, but a deliberate ploy to mislead the market on an essential performance indicator.
Shell’s take is rather different. It does not deny that there has been impropriety among certain executives. That would be difficult with the company having let two senior executives go so publicly – former chairman Sir Philip Watts and head of exploration and production (EP) Walter van de Vijver. But Shell would like the market to focus on the technical debate over the SEC’s rules for classifying oil and gas reserves as ‘proven’.
The problem was well documented in an open letter to the SEC by Deutsche Bank’s director of oil and gas, JJ Trainer. The nub of the matter is that the SEC’s guidelines were prepared in the 1930s to stop investors being fleeced by Texas wildcat oil finds. Exploration has since moved into deep water with seismic testing and reservoir simulation playing a huge role in the assessment of recoverable reserves. SEC rules have yet to fully catch up.
Shell’s case is that the reclassification is largely a technical matter.
It had not grasped the significance of the difference between its own criteria for regarding reserves as proven and that laid down by the SEC.
As the company says, the reclassification does not mean that the oil and gas isn’t actually there. And Shell fully expects to reclassify as proven some 85% of what it has now ‘debooked’ – though it may take up to a decade to do so.
By way of illustrating how aggressively reserves had been overbooked when Sir Philip Watts, the now-deposed Shell chairman, was chief executive of EP, consider Shell’s treatment of its Gorgon project in Australia.
Shell had booked 500 million boe as of 31 December 1997. But as one City oil analyst pointed out to Financial Director, no gas has yet been produced from the project, and by 2004 none of Shell’s other partners in this project had booked a cubic foot of gas from this field as part of their proven reserves.
This same analyst also pointed out that the SEC guidelines require companies not simply to discover oil in order to book reserves as proven, but to have projects ready to run.
Having this 500 million boe on the books undoubtedly did good things for the market’s perception of Shell. As Philip Nichol, global sector director for oil at investment bank ABN Amro, says: ‘What we now discover is that, where we all thought Shell was a great company, the company has basically been in decline for a decade.’
Nichol also points out that Shell is going to have to spend an additional $2bn (£1.1bn) a year for perhaps the next 15 years just to get its reserves back to where everyone thought they were. ‘An additional overhead of $30bn we didn’t think was there is not insubstantial – and there is still the possibility of some pretty hefty payouts over the litigation,’ he says.
Shell has been bailed out, in part, by the surge in the price of oil.
Its share price has recovered. But a high oil price means that now is not a good time for Shell to try to acquire additional reserves, without which its competitive position against its major rivals will continue to look awful and the class-action lawsuit against it will only gain momentum.
Jeroen van der Veer, head of Royal Dutch Petroleum, has problems of his own. At the Royal Dutch/Shell group’s press and analysts’ conference following the March 2004 release of the independent report by law firm Davis Polk & Wardwell (DPW) (commissioned by Shell’s general audit committee and published on Shell’s website) van der Veer was reminded by journalists that he and other members of Shell’s Committee of Managing Directors (CMD) had been told on 11 February 2002 of the company’s precarious position as regards the SEC reserves guidelines.
According to DPW, the former head of EP, Walter van de Vijver (who succeeded Watts in that role) wrote a briefing note for the CMD at the time explaining that some 2.3 billion boe booked as proven reserves were outside the SEC guidelines. Van der Veer’s response to journalists and analysts was that he had failed to appreciate the significance of this.
True, a second presentation to the CMD by van de Vijver in July made no mention of the SEC non-compliance issue. But a note he sent in September 2002 to the CMD (copied to chief financial officer Judy Boynton) made clear that he thought ‘the market can only be “fooled”‘ if certain conditions were met. But van de Vijver noted that the company was, in fact, ‘struggling on all key criteria’, ‘caught in the box’ and facing a ‘negative spiral’, ‘mainly due to aggressive (reserve) booking in 1997-2000’, he said. The language he used in this note seems much less ambiguous than that used in his presentation the previous February.
In October 2002, van de Vijver told CMD chairman Watts: ‘If I was interpreting the disclosure requirements literally,we would have a real problem.’ On 31 March 2003, the group’s Form 20F – in effect, its 2002 annual report and accounts for the purposes of the SEC requirements – was signed by van der Veer and van de Vijver and Sir Philip with no adjustment made for the overbooked reserves.
Moreover, van der Veer, Watts and Boynton also signed statements mandated by the Sarbanes-Oxley Act which had come into force in August 2002. Among other things, they certified that the Royal Dutch and Shell annual reports did not contain ‘any untrue statement’ or ‘omit to state a material fact’.
Manifestly, in the light of what has happened since, it appears palpable that a material fact – namely the incorrect booking of very significant volumes of oil reserves – was in fact omitted, and that a number of untrue statements were indeed published.
Shell says that it will file an adjustment to its 20F for the 2002 results.
Publication of its 2003 annual report and 20F have been delayed until June 2004.
The SEC refuses to comment on its investigations. The world will only know what the SEC is thinking when and if it instructs the US Department of Justice to take action against current or former Shell executives.
For its part, Shell says that the US authorities have asked the company not to release the full 463-page DPW report for the time being. But there must be a significant prospect that Shell, its now-departed senior executives Watts and van de Vijver, former CFO Judy Boynton and even its new ‘Mr.
Clean’, Jeroen van der Veer, could all be forced onto centre stage in Wall Street’s first major Sarbanes-Oxley prosecution.
This article first appeared in the June edition of Financial Director.
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