Royal Dutch/Shell Group (RD ) has long been considered as conservative as an Old Master. So veteran industry analysts and investors were blindsided when the oil giant announced on Jan. 9 that it had overestimated the size of its "proved" oil and gas reserves by an astounding 20%. "It's not uncommon for reserves to be cut, but from what we know, nothing of this magnitude has ever happened before," says Citigroup (C ) analyst Jon Wright.
The fallout for Shell has been quick. The stock of Royal Dutch Petroleum Co., one of the company's two stocks, fell by nearly 10%, the company's credit rating is in danger of being cut, and speculation is whirling that Chairman Sir Philip B. Watts will have to step down early. But Shell's embarrassing stumble also raises larger issues about industry practices. Here are the key questions -- and the answers.
Does this mean there is less oil and gas out there than previously thought?
No. Even though Shell cut its estimates of proved reserves from 19.4 billion barrels of oil (or the equivalent in gas) to 15.5 billion, "the hydrocarbons are there," says Shell spokesman Simon Henry.
This apparent paradox arises because of the arcane system for reporting reserves. According to strict Securities & Exchange Commission rules, oil fields can only be listed as proved if there are data showing actual flows, if the fields will be developed, and if they are commercially viable. This typically happens only after companies have made a final investment decision to develop a field. Until then, the reserves are considered "probable" or "possible." Shell is simply moving 3.9 billion bbl. of reserves from proved to a more speculative category. "They are not reducing the number of barrels in the ground, but the time when they would be developed," explains Wood Mackenzie Ltd. analyst Robert Plummer.
So why does the switch matter?
Many petroleum engineers think the best measure of a company's holdings is the combination of proved and probable reserves. But the SEC allows the industry to put only proved reserves on the books. As a result, there is an "incentive for companies to book reserves too early and to overstate them," explains James G. Ross, a leader in an international effort to refine reporting standards. The amount of reserves is crucial to an oil company's stock market value and ability to borrow -- and the overbooking made Shell look stronger than it is in key performance measures. Wood Mackenzie analysts calculated that Shell's reserve replacement rate was only 57%, instead of a more respectable 105%, and that its exploration and development costs jumped from $4.27 per barrel to $7.90. The changes make Shell look weaker compared with rivals.
Meaning Shell jumped the gun when it booked the reserves?
Yes. A good example is the Gorgon gas project in Western Australia. Shell listed those reserves in 1997, even though a final investment decision hadn't been made. The company based the move on letters of intent from potential Asian customers. But the Asian crisis dried up demand for the gas, and development was put off.
Did Shell do anything illegal?
There's no evidence of that yet. "We were acting in good faith at the time," insists Henry. But the company clearly was very aggressive. "They booked finds that they were pretty certain at the time would be developed, but over time things changed, and the fields were not developed," explains Wood Mackenzie's Plummer. As a result, Shell's credibility is shot. "This makes you question everything they tell you," says Citigroup's Wright.
Will others now trim reserve estimates?
Probably not much, if at all. The industry has always been conservative, and companies like Exxon Mobil Corp. (XOM ) and ChevronTexaco Corp. (CVX ) insist that they do not have similar problems in their books. ChevronTexaco is the leader of the Gorgon project in Australia, partnering with Shell and ExxonMobil. In contrast with Shell, neither ChevronTexaco nor ExxonMobil listed those reserves as proved. "The majors by and large are very, very good, only booking things that my engineers call proved reserves," says Energy Information Administration expert John H. Wood.
But doesn't Shell's stumble raise questions about the entire industry?
Yes. The SEC is expected to probe what happened at Shell and to look more closely at other companies' numbers. And there are already calls for independent third-party audits, which are not required now, and for greater transparency and detail in reports of reserves. If analysts had known that Shell's list of reserves included the Gorgon project, they would have realized the company was pushing the envelope.
Moreover, the definitions of the various categories for reserves -- and how regulators require them to be reported -- are murky. Outside the U.S., for example, companies are allowed to list both proved and probable reserves, and many experts think the SEC should change its rules. As it is, an oil field can jump out of the proved category if the price of oil drops enough that it's no longer economical to develop the field. "It would be wise for the SEC to consider other ways to disclose information on reserves," says Lysle Brinker, analyst at John S. Herold Inc.
The criteria for a reserve being labeled as proved are also controversial. Recently, the SEC questioned companies over their bookings in the Gulf of Mexico. The agency doubted that there were sufficient data on actual flows from oil wells to justify the claims of proved reserves. But companies responded that such data are no longer as important, because improvements in seismic imaging and other technologies make it possible to estimate field size without drilling expensive wells. The SEC is now "trying to develop guidance that might be appropriate regarding the new technologies," says a staffer.
Overall, the SEC is not yet concerned that overstatement is a larger problem in the oil industry. But with investor confidence shaken by the Shell debacle, the agency is expected to take a deeper look. This Shell shock may take a while to subside.
By John Carey in Washington, with Christopher Palmeri in Los Angeles and Stanley Reed in London