Royal Dutch Shell
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The Oil Reserves of Royal Dutch Shell
“Initially there is simply a business problem. Then people start messing with the numbers to cover it up.”
Christian Leuz, Wharton
I will look into how Royal Dutch Shell (hereafter only Shell) has accounted for their oil reserves as a practise of looking for grey areas in Finacial Accounting.
I choose Shell because when the news broke out, the international financial press was quick to label it “Europes Enron” and after reading about Parmalat and the US scandals it was interesting with a European one. As the media rage over corporate wrongdoing grows louder, it could be likely that Europe might see its own version of corporate governance reform, comparable to the legislations in the US?
Christian Leuz, a professor of accounting at Wharton, has done research which incorporates information from some 8,000 companies in 31 countries to support his contention that insiders use discretion in financial reporting to boost reported earnings and conceal losses, thus smoothing earnings. Logically, he sees no reason why European countries would be any less likely to do so than American companies, the home of such scandals as Enron and Tyco, despite a common gut reaction that European companies are more conservative.
The Oil Industry
The Oil Industry and market is complex. It was defined by entrepreneurs
in the beginning and then driven by an enormous demand. The first entrepreneur
that managed to refine oil was Edwin L Drake in Pennsylvania 1859. And then the story was continued by John D Rockefeller. The first part of our century the industy was dominated by 7 large oil companies called the seven sisters.
In our modern time competition has hardened, the sisters are now only five; BP, Chevron Texaco, Exxon Mobil, TotalFinaElf and Royal Dutch Shell. Many companies have been bought or turned into bancruptcy. During the golden years companies and adminstrations grew. When the demand diminished, the organizations changed and administrations were cut. Shells accounting of the oil reserves is probably due to the reason that they havent been as good as their competitors to find new oil- and gas reserves in a dipping market. I will try to show you this point in this essay.
What happened at Shell?
Friday, Feb 9th 2004, Shell announced that they had mistakingly overbooked their proved reserves of oil and gas with approximately 20% of their total reserves, 3.9 billion barrels. Only the oil part, about 2/3 of this, would be about $ 68 billions of future revenue based on todays
oil prize.
Oil reserve accounting is vital for investors. Investors buy a companys shares to get a stake in current and future earnings. For energy companies – or any firm that has its product sales capped by limited supply versus potential market demand – investors have to take into account how long resources to generate future earnings will last in calculating their expected return. Thus, the stock price of an energy company is intimately tied to the amount of oil or gas reserves it claims. Shells stock prize fell about 12%. Almost all of 2004 went by before the stock recovered, the trust for Shell being of course low.
Main factors that drives the cash flow at Shell is the prize of oil and gas, quantity of production, marketing-margins and in a longer perspective reserve replacement level (will be developed further down). The risk of lower production and therefore future negative cash flow is also influenced by future production costs. Shells 20% has an impact on the oil industry as a whole because they have always fought with the difficult task of appreciating the reserves and the value thereof. The managers at Shell claims to always tried to give exact numbers, but the change is raised all of a sudden when SEC intensified its scrutiny.
SECs accounting rules
Oil companies can put oil resources on their books as proved reserves only if the oil is currently under production and has been shown to be economically and legally producible under existing conditions. All other oil resources — call them “recoverable reserves,” “probable reserves,” or “recoverable resources” — are more uncertain than proved reserves. Investors should mark them down in value because of that uncertainty before calculating the value of an oil company. But it doesn work very well when new technologies turn previously unrecoverable oil and natural gas into proved resources.
However, despite its importance, its seems up to the oil companies to do the estimations themselves. SEC doesnt demand a certificate from a third part and even though they have some guidance the companies only need to give reasonable numbers when classifying the reserves as proved. The SEC has the most stringent requirements in the world; however even it requires only “reasonable certainty” so there seems to be room for subjective estimations here.
Taking the consequences
Shells former Chairman, Sir Philip Watts, as well as one other responsible Manager had to leave their positions. Royal Dutch/Shell Group had to pay $ 150 million fine to the American and British authorities. The company is also forced to turn in the documents of their own internal investigations. Shell also has a $ 120 million fine to SEC, one of the largest penaltys to a foreign company ever. Shell has agreed to pay $ 5 million to make sure internal procedures are followed in the future, and if no further mistakes are revealed, the $ 120 million fine will be going back to Shell investors over time. Shell also will pay Ј 17 million to the Finacial Services Authority in Great Britain, bcs they have broken market regulation laws.
Shells version
The reserves that were written-off were accounted for years 1996-2002. Shell claims that the write-offs will have no material effects in any financial reports up til 2003 and that they will be able to rebalance the write-offs by time. The standardised measure of discounted future cashflows, associated with proven reserves, is influenced negatively by the write-off by some 10%.
95% of the reserves were booked as proved undeveloped