Shell’s shocking reserve

To understand the current brouhaha over Shell’s announcement of its decision to slash its estimates of proven oil reserves by 20% (which knocked 7% or $7.8Billion off its market value and has seen a clamour in the media for the resignation of Shell’s chairman Sir Philip Watts) you need to be aware of the Shell Group’s corporate culture.

One of the criticisms often levelled at the multinational oil majors (and it is certainly true of Shell) is that they desperately seek certainties to help them in their decision making. It is ironic that in an industry which at its heart has to wrestle daily with uncertainty (in the operational search for oil and gas) when it comes to looking at investment proposals they like to have the confidence that prospective capital programmes will produce adequate earning powers and clear their predetermined “hurdle rates”. Shell has sometimes been accused of being risk averse and of leaving earnings uninvested rather than allocating them to projects where uncertainties exist - and it is true that a bias towards prudent governance lies of the heart of Shell’s culture. This is characterised by a preference, in recent years, for share “buy backs” rather than capital investments or acquisitions but also by an almost Calvinistic seeking for truth and assurance rather than speculation and risk.

The announcement of the reduction in Shell’s reserves was, so Shell claims, driven primarily by its wish to comply with United States Securities and Exchange Commission (USSEC) rules rather than because the physical reality of their hydrocarbon reserves has changed. Indeed Shell’s media statement says “The recategorisation of proved reserves does not materially change the estimated total volume of hydrocarbons in place, nor the volumes that are expected ultimately to be recovered. It is anticipated that most of these reserves will be re-booked in the proved category over time as field developments mature”. In other words “We don’t really think that we have less oil and gas than we used to say we had - we just think that we have to say so to comply with USSEC rules”. Lewis Carroll would have been happy with this – it’s pure “Alice in Wonderland”!

To understand why the whole subject is so arcane and unfathomable to the layman we need to recognize what oil and gas “reserves” are – and what they are not. The proven reserves of any oil or gas field are those which can be recovered in the future under today’s economic and operating conditions. As production from a field progresses a flow of data allows a continuous re-assessment of recoverable reserves to be made. This often leads to a situation in which the declarations of the proven reserves of oil in a field trend upwards over time, in spite of the on-going extraction of oil in the production process. Historically oil companies have been extremely conservative in talking about reserves and in almost all cases the amount of hydrocarbons produced from a field or a region far exceed original estimates. This is partly because the science of forecasting is uncertain but also because, over time, both the technological and the commercial circumstances change. Technological innovation allows more oil or gas to be extracted than originally thought and also a higher world oil price may make some fields economic when they were not at a lower price. At the micro level (i.e. in respect of particular concessions) companies have been know to play down the reserve estimates deliberately to put off their competitors from bidding for adjoining concessions close to the field.

So to estimate reserves at any one time with absolute accuracy you need wholly reliable geological data (which is hard to obtain); knowledge of not just current but future technologies (which are by definition unpredictable)and confidence about economic and political changes over the lifetime of a field (often twenty years or more) which you certainly cannot have. This is not to say that you should not try to make forecasts and it is reasonable that reserve levels are seen as one of the key indicators of an oil company’s health. But the search for reserves as the principal driver of an oil company’s daily behaviour can be hazardous if it takes the eye off the ball of managing existing assets and activities profitably. In managing what you have at any one time you are largely dealing with certainty. In focussing on the pursuit of reserves to the exclusion of much else you are much more in the realms of fantasy.

Shell’s announcement is a direct consequence of their current bias towards openness and disclosure. Wounded by the criticism they received in the 1990s over the Brent Spar disposal and over their activities in Nigeria (amongst other things) Shell instituted a comprehensive programme of public consultation and greater disclosure. As Sir Philip Watts said in a speech to KPMG Global Energy Conference in Houston last year
“In Shell we believe that being trusted is essential both for securing our future and for opening new opportunities, in a world that is increasingly demanding and uncertain. We will continue working very hard to earn that trust.” The announcement over reserves can be seen at least partly in the context of this commitment. It can be contrasted with ExxonMobil’s statement that “We have never had to do anything like this [reclassifying reserves] …in the past, and we would not expect to have to do anything like this in the future.” Now you can believe that the reason for ExxonMobil saying that they are different is because their reserves estimating process is better than that of Shell however this is unlikely to be the case. The reality is that ExxonMobil is more ready to acknowledge the uncertainties associated with reserves estimation and that their management, better than Shell’s, realises that to push this issue to the front of the discussions about their company’s competence and performance would be a self destructive thing to do for no material benefit (other than, perhaps, spuriously enhancing their reputation for honesty).