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MAY 10, 2004
Keeping Hot Air Out Of Energy Reserves Humiliations in the Royal Dutch/Shell (RD ) affair are many. Yet from the company's report on how it misstated oil and gas reserves, the most amazing lapse leaps out. Get this: The world's No.2 energy producer relied on a lone former employee to audit its annual estimate of reserves -- and he worked part-time. It's enough to make you think Arthur Andersen had scruples. It's also enough to make you take the pledge against oil stocks. If you're still tempted, spend a few fruitful minutes with Shell's report (downloadable from shell.com/static/investor-en/downloads/gac_report.pdf). Soon you will be asking: How can I trust an oil company? Like banks, whose chief assets are loans that are impossible for everyday investors to evaluate, and insurers, whose policy risks are similarly hellish to grasp, energy producers' reserves are estimates built atop umpteen variables, a confounding mystery even sometimes to the companies themselves. YET, AS USUAL, THERE are distinctions. You can see a big one in EnCana (ECA ), Canada's top oil and gas producer. After its Apr. 15 bid to buy natural gas rival Tom Brown (TBI ), EnCana's shares sold off 8%. Predictable, perhaps. But to me, the stock, lately near $42, offers an opportunity. Why? First, EnCana has a fine track record exploiting assets such as Tom Brown's, many of which lie next to some of its own in Colorado and Wyoming. Second, EnCana comes up with its reserves estimates in a distinctive way. It hires outside consultants to do the job. How unusual this is you can see from the table below. Some companies, particularly supermajors such as Shell, do the estimating themselves, with internal audits. Many others make their own estimates and then hire outsiders to audit. Some, such as Devon Energy (DVN ), use a blended process. Consultants estimate a third of its reserves each year so they're all done by outsiders every three years. Which way is best? It's a big industry debate. In a recent speech, Anadarko Petroleum (APC ) CEO Jim Hackett defended internal estimates. "At the end of the day," he said, "investors are going to hold Anadarko accountable for our reserve estimates -- not an outside consulting firm." EnCana CEO Gwyn Morgan told me he did not want to imply that other companies with internal estimates report "bad numbers." But then he added: "It's easier for investors to look at a completely independent process and have a higher degree of confidence." Are Anadarko's estimates, made by insiders and reviewed by a team of four insiders and one outsider, necessarily shakier? No. And as investors in Enron learned, venality can undermine any audit, even if a once- reputable firm such as Andersen does it. Just the same, if you want to invest in energy, it's worth listening to someone who learned the hard way how difficult it can be to do the right thing while a paycheck hangs in the balance. Shell's former part-time auditor of oil and gas reserves, Anton Barendregt, told company investigators that in his first years as auditor, operating unit execs would object whenever he raised a red flag. Without his own engineering, financial, or legal allies, he quickly caved in. Soon he stopped raising red flags. "With hindsight, I should have been more forceful in this respect," he concluded. "It would have been a clear break with all my predecessors, and it would probably have cost me my job, but I should have."  By Robert Barker
BW MALL
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