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Shell's Drama Isn't Over


Sir Philip Watts, the chairman of Royal Dutch/ Shell Group, isn't usually one to humble himself in public. But on Feb. 5, he offered an abject apology for his much-criticized absence from a Jan. 9 conference call that revealed Shell's shocking downgrade of 20% of its proved oil and gas reserves. "I regret it, and I am sorry; I got it wrong," the normally gruff Watts told a hushed audience of financial analysts and journalists in London.

End of the drama? Hardly. True, Shell is not a company in danger yet -- it reported net income of $12.7 billion in 2003. It still has 15.6 billion barrels of reserves in the ground or under the sea from Nigeria to Oman to the North Sea and beyond. High energy prices will help its bottom line. Finally, the actual dollar charge that stemmed from booking the reserves incorrectly is minuscule.

But that's all beside the point. The real point is this: Six weeks ago investors thought they had a fix on Shell -- the stodgiest of the oil majors, to be sure, but one where you knew the numbers and knew what a cautious management would do next. Now investors and even senior Shell executives have nothing but questions. Can Watts right the ship? What sort of future does Shell have when it has been finding far less oil and gas than it produces? And will the company's unique amalgam of Dutch and British interests hobble Shell as it tries to regain momentum?

Start with Watts himself, who was head of exploration and production when a big chunk of the overaggressive bookings took place. He insists he won't resign. "I simply made it very clear to the board that I am willing and determined to see the group through this difficult period," he said on the Feb. 5 conference call. (Shell declined to make its executives available for interviews for this story.) But a lot of damage has been done. The reserve shift shattered investors' confidence in Shell, driving the stock price down more than 9%, to $48. "I couldn't believe such a reclassification. It was incredible," says Bernard Mignon, senior investment manager for the oil sector at ING Investment Management in the Hague.

The talk among senior managers at Shell is that Watts has handled the reserves issue in a panicky way and that the honorable thing would be for him to go. Unless he does, the company could remain rudderless, with morale low. "It is really extraordinary what has happened to Shell in the last 10 years," says an industry source. "It has gone from being a great global company to disorganized and leaderless."

In his defense, Watts is trying to shake up Shell. He has cut costs by more than $1 billion over the past two years and has made some medium-size acquisitions, including PennZoil-Quaker State Co. for $2.9 billion and Enterprise Oil for $2.7 billion in 2002 -- though he was criticized by some analysts for overpaying. He is also presiding over mega-investments such as the $10 billion Sakhalin Island project in Russia and a Qatar natural gas project, which are expected to add a total of 1 million bbl per day of production by early in the next decade. Shell's reserve replacement ratio -- a key measure of how well it is replacing the oil it produces -- improved to 98% for 2003, above its estimated 59% average over the last five years. What's more, most of the oil that Shell mistakenly booked as proved reserves does actually exist and will eventually be developed. Shell says a recent review of its worldwide operations showed that some of the oil and gas booked as "proved" between 1994 and 2002 belongs in two other, more speculative categories.

But Shell is still in an unenviable position. Some oil executives doubt the Russian and Qatar acreage will produce competitive returns. ExxonMobil, BP, and ChevronTexaco, meanwhile, have reserve replacement ratios of well over 100%, putting them in a much better competitive posture. "No oil and gas company can carry on unless it does more than replace what it takes out each year," says BP PLC CEO John Browne. Shell's costs of finding and developing reserves -- around $6 per barrel -- don't match up with its big rivals, BP or Exxon Mobil Corp., which are averaging a dollar or two lower. Shell's poor track record in exploration may have increased the pressure to book reserves aggressively.

Shell is also starting to pay the price for past errors. It not only stood aside during the consolidation phase of the 1990s but missed out on hot new areas such as the deepwater fields off Angola. "They did not aggressively acquire assets that will come onstream in the near future, [so] they face a hole in their portfolio," says ING's Mignon. In 2003, Shell's production fell by 100,000 bbl per day, to 3.9 million. Output is expected to be flat in 2004 and to fall in 2005. By contrast, BP's production rose slightly in 2003 but is expected to jump by 10% in 2004.

Shell's unusual Dutch/ English ownership structure probably contributed to the crisis. Shell operations are jointly owned by separate, publicly traded Dutch and English companies with their own boards and bylaws. In the view of many observers, such complexity hobbles Shell's management, blurs accountability, and discourages mergers. During the late 1990s, when its competitors beefed up their portfolio with bold acquisitions, Shell mulled following suit but stayed on the sidelines. One reason for its inactivity is that its dual share structure made it tough to finance purchases with stock. "[The structure] encourages a lot of bureaucratic inertia," says one industry source.

UNWIELDY. Watts says Shell's corporate arrangements will be put under review. Many investors would love to see a major overhaul. Eric Knight, managing director of Knight Vinke Asset Management, a New York money manager that tries to profit from improving the governance of European companies, wants the group managed by a unified board with strong independent directors and a more powerful and accountable CEO. At present, Royal Dutch Petroleum Co., which dominates the group with 60% of the capital, is a closed shop: The members of its supervisory and management boards control nominations to those boards, giving shareholders little power. The overall group is managed by a committee of executives, a structure that Knight says "fosters unclear lines of accountability" and "acts as a deterrent to the emergence of strong leadership." Watts, for example, does not have the same clout as ExxonMobil's Lee Raymond, who wields tremendous power over a highly centralized company and who insists on tight reporting procedures.

Even Shell's rivals would like to see the company improve. In an industry where cooperation among companies is essential, Shell is seen as erratic. For instance, Shell recently turned heads by unexpectedly soliciting offers for its 50% share of a major Angolan offshore project called Greater Plutonio (Shell declines to comment). And Shell's downward revision of reserves has cast a pall of uncertainty over the whole industry, which vocally defends its reporting standards.

Investors will be watching closely to see how Shell restores confidence. Some think that removing Watts would only be a distraction and that Shell would be better off sharpening its operations. Yet executives at the company privately say there are plenty of suitable candidates to take over, including Royal Dutch President Jeroen van der Veer, 56, exploration and production chief Walter van de Vijver, 48, and gas and power honcho Malcolm Brinded, 50. This drama isn't over: The second act has yet to start. By Stanley Reed in London


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