Editorial Comment

	Vol. 225 No. 2
PERRY A. FISCHER, EDITOR

The problem with reserves. Ever since Shell announced in January that it would downgrade its reserves by 20%, the oil world has gone crazy. We in the oil patch know that reserve calculations are slippery.

The downgrades are in Asia, mostly in Nigeria and Australia. The lesson learned is that while Shell booked its Australian Gorgon reserves in 1997, partner Chevron held them in its pocket, waiting on project particulars and approvals, which were only recently granted.

Nigeria is making a separate allegation that Shell underpaid the country in taxes, and that “Reserves Addition Bonuses” must be repaid. Shell denies this, saying that “the dispute had nothing to do with the reserves downgrade. The reserves reclassification will have no impact on Nigeria's overall reserves.” Meanwhile, a US investor lawsuit was filed in New York. Furthermore, leading Shell investors set out conditions if Sir Philip Watts is to continue as chairman. Other oil companies are issuing statements reassuring their shareholders that “[Shell's announcement] will not affect how worldwide reserves are currently categorized.” What a mess.

It is just possible that this will permanently change our business. There is a growing clamor for third-party handling of reserves. (Not one of whom will in any way be influenced by the fees they receive. Hey, maybe they'll reconstitute the old Arthur Andersen!)

Wood Mackenzie gets my respect. They are for the idea of outside auditors, reports The Guardian. But this editor is ambivalent on the topic. Maybe it'll do some good, but we'll never be able to hire enough police to police the police, enough judges to judge the judges, auditors to audit the auditors – trust remains the coin of the realm. If the vast majority are not worthy of it, nothing will work.

Some of the most onerous disincentives to trust are: stock valuations; a company's debt rating and the impact on financing of exploration and proposed projects; terms concerning “owned” proved reserves in production-sharing contracts; and compensation packages. All of these can be affected by year-to-year changes in reserves.

For many years, a lot of folks have said that reserves figures in general are exaggerated, especially by OPEC members and state-owned oil companies. I've even heard rumors to the effect that a company might “reserves balance” from one year to the next by a small change in “conservatism,” so as to always show good results at the right time, without having to lie about the total.

These suspicions are especially true of those devotees of King Hubbert, who take the common sense, true notion of a bell-shaped depletion curve, which undoubtedly can be a predictor of small reservoir performance, and apply it to giants, elephants and the world.

The problem is, very large oilfields take many years to delineate, characterize and develop, and are part of the phenomenon of “reserves growth.” The implied assumption that the earth is maturely explored, including areas such as offshore Greenland, the Barents Sea and Siberia, and therefore predictable in terms of reservoir size, cannot possibly be true. Extending Hubbert's curve to the entire planet does not seem reasonable – there's just too much unexplored territory. But this reserves debacle is sure to bring 'em out of the woodwork with, “We told you so.”

The management of Shell should be simultaneously forgiven, lauded and horsewhipped.

   Forgiven, because of the difficult nature of determining all manner of reserves estimates. Honest mistakes can happen. According to SPE paper 84388, SEC defined booking: What the petrophysicist needs to know, by authors from Baker Atlas and Netherland, Sewell and Associates, the SEC defines two categories of proved reserves: 1) proved developed, and 2) proved undeveloped.

The first category requires either actual production or at least a well test. However, well log, core and other data might be sufficient if the case for “reasonable certainty” can be made. SEC prohibits probable and possible reserves categories. Much of the rest of the world does not, and Canada requires probable reserves reporting.

An excellent view by the consultants from IHS Energy describes the crux of the issue: “... the standardized measure of discounted future net cash flows relating to proved reserves.” This requires future cash inflows to be calculated by applying year-end oil and gas prices (no matter how atypical) to year-end reserves, and bases future costs on year-end costs and assumed continuation of existing economics. As Shell said, “The information so calculated does not provide a reliable measure of future cash flows from proved reserves...” Over 90% of Shell's reserves change is a reduction in the proved undeveloped category.

Adding to the vagaries, the SEC doesn't ask for a confidence level. SPE, conversely, has specified a 90% confidence level for proved reserves. It is interesting that Russia's Yukos reported SEC proved liquid reserves of 10.45 billion bbl at end-2002 and SPE proved liquid reserves of 13.73 billion bbl. So pick a number!

   Lauded, because the management showed enormous gumption by disclosing the error, even though it had to know it would not play well, and it would possibly cost the chairman his job. Everything about this points to terminal honesty. It appears to be entirely internal, with no prodding from any governmental agency. I'm sure that some investors would have preferred if Chairman Watts had said nothing. Although wrong, it likely would have been less politically risky, making up the error in coming years, which undoubtedly will happen anyway. The changes increase Shell's per barrel finding and developing costs over a five year period from $4.27 a barrel to $7.90. This compares with $3.73 at BP and $3.93 at Exxon.

And horsewhipped, not for the magnitude of the mistake – it was, after all, a 3.9-billion barrel error – nor for the negative effect on stakeholders – Shell's stock fell abruptly about 10% relative to its competitors and is still down as of early February, nor for reminding everyone of the shaky and tentative nature of reserve figures in general. But for crossing the line. It's that all important line that says you replaced at least as much as you produced. Wood Mackenzie says Shell's organic reserve replacement for 1997 – 2002 falls from 105% to 57%, while BP and ExxonMobil are 152% and 116%, respectively. It's the line that says the doomsayers are wrong, that there their will be enough oil for years to come, that the future is bright. Our industry needs to protect an ill-informed public that does not understand the intricacies of calculating reserves. Indeed, do the politicians understand them? And when viewed collectively, all that we ask of our leaders is that they plan the future of the world based on them.