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Case 8-4
Royal Dutch Shell plc
From 1907 until 2005, Royal Dutch Petroleum Company, a Netherlands-based company, and the
Shell Transport and Trading Company, plc, a UK-based company, were the two public parent
companies of a group of companies known collectively as the Royal Dutch/Shell Group (Group).
Operating activities were conducted through the subsidiaries of Royal Dutch and Shell Transport.
In 2005, Royal Dutch Shell plc became the single parent company of Royal Dutch and Shell
Transport. Today, Shell is one of the world’s largest independent oil and gas companies in terms
of market capitalization, operating cash flow and oil and gas production.
Proved Reserves
Petroleum resources represent a significant part of the group’s upstream assets and are the
foundation of most of its current and future activities. The group’s exploration and production
business depends on its effectiveness in finding and maturing petroleum resources to sustain
itself and drive profitable production growth. The Group reports its reserves of oil and gas to the
SEC as part of its 20-F filing for a foreign company selling stock on the NYSE.
Reporting internal and external volumes properly is very important to Shell. This is based
on the SEC-compliant proved reserves estimation and reporting process that enables access to
funds needed for the group’s capital-intensive business. The SEC requirement of “reasonable
certainty” represents the high standard of evidence/confidence consistent with the meaning of the
word proved. Proved oil and gas reserves are the estimated quantities of crude oil, natural gas,
and natural gas liquids which geological and engineering data demonstrate with reasonable
certainty to be recoverable in future years from known reservoirs under existing economic and
operating conditions (i.e., prices and costs as of the date the estimate is made). Prices include
consideration of changes in existing prices provided by contractual arrangements, but not on
escalations based upon future conditions.
In 2004, Shell amended its Annual Report on Form 20-F/A for the calendar year 2003
financial statements following an agreement with the SEC reached on August 24, 2004, with
respect to the amount of proved reserves. The SEC had charged that 4.47 billion barrels of oil
equivalent (boe), or approximately 23 percent of previously reported proved reserves, did not
meet the standard set by law. Shell also reduced its reserves replacement ratio (RRR) -- the rate
at which production was replaced by new oil discoveries. According to the SEC Complaint,
Shell’s overstatement of proved reserves, and its delay in correcting the overstatement, resulted
from (1) its desire to create and maintain the appearance of a strong RRR, a key performance
indicator in the oil and gas industry, (2) the failure of its internal reserves estimation and
reporting guidelines to conform to applicable regulations, and (3) the lack of effective internal
controls over the reserves estimation and reporting process.
Reduction of RRR
In a series of announcements between January 9 and May 24, 2004, Shell
disclosed that it had recategorized 4.47 billion boe, or approximately 23
percent, of the proved reserves it reported as of year-end 2002, because they
were not proved reserves as defined in Commission Rule 4-10 of Regulation S-X. This
recategorization reduced the standard measure of future cash flows by approximately $6.6 billion
as reported in Shell’s original 2002 Form 20-F, Supplemental Information under SFAS 69.
On July 2, 2004, Shell filed an amended 2002 Form 20-F reflecting the restatement of its
proved reserves and standard measure of future cash flows for the years 1999 to 2002 as follows:
As a result of the overstatement of proved reserves, Shell also announced a reduction in its RRR
for 1998 through 2002, from the previously reported 100 percent to approximately 80 percent.
Had Shell reported proved reserves properly, its annual and three-year RRR over this span would
have been as follows:
According to the SEC complaint, these failures led Shell to record and maintain proved reserves
it knew, or was reckless in not knowing, did not satisfy applicable regulations and to report for
certain years a stronger RRR than it actually had achieved in supplemental information filed
along with its 10-K report. The SEC had warned about the proved reserves but Shell either
rejected the warnings as immaterial or unduly pessimistic, or attempted to manage the potential
exposure by, for example, delaying debooking of improperly recorded proved reserves until new,
offsetting proved reserves bookings materialized.
Failure to Maintain Adequate Internal Controls
The charges against Shell include the failure to implement and maintain internal controls
sufficient to provide reasonable assurance that it was estimating and reporting proved reserves
accurately and in compliance with applicable requirements. These failures arose from
inadequate training and supervision of the operating unit personnel responsible for estimating
and reporting proved reserves and deficiencies in the internal reserves audit function. Shell’s
decentralized system required an effective internal reserves audit function.
To perform this function, Shell historically had engaged as Group
reserves auditor a retired Shell petroleum engineer who worked only part-
time and was provided limited resources and no sta( to audit its vast
worldwide operations. Although the Group reserves auditor was an
experienced reservoir engineer, he received little, if any, training on such
critical matters as how he should conduct his work and the rules and
standards on which his opinions should be based. He also lacked authority to
require operating unit compliance with either commission rules or group
reserves guidelines. Moreover, he reported to the management of Shell’s
exploration and production division, which were the same people he audited.
The Group reserves auditor visited each operating unit only once every
four or more years. Subsequent to his visits, he issued reports rating the
operating unit’s systems, compliance with Group guidelines and audit
response as “good,” “satisfactory” or “unsatisfactory,” opining whether the
operating unit’s reported reserves met Group guidelines. From the start of his
tenure in January 1999 until September 2003, the Group reserves auditor did
not issue a single “unsatisfactory” rating. The Group reserves auditor also
issued an annual report on the reasonableness of Shell’s year-end total
reserves summary. Until his February 2004 report on Shell’s 2003 proved
reserves, the Group reserve auditor focused as much on whether Group
proved reserves complied with group guidelines as he did on whether they
complied with SEC requirements.
Further, the group reserves auditor failed to act independently in
several respects. At times, he allowed proved reserves associated with a
project to remain booked because he was more “bullish” on its prospects
than the local management responsible for the project. At other times, solely
to support booking proved reserves for otherwise uneconomic projects, he
advised local management to submit development plans that were unlikely
ever to be executed. This lack of independence facilitated the booking of
questionable reserves well after they should have been debooked.
Finally, the nonexecutive directors of Royal Dutch and Shell Transport, including the
members of the Group audit committee, were not provided with the information necessary for the
boards of the two companies to ensure that timely and appropriate action was taken with respect
to the proved reserves estimation and reporting practices.
Group Reserve Auditor’s Report
In January 2002, the Group reserves auditor’s report on Shell’s 2001 proved
reserves stated that “recent clari6cations of FASB reserves guidelines by the
SEC have shown that current Group reserves practice regarding the first time
booking of Proved reserves in new 6elds is in some cases too lenient.” The
auditor stated that the “g[G]roup guidelines should be reviewed [and] first-
time bookings should be aligned closer with SEC guidance and industry
practice and they should be allowed only for 6rm projects with technical
maturity and full economic viability.”
On February 11, 2002, an internal note addressed the divergence
between Shell’s guidelines and the Commission’s rules and estimated the
possible impact of this divergence on Shell’s reported proved reserves. The
note explicitly stated that “recently the SEC issued clari6cations that make it
apparent that the Group guidelines for booking Proved Reserves are no
longer fully aligned with the SEC rules.” Potential exposures identified in the
note included approximately 1 billion boe of proved reserves relating to
projects. The note failed to recommend debookings, and Shell did not take
action to debook any of these proved reserves at that time.
By September 2002, the CEO of EP internally spoke in blunt terms of
his perception of the operational and performance problems facing EP,
noting to his colleagues that “we are struggling on all key criteria” and that
“RRR remains below 100% mainly due to aggressive booking in 1997-2000.”
He further observed that “we have tried to adhere to a bunch of criteria that
can only be managed successfully for so long” and admonished that “given
the external visibility of our issues…, the market can only be ‘fooled’ if: (1)
credibility of the company is high; (2) medium and long-term portfolio
refreshment is real; and/or (3) positive trends can be shown on key
indicators.”
A month later, the group chair emailed the EP CEO that he was “not
contemplating a change in the external promise . . . .” The next day, the EP
CEO responded, stating “I must admit that I become sick and tired about
arguing about the hard facts and also cannot perform miracles given where
we are today. If I was interpreting the disclosure requirements literally under
the Sarbanes-Oxley Act and legal requirements we would have a real
problem.”
None of these events prompted Shell to debook signiticant volumes. To
the contrary, Shell continued to make large, questionable proved reserves
bookings during this period. By the summer of 2003, Shell’s analysis of
reserves exposures had progressed, but still no debookings were
recommended even though internal information indicated that “some 1040
million boe (5%) is considered to be potentially at risk.” The note concluded,
however, that “at this stage, no action in relation to entries in the [proved
reserves exposure] Catalogue is recommended… It should be noted that the
total potential exposure is broadly o(set by the potential to include gas fuel
and Gare volumes in external reserves disclosures.” The note apprised the
committee of steps taken to address possible noncompliance with the SEC’s
regulations. However, management was advised that “much, if not all, of the
potential exposure is o(set by Shell’s practice of not disclosing reserves in
relation to gas production that is consumed on site as fuel or (incidental)
Garing and venting.”
According to the SEC complaint, Shell has undertaken substantial
remedial effort in connection with the reserves recategorization and had
cooperated with the Commission in its investigation.
