Oil giant Shell is facing an avalanche of lawsuits since cutting oil reserve estimates, but other energy companies may be following suit - with implications for the re/insurance sector

The major challenges to the international petroleum industry today come from the fast and fundamental changes in the global economic, social and political arenas. These developments make me think of Sam Goldwyn, the film producer, who wanted a story that 'begins with an earthquake and then builds up to a climax'." These were the words in 1997 of Philip Watts, who was fired as Chairman of Royal Dutch/Shell in March this year.

Shell has had the earthquake, but the climax is yet to come.

Mr Watts, then the company's Managing Director, was speaking at a workshop held in Norway and organised by London's Royal Institute of International Affairs on how corporations tackle corporate responsibility. At the time, Shell was besieged by activist groups. Environmentalists claimed that the company's policy to dump the Brent Spar, a redundant concrete oil production platform, into the North Sea would cause irremediable environmental damage. The company was also accused of complicity in human rights abuses in Nigeria. Together with other multinational oil companies which operate in that country, it still faces lawsuits filed by human rights activists on this matter in the US courts under the Alien Tort Claims Act (ATCA).

The environmentalists' claims against Shell were flawed. Marine life in regions such as the North Sea and the Gulf of Mexico is attracted to structures dumped on the seabed, and quickly creates a thriving community around them. Equally, investors acknowledged the possibility of political manipulation of the allegations of human rights abuses. The company's reputation was damaged but recovered considerably as Shell engaged in a major public relations battle to prove its environmental and social accountability. Shell became an icon in the nascent discipline of corporate social responsibility, and its then Chairman, Mark Moody Stuart, was one of the most respected businessmen in the world.

Image crumbles

Shell's image, and the reputations of its past and present senior management, crumbled with its announcement in January that it will cut its estimate of proven oil reserves by 20%. Many other oil and gas companies followed suit. Houston-based El Paso Corp cut its own oil and gas reserves by 41%.

The drastic asset write-downs have triggered an ongoing debate about probity in the oil industry as a whole, and an avalanche of international comment on whether the world is running out of oil. Two of the largest pension funds in the US, the Pennsylvania State Employees' Retirement System and the Pennsylvania Public School Employees' Retirement System, which have combined assets of about $70bn, have been elected as lead plaintiffs to consolidate a class action from shareholders against Shell. As Shell's own employees join in the lawsuits, US claims against the company could rise to several billion dollars, and its past top management could be indicted. Institutional investors in Britain are also angry. According to Peter Montagnon, head of investment affairs at the Association of British Insurers, Shell must install a governance arrangement which "provides for proper accountability and no longer tolerates chronic underperformance."

Such investor outrage contrasts sharply with the reactions of technical professionals throughout the oil industry, the geologists, geophysicists and petroleum engineers who find oil in the first place, and then estimate how much of it is in the ground and how much may be produced. The prevailing sentiment is a disdainful, "we've seen it all before." Nothing the financial regulators or investors try to do will make the uncertainties in the industry go away, according to Gary Swindell, a Dallas-based petroleum engineering consultant. But equally, the technicians claim that Shell's woes today, and those of the oil industry as a whole, were a long-recognised disaster waiting to happen.

SEC rules

The oil industry's current accounting problems stem from new regulations issued by the US Securities and Exchange Commission (SEC) which require an annual and ongoing disclosure of any given company's oil reserves.

These rules were modeled on similar regulations introduced in Alberta Province, Canada in 2003. The rules have been designed to create a standardised form of disclosure for oil and gas companies, and thus to boost investor confidence in their veracity. So since end-2003, companies doing business in the US are obliged to provide data for proven, and proven plus possible oil and gas reserves they hold, as well as an estimate of the net revenue the production of such reserves would generate.

But Charles Maxwell, an oil analyst at Greenwich, Connecticut-based stockbroker Weeden & Co with over 40 years professional experience in the oil sector, thinks the new regulations are merely an insurance policy for the financial regulators. Past corporate scandals have persuaded the regulators to demand certainty in corporate disclosure. For oil and gas reserves, such certainty does not exist and there are no magic numbers.

Finding oil

An oil field starts life as a figment of a geologist's imagination who reconstructs a region's past geography and climates of up to hundreds of millions of years ago, and estimates where various forms of marine and lacustrine organic matter would have been deposited, accumulated and covered over with later sediments. As the overburden increases the pressure and temperature at depth, this organic matter 'cooks' and produces crude oil. In turn, the oil may accumulate close by, or may migrate up to hundreds of kilometres away before it is trapped. The oil field takes shape through a series of geophysical investigations involving gravitational, magnetic and seismic surveys. But in order to persuade a company's management to spend money on these, a geologist has to make a hard sell, often involving very optimistic estimates of the potential oil and gas reserves which could be found.

Sometimes, company management can be extremely conservative. In the 1960s the late Peter Kent, who was both President of the Geological Society of London and Chief Geologist for BP, was so pessimistic about prospects in the North Sea that he said he would drink every drop of oil found there.

Oil is only discovered when a well is drilled in the right locations to find it, and requires considerable luck - or misfortune. It took the drilling of over 100 wells in the North Sea before a commercial oil discovery was made. In Yemen, oil was discovered with just one well. The possibility of oil in what is today's Cusiana oil field in Colombia was first suggested in the 1930s, but no well was drilled there until the 1970s, and only in the early 1990s was a commercial discovery made. In the former Soviet Union, Gulag prisoners identified oil fields in western and northern Siberia.

The assessment of the size of reserves found is a continuous process requiring the drilling of more wells, running more seismic surveys, taking core samples, and the analysis of the pressure, temperature, volume and chemical content of the liquids recovered. As the oil and gas is produced, the physical balance in the field changes. Rather than depleting, some oil fields show characteristics of being recharged with more oil. This has led to accusations from host governments that companies had underestimated their oil and gas reserves in order to avoid tax. By contrast, gas fields in particular may snuff out suddenly. Such an occurrence happened recently at the Seven Heads gas field offshore of Ireland, wiping 95% off Aberdeen-based Ramco Energy's share price. Shell's accounting problems wiped just 12% off its share price.

Gary Swindell explains that there is never enough information for certainty in these estimates. "It's like going to the doctor. He takes your temperature and blood pressure and has to decide what's wrong with you. And 95% of the time he will be right when he tells you that you have the flu and not cancer." But the doctor has the advantage in being able to see the patient. The petroleum engineer cannot see an oil field thousands of metres underground.

Different criteria

Under rules introduced in 1978, the SEC required that companies estimate proven oil and gas reserves with "reasonable certainty". Now, the rules require that commercial proven reserves have a 90% chance of recovery.

Probable reserves are defined as those with a 50% chance of recovery.

These rules forced Shell to move 3.9 billion barrels of oil reserves from the proven to the probable category, thus cutting the 'proven' figure by 20%. The uncertainties increase with field size. As the major oil companies hold a greater number of larger fields in their portfolios than the smaller companies, the majors' reserves estimates were subject to even greater uncertainty. Paris-based geological consultant Jean Laherrere thinks that the numerical requirements are meaningless as all the different professionals involved in the discovery and assessment of hydrocarbons reserves judge by different criteria. There are different estimates for reserves depending on whether these are for geologists, engineers, journalists or financial analysts. The best way to represent reserves is to give a range of figures, he says.

The new SEC rules which require the value of oil reserves to be based on end-year oil prices will introduce distortions because of the price volatility, Mr Swindell says. The regulators' inclusion of "commercial productivity" is also questionable as the commerciality of a project may vary with overnight changes in any government's fiscal polices. The political risk insurance market has not produced a policy to adequately cover this risk.

The uncomfortable truth, however, is that the financial regulators have just caught up with what oil industry insiders have been saying for the past 20 years. Over this period, the companies have created earnings growth through mergers, cost cutting and share buy backs. Growth has not come from new oil discoveries. Over the past 25 years, these new discoveries have accounted for only about a quarter of the volumes of oil produced during the same period. Major oil companies virtually disbanded their exploration departments and have concentrated on producing more oil from existing fields or by diversifying into the utility sector, which has produced far lower returns for investors. Yet oil companies have reported continuing growth for their shareholders. In the late 1990s, Shell executives and their counterparts from other major oil companies would say privately, "we don't want assets, we want to be contractors."

Massaging the figures

Charles Maxwell reports that one - at the time legal - trick employed by the companies was to underestimate one year's reserves growth in order to report some growth the following year, should management perceive there may be lean times ahead. Technological advances have improved the recovery of oil from existing fields. But few financial regulators or auditors would be qualified to uncover how companies inflated their reserves estimates by asking an engineer to increase one parameter, such as reservoir porosity, by say, 10%, and increase the volume of oil the reservoir may hold. A geophysicist may be persuaded to 'fine-tune' his velocity analysis, used in the interpretation of seismic surveys, to increase the possible thickness of the same reservoir. A geologist may be required to rethink his original assumptions, and 'improve the depositional model', allowing for a broader extent of the reservoir.

Just as Enron executives blinded investors with complicated equations about the performance of electricity markets, so oil company management blinded the financial sector with exaggerated assumptions of oil reserves.

In both cases, the financiers were reluctant to listen to those technically qualified professionals who told them they were being taken for a ride.

Energy industry professionals confess to feelings of schadenfreude when they reflect that the two companies which, over the past decade, acquired the highest reputations for attention to the "environment, corporate responsibility and sustainable development", have been Enron and Shell.

Until the current scandals, the majority of fraudulent representations of oil reserves estimates were made by small, undercapitalised companies quoted on minor stock markets. Now the spotlight is shifting onto the state-owned oil companies. "Their reserves estimates are highly suspect," says Gary Swindell. Pemex, the Mexican state oil company, was obliged under SEC rules to write-down 23% of these at end-2003. OPEC member countries have politically inflated their official estimate of oil reserves to qualify for higher production quotas, or to persuade the international capital markets they hold potential wealth. But the long-term consequences of large asset write-downs by some of the world's most highly capitalised companies could imply a drastic future reduction in perceived wealth.

The challenge now is for financial regulators and oil industry practitioners to find a common language where the words 'risk' and 'uncertainty' mean the same to both, and that a company's public image of corporate responsibility is not used to mask its malpractices.