Fraudulent Oil and Gas Reserve Reporting

Shell Oil and Gas Reserves Scandal

The Shell reserves scandal shows that even the world’s oldest and largest oil and gas companies are not immune to the temptation to overstate their reserves.

For companies invested in oil and gas exploration and production, oil and gas reserves are a crucial asset, and estimates of “proved” reserves are the most important calculation of those reserves. The way that a company calculates its “proved” reserves, meaning the amount of oil or gas that a company reasonably believes it can recover at current prices, plays a large role in defining a company’s value and predicting its future growth. Accurate calculations are therefore an important tool for investors who are evaluating companies against competitors, but the accuracy of these estimates can also have a wider impact on energy trends and the environment. If oil and gas companies inflate their proved reserves, and, consequently, their energy and economic potential, they can fraudulently gain an unfair advantage over alternative energy sources.

To prevent false or misleading statements to investors, the U.S. Securities and Exchange Commission (SEC) regulates statements about proved reserves by all publicly traded companies with shares sold in the U.S. and their subsidiaries. However, without inside information, it can be difficult to determine the accuracy of proved reserves estimates. To encourage those with inside information to step forward, the Dodd-Frank SEC Whistleblower program allows whistleblowers to confidentially report companies who are overstating their oil and gas reserves, and whistleblowers who provide original information that leads to successful SEC prosecution can receive between 10% and 30% of monetary sanctions.

Recent research suggests whistleblowers may be needed more than ever to report on companies who are overstating their reserves. A recent scientific analysis argues that proved conventional oil reserves as detailed in industry sources are likely “overstated” by half. A growing focus on the financials of fracking companies in particular has drawn attention to questionable patterns in how these companies calculate their proved reserves. So far, this attention has focused on newer companies or particular individuals. A previous case, however, shows that even the world’s oldest and largest oil and gas companies are not immune to the temptation to overestimate their reserves, to provide structural incentives for overestimation, and to believe that they can hide the results for years.

The Shell Reserves Scandal

On January 9, 2004, the Royal Dutch/Shell Group (Shell), at the time the world’s largest publicly-traded oil and gas company, shocked investors by announcing that it had substantially reduced its “proved” reserves. In the months following the initial announcement, the Shell ultimately revealed that it had reduced its proved reserves by 4.47 billion barrels, representing more than one-fifth of its proved reserves, as well as a reduction to its Reserves Replacement Ratio (RRR), a crucial measure of future performance. The abrupt changes quickly raised concern about how the company “could miss so badly.” What investors particularly wanted to know was whether those miscalculations were the result of fraud.

Two exchange regulators, the SEC and the British Financial Services Authority (FSA) investigated and alleged that they were. While neither Shell nor its parent companies were headquartered or incorporated in the United States, the shares of both parent companies, Royal Dutch Petroleum Company and Shell Transport and Trading Corporation, were listed on the New York Stock Exchange, allowing the SEC to investigate. According to the SEC’s cease and desist order, released on August 24, 2004, a series of failures beginning in 1998 led Shell to “record and maintain proved reserves it knew or was reckless in not knowing did not satisfy SEC requirements.” The SEC’s investigation and subsequent reporting and internal investigations provide a window into the five-year period in which seemingly subtle changes snowballed into million and billion-dollar overstatements.

In a 1998 Shell annual report to investors, a single sentence described a new process for estimating proven reserves, stating simply that “[e]stimation methods have been refined.” This sentence belied a much more substantial shift: Shell had created a new set of guidelines for measuring reserves, one later described by the SEC as “excessively permissive.” In order to categorize a reserve as proven, the guidelines required neither the existence of a market for the oil or gas nor a plan by the company for how it would be developed.

Additionally, the guidelines strongly stated that proven reserves should not be de-booked (removed from the list of proven reserves) unless it became “absolutely clear that development will not proceed in a reasonable time-frame.” This statement strongly discouraged the re-categorization of even highly questionable reserves. As a result, the conditions were set for too many risky reserves to be booked, and, once they were added, even if they became even more risky, it was extremely difficult to de-book them.

The SEC order details how these new guidelines began to create problems as they merged with an existing auditing environment at Shell that was ripe for fraud. To estimate their total proved reserves, the company had employed just one under-trained and part-time retired engineer as its “global reserves auditor,” a position charged with auditing the company’s entire global operations. Additionally, the global reserves auditor reported to the Exploration and Production (EP) division, the same division he was responsible for auditing.

Unsurprisingly, the SEC found that the auditor “failed to act independently” and these practices, combined with the permissive guidelines, led to a series of questionable bookings. For example, Shell had booked 550 million boe (barrels of oil equivalent) as proved reserves in Gorgon, an undeveloped gas field off the coast of Australia, before it had a contract to sell the gas or a plan to develop it. In 1999, the Asian economic crisis further delayed any chance of development. Yet, it still remained listed as a proven reserve.

While the company’s lenient approach to booking reserves created a mounting problem, the responses of Shell executives only dug the company further into a hole. As early as 2000, EP management had received several internal communications suggesting that the company was overstating its reserves. The Chairman had become aware of these problems by 2002. Yet, executives frequently dismissed warnings about the severity of the situation, instead downplaying concerns and strategically attempting to delay de-booking the reserves until new reserves could be added to replace them.

EP management knew by December of 2002 that the Gorgon booking, for example, was a highly questionable booking that no longer met even Shell’s lenient guidelines for a proven reserve. Yet, the reserves were continually listed as proven while executives fought over how long to keep the misstatements hidden. By the end of 2003, the strategy of using new, legitimate reserves to quietly replace earlier questionable bookings began to lower the company’s Reserve Replacement Ratio. Faced with this growing indicator of either fraud or poor company performance, the company announced a dramatic reduction in its proved reserves in 2004, prompting the two concurrent investigations.

Key Takeaways from the Case

Had a whistleblower reported to exchange regulators, the scheme might have been uncovered earlier. In similar cases, employees have used the Dodd-Frank SEC whistleblower program to alert the SEC to companies who were fraudulently overstating assets. Instead, the false statements in this case were uncovered only after investigations by the FSA and the SEC. As the scandal caused the two parent company’s share prices to plummet, Shell settled claims with the SEC and the FSA for a combined total of $150 million. Shell ultimately settled two class action suits with shareholders as well, for a total of $470 million. The settlements also resulted in the departure of three executives.

Shell’s settlement with the SEC and FSA stands out as a particularly notable example of what happens when companies overstate their proven oil and gas reserves. The growing attention to how companies calculate proved reserves suggests that this may not be an isolated case. Recent attention has pointed to a series of similar indicators, including looser standards for what companies categorize as proved reserves, companies overestimating how much oil will be produced by future wells, and companies underestimating break-even prices. What the Shell case demonstrates is that, rather than being a problem limited to small companies or rogue operators, a pattern of overstating of oil and gas reserves can take place at even the world’s largest and oldest companies.

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