[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
SHELL GAMES: CORPORATE
GOVERNANCE AND ACCOUNTING
FOR OIL AND GAS RESERVES
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JULY 21, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-105
U.S. GOVERNMENT PRINTING OFFICE
96-549 WASHINGTON : 2004
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
C O N T E N T S
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Page
Hearing held on:
July 21, 2004................................................ 1
Appendix:
July 21, 2004................................................ 27
WITNESSES
Wednesday, July 21, 2004
Dharan, Bala G., J. Howard Creekmore Professor of Accounting,
Jeese H. Jones Graduate School of Management, Rice University.. 13
Duchac, Jonathan E., Associate Professor of Accounting, Wayne
Calloway School of Business and Accountancy, Wake Forest
University..................................................... 11
Knight, Eric, Managing Director, Knight Vinke Asset Management
LLC............................................................ 5
Simmons, Matthew, Chairman and Chief Executive Officer, Simmons &
Company International.......................................... 8
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 28
Gillmor, Hon. Paul E......................................... 30
Dharan, Bala G............................................... 31
Duchac, Jonathan E........................................... 51
Knight, Eric................................................. 55
Simmons, Matthew............................................. 96
SHELL GAMES: CORPORATE
GOVERNANCE AND ACCOUNTING
FOR OIL AND GAS RESERVES
----------
Wednesday, July 21, 2004
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to call, at 2:20 p.m., in Room
2128, Rayburn House Office Building, Hon. Michael G. Oxley
[chairman of the committee] Presiding.
Present: Representatives Oxley, Feeney, Sherman, Inslee,
Lucas of Kentucky, Clay, Scott, and Bell.
The Chairman. The committee will come to order. I apologize
for being late.
I understand you offered to chair, Mr. Sherman.
Mr. Sherman. Yes.
The Chairman. We will take that under advisement.
Nearly 2 years ago, this committee passed the most critical
securities legislation enacted since the 1930s, the Sarbanes-
Oxley Act of 2002; and with the Act's corporate reforms and
rigorous measures taken by the Public Company Accounting
Oversight Board, it helped rebuild investor confidence in our
capital markets.
The corporate governance failures that led to the passage
of the legislation have not completely disappeared. Tomorrow
this committee will hear reports from a panel of experts on how
the Sarbanes-Oxley Act has benefited the American investor and
helped to restore accountability in the governing bodies of
publicly traded corporations. Today, we examine some
unfortunate examples of why that reform was necessary.
The abuses of corporate insiders who contemptuously
disregarded the interests of public shareholders while seeking
their own personal enrichment unfortunately were not limited to
any one industry. However, the problems that have recently been
alleged at El Paso and Shell, among others, raise some
compelling questions about accounting practices and internal
controls at energy companies. There has been growing unease in
the industry about a widespread tendency to overlook reserves.
Regulators cracked down on energy companies in the 1970s
when it appeared they were being cavalier with their reserves
disclosures. A report by Energy Consultancy in 2001 noted the
pressure on managers of publicly traded energy companies,
quote, ``to push the envelope of credibility in efforts to buoy
investor confidence and thus increase stock value,'' end quote.
The consultants blame the overbooking on incentive programs
that offer bonuses for big reserves estimates.
Financial statements of energy companies like those of all
public companies necessarily include estimates that may not
ultimately prove to be accurate. In the oil and gas industry,
the most important number which is an estimate is a company's
proven reserves, the oil and gas in the ground that a company
claims to own. If reserves estimates are made in a way that is
biased, for example, because bonuses are tied to high reserves
estimates, this obviously compromises the financial statements
of any company.
I understand that Shell has since removed reserves bookings
as a component of executive performance reviews that are used
to calculate bonuses. We will examine whether additional steps
should be taken to ensure that oil companies' reserves
estimates are not compromised by improper incentives. We will
examine the accounting rules themselves to ensure that the
rules that the SEC has put in place have kept up with
technology to provide investors with the most accurate possible
information about a company's true reserves and, accordingly,
its financial position.
Some critics contend that the rules of the Commission, that
currently apply to whether reserves can be treated as proven or
not, are outdated. We will learn more about these concerns
today.
And we will examine questions of appropriate governance in
light of the unusual corporate structure at Shell. Some experts
have attributed the lack of transparency at Shell to the
company's unique corporate arrangement, which consists of two
separate boards charged with overseeing the company.
I am encouraged by reports that Shell has already
undertaken a review of its corporate structure in response to
this criticism. I believe there is significant opportunity for
Shell to repair some of the confidence that has been lost by
remaking its corporate structure to reflect the image of
transparency and candor that is embodied in the majority of
publicly traded corporations as a result of the Sarbanes-Oxley
Act.
I look forward to hearing testimony from our distinguished
panel of witnesses, and the Chair's time has expired. Are there
further opening statements?
[The prepared statement of Hon. Michael G. Oxley can be
found on page 28 in the appendix.]
Does the gentleman from California seek recognition?
Mr. Sherman. First, Mr. Chairman, thank you for the
brilliance in deciding to hold these hearings, first, because
it gives us a chance to talk more about accounting issues, and
second, because it helps illustrate our cooperative role with
the Committee on Energy and Commerce, where we are engaged in
protecting investors in securities markets and they focus on
industrial regulation.
I have spoken often at this committee of the need to have
verifiable information that goes outside the four corners of
the financial statements. Over the last century and-a-half, we
have developed a system for reporting historical, completed
transactions in an organized way and in a way that, in the
absence of truly egregious behavior, is reliable. But we have
been forwarding the same information, that is to say, only if
it is a transaction with an outsider from the company, it is
financial, it is completed, then it affects the income
statement or the balance sheet. And we have discovered how to
do this, how to give investors reliable information.
You need GAAP, and you need what I would pronounce ``GAAS.
That is to say, you need generally accepted accounting
principles or some other system that defines what you are
reporting--that is to say, define what is a proven reserve
barrel of oil.
Second, you need Generally Accepted Auditing Standards. And
you need some system whereby a third party comes in and
verifies that a particular fact meets the definition.
Now, we do that with financial information. We do that for
a balance sheet and income statement, which we have been doing
for well over a century. They added a funds statement, which is
just a recapitulation of the information on the income
statement. The balance sheet, that is recent, only 20, 30 years
old.
We haven't done anything for a long time to expand what
accountants and auditors do. But we all know that very
important for investing in oil companies is, what are the
reserves; if you are investing in a manufacturing company, what
is their back order. That would be the first question I would
ask at Boeing before I cared what their earnings per share
were. If I were looking at a retailer, I would like to know
what their same store year-to-year sales were.
But the fact that this information is quite relevant to
investors has been ignored by an accounting world that reports
only the irrelevant, verifiable information. And so we need a
system, either from this committee or from the SEC, that
defines the information that investors deserve--and it will
vary from industry to industry--that has a system for defining
the terms whether you are defining a dollar of income on an
income statement or a barrel of reserves on a reserves
statement, and defines and has some profession--perhaps the big
four would want to do this; they haven't done it so far; I am
sure there are other entrepreneurs that can get into the
attestation business--but defines how you are going to have
professionals verify that the information in the report is
reliable.
If we--either our committee should do that or the SEC
should do that, or the SEC should appoint an outside body
similar to the FASB or the ICPA, or perhaps those
organizations, to define this information that we need,
describe the professional qualifications of those who will
verify it, define materiality standards so we know what
standards to hold the verification of professionals to.
Until then, we will have verifiable, audited information
about Shell, about what their financial transactions were, and
we will have to guess whether their statement of oil reserves
is accurate. We will not have any verification of it.
And, oh, by the way, that might be more important than the
information that is verified.
So I think that the Congress was wise in getting this
committee involved in the investor protection area. We have had
that responsibility for less than 2 Congresses. And it is now
time for our committee to prod, or legislate, and make sure
that all the important information to investors, or as much as
possible, is laid out in the SEC-filed statements with
definitions that are established with a verification profession
that investors can count on. And perhaps the first place to
start is that oil companies should publish a statement of
reserves with some attestation professionals signing an opinion
indicating that we can rely upon it.
The Chairman. The gentleman's time has expired.
Mr. Sherman. I thank you for your indulgence.
The Chairman. Other members seeking an opening statement?
The gentleman from Georgia.
Mr. Scott. Thank you very much, Mr. Chairman. Let me
congratulate you as the winning manager of the congressional
baseball team. You did an astounding job and did it in the
Casey Stengel way, with grace, style and charm.
The Chairman. The gentleman can have as much time as he
wants.
Mr. Scott. I want to thank you, Chairman Oxley and Ranking
Member Frank, for holding this hearing today on corporate
governance and the accounting for oil and gas reserves.
The Royal Dutch Shell group had unique corporate
structures, which have led to accounting inconsistencies. In
addition, the company had perverse incentives for corporate
executives which led them to overstate energy reserves. This
corporate combination finally came to a head when Shell had to
restate its oil and gas reserves statement by 20 percent. As a
result, Shell had to admit that it overstated profits by $276
billion over several years.
The El Paso Corporation also had to restate its reserves by
41 percent.
The chain of events at Shell may have been prevented if
third-party certification of a company's energy reserves was in
place. This committee should consider whether or not additional
corporate governance rules may be necessary to better account
for our energy reserves.
I look forward to hearing from this distinguished panel. I
am very interested in a few issues, such as third-party
verification of energy accounting, the SEC investigation into
the Shell accounting procedures, and a discussion on successful
methods versus full cost methods of accounting reserves and
whether they are accurate and dependable. I look forward to a
very informative hearing.
Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired.
Does the gentleman from Texas seeks recognition?
Mr. Bell. Thank you very much, Mr. Chairman. I am not going
to engage in the shameless sucking up, as demonstrated by my
colleague from Georgia. I do appreciate your holding this
hearing and putting together such a distinguished panel that
features not only one, but two individuals from Houston, I am
very proud to say.
I represent a large part of Houston, which many consider
the energy capital of the world. We will probably hear more
about that today. My perspective may be a little bit different
since the industry employs hundreds of thousands of people in
the Houston area. So it is vitally important to me and my
constituents that we avoid any suggestion of scandal or taint
in the industry, that we avoid any further corporate collapses
in the energy industry. As everybody here knows, we have
suffered through Enron in a very up-close and personal fashion
in Houston, along with the rest of the country.
I believe what we are here to discuss today could point to
looming problems in the industry, and if we continue to see
similar problems on a wider level in the energy industry, I am
anxious to hear how that might translate to the hard-working
men and women in the field. Could we be looking at heavy job
losses, and just what might the impact be to investors?
So I look forward to the testimony. And thank you, Mr.
Chairman, for holding this hearing.
The Chairman. The gentleman's time has expired.
The Chair now turns to our distinguished panel and let me
introduce them from my left to right: Mr. Eric Knight, Managing
Director of Knight Vinke Asset Management LLC; Mr. Matthew
Simmons, Chairman and Chief Executive Officer of Simmons &
Company International; Mr. Jonathan E. Duchac, Associate
Professor of Accounting, Wayne Calloway School of Business and
Accountancy from Wake Forest University, the Demon Deacons; and
Dr. Bala G. Dharan, J. Howard Creekmore Professor of
Accounting, Jesse H. Jones Graduate School of Management from
Rice University, the Owls.
We are glad to have you all with us, and we appreciate, on
relatively short notice, your ability to appear before the
committee. And Mr. Knight, we will begin with you.
STATEMENT OF ERIC KNIGHT, MANAGING DIRECTOR, KNIGHT VINKE ASSET
MANAGEMENT LLC
Mr. Knight. Before I start, since we have had little
advance notice, maybe you haven't had a chance to read the
materials attached. I want to bring to your attention a couple
of the exhibits which I am going to refer to.
After my biography, there is a letter which we and CalPERS
wrote publicly to the boards of Royal Dutch and Shell
Transport. There is an editorial which I wrote for the
Financial Times in March. And there is something I wanted to
point out, which is the agenda for the Royal Dutch meeting,
which I am going to refer to because it brings up an
interesting point.
My name is Eric Knight, and I am the Managing Director of
Knight Vinke Asset Management, a New York-based asset
management firm registered with the SEC as an investment
advisor under the Investment Advisers Act of 1940. Our
investment strategy involves investing in fundamentally sound
public companies where suboptimal stock market performance can
be attributed in some way to poor governance structures and
practices which we interpret in the broadest sense. In such
cases, we work with the company's institutional and other
shareholders to overcome or redress these governance problems
and aim, thereby, to obtain a rerating of the stock and make a
profit on our investment.
Through Knight Vinke Institutional Partners, an investment
fund which invests in European equities, we hold approximately
1.32 million shares of Royal Dutch Petroleum with a market
value of approximately $70 million. CalPERS, who have a $200
million commitment to invest in our fund separately, also have
holdings in Royal Dutch Petroleum and Shell Transport &
Trading, amounting to stock with a combined market value of
approximately $580 million.
We have been working with CalPERS and other institutional
shareholders of the Royal Dutch Shell group, both in Europe and
in the U.S., with a view to pressing its boards and management
into reexamining their unusual governance practices and
accepting a more orthodox corporate governance framework.
Why are we interested in governance at Shell? Although as
recently as 2002, the boards of the Royal Dutch Shell group
declared that they prided themselves in upholding the highest
standards of integrity and transparency in their governance of
the company and that they aim to be at the forefront of
internationally recognized best governance practice, we believe
that reality presents a different picture.
In light of the multiple reserves restatements over the
past few months and the astonishing revelations of the Davis
Polk report, shareholders can perhaps be forgiven for being
skeptical. The group concedes that the framework within which
the boards operate is conditioned to some extent by Royal
Dutch's unique relationship with Shell Transport, and this
results in some special arrangements which may not be
appropriate to other companies. We felt it necessary,
therefore, to look carefully into these special arrangements.
During the course of our due diligence, we asked our
counsel in the Netherlands, the U.K., and the U.S. to prepare a
report on the Royal Dutch Shell Group's governance structures
based on publicly available information, and a copy of this
report is included in the attached materials.
By way of background, the Royal Dutch Shell Group of
companies is 100 percent owned by two holding companies: Royal
Dutch, which owns 60 percent, is the largest listed company in
the Netherlands; and Shell Transport, which owns 40 percent, is
one of the 10 largest in the U.K. Royal Dutch is managed by a
supervisory board and a management board, as is usual in the
Netherlands, whereas Shell Transport has a unitary board
comprised of executives and nonexecutives which is the
structure most commonly found in the U.K. It is important to
realize, however, that both Royal Dutch and Shell Transport are
pure holding companies with no operating activities of their
own.
The following is a summary of some of the more surprising
facts which emerged from our analysis.
The operating companies of the Royal Dutch Shell Group,
i.e., a group of companies below the two parent holding
companies, are managed on a day-to-day basis by an informal
committee of senior managers, the so-called ``Committee of
Managing Directors,'' and not by a chief executive officer.
Substantial power and autonomy is given to the CEOs of each of
the Group's four main operating companies. And although there
is a chairman of the CMD, none of these executives reports
formally to this person.
The boards of Royal Dutch and Shell Transport are comprised
of different groups of individuals responsible to separate
shareholder constituencies, and it is unclear, therefore,
exactly to whom the CMD and its chairman report or are
accountable. The two parent company boards come together on a
regular basis in a large gathering known as ``the Conference,''
and this is yet another informal body vested with no formal
powers and unaccountable directly to the shareholders of either
holding company.
The Royal Dutch supervisory board, which is perhaps the
most powerful of the different Shell governing bodies, as it
controls the majority shareholder in the operating companies,
is effectively a close-knit self-perpetuating body. This
results from the existence of a class of so-called ``priority''
shares which have the exclusive right to nominate board
representatives at Royal Dutch and to reject nominations by
shareholders.
As of now, the members of the Royal Dutch supervisory
management boards hold or control 100 percent of these priority
shares and have the ability to control their own nominations.
This self-perpetuating mechanism is wholly inconsistent with
internationally accepted principles of good governance.
Despite mounting evidence of poor internal communication,
inadequate controls, lack of accountability and unclear
reporting lines Shell's management and board members still
maintain that the reserves debacle had nothing to do with
structure.
We disagree.
Shell's management has operated for years, indeed decades,
with none of the basic building blocks of modern governance.
Its divisional management did not report formally to a group
chief executive; its divisional CFOs did not report to a group
CFO. The person presented as the chief executive, the chairman
of the CMD, apparently lacked either the authority or
responsibilities or the accountability normally associated with
a chief executive. He reported to two boards comprised of
different individuals and so, effectively, to none. And the
boards of Royal Dutch were shielded from shareholder
intervention through the priority share mechanism, which made
them effectively a closed shop.
The Royal Dutch Shell Group's unusual board and management
structures may not have been entirely to blame for the
misstatement of reserves, but we believe that they and the
corporate culture they foster certainly contributed to the
problem.
Royal Dutch, as a foreign private issuer, is currently
exempt from the proxy rules under the U.S. Securities laws,
despite the fact some $25 billion in market value of its shares
are represented on the U.S. markets. Nevertheless, in the
build-up to this year's annual meeting, Royal Dutch employed a
permanent U.S. proxy solicitor to obtain support for a
resolution giving a shareholder discharge to its supervisory
and management board members. I refer to the third exhibit,
which is the agenda for the Royal Dutch annual meeting.
In itself, this would not be remarkable were it not for the
fact that the resolution was strongly opposed by the mostly
European shareholders who attended the annual meeting and that,
despite this opposition, the resolution was passed thanks to a
large block of proxies coming mostly from the U.S., these
proxies held by the board coming from mostly the U.S.
shareholders.
Approximately 25 percent of Royal Dutch shares are held in
the U.S. in the form of ADRs; and in this context, we ask
ourselves:
Did U.S. shareholders know, or were they made aware, that
item 2 of the agenda, covering approval of the accounts,
payment of the dividend and discharge of the board members, all
presented as a single item, were in fact separate resolutions
each to be voted on separately?
Did they know that shareholders could have voted in favor
of the accounts and the dividend, of course, which is
important, but against the discharge?
Had Royal Dutch not been exempted from the provisions of
the U.S. proxy rules, we believe that the SEC could have asked
for clarification on these points; and in light of recent
events, the votes could have gone the other way.
In conclusion, if Shell and other multinationals want
substantial access to the U.S. capital markets, it seems
anomalous that they should be held to lower disclosure
standards than their U.S. peers, EXXON, for example. This
applies to proxy solicitation just as it does to reserves
accounting.
The Chairman. Thank you, Mr. Knight.
[The prepared statement of Eric Knight can be found on page
55 in the appendix.]
The Chairman. Mr. Simmons.
STATEMENT OF MATTHEW SIMMONS, CHAIRMAN AND CHIEF EXECUTIVE
OFFICER, SIMMONS & COMPANY INTERNATIONAL
Mr. Simmons. I am honored to address the accounting and
financial disclosure of the oil and gas industry. I believe the
topic is timely and extremely important, as I feel that our
entire energy reporting system, globally and in the United
States, is badly in need of reform.
The Chairman. Mr. Simmons, could you give a little bit of
background of your company?
Mr. Simmons. For the last 30 years, I have chaired and
founded a company called Simmons & Company in Houston. We are a
specialized investment banking firm that concentrates entirely
in energy. We are a research-driven firm, and I am a member of
the National Petroleum Council and the Council on Foreign
Relations and the Atlantic Council of the United States. We
have about 150 employees and have completed 550 transactions at
a value of about $60 billion.
I do believe that our energy reporting system is badly in
need of reform. I think our current system lacks the
reliability and transparency that should be mandatory for
something as important to our economy and way of life as
energy.
Until Shell Oil Company shocked the world with its 20
percent reserves reclassification, followed by a litany of
other reserves, I think too many energy industry observers
casually assumed that the information presented by our publicly
held oil and gas companies was quite accurate.
In fact the system has always had numerous flaws, and these
flaws grew in magnitude in recent years as fewer appraisal
wells were drilled, as new oil and gas exploration and
exploitation projects became increasingly complex, as decline
rates in existing oil and gas fields accelerated and as new
projects got increasingly smaller in terms of potential
reserves.
A tell-tale sign that the reported oil and gas results were
askew was the wide number of public companies who have
routinely reported additions of 120 to 150 percent, compared to
the annual gas and oil production each year, while fewer and
fewer of these same companies were showing any meaningful
growth in production volumes.
In reality, a host of time-tested measures to assess
reserves and their potential recovery dwindled as the price of
oil and gas stayed too low to commercially afford the standard
tests. The industry ended up using far fewer outside third-
party reserves engineers. The number of appraisal wells that
always follow a new field discovery fell. The use of coring to
test a new reservoir's rock properties started to be dismissed
as becoming obsolete. Instead, the industry began relying far
more heavily on less costly geophysical data and computer
modeling. And while the geophysical technology has improved by
quantum leaps, as have computer techniques to interpret this
data, neither of these data can begin to determine the limits
of where the producible reserves lie.
In a low price environment that the industry struggled
through for too long, pressures also mounted to declare proven
reserves status as early as possible so all additional costs
could be capitalized, and too often, the proved declaration
status was probably premature.
This led to a widespread industry bias of booking
aggressively high levels of proven reserves while spending far
less money to create these reserves than would have occurred a
decade ago. This not only created a cushion of proved reserves
that might or might not ever get produced, but it also led to a
possible illusion that the cost of finding and developing a
barrel of gas was actually less than the amount of money that
needed to be spent.
These are not the only deficiencies in our energy data
system. Today, the single biggest factor to begin estimating
the company's or country's future oil and gas production is to
properly assess the decline rates in the company's existing gas
and oil production base. Yet these decline rates are now
accelerating through the use of modern technology that draws
reserves out of the ground far faster. Yet there are no reports
issued by any public company, any private company or any
national oil company that even hint at the annual decline rates
for the entire production base, let alone the decline by
production region or on a field-by-field basis.
Reserves estimating will never be a precise science. It is
a series of complex estimates. But even if the reserves
estimates could be found to be precise, the data would still
not provide an analyst with any reliable tool to begin
assessing field-by-field production declines or provide
information on the degree to which a reporting company possibly
is being overly conservative or overly aggressive.
The data deficiencies extend to the global oil and gas
systems. In fact, the lack of quality data is far worse for all
national oil companies, particularly the OPEC member companies.
We have now evolved into a systematic ``trust me'' era for
energy providers. With the capital intensity of the industry
now starting to soar with the world's remaining spare oil
capacity slim to possibly now becoming nonexistent, with our
petroleum inventories now operating on a just-in-time basis,
this ``trust me'' era needs to end. The time has come for all
key oil and gas producers to join in a reform of how reserves
and current production is reported.
The Energy Information Agency in the United States has
recently requested that all natural gas producers begin
supplying timely current production data to our government.
Today, the best natural gas supplying information lags real
production by as much 6 to 24 months. We can no longer tolerate
such a time lag. While company-by-company reporting of their
production data to the EIA would be costly, I would argue it is
too costly to our economy's well-being to not have such timely,
accurate production data.
This fall, the National Energy Agency will be calling for a
mandated new set of proven reserves reports and a detailed
field-by-field production report by all key global oil
producers. I applaud the EIA and the IEA's data reform efforts.
But as the IEA, in particular, begins pressing the national oil
companies and, in particular, the OPEC producing companies for
this new data reform, it is critical that our leading U.S. oil
and gas producers join in and take the lead in this data
reform. Otherwise, it will be easy for any OPEC producer to
balk at reform if Exxon Mobil, BP, Shell, et cetera, are not
held to the same standards.
In my opinion, the single best data reform is to require
all significant oil and gas producers to begin timely reporting
of field-by-field daily oil production or production from key
producing units, and accompany this new disclosure by the
number of producing well bores from each production unit so
analysts and public policy planners can begin assessing field-
by-field production declines. Absent such data, there is no way
to guess at future supplies by company or by country.
On the proven reserves side, an important change would be
to begin reporting, by key production unit or field, three key
reserves estimates. First is the current estimate of the
original hydrocarbons in place, second is the current estimate
of the ultimate recoverable reserves, and third is the
cumulative amount of reserves already produced. The remaining
recoverable reserves can then be broken into proven, probable
and possible.
With this added layer of disclosure, it is not so crucial
that every producer meet the same 90 percent probability test
embedded in proved reserves. Analysts can gauge the quality of
layers of reserves left to produce and then dig out better
answers through follow-up analysis. Today there is so little
data that is disclosed that such analysis is either difficult
or impossible.
These new reforms also need to have some form of third-
party expert certification to ensure that the data is being
accurately reported. Third-party reserves engineers do not need
to calculate proven reserves, just as CPA firms do not need to
produce a company's financial statement; and it adds a degree
of comfort to have an independent expert certify that the data
was properly prepared.
The beauty of enacting the detailed breakout of key
production reserves data by key units is that all companies
already possess this data. It is the data that a lender
requires when a company wants to borrow funds against reserves.
It is what any company wanting to sell reserves needs to
furnish to knowledgeable buyers. If it means a company has to
add 20 or 30 more pages to its financial reports, this is a
small cost when compared to today's system, which leaves too
many shareholders or potential shareholders in the dark. Why
should shareholders not have the same access to the same data
any lender or reserves buyer demands?
If this data reform happens, and it could happen quickly if
all stakeholders join in the request for such key data, the
whole world would be better off. We will begin a new era when
genuine analysis of our energy system's reliability and true
profitability can be ascertained. The time for this reform is
at hand, and this committee can play an important role in
helping this reform be effective.
Thank you for the opportunity of addressing this issue.
The Chairman. Thank you, Mr. Simmons.
[The prepared statement of Matthew Simmons can be found on
page 96 in the appendix.]
The Chairman. Professor Duchac.
STATEMENT OF JONATHAN DUCHAC, Ph.D., ASSOCIATE PROFESSOR OF
ACCOUNTING, WAYNE CALLOWAY SCHOOL OF BUSINESS AND ACCOUNTANCY,
WAKE FOREST UNIVERSITY
Mr. Duchac. Thank you, Mr. Chairman.
The accounting for oil and gas reserves has a long and
tumultuous history and has been periodically the subject of
considerable debate in Congress, the accounting community and
the financial markets. The recent reserves restatements by a
number of companies in the oil and gas industry have once again
placed increased scrutiny on the calculation and determination
of oil and gas reserves information and prompted this committee
to consider the current accounting rules for oil and gas--
whether the current accounting rules for oil and gas reserves
should be revisited.
Oil and gas reserves are, by definition, an estimate and
subject to considerable uncertainty. The amount of oil and gas
reserves that are disclosed in a company's financial reports
are determined by two factors, the definition of reserves and
the reserves estimation process.
The definition of reserves for companies listing on U.S.
securities exchanges is established by the Securities and
Exchange Commission and provides a conceptual foundation for
the reported estimates. This definition focuses on proven
reserves and attempts to limit the variability of reported
reserves information. While the SEC's definition is not
flawless, it is widely considered to be one of the more
rigorous and conservative reserves definitions in place.
The reserves estimation process is a complex process
whereby companies use a wide array of data to develop an
estimate of a company's crude oil and gas reserves. Because the
process is complex, uncertain and relies heavily on estimates,
the resulting reserves values are subject to considerable
uncertainty and estimation. The use of estimates such as these
is not uncommon in financial accounting as estimates are
frequently relied upon when financial information, subject to
uncertainty, provides relevant data points for the users of
financial information.
Central to the accounting estimation process is the
presumption that these accounting estimates will be unbiased
and made in good faith. Random error is an inherent and
unavoidable aspect of the reserves estimation process and
cannot be eliminated. However, for reserves estimates, to be an
effective source of information for external constituencies,
this information must be free of bias or intentional error.
Because of the uncertainty associated with reserves
calculations, additional information often becomes available
that prompts subsequent adjustments to reported reserves. If
that information is incorporated in the reserves estimates in a
timely and unbiased fashion, the adjustments are treated
prospectively. However, if the reserves estimates are known to
change and a company fails to adjust reserves estimates to
reflect these known changes in the underlying fact pattern, the
disclosed reserves are problematic because they do not portray
the best estimate of the company's reserves at the time they
are reported. Thus, the most significant challenge associated
with oil and gas reserves estimates lies not in the use of
estimates but in ensuring that the estimates are made in good
faith and accurately reflect the most recent information about
a company's reserves. If the disclosed reserves do not meet
these constraints, then the value of the information is
significantly diminished.
When reserves estimates are biased or not made in good
faith, correction of these estimates may lead to the
restatement of reported reserves, as we have seen in recent
months. In these situations, the accounting rules have little
influence on the ultimate outcome because the errors were the
result of a breakdown in the reporting process for the reserves
estimates, as opposed to a poorly functioning accounting rule.
The more salient question to consider in this case is, what
steps could have been taken that would have reduced the chances
of presenting reserves estimates that did not accurately
reflect the underlying data, data set and fact pattern.
I would argue that the most effective remedy for this
problem is not to focus on the accounting rules for reserves
estimates, but to improve the procedures surrounding the
reporting and determination of those reserves estimates.
While there is no question that expanding the detail on
reserves disclosures will provide relevant information to the
users of financial information, such additional information
would not directly address the problems underlying the recent
reserves restatements. Rather, process-oriented improvements
would have the greatest impact on reserves disclosure quality.
This can be accomplished through several possible actions,
including ensuring the companies have in place a well-developed
and well-functioning internal control system for the
calculation and reporting of reserves estimates; two,
conducting an independent review of oil and gas reserves
estimates that follows closely along the lines of an audit; and
three, limiting the amount of performance-based compensation
that is tied to reserves balances.
Focusing on process-oriented solutions such as these would,
in my opinion, have the greatest impact on improving the
quality and usefulness of oil and gas reserves information.
The Chairman. Thank you, Professor.
[The prepared statement of Jonathan E. Duchac can be found
on page 51 in the appendix.]
The Chairman. Professor Dharan.
STATEMENT OF BALA G. DHARAN, J. HOWARD CREEKMORE PROFESSOR OF
ACCOUNTING, JESSE H. JONES GRADUATE SCHOOL OF MANAGEMENT, RICE
UNIVERSITY
Mr. Dharan. Chairman Oxley, Ranking Member Frank and
members of the committee, I want to thank you for this
opportunity to present my analysis of the accounting and
disclosure issues related to oil and gas reserves. I am a
professor of accounting at the Jesse Jones Graduate School of
Management at Rice University, Houston, where I have taught
since 1982. Given the time available for my oral testimony, I
will present here only the summary of my analysis, and my
written testimony has been submitted to the committee.
The Chairman. Without objection, all of the statements will
be made part of the record.
Mr. Dharan. Having useful and reliable information on oil
and gas reserves is enormously important to the U.S.
policymakers, managers of the companies, investors and the
public. Over 150 publicly owned U.S. oil and gas producers
filed reserves data in recent years and the reported total
reserves for oil and gas is valued at over $3 trillion.
Companies currently are required to provide unaudited
estimates of proved reserve quantities to the Securities and
Exchange Commission, using definitions provided by the SEC. In
theory, since the SEC definitions are conservative and, in this
era of rising oil and gas prices and improving recovery
techniques, it is hard to envision scenarios where companies
could report significant downward ``technical revisions'' in
proved reserves. In practice, however, recent large downward
revisions in proved reserves by Shell and El Paso, and smaller
restatements by a handful of other companies, have shown that
the reserves data are indeed vulnerable to disclosure quality
risk. In fact, as investors learn more about how reserves are
estimated and reported, it might come as a shock to them that
items on a company's balance sheet such as cash and receivables
are subject to far more external audit and internal controls
than proved reserves estimates.
Some in the industry argue that we just need some small
fixes to improve the usefulness and reliability of reserves
data. Others are calling for more disclosures. However, I think
it is really a case of a larger credibility gap that affects
the reserves disclosures, and it requires potentially new
regulations or at least new industry action to address the
problem.
The credibility gap is caused by what I call two related
factors, quality credibility and reporting credibility. The
quality credibility which affects the relevance of the reserves
information is caused by a lack of common technical standards
and lack of training and certification programs to propagate
the standards among all evaluators. There is also no industry-
wide peer review or monitoring program.
The reporting credibility which affects reliability is
caused by the fact that reserves disclosures are not audited by
external auditors or by external or independent reserves
evaluators. Despite this lack of any auditing requirements, it
is indeed a credit to the hard work and dedication of the
industry's engineers and evaluators that the reserves numbers
they produce are generally stable and are subject to very few
downward adjustments overall.
Rather than relying on continued luck, it is preferable for
the industry to seriously consider proposals for certification
and reserves audit. The five proposals I am going to outline
here, if accepted, would make reserves data more reliable and
subject to the same level of auditing standards as other key
items on the company's financial reports.
The first proposal is to require a certification program
for reserves evaluators. Several industry leaders have called
for certification requirements. Also, ethics education needs to
be part of the training. Such a program should be easy to
implement, given the highly talented work pool that constitutes
this expected technical field and the technical nature of the
reserves estimation process.
The second proposal, to improve the reliability of the
reserves is to require an independent reserves audit. The term
``reserves audit'' refers to the use of independent external
evaluators to audit the reserves report prepared by the
company. If a reserves audit requirement is to be adopted, the
SEC would need to work with the new auditing regulator and the
petroleum industry to go over the technical auditing standards.
The third proposal is for the separation of the reserves
auditing function from the reserves consulting. As we learned
from the recent corporate scandals involving the mixing of
auditing and consulting, the SEC should require a strict
separation between reserves auditing and reserves consulting
functions by a firm for the same client.
Fourth, the industry and the SEC need to adopt a
principles-based approach. The SEC and the industry tend to
rely on a rules-based rather than a principles-based approach.
Instead, they should, along with the FASB, allow a principles-
based implementation of the disclosure requirements, while at
the same time imposing strict internal control and external
audit requirements on the industry.
Finally, the SEC should work toward common international
standards for reserves disclosures by working with the IASB.
Despite the highly technical nature of the reserves estimation
process, both preparers and users of reserves information know
that reserves estimation is not an exact science. This makes
reserves disclosures inherently subject to information quality
problems.
I had mentioned that the current credibility gap is a
product of quality gap and the reporting gap. In my testimony,
I will outline five proposals for regulators for closing the
credibility gap of the disclosed data. These changes which I
support will lead to a significant improvement in the quality
and reliability of reserves data for all users, including the
management of energy companies.
Thank you for the opportunity to present my views. I will
be glad to respond to your questions.
[The prepared statement of Bala G. Dharan can be found on
page 31 in the appendix.]
The Chairman. Thank you and thanks to all of our panel
members. Let me begin with a question for all of you.
First of all, I would like each one of you, perhaps
starting with Dr. Dharan: Why are so many companies at fault
for overstating reserves? Is there one particular cause? Is it
the incentive to do so, or is it just simply incompetence or is
there a bad intent?
Succinctly, where do we stand on that whole issue?
Mr. Dharan. Chairman, I think the low oil prices that we
had in the late 1990s was part of the problem, along with the
lack of attention to internal controls that would have caused
and prevented many of the conflicts that came over the last 6
months. The Sarbanes-Oxley Act clearly has allowed companies,
or forced companies, to focus on these issues today, but they
should have been doing this all along for the last 5 or 10
years.
Mr. Duchac. I would agree with Professor Dharan. I think
the real issue here is that there has been a lack of internal
controls in terms of getting the information from the
estimation process to the financial reports. And there seems to
have been--at least if you look at the big restatements, there
has been a big breakdown in the internal controls between the
estimation process and what shows up in the financial
statements.
So really, especially if you look at the big breakdowns we
have had, it is an internal control problem; and hopefully that
is being resolved by the Sarbanes-Oxley Act.
The Chairman. Thanks for the advertisement. Actually, we
are having an oversight hearing tomorrow on that very subject,
and obviously internal controls will be a major function. This
dovetails very well with what we are going to go after
tomorrow. So I thank both of you.
Mr. Simmons.
Mr. Simmons. I agree with what both of the previous
speakers have said, that the lack of oversight and the lack of
attention was the problem.
But I think the heart of the issue was that the collapse of
oil and gas prices basically didn't commercially allow these
companies to actually collect the same data that they used to
be able to do. And we then coincidentally developed a suite of
technology that essentially convinced too many people that you
didn't need to do these tests.
So it wasn't any sort of a systematic way of overstating
our reserves. These are decent companies, by and large, but we
ended up trapping the industry into a system of not being able
to afford to do the data collection that has effectively set
the limits to what the reserves were. We created the illusion
that costs were coming down and the whole thing ended up
creating a house of cards. So it was low price.
Mr. Knight. I can only speak about Shell, because I have
not looked at the U.S. companies. But what I can say about
Shell is, I think the reason for the problem is really two
reasons. The first is there was a lack of resources allocated
to this issue internally. And the other issue is, I think there
is a cultural disregard for the need to satisfy reporting
requirements within the company that were just felt not
important enough.
I would like to illustrate, because what I am saying, I
think, is quite important.
With respect to the resources which were allocated,
information has been coming out in dribs and drabs over the
last few months about how Shell has been organized, how it is
organized internally. And one of the things that struck me was
my understanding that they only had one part-time reserves
accountant working within a group of this size, responsible for
collecting this data. The data was not being collected
annually; it was on a sporadic basis.
One person for a group of this size, it just gives you some
idea of just how little regard internally, within the
organization, there was for the issue of reserves reporting
under the regulatory definition. And the reason, I think, is
that, throughout the organization, Shell has for years prided
itself on its technology with respect to deep-water drilling,
seismological testing and so on. It has been at the forefront
of this technology. And I think what permeates from this is,
the organization had far more confidence in its own estimates
of what it regarded as proved reserves than anything else.
It is striking when one reads the annual reports to see the
preface to this unaudited reserves data section, which always
starts by saying that ``We don't believe any of this stuff. It
is not important. No one in the industry cares about it.'' I am
paraphrasing a little bit, but that is what they say.
The first point is that within the organization, which is
where the resources are necessary to collect the data, it
wasn't given enough importance. And the second thing is the
question of culture. And what perhaps better illustrates this
is something that came out of the annual meeting of Royal Dutch
2 weeks ago. I was there. What I can tell you is that the
supervisory board chairman, Mr. Aad Jacobs was being questioned
by shareholders pretty hard as to how this whole reserves issue
could have happened. Why weren't the board members aware of
this? And why were they not paying more attention to reserves?
After all, this is an oil company.
And the response was, We do meet with the management very
frequently, and we have breakfast with them.
And the next question was, When did you last meet with the
head of exploration?
And the answer was, I think October or November, 2 full
months before this whole issue started coming out in the public
arena.
And what emerged at this breakfast meeting, the head of
exploration did, in fact, mention to Mr. Aad Jacobs, the
chairman of the supervisory board, that there was a problem
with reserves.
And when one of the shareholders asked, Well, what did you
say to the head of exploration?
I asked him whether he had spoken to his boss.
And the next question was, Well, did you discuss this with
any of your other board members?
And the answer was, I didn't feel it was necessary.
So I think that gives you some idea as to how groups such
as Shell treated the issue of reporting.
Now, I think all of this is changing, of course, and it is
now becoming evident that in order to have access to the U.S.
capital markets there are certain rules which need to be
respected regardless of whether or not you think this is
important. This is changing, but that gives you some idea as to
what was behind all of this.
The Chairman. Let me start with you, Mr. Knight, and go
back here.
And that is SEC accounting standards, they need to be
updated. If so, how?
Mr. Knight. If I can give you my answer as an investor, we
are an investor in Royal Dutch. We do a lot of due diligence.
We didn't give a lot of importance to the SEC reserves data in
our analysis. We looked at the data, but we did an analysis
which went far beyond.
Essentially, what we were looking at was a company which
had a very long tradition of planning for not the next year or
the next 5 years, but the next 2 or 3 generations. That was the
tradition of Shell and that was the reason why one bought stock
in Shell. You bought it because of the dividends. You knew the
dividends were going to increase and you could count on Shell.
That was the tradition and the reason for investing in Shell. A
little bit like gilt.
What was important to us, therefore, was to establish
whether or not the company had the reserves, the long-term
reserves in order to continue paying this dividend and in order
to continue producing an increase in production and so on.
Clearly, the other thing which struck us was the fact that
this company until the last year was doing all of its planning
with an oil price not--unlike in the U.S., it was planning on a
$16 oil price. This is at a time when the oil price was already
over $30. They were doing their capital expenditure based on an
assumption. It was clearly a long, long, way short.
This is the only industry which basically does its
projections on the basis of their price, which is half of what
the current market price is. And the reason that they did that
was because they were all so shocked when the oil price went
down to below $10 a barrel. They started planning on that
basis; and therefore, that is what led, I believe, also, to a
reduction in capital expenditure for about 2 years, which led
to the Group's falling behind in terms of exploration and led
also to what we regard as a temporary drop in its reserves
replacement ratio.
To answer your question, I think--what I believe is
required is that the rules, I think today, need to reflect the
fact that many companies are exploring, producing an
environment which is no longer the onshore environment of 20,
30 years ago. The cost of proving continuity of pressure
between two wells is not $20,000 a hole or $50,000 a hole, it
is $20 million a hole, and there are environmental risks
associated with every hole that is drilled. That needs to be
taken into account.
Companies such as Shell are able to make commercial
assessments to develop these reserves on the basis of
seismological and other data, which today I believe is not
fully taken into account in the SEC rules. So I think that does
need to be taken into account and the rules need to be changed.
And if they are changed, it will be easier for the companies to
follow the rules; and I think it will be more useful for
investors because at least then the reserves data will more
closely match the commercial data.
The Chairman. Mr. Simmons.
Mr. Simmons. I actually applaud the SEC's efforts in this
area. And I think there are some flaws within the system that
need to be addressed, but I actually take issue with a lot of
my friends in the industry that argue that the standards are
outmoded, the technology is removed. I believe actually that is
part of the problem.
But I also think that the reality is in deep-water areas.
It is hard to do flow meter tests. It does cost a lot to core a
well. So I think the issue is far more complicated.
The standards are not outdated. I think we have kidded
ourselves as an industry that technology created some knowledge
it didn't.
Mr. Duchac. Consistent with what I said in my opening
testimony, what you have got with the SEC's definition of
``reserves'' is an estimate; and the question is, does the SEC
rule accurately reflect that estimate and would it change in
the SEC rule, kind of narrow the level of uncertainty
associated with it? Because estimates are going to be
uncertain; they are inevitably going to be wrong. But as long
as they are not wrong in a biased fashion, then you can't
really say that the rule is outmoded.
The question is, can you reduce that level of uncertainty
by changing the SEC rule? Possibly, but the question is, how
much can you narrow the distribution on the uncertainty of
these estimates and what are the costs of narrowing that
uncertainty? And I guess, at the end of the day, the problems
we have seen are not problems with the accounting rule.
The problems we have seen in these recent restatements are
internal control problems. So a different accounting rule would
not have generated a different result in these situations. And
I am not necessarily sure a change in the accounting rule will
get us any further down the road to more reliable or more user-
friendly data. So I would tend to argue that the accounting
rule per se is not the problem here.
Mr. Dharan. The SEC rules are fairly strict and
conservative as they stand right now with respect to the
definition of proved reserves, and I am very comfortable with
them. There is no reason to change them at this point. However,
having said that, the rules are really a function of the audit
process.
The reason why the SEC rules are as conservative as they
are now is because it is rules-based as a result of the lack of
audit requirement at the user end. And as companies adopt
certification and external audit requirements, then we can
expect or we can anticipate that the SEC would be more flexible
in allowing companies to understand the principles behind the
rules rather than trying to use the rules as bright lights.
At this point, I would not change the SEC rules until I set
up those additional control mechanisms.
The Chairman. My time has expired.
The gentleman from Georgia, Mr. Scott.
Mr. Scott. Thank you very much, Mr. Chairman.
I would like to talk with you for a moment, Mr. Knight, on
the governance issue of the Royal Dutch Shell Group. Could you
explain to me the significance of the certain percentage, 25
percent, I think, of the Group's shares are exempt from U.S.
proxy rules. And why is that and what is the downside of that
in the governance issue?
And the other part is that in your testimony you mentioned
that the CEOs of individual energy companies comprising Shell
are powerful and they are autonomous, but it is yet unclear in
terms of their boards of directors, who they report to, who
they are accountable to.
For example, it points out that the parent company boards
meet at a conference, but this is an informal group and is not
vested with any authority, and they are not accountable to the
shareholders of either holding company. And it is somewhat
confusing, but if you could clear up for us this rather
roundabout way of the governance issue, the board of directors,
the CEOs, and who is accountable to what; and why, given the
fact that you have U.S. investors investing in 25 percent of
the companies, they are exempt from U.S. proxy rules?
Mr. Knight. Let me answer the second question first.
The--in any normal, large organization, you would expect to
find the head of exploration, for example, the CEO of the
exploration division, the exploration subsidiary, reporting to
the group chief executive. That is what you find at any large
company.
In the case of Shell, that is not the case. The CEO,
Exploration, does not report to the Group CEO. Mr. Malcolm
Brinded, who is the head of Exploration, does not report to van
de Vijver, who is the Group chief executive.
The question is, who does he report to? There is no real
answer. I believe he does what he wants. I think that is at the
heart of the problem.
The question is then, who does the Group chief report to?
There isn't a real answer to that. The way they have operated
is a way which is totally informal. There is this committee
that is described probably as the best way to run a club. But
to run a major multinational company this way is astonishing.
The analogy I use, Shell is like a big oil tanker. And at
the helm, you don't have one person who is responsible for
getting the tanker to the destination; you have a committee of
people, all of whom are sitting around the helm. The chief
engineer, continuing my analogy, the head of the Exploration
Department, does not report to the bridge. He does what he
likes, goes forward, backwards. They have tremendous autonomy.
There are cases where Shell has been competing--different
departments of Shell have been competing against each other for
acquisitions using their own departments, their own finance
departments and legal departments. It is really, truly
astonishing that a group of this size and this importance can
be managed in this way. The conference, which is the informal
group on these two boards, informal committee, and an informal
group of people. So once again the whole structure is
unaccountable to any one group of shareholders.
So, under these circumstances I think it is--is it
surprising, really, that you don't have any strong central
guidance as to what the basic values of the group should be?
My answer is that under these circumstances, there is--it
is not surprising at all, and the first thing shareholders and
regulators and others should be doing is to ensure that these
things are tidied up to ensure that this isn't going to happen
in the future, because they can beat their breasts and be sorry
about it, but, frankly, I don't see anything which is going to
prevent this from happening again at the moment, unless these
very basic governance issues are sorted out.
Mr. Scott. Well----
Mr. Knight. Now if I may turn to the first question. Royal
Dutch, which is the holding company and owned 60 percent of the
group, and is the largest public company in the Netherlands, is
owned to a very large extent by U.S. institutional
shareholders. Twenty percent of its stock is held in the U.S.
in the form of ADRs, stock which is traded in New York, which
is just held by U.S. institutions. In fact, of the top seven
shareholders of Royal Dutch, four are American institutions.
Only one is Dutch. It is not as if it is a quasicompany
controlled by Dutch, you have a number of other German
institutions and so on. So this group has a very strong, a very
strong tie with the United States. When I say that 25- or $30
billion of stock is traded every day in the United States, that
is what I mean; a quarter of the company is held by U.S.
investors.
It just seems strange, therefore, that under the current
rules which applied with respect to the private issuers means
that foreign companies which come to the United States and have
access to the U.S. capital markets are not obliged to publish a
proxy statement, for example. When they hold their annual
meeting, they are not obliged to publish information which they
may be giving to ISS and others, for example, for the case they
are making in favor of voting for or against a specific
resolution. There is nothing which shareholders can find out
about in the public domain which will tell them what the
company is doing until they get to the annual meeting and they
discover there is a large block of proxies which is held by the
shareholders and makes any vote by the shareholders completely
a waste of time.
Mr. Scott. Let me ask you this. This is the final minute of
my time.
Mr. Feeney. [Presiding.] Without objection, the gentleman
has an additional minute.
Mr. Scott. Thank you very much.
How prevalent is this when you look at what they are doing
as compared with what other international energy companies are
doing? Is this the standard operating procedure with these
loose governance and lack of accountability?
Mr. Knight. My experience with most non-U.S. companies
which have shares traded in the U.S. is that generally speaking
they don't bother to solicit proxies, because they don't really
need to. Shares in Europe, for example, are mostly held in
bearer form. It is very difficult for institutions to again
actually vote their stock.
In this case Shell had a very good reason for doing this.
They wanted to get their shareholders to give the board members
and the management members a clean slate. They wanted them to
give them an absolution. They were looking for what is known as
a legal discharge, and they got it, and they got this through
the mechanism, by using this, by using this exemption. I just
think that under the circumstances, as a shareholder who voted
against giving the discharge, it is a little--is perhaps--is
perhaps a little bit irritating, to say the least.
Mr. Scott. So you have 60 percent of the shareholders of
the United Kingdom, another 30 or 40 percent with the
Netherlands, and 25 percent with the United States?
Mr. Knight. Excuse me, if I may correct you. There are two
companies. Royal Dutch, which owns 60 percent of the group,
Royal Dutch is a Dutch company. You have Shell Transport, which
is an English company, which owns 40 percent of the group. Each
of these has its own shareholders and has its own board
members. So you have two companies, public companies. The Dutch
company, which owns 60 percent of the group, has a very large
U.S. component in the shareholders.
Mr. Feeney. The gentleman's time has expired.
Mr. Scott. Thank you.
Mr. Feeney. Mr. Duchac, you suggest that it is not simply
the accounting issues at Shell, but it is an industry wide
epidemic of overreporting reserves. One of the things that you
touch on, I didn't hear you speak to, but in your written
testimony, is the incentives and bonuses that are delivered to
officers based on the amount of reserves.
Can you describe in greater detail what those incentives
and bonuses look like across the industry, and how we could
disincentivize overreporting by the executives?
Mr. Duchac. I would probably put a disclaimer there. I
don't think I was quite that aggressive in my comments.
Mr. Feeney. We are inviting you to be as aggressive as you
like.
Mr. Duchac. But one of the issues that I think surfaced was
that as part of the bonus compensation or as part of the
compensation schemes for some of the management teams was that
they were compensated at a number of factors, one of those
factors being an increase in the amount of the reserves, which,
you know, intellectually, at least, up front makes sense.
If you are an oil company, you want to expand your reserve
base, so you want to incentivize your managers to have
successful drilling exploration efforts. The downside of that
is that when you put that incentive into the bonus scheme, you
are now in a situation where you may provide an incentive for
many engineers to not report downward or revisions of that
number because of the impact that it will have on their own
personal compensation schemes.
Different companies have different plans. I can't really
speak to across-the-board generalizations, but there are
certain--different companies have different plans. But to the
extent that those reserves are used as part of their bonus
schemes, it is a--it is a potential factor that will contribute
to reserve estimation problems.
Mr. Feeney. Mr. Simmons, in light of Mr. Duchac's testimony
about the incentives, your testimony includes the notion that
there is no such thing as proven reserves until the well runs
dry essentially. You don't know until you are tapped out how
much is down there. So, with respect to reporting requirements,
and in light of the fact that some or most companies want to
encourage the accumulation of reserves, understandably, how can
we best define actual reserves, or what term would you use and
how would you go about diagnosing? You suggested independent
auditors, for example, but give us some suggestion about how we
can more accurately define these things.
Mr. Simmons. Well, I think at the heart, at the heart of
the issue is forcing or suggesting or voluntarily getting the
disclosure standard so enough key data is in the company's
reports that analysts can basically dig into it and analyze the
data. Which is why I come back so strongly to field-by-field or
key production-unit-by-production-unit reports on production,
on number of well bores and on these three variations of
reserves, the amount that you think the structure totally
holds, because that is the starting point of coming to finally
P1 or 90 percent, the amount you think you can ultimately
recover, and both of those should change over time as you find
more data, go up or down, and then finally the amount that has
been totally produced so that you know what the residue is.
Whether you want to go out and further break out P1, P2 and
P3, which is proven, probable or possible, it is a good idea.
But I would say just breaking the data out, it is the
equivalent, or maybe a little bit towards the equivalent, of
towards the tail end of the conglomerate era who finally decide
that it was really sort of crazy to have a company just total
their sales and total their earnings, because analysts actually
couldn't tell whether LTV was an aerospace company or sporting
goods company, and out of that came the business segment
reserve report, business segment reporting.
I think until we get to some form of unit-by-unit breakout,
we can do all sorts of changes, we can do all sorts of
government issues, and we are still going to leave analysts in
the dark. I think until analysts have the right data--my sense
is that there are still smart analysts around that will dig
into the data. It is just when you don't have the data, we
basically have the blind leading the blind.
Mr. Feeney. Mr. Knight, speaking about the blind leading
the blind, you have talked about the governance problems at
Shell and the fact that they basically report to themselves. It
is a very closed organization, based on your testimony. But we
do have sort of an industrywide issue about overreporting,
according to the other testimony.
So have you looked at the other companies in the industry
and what has motivated them to overreport, since you have
concentrated on Shell's governance structure? How does Shell's
governance problems relate to the industrywide aspect of this
overreporting problem?
Mr. Knight. Well, Shell has some very particular problems
of its own, which I have talked about, and which I don't think
I need to repeat. I think it is quite interesting with the data
which has been coming out on reserves. There is a field in
Norway called Ormen Lange, which is a field on which there is
very little hard data available. I think I was talking to one
of my colleagues on the panel here. I understand there are only
four wells that have been drilled in this field, but there are
a number of companies, reporting companies, which have shares
in this field.
The percentage of the total of the overall--the overall
reserve part, if you like, which they are reporting as proven
is very different from one company to the other. It goes as low
as 25 or 35 percent in one case or as high as 80 or 85 percent
in another for the same field, same--the data in theory should
be identical.
I think that to the extent that the information is made
available, analysts, as Mr. Simmons was saying, being perfectly
skeptical about this company's submission because they can
compare it with some other companies'--other companies' data
with regard to a specific field--it becomes very difficult,
when the world is broken down into four regions, and you really
don't know which fields we are talking about. We don't even
know which countries we are talking about in some cases.
Mr. Feeney. Thank you.
The gentleman from Texas. Mr. Bell. You are recognized for
5 minutes.
Mr. Bell. Thank you, Mr. Chairman.
Mr. Simmons, I wanted to go back to something you testified
about earlier, just to be clearer about the data being
unaffordable, and you talked about some of the data collection
techniques. Is that what made it unaffordable, because the
technology involved in collecting the data was so expensive, or
did I not follow that correctly?
Mr. Simmons. Let me take the example of cutting the core on
an appraisal well. I sat next to the senior vice president of
exploration of one of our major oil companies in charge of
Latin America about 6 or 8 weeks ago, and I said, let me ask
you about your impression about coring. Has that become kind of
obsolete? Because if I ask about 100 people, I would get, oh,
yes, we just don't do that much in boring. He said, you know,
when we are operating the field, I would not dream of not
cutting the core and flow-testing, he said; it can cost 20- to
$40 million more, but it is the only insurance of saving a $2
billion mistake. But the longer we had this low-price
environment, you literally--you basically turn a project into
being uncommercial if you did that.
Mr. Bell. If you cut the core.
Mr. Simmons. If you basically drilled the multiple number
of appraisal wells. So out of necessity, as opposed to a
conspiracy, company after company started tossing the towel in.
That is one of the reasons that the independent reserve
engineers started not getting hired. It was a cost-cutting
measure. People started all getting comfortable that we really
didn't need to do that anymore, and, in my opinion, that was
wrong and led to an enormous potential overstatement of
reserves as a systemic problem.
Mr. Bell. Dr. Dharan, I see you shaking your head.
Mr. Dharan. Well, not that I disagree or anything, but I
was just also commenting, thinking about the fact that with a
large energy company, there is always competition for
resources, and when the oil prices were as low as they were--
even hard to believe now--but just 6, 7 years ago, the
competition within the companies was such that the exploration
side was usually getting the least amount of budget.
And some of the problems that the other panelists have
mentioned really are the result of those internal problems. But
at the same time, I totally agree with Mr. Simmons that none of
that should have permitted companies to cut down on the
necessary validation process that they needed to do to evaluate
the reserve quantities. I think that should have been the
number one budget item regardless of the other commitments the
companies had.
Mr. Bell. Mr. Simmons is someone who is intimately involved
in the financing of energy companies and projects. What do you
see as the best route for regulators to take in the wake of the
Shell case? And also, should we be concerned with the reactive,
overreaching policy that could perhaps hamper long-term
production?
Mr. Simmons. I think the worst long-term thing that could
happen to our entry into the oil and gas business in the United
States is a crisis of confidence in the whole reserve issue. We
have just had the convergence, market-to-market accounting, and
this is a totally different deal. But I think if we have a
litany of reserve writedowns, we are asking for a crisis of
confidence in an extremely capital-intensive industry, in a
risky industry, and there is nothing capital hates more than
geological risk and disclosure risk.
So I really think it is really important that the key
stakeholders in this area realize we have a badlyflawed energy
system. We will never get perfection on 90 percent. Trying to
get any 5 companies to try to agree on what is 90 percent
certainly is a joke.
But there are so many strides we could be making. I go back
to my remarks that I made in my oral and my written is watch
the efforts of IAA in Paris, because they are really going the
same 9 yards and trying to get the same disclosure of OPEC,
where we have no data.
One of the reactions that they are getting from the key
OPEC members is why should we have to report things that we are
not insisting on U.S. public companies? I say, no, everybody
ought to be held to these standards.
So I think data reform is extremely important. Whether,
again, field-by-field is the best answer or not--the nice thing
about it is everyone should have the data so you are not
talking about a whole new generation of accounting. But I just
think we need to move quickly into that area, or we are going
to have a crisis of confidence, and it will badly hurt our U.S.
energy supplies. This is too capital-intensive an industry to
scare capital away right now.
Mr. Bell. Whenever you are talking about perhaps more
regulation, there is always a fear of overreaching, and I would
like to pose this to the whole panel in closing: How do you
think we will best avoid overreaching?
We will start down here and just move down the line.
Mr. Dharan. I think as long as we focus on the quality of
disclosures and not the quantity of disclosures, we could first
improve the existing disclosures; make sure that is working
before imposing additional cost of new disclosure. So to some
extent we should always, of course, be concerned about
potentially regulating to prevent the problem that has already
gone away in some ways.
I am not saying that it has happened here, but I just feel
that by first focusing on the quality of disclosures by helping
the industry implement an auditing system, we could then set up
the environment where we could ask questions about do we need
more information, and if so, what is the cost of collecting it,
what are the downsides, and have those kinds of discussions,
without somebody also questioning the validity or usefulness of
even existing information.
Mr. Duchac. I would probably agree with that and say that
the focus really needs to be on process rather than product. If
at the end of the day--I am not sure adding to the disclosure
base right now is really going to do anything right now,
putting four pages in an annual report with more detail will
really help the external constituents.
I think what will help them is focus on improving the
process that generates that estimate so that that process is
more consistent across companies. So if you are comparing two
or three companies, you know that the reserve estimation
process is done in a rather consistent basis for each company
so that you are comparing apples to apples, and that the
process is thorough so that the estimates that are ultimately
generated are the numbers that end up in the finance reports.
So I would argue more focused process in which those numbers
are generated.
Mr. Simmons. And I would just conclude, among my whole
field-by-field reporting, that if the industry actually had
this, it would actually help the industry run itself infinitely
better, so I think everybody wins. And, yes, it is a bit more
complicated, but, again, analysts are actually smarter than we
give them credit for if they have stuff to analyze, but not
right across the board, and right now we are in the dark, and
something has to change.
Mr. Bell. Mr. Knight.
Mr. Knight. I would like to put a slightly different
perspective on this. The idea that you publish proved reserves
lends--leads me perhaps to think what is not proved reserves
just isn't there. The truth of the matter, it is there.
Frequently the only difference between what is proved and
isn't is how much is budgeted by a company to take it out of
the ground. It is a question of budgeting. I think companies
need to be free to allocate capital as they see fit. The idea
of trying to impose on that company a standard which is
presented in a way as being an all-encompassing measure of
reserves is, I think, slightly--is, I think, difficult to
apply.
I think the reality is that most people who invest in this
industry, particularly when they invest outside of the U.S.,
whether it is less consistency of data, if you like, we are
looking at companies which operate in different areas and
regimes and so on, you need to look at other data.
What I think is important is to get the data out there.
There is maybe a slight cost in the sense of getting
consistency of that data may be difficult, but actually having
the information out there and allowing people to form their own
views as to what are probably reserves or possible reserves.
What do I think of allowing people to make investment
decisions on the basis of their own assessment and on the basis
of more complete information? By focusing solely on proved
reserves, which are only a small part of the iceberg since
companies have projects which last decades, if you like, and
which are going to create reserves in the future, I think
misses a large part of the equation. I think, therefore, what I
would like to see is more information, less focus on what is
proven and what is not proven, because, frankly, the idea of
what is proved is slightly artificial.
Mr. Bell. Thank you. Thank you very much.
Mr. Feeney. Thank you.
Congressman Scott, do you have additional questions?
Mr. Scott. No thank you, Mr. Chairman.
Mr. Feeney. Congressman Bell.
Thank you, gentlemen, very much for your testimony. We
appreciate your view, and it is an interesting insight.
With that, Congressmen Scott and Bell, we adjourn.
[Whereupon, at 3:40 p.m., the committee was adjourned.]
A P P E N D I X
July 21, 2004
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