SPEAKERS CONTENTS INSERTS
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SHELL GAMES: CORPORATE
GOVERNANCE AND ACCOUNTING
FOR OIL AND GAS RESERVES
Wednesday, July 21, 2004
U.S. House of Representatives,
Committee on Financial Services,
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.
Page 2 PREV PAGE TOP OF DOC 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.
Page 3 PREV PAGE TOP OF DOC 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.
Page 4 PREV PAGE TOP OF DOC 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 reportingthat 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 deserveand it will vary from industry to industrythat 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 professionperhaps 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 businessbut defines how you are going to have professionals verify that the information in the report is reliable.
If weeither 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.
Page 5 PREV PAGE TOP OF DOC 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.
Page 6 PREV PAGE TOP OF DOC 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?
Page 7 PREV PAGE TOP OF DOC 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.
Page 8 PREV PAGE TOP OF DOC 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.
Page 9 PREV PAGE TOP OF DOC 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.
Page 10 PREV PAGE TOP OF DOC 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:
Page 11 PREV PAGE TOP OF DOC 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?
Page 12 PREV PAGE TOP OF DOC 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.
Page 13 PREV PAGE TOP OF DOC 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.
Page 14 PREV PAGE TOP OF DOC 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.
Page 15 PREV PAGE TOP OF DOC 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
Page 16 PREV PAGE TOP OF DOC 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 gaswhether 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.
Page 17 PREV PAGE TOP OF DOC 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.
Page 18 PREV PAGE TOP OF DOC 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.
Page 19 PREV PAGE TOP OF DOC 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.
Page 20 PREV PAGE TOP OF DOC 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.
Page 21 PREV PAGE TOP OF DOC 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.
Page 22 PREV PAGE TOP OF DOC 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 beenat 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. 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.
Page 23 PREV PAGE TOP OF DOC 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.
Page 24 PREV PAGE TOP OF DOC 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.
Page 25 PREV PAGE TOP OF DOC 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 notunlike 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 thinkwhat 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.
Page 26 PREV PAGE TOP OF DOC 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.
Page 27 PREV PAGE TOP OF DOC 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.
Page 28 PREV PAGE TOP OF DOC 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.
Thein 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 competingdifferent 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.
Page 29 PREV PAGE TOP OF DOC So, under these circumstances I think it isis 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 isit 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.
Page 30 PREV PAGE TOP OF DOC 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 littleis perhapsis 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.
Page 31 PREV PAGE TOP OF DOC 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 certaindifferent companies have different plans. But to the extent that those reserves are used as part of their bonus schemes, it is ait is a potential factor that will contribute to reserve estimation problems.
Page 32 PREV PAGE TOP OF DOC 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 datamy 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.
Page 33 PREV PAGE TOP OF DOC 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 overallthe 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, samethe 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 fieldit 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.
Page 34 PREV PAGE TOP OF DOC 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 literallyyou 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 wereeven hard to believe nowbut just 6, 7 years ago, the competition within the companies was such that the exploration side was usually getting the least amount of budget.
Page 35 PREV PAGE TOP OF DOC 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.
Page 36 PREV PAGE TOP OF DOC So I think data reform is extremely important. Whether, again, field-by-field is the best answer or notthe 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 dayI 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.
Page 37 PREV PAGE TOP OF DOC 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 lendsleads 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, slightlyis, 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.
Page 38 PREV PAGE TOP OF DOC 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.]