Reservations about Reserves

Royal Dutch/Shell Group's reclassification of proven reserves downward has revived questions about whether the industry's self-reported numbers are inflated. At least one study indicates the industry generally understates U.S. numbers.

Now you see 'em; now you don't.

Shell Oil Company set the energy community spinning last week with an announcement the company planned to revise its proven reserves and remove 3.9 billion barrels of oil equivalent from the company's books.

It amounted to a 20 percent reduction in the company's 19 billion barrels of oil equivalent reserves.

Technically the reserves didn't disappear as much as they were reclassified. Essentially the company was aggressive in booking readily accessible reserves in the late 1990s--particularly from foreign projects--as it struggled to overcome the curse of the majors: namely, critical mass is so large, the companies face a greater challenge each year in finding enough new oil and gas to demonstrate meaningful growth.

Shell has been under pressure from the analyst community in recent years because its growth profile, particularly on proven reserve replacement, has not been on par with its peers, BP, ExxonMobil, or ChevronTexaco.

Shell's revisions primarily involve the Gorgon gas project in Australia, which shocked the Australian oil and gas community, and Shell reserves in Nigeria. But the angst that accompanied the announcement is generating calls for the resignation of Shell chairman Sir Philip Watts who, ironically, was in charge of the company's exploration and production segment during the time the original reserves were booked.

The Shell incident re-awakened slumbering disaffection with the method for defining reserves. After all, even "proved" reserves are an estimate of economically and technically recoverable oil or gas. Unfortunately, no one can see with certainty into the earth. Proved reserves are what a company's technical staff says they are, and one has to trust that the company is playing straight--that the check is, in fact, in the mail.

The Shell incident is prompting analysts, rating agencies, and investors to call for greater transparency from oil and gas companies on "proved" reserves, or oil and gas which a company can produce with reasonable certainty.

Definitions of reasonable certainty vary by company. And while the U.S. Securities and Exchange Commission (SEC) has guidelines for defining reserves, even the SEC is not always sure. In October 2002, the agency sent letters to operators in the Gulf of Mexico inquiring how they went about compiling reserve figures. That inquiry has not produced results to date and it is difficult to discern whether the investigation is even moving forward, since the agency has had its hands busy with corporate governance issues.

However, developing greater transparency may be a challenge since some companies view the information as strategic. The lack of an independent third-party opinion is one area ripe for review in the opinion of some analysts. So far, the industry has avoided requirements for independent third-party review of U.S. reserves.

But reserve revisions are nothing new, particularly for international holdings. BP revised reserve estimates down for some of its Russian holdings in 2002 following a third-party review.

And while Shell may be on the way to making the reserve revision Hall of Fame, last week's announcement pales in comparison to the revision in global reserves among OPEC nations in the 1986-1990 era. As the organization set about finalizing quotas among members, it determined that the apportionment should be based on each country's reserves.

The world witnessed the biggest reserve jump ever the following year. In 1987, the Middle East was home to 401 billion barrels in proven reserves. By 1990, the number had risen to 654.7 billion barrels.

Iran and Iraq, then at war with each other, saw reserves rise from a combined 95.9 billion barrels in 1987 to 192.8 billion barrels the following year. Saudi Arabia got to the game a year late, but between 1988 and 1990 Saudi reserves jumped from 169 billion barrels to 257.6 billion barrels.

These are not modest changes.

Closer to home, the U.S. has a reputation for conservatism when it comes to reserve identification. For perspective, it helps to examine U.S. reserves compiled by the U.S. Department of Energy. The agency, displaying uncanny timing, just released its 2002 figures (see "U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves 2002 Annual Report" on the organization's website: The report provides solace to those worried about the possibility that the energy industry has been masquerading behind an Enron-esque "big lie."

The easiest way to conceptualize the DOE's study is the biblical analogy of the loaves and fishes. Despite its nature as a mature province, U.S. reserves continue to stay flat, or even expand a little every year. In 2002, crude oil reserves were up one percent to 22.7 billion barrels. Indeed, U.S. crude reserves have risen in five of the last six years.

Over the last 25 years, U.S crude oil reserves have been characterized by an appreciation in recoverability for existing fields either through better technology, additional exploratory work, or improved downhole information.

In other words, the industry is getting better at what it does.

This is particularly true for natural gas. In 2002 dry natural gas reserves rose two percent to 186.9 trillion cubic feet. Natural gas reserves have increased in eight of the last nine years. In 1992, the U.S. had an estimated 165 trillion cubic feet in gas reserves. It has added 20 trillion cubic feet in 10 years, thanks to the evolution from conventional gas production to nonconventional gas production such as tight sands and coalbed methane.

It points to a unique phenomenon in the oil and gas industry: Sometimes the more effort the industry generates in producing reserves, the more reserves there seem to be. This fact is the nemesis of Hubbert Curve enthusiasts who speculate that the world faces imminent peak oil production based on declines in new discoveries.

The U.S. demonstrates that even mature provinces without a continuing record of dramatic discoveries have plenty of oil and gas left for an industry with initiative, insight, and technological capability. Despite scare talk about accelerating depletion, natural gas crises, declining prospects--and other "Chicken Little" terminology, the trend over the last decade indicates the U.S. energy industry continues to replace more than it consumes.

When it comes to proved reserves in the U.S., you can take the industry's word for it.