There are more questions than answers as the industry and the market react to Royal Dutch/Shell's writedown of 20% of its proved reserves. How will Shell redeem itself in the eyes of investors? Are any other majors primed for a similarly shocking announcement? Will new rules and regulations be developed? "It would appear that Shell may have rolled up a series of genuine errors with a sudden shift to very conservative booking policies," analysts with Deutsche Bank in London report. "...We don't know for sure if Shell's problem is contagious." In January, Shell bumped 3.9 billion barrels of oil equivalent of reserves-the equivalent of Anadarko Petroleum and Devon Energy's combined year-end 2002 proved reserves-out of the proved category. More than 90% were classified as proved undeveloped. Two-thirds are oil and gas liquids. About 50% of the reserves are in Nigeria and Australia, and the rest are elsewhere in the company's "other Eastern hemisphere" segment, which includes operations in Africa, Asia-Pacific, the Middle East and Australia. They were booked mainly between 1996 and 2002. Both Shell and some financial analysts emphasize that the writedown does not affect the company's near-term production, or even its overall reserve potential. However, analysts noted that the change wreaks havoc with many of Shell's metrics, by which investors size up company performance vs peers. U.K.-based analysis firm Wood Mackenzie revised its numbers on Shell's organic reserve-replacement performance from 1997 to 2002, and found that the writedown caused the rate to plummet from 105% to 57%. This compares with 116% for ExxonMobil and 152% for BP. For 2003, Shell estimates its reserve replacement will be 70% to 90%. Analysts had hoped for 100% or better. "This continues [Shell's] disappointing recent record of organic reserve-replacement performance," WoodMac reports. In addition, with the new proved-reserve figures, Shell's finding and development costs from 1997 to 2002 rose from $4.27 to $7.90 a barrel equivalent, compared with $3.93 for ExxonMobil and $3.73 for BP, WoodMac reports. Investors were rattled by the news. Royal Dutch shares fell 7.87% after the news. Shell Transport & Trading fell 6.96%. "Shell's announcement has highlighted the problem of relying solely on reported oil and gas metrics in assessing a company's underlying exploration performance," WoodMac reports. "The control of reserve-booking is largely regulated by the companies themselves and there is little transparency as to which discoveries are being included in the 'proved' category." Indeed, a harsh spotlight has been pointed at the issue of reserve-booking, revealing the mystery behind the science. "There is no industry-wide standard for reserve audits, and very poor disclosure," Deutsche Bank reports. WoodMac adds, "We believe that the current situation points to a need for greater transparency in the reporting of reserves. There is also likely to be a call for third-party certification of reserves given the importance of this area as a proxy for a company's exploration performance." Ryder Scott Petroleum Consultants, which prepares third-party reserve reports for many producers, highlighted some of the controversies surrounding the booking of reserves in its most recent quarterly newsletter. The company reported that at the Society of Petroleum Evaluation Engineers Forum in October, a petroleum engineer with the Securities and Exchange Commission blamed undue reliance on "can't-miss technology" for several oil and gas reserve writedowns and impairments during the past two years. At the same time, 82% of attendants who were surveyed at the forum said they did not believe the SEC adequately incorporates today's technology into its reserve definitions, which are 25 years old. More companies are looking for third parties to ratify their calculations. Ryder Scott quoted a survey from John S. Herold Inc. that found that 86% of producers that identified the engineers who calculated the company's reserves in 2002 annual reports used independent engineering consultants versus internal engineers. This is 11% higher than two years ago. Shell's writedown came after an internal review, not a third-party audit. The company has shifted to a group-wide booking standard, rather than leaving the issue to the discretion of local management as in the past, analysts say. Shell's standard for booking reserves has historically hinged on a final investment decision, or FID, says Michael Mayer, an analyst with Prudential. But it appears that some managers did not strictly follow that guideline. "Apparently, there were no FIDs on the reserves that have been recategorized," Mayer says. Gorgon-a major gas venture in Australia-is a good example. It's surprising that reserves from Gorgon were initially booked as long ago as 1997, when a final development decision on the project has not been made, WoodMac reports. "Typically for a large-potential LNG project such as Gorgon to be classified as proven, final gas-sales agreements plus a firm commitment to proceed with the project from the partners would be required." According to media reports, the decision to book Gorgon reserves reflected letters of intent for gas sales and an expected development timetable that have not panned out. ChevronTexaco, the operator of Gorgon, has not yet recognized any proved reserves for the project. Neither has project partner ExxonMobil. Shell's management credibility is hurt, and analysts want to hear from Phillip Watts, chairman and who headed the group's upstream operations when the reserves in question were booked. Watts did not participate in Shell's conference call, which was a surprise and a disappointment, says Mayer. According to London-based analysis firm Evaluate Energy, Shell has long had a reputation for not being as responsive as the other oil majors to investor-relations issues. "...But this latest announcement tests disgruntled investors to the limit. Hence the calls for the resignation of [Watts]," the firm reports. "Initial indications that Shell's directors look likely to support his position suggest the focus is still very much internal." Analysts would get their shot at Watts in early February, when Shell reports 2003 results. They will be looking for more details on the writedown, and a plan for the future. Deutsche Bank expects Watts could re-start a share buyback program to deflect criticism. And it will be interesting to see whether Watts can frame the issue as a fundamental restructuring of the company toward strong top-down management. Deutsche Bank concludes, "Watts is changing Shell...but is it happening quickly enough to offset the sins of the past?" -Jodi Wetuski