The conference call in January 2004 that highlighted Royal Dutch/Shell's incredible downgrade of 20% of its proved oil and gas reserves set off a snowball effect that has barely slowed down, though the company is believed to not be in danger of going out of business. It reported net income of $5.4 billion in third-quarter 2004, and had nearly 2.3 billion barrels of reserves under its belt during that same period. Yet the earlier reserves faux pas left a bad taste with investors, and even executives at Shell had questions. As the company tried to regain momentum and the public's trust, in the fourth quarter of 2004 it embraced a drastic restructuring that, to some, is a very small step on the road to recovery and is long overdue. After a reserves review by reservoir-analysis firm Ryder Scott in 2004, Shell downgraded 200 million barrels of oil equivalent (BOE) of proved reserves that were on its year-end 2002 statement, and reduced the volume of proved reserves it anticipated reporting for year-end 2003 by 500 million barrels. Total downgrades thus far are 4.35 billion BOE for 2002 and 720 million for 2003. In the wake of the reserves fiasco, Philip Watts, chairman of Royal Dutch/Shell Group at the time, dug his heels in and tried to turn things around with cost-cutting and strategic midsize acquisitions. Shell's reserve-replacement ratio improved to 98% for 2003, above its estimated 59% average during the previous five years. Because of the debacle, in March 2004 he stepped down as chair and managing director. Jeroen van der Veer, the president of Royal Dutch Petroleum, succeeded him. In a further step to bolster its reputation and improve future production figures, RD/Shell executives announced in late 2004 that capital spending will increase to $15 billion per year for 2004-2006, with $11.5 billion annually dedicated to the major's upstream business. Divestments of nonstrategic and underperforming assets are expected to grow to between $10- and $12 billion during 2004-2006. In 2004, the company estimates that its cash proceeds from divestments totaled more than $4 billion. Company representatives repeatedly said that the changes in reserves estimates would not affect near- to medium-term earnings since the reserves were undeveloped, but "this fails to address one of the key issues-whether investors can really be sure of Shell," says an analyst with London-based research firm Evaluate Energy. "[It] has long had a reputation for not being as responsive as other majors in its investor relations, but this announcement tests disgruntled investors to the limit." To add to investors' dismay, Shell's unique ownership structure that dates back to the 1890s-two separate, publicly traded Dutch and English companies with their own boards and bylaws-remained under fire. The complexity of such an arrangement, in the eyes of many analysts, weakens management, discourages mergers and makes accountability impossible. In a surprising move, in October 2004, the boards of Royal Dutch/Shell and Shell Transport & Trading Co. agreed to unite the companies under a single parent, Royal Dutch Shell Plc. As part of the restructuring, Royal Dutch shareholders would receive 60% of shares of the new company and Shell T&T shareholders would receive 40%. The new RD Shell, which will be headquartered in the Netherlands, will have one board, led by van der Veer, and will consist of 10 nonexecutive and five executive directors. The full transition is expected by May. Though company executives may have expected a strong reaction to the decision, analysts' reception is, at best, lukewarm. Michael Mayer, an analyst with Prudential Equity Group LLC, believes the combination of the companies will improve valuation, modestly, but expects this positive effect "will be negated by the overhang of another negative reserve reclassification." Jacques Rousseau, an analyst with Friedman Billings Ramsey, sees the move as positive in corporate governance, but he continues to have concerns about production pitfalls. Royal Dutch/Shell's production-volume growth rate is lower than its peers' and its return on capital employed may decline in coming years due to rising capital investments, he adds. "...We believe it will take a number of years before the company can become competitive with other major integrated oils in terms of financial performance and shareholder returns," Rousseau says. He recommends that investors reduce their exposure to Underperform-rated Royal Dutch/Shell in favor of more stable entities such as ExxonMobil and Total. At the annual IPAA meeting last fall, Raoul Restucci, chief executive, Americas, for Shell Exploration & Production Co., encouraged the industry to once again support Shell's efforts in the U.S. He said that, while the company's focus had drifted from North America in the past, it is now back and plans to stay. He asked for cooperation from fellow producers and expressed the need for solid partnerships. "Don't see us as a predator, see us as a partner of choice," Restucci said. Though the reserves-reporting mishap developed a year ago, its shadow continues to hang heavily over any positive news coming out of the RD/Shell camp, despite Restucci's pleas for trust and the herculean efforts of management. Rousseau says, "Royal Dutch indicated that its ongoing assessment, which has so far encompassed only 55% (8 billion BOE) of reserves, may lead to an additional 900 million of reserve write-downs. The definitive figures will be provided in early 2005." This latest warning about Shell's reserves was the fifth such announcement in 2004. Standard & Poor's credit analyst Eric Tanguy acknowledges Shell's robust operating performance and cash flow generation in late 2004, as well as the company's solid financial profile based on end-September credit measures. "The current CreditWatch status reflects the negative impact that another reserves restatement would have on the company's business profile." S&P will resolve the CreditWatch status when Shell provides results from its review of the proved-reserves base in early 2005. Deutsche Bank analyst JJ Traynor is also cautious. "Shell's investment case has moved from reserves controversy, to a two- to three-year industrial recovery story," Traynor says. "With oil prices peaking here, and the majors rallying recently, we recommend a more cautious stance on Shell, and the group." He had a Hold recommendation on Shell at press time. "The positive news on corporate structure has clearly provided a technical lift to the shares," says Merrill Lynch analyst Mark Iannotti. "However, on fundamentals we now view the absolute and sector relative valuation as being fully up with events, which by the way include a further major downgrade to booked reserves. Quite frankly, despite a good set of numbers that exceeded the consensus, we would have called the shares sharply lower on the reserves news had it not been for the announcement of unification of the two holding companies into a single entity." Shares of Royal Dutch have held up well in the face of such tremendous controversy, trading in early January at around $56 each, and up from around $45 in March 2004. The percentage change, 24.4%, was about that of ExxonMobil shares, which were improved 25% at press time from March 2004, and BP shares, which were up 25% as well from March 2004. Despite the ripple of excitement over the company's decision to ditch its current corporate structure in favor of a more American model, what continues to capture everyone's attention-rightly-is the company's reserves. "Long before this announcement, some analysts were questioning how Shell was going to sustain its reserve-replacement rates unless its revisions were sustained at historically high levels," says an analyst at Evaluate Energy. "The answer appears to be: 'with difficulty.'" It seems this spring might be a bit too soon to expect a complete turnaround-whether the board becomes a single unit or not. Yet some analysts still hope that, in time, it will be safe to have faith in the company's forward-looking statements. "Ideally, you would like to invest in an oil and gas company that has both high reserve-replacement rates and relatively low finding and development costs," the Evaluate Energy analyst says. "Shell, unfortunately, now appears to offer neither."

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