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Shell prepares for the next merger round

Financial Times: Shell prepares for the next merger round

“The reserves debacle had seriously dented shareholder confidence”

Tuesday 28 June 2005

By Ian Bickerton, James Boxell, Thomas Catan and Henry Tricks

On the top floor of London’s towering Shell Centre, a cavernous boardroom looms over the Houses of Parliament, filled with high-backed chairs and rows of angled microphones. For decades, British and Dutch directors from two separate companies have held eight “conferences” a year, alternating between there and The Hague, to decide on the business of Royal Dutch/Shell Group. But if shareholders on Tuesday approve the most radical restructuring in its history, the London room will fall into disuse. Instead, board members will assemble each time in a gabled building, topped by a clock tower, in the vicinity of the Dutch parliament.

After nearly a century of quirky cohabitation, shareholders of Royal Dutch Petroleum and Shell Transport and Trading will on Tuesday be asked to approve the formal marriage of the two, which together make up the world’s biggest publicly traded oil company after Exxon­Mobil and BP. The union will put the relationship on a new footing and fundamentally alter the way the company is governed. Shell’s eccentric corporate governance structure – long a source of befuddlement to outsiders – will be scrapped in favour of a modern, “Anglo-Saxon-style” system designed to bring it into line with Exxon and BP, its more successful rivals.

Executives say the shift represents a dramatic transformation of the company’s conservative and consensus-driven culture – changes they say are badly needed if it is to compete in a rapidly changing oil industry. But critics ask why it took them so long to accept the need for change and why Shell had to be forced into it by shareholders following a scandal last year in which the group was forced to slash what it had recorded as proved reserves of oil and gas no fewer than five times. That reduced the level of reserves by one-third, led to a boardroom purge and brought $150m in fines imposed by US and British regulators. Investors question whether the merger will do enough to alter the ponderous way in which the group operates.

“We changed a lot of the culture of this company,” insists Jeroen van der Veer, appointed as Shell’s first-ever chief executive following the reserves scandal and the decision to streamline the group. A soft-spoken Dutchman with a kindly manner, Mr Van der Veer – still eager to show that he and the other executives have taken a firm grip following one of the worst crises in its history – adds: “We were very much a ­bottom-up company. Now there is certainly more direction from the top. I try to give very high clarity on where to go.”

He makes clear that the direction the group is headed will include takeovers. Shell had missed out on the wave of mega-mergers in the late 1990s that saw Exxon merge with Mobil and BP buy Amoco. The failure to participate was prompted largely by a prediction that oil prices would remain low – at around $10 a barrel instead of the $60 seen today. But Shell’s dual structure also meant it would have been hard for the group to use its stock as currency to finance takeovers, as its rivals were doing.

With today’s high oil price, the cost of any deals is much higher. But Mr Van der Veer says the company must be ready for the next wave of consolidation in the industry. “If you study – and I do that fairly regularly – the last 100 years of the oil industry, it is one long story of consolidation,” he says. So you [had] better [be] prepared. You must have the tools in your toolkit.”

The necessary tools were absent when the reserves crisis hit. Shell seemed paralysed. It took some measures to improve the way in which it booked reserves and addressed other compliance issues. But investors were unhappy about the speed at which it was moving after Mr Van der Veer and his new team took over in March last year. Advisers intervened on behalf of large institutional investors to try to press their views about the need for a thoroughgoing overhaul of the company’s structure. Shareholders wanted an end to the company’s dual-board system which, they maintained, hamstrung the company with a cumbersome decision-making process and obstructed accountability.

At first, the group resisted the calls. “They thought the structure was doing well and when the reserves debacle hit, to some extent they were in denial,” says one senior adviser to the company. “They quickly went away from that into a phase where I quite frankly realised they didn’t know what to do.”

Lord Kerr, a non-executive director at Shell Transport and a key architect of the plan to create a single company, admits the company was slow to react to shareholder concerns. However, he defends Mr Van der Veer’s executive team, saying they had first to deal with the reserves issue. “They were mending the roof,” he says, “and we non-execs perhaps took a little time to get our act together, to decide how to go about it. So yes, there were a couple of months in the spring of last year when it may have looked a bit slow.”

Eventually, stung by a campaign from shareholders upset by its apparent inaction, Shell conceded that root-and-branch reform was required. In July, the company hired Citigroup and NM Rothschild, the investment banks, to plan a “radical” restructure.

“The whole reserves issue was a wake-up call for the organisation,” says Rob Routs, who heads Shell’s downstream business. “If you get hit over the head . . . you react – also for your employees. They see us going through mud every day in the papers. You have to react and do things.”

Shell had periodically considered altering its structure, most recently during the 1990s. At that time, the company was doing well and there was little support for change. But things had now changed and reformers saw their opportunity.

Lord Kerr agrees: “The reserves crisis meant that it was not possible for anyone sitting around the table to use the old ‘If it ain’t broke don’t fix it’ argument. Clearly there was something wrong. It wasn’t a direct consequence of a funny governance system that we had the reserves crisis. But the mood of the board was ‘Hey, we’ve got to do better than this’.”

Two broad options were on the table. The first was to create a single unified board while maintaining separate Dutch and British companies – a so-called “dual-header” company such as Rio Tinto or BHP Billiton. This choice represented a tidying-up of the existing arrangement and had the advantage of being easier to do. But the big-bang approach of a full merger had the virtue of simplicity and would do away with the complex corporate structure that so bothered investors. Lord Kerr preferred the more radical option and tried to turn the tables on the conservatives who argued against change. “Those who were nervous about [change had] to explain why they thought it was better to stay complex,” he said. “By the end there was nobody.”

Any changes also had the potential to upset the delicate balance of power within the group that had existed for 98 years. Royal Dutch was in the ascendant when they joined forces in 1907. The then troubled Shell side was forced to join up with Royal Dutch on somewhat humiliating terms – a 60/40 split in the Dutch company’s favour.

Under the new plan, however, the merged company will be incorporated in Britain and listed on the London Stock Exchange. “For some people in the Netherlands, seeing by far the largest company in the Netherlands become a plc with its primary listing London is quite a difficult issue,” says one director.

To offset the perception that it is becoming too British, the company will be headquartered in The Hague and will be a tax resident of the Netherlands. The 60/40 split will also be maintained. A senior adviser to the company says: “The idea was to try to preserve the Anglo-Dutch heritage in as many ways as possible. There was a tax advantage to having the headquarters in The Hague, which made no sense to give up. To the extent that you needed to pacify political interests in the Netherlands, that clearly served the purpose. Equally, having a UK listing played to the UK gallery.”

On October 28, Shell announced a shake-up to create a single company governed by a single chief executive and a single board of directors. The proposals went beyond what many investors had been calling for. The number of board members is being cut from 21 to 15, with a majority of independent non-executive directors. The structure will enable the company to make decisions more quickly and efficiently, the leadership says.

That raises again the question of takeovers. For western oil companies struggling to replace their reserves, acquisitions make an attractive option, although they will need to fight off growing competition from Chinese and Indian rivals. As one adviser says: “Shell has always denied their strategy was to be part of the consolidation that took place a few years ago but when you talk to them there are signs of regret. There is a relatively concentrated layer of super-majors, but in the next layer down there is enough scope to have at least two or three big moves. If Shell didn’t take the step now, it would have disadvantaged itself in that potential endgame.”

In some respects, however, the new structure is not ideally suited for takeovers. Shell says it has introduced two lines of stock for purely technical reasons – mainly to avoid former Shell Transport shareholders having to pay Dutch withholding tax. But some bankers involved in the deal admit the need to appease the British and Dutch sides also played into the decision. “It’s been done in a politically correct way,” says one adviser. “If Shell was a private company and about to float, would it have been structured like this? Probably not.” A board member also concedes the deal represented a “political bargain” as well as a practical solution.

Some worry that the share split may make it more difficult for Shell to use equity for takeovers. A target may have trouble deciding if it wants the A or B class of shares that are to come into existence (see below). It makes it more complicated for index trackers as well, who must also decide whether to hold both classes of shares. Advisers warned of these difficulties when designing the new structure but, because of national considerations, concerns were shrugged off. “Everyone recognises the A and B shares are sub-optimal,” said one adviser. “But it’s not a deal-breaker.”

Lord Kerr concedes the decision was part of the bargaining process, but insists it still represents a big improvement on the existing structure. “Nothing in the world is absolutely perfect, but this is damned near it,” he says. “A single class of shares? I agree, it would have been tidier. But it would not have been deliverable. As to [whether the new structure is] optimal for acquisitions – it’s a hell of a lot better than where we are now.”

Investors have broadly welcomed the changes to Shell’s corporate governance. But some say moving boxes around on an organisational chart will not alter the fundamental problems faced by the company – principally its failure to find new oil and gas. “This restructuring stuff is marginal,” says a banker. “What investors really want is for them get back to business of finding and producing oil; this is what generates the numbers. If you can’t do it at a $60 oil price, you should give up.”

Shell executives insist the changes are not cosmetic. Mr Routs, head of downstream operations, says he is already seeing tangible benefits. If I compare differences in the team in terms of operating, it is night and day,” he says. “We are now a more transparent, supportive, action-orientated executive team that makes things happen. There is not a lot of consensus-seeking in the old way of expressing it. We come to conclusions faster. We come to deals faster.”

Mr Routs has divested about $5bn of his business in 18 months, more than 10 per cent of the downstream asset base. Such quick action would have been “unthinkable” before, he adds. “Things are happening clearly at a higher speed.”

The reorganisation of the company would not have happened without the reserves crisis, many believe. But Shell still does not accept that the reserves crisis was a result of its management structure. That has left investors baffled. If there is no connection between the reserves crisis and the structure, then why change at all? Conversely, if much of what is proposed is “common sense”, as Mr Routs now says, then why was it not done sooner?

Some believe that the directors of Royal Dutch/Shell agreed to the restructuring not because they really believed in it but as a sop to disgruntled investors. As a senior adviser to the company says: “The reserves debacle had seriously dented shareholder confidence and I suppose [the big-bang approach] was ultimately also a way of demonstrating to shareholders that we can deliver.”

Lord Kerr is adamant that the restructuring was no mere exercise in public relations. “I gave up my summer last year and it wasn’t for a PR bang. I mean, come on,” he says. “It was not to achieve a positive PR impact that we worked our butts off.” And although the reserves crisis was not the direct result of the company structure, he adds, the changes will help the company deal with any future issues that come up.

“This was the right thing to do,” he says. “It doesn’t guarantee that we will deal better in the future with the problems that come up than we have in the past. But it gives us a better chance.”

Sources for charts: Thomson Datastream; CSFB

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