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The Times: Problems arise when tails are counted as legs

August 31, 2006

Analysis by Patrick Hosking
THE worst scandal to hit Shell in its 170-year history came out of the blue one January morning in 2004.

Shell executives confessed in a conference call to amazed City analysts that the company’s reserves of oil and gas had been overstated by 25 per cent. 
They admitted that reserves — from Nigeria to Australia to Russia — that had been described as proven were, in fact, much less certain of being exploited. All told, they had exaggerated the company’s energy wealth by 3.9 billion barrels, enough to supply the world for 50 days.

It was a ghastly admission for a blue chip company that had built a reputation for conservative accounting and absolute probity.

It was made worse by the failure of Sir Philip Watts, the executive chairman at the time, to deliver the news in person. Furious investors felt duped and slighted and dumped the shares, and Shell lost 7.5 per cent of its value in minutes.

However, that was only the start of a slow-motion corporate train wreck that lasted for more than 18 months. Even today, after a clearout of senior executives and a restructuring of the cumbersome Anglo-Dutch management structure, Shell continues to suffer.

To the horror of its shareholders, Shell downgraded its reserves estimates four more times. Results were delayed, the original annual report had to be pulped and an atmosphere of panic and recrimination pervaded Shell’s UK headquarters on the South Bank in London.

Senior managers were dismissed. Sir Philip went first, with a £1.06 million payoff and a £469,000-a-year pension, along with Walter van de Vijver, his exploration chief. They were followed by Judy Boynton, the chief financial officer.

Meanwhile, the Financial Services Authority (FSA) in Britain and the US Department of Justice and the US Securities and Exchange Commission started investigations.

What reverberated the most was an explosive e-mail from Mr van de Vijver to Sir Philip, revealed in an external report in April 2004, in which he complained: “I am becoming sick and tired about lying about the extent of our reserves.”

That seemed to support the view that the affair might be more than a simple management cock-up, and that it might involve knowing conspiracy in the senior echelons of Shell. That suspicion was underlined in August 2004 when the FSA and the SEC imposed fines of £17 million and $120 million, respectively, for misconduct and made clear that their investigations into individual culpability were continuing.

Then the tide started to turn for Sir Philip. The Department of Justice abandoned its criminal investigation in July of last year.

The FSA shelved its inquiry into Sir Philip and one other unnamed Shell executive last November, despite a successful initial skirmish with Sir Philip in the Financial Services and Markets Tribunal. Yesterday the SEC closed its investigation into Sir Philip.

Shareholders who bought Shell stock between 1998 and 2004 were, in effect, buying under a false prospectus. Tens of millions of workers whose pension funds invested in the company during that period were unwittingly short- changed, paying inflated prices.

Yet, so far, the UK and US regulators have found that no individuals were seriously culpable; or, at least, they have not been able to amass sufficient evidence if anyone was.

As much as anything, pride probably lies at the heart of the scandal. In the mid-1990s Shell was falling behind its peers in its reserve replacement ratio, a key measure of whether an oil company is growing or shrinking.

Rather than redouble its efforts to find new reserves, Shell opted for the altogether easier method of relaxing the methodology by which it booked reserves.

A favourite riddle of Warren Buffett, a zealot for conservative and honest accounting, goes like this: how many legs does a dog have if you count tails as legs? Answer: four, because tails aren’t legs.

Shell counted tails as legs for years. The failure of regulators to pursue individuals doggedly for that collective failing can only shorten the odds on more egregious tail-counting by other companies in future. Shareholders, be warned. and its also non-profit sister websites,,,,, and are all owned by John Donovan. There is also a Wikipedia article.

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