Once again, accounting and nature collide. This time, the wreck occurs in a regulatory climate made volatile by recent scandals of corporate governance.
Royal Dutch/Shell Group is no Enron Corp. Its Jan. 9 reclassification of oil and gas reserves is no scandal. Distinguishing Shell's action from the deliberate deceptions of some other companies is the first step toward understanding and maybe one day resolving a longstanding dilemma.
Role of uncertainty
Investors detest uncertainty. Yet little in business can be more uncertain than quantifying an event crucial to oil and gas companies: changes in oil and gas reserves. The discipline of accounting limits uncertainty reasonably well, when everybody abides by the rules, with performance indicators it can measure. Oil and gas reserves frustrate accounting because they're impossible to measure.
The fault lies with nature. Oil and gas occupy a dauntingly irregular lithosphere that is dauntingly difficult, from the surface, to observe. Even with modern technology, engineers can only estimate volumes in place and recoverable. As drilling and production proceed in any given reservoir, and as technology evolves, estimates usually change.
Confounded by the inherent imprecision and variability, accounting has found no way to evaluate reserves in financial terms satisfactory to investors. In the late 1970s, the US Securities and Exchange Commission addressed the deficiency by testing a method called reserves recognition accounting. It wisely refused to implement the scheme, citing the great extent to which reserves evaluations depend on who performs them. The experiment yielded the current requirement that public companies disclose reserves, strictly defined, in sections of financial reports not subject to audit.
While unaudited reserves disclosures provided important insight into the health and future performances of oil and gas companies, they also spawned a set of metrics that became strained from overwork. An example is "finding cost," which analysts calculate by dividing costs in appropriate categories, which are measurable, by additions to reserves, which are not. They use finding costs as a basis for comparing companies, which employ various approaches to reserves estimation and have legitimate and ineradicable leeway to do so. To an unknowing investor, the convenient dollar-per-barrel ratio can look like a far more precise gauge than it actually is.
Investors, including those knowledgeable enough to account for such ambiguity, nevertheless base decisions on reserves data. When Shell cut its estimate of company-wide reserves by 20%, therefore, analysts had to recalculate many of the measures by which they compare the company with its peers. By those standards, Shell suddenly didn't look as good as it had before. The price of its shares dropped, although not immediately by as much as the reserves change.
What really changed in all this were evaluation parameters, not long-term value. Shell's disclosure didn't mean the company suddenly had lower volumes of oil and gas to produce in the future. It meant it had lower volumes qualifying as "proved" under established definitions. The discrepancy involved extent of development and commercial negotiation, not—in most cases—exploratory success. The difference is significant and easy to overlook in the uproar triggered by Shell's announcement.
Significant, too, is that Shell itself initiated the correction. Its own audit revealed the misclassifications. It doesn't seem to have tried to hide anything, which would have been uncharacteristic.
Any regulatory response to Shell's adjustment needs to be tempered by these distinctions. The issue isn't a lapse in corporate governance. It's the eternal tension between geophysical complexity and the yearning of investors for precision that is, under current technology, supernatural.
Seeking confidence
The potential for overreaction is great. Appeals for remedy abound. One suggestion is that large companies now evaluating their own reserves give the task to independent firms. The results might not be superior. But requiring the external assessment, say proponents of the move, would raise investors' confidence.
Maybe. The confidence, though, would come from the illusion of auditability, which the reserves-recognition-accounting experiment rejected. A central lesson was that different teams of evaluators can produce widely varying estimates of reserves for a given deposit of hydrocarbons. Great technical advances since then haven't standardized outcomes much. Until interpretation becomes far less important to reserves evaluation than it is now, what regulators should seek on behalf of investors is not just confidence, but confidence tempered by caution.