Running out of Gas

Royal Dutch Shell was recently caught with their pants down…to the tune of 4.35 billion barrels of non-existent crude sitting in their inventory. The worst part: management didn’t even know. They do now!

Anton Barendregt could have blown the whistle on his bosses at Royal Dutch/Shell…but he didn’t.

"It would have cost me my job, but I should have," says Anton today.

Anton is an employee of Royal Dutch/Shell. His job is to audit Shell’s oil and natural gas reserve estimates. He’s supposed to make sure they’re not saying they have more oil and gas reserves than they really do.

The fact that Anton didn’t question reserve estimates because he feared for his job is not remarkable…it’s typical to see blame cast where it doesn’t belong. But I was really surprised when I found out that Anton works part-time…and that he works alone.

That’s right. A lone, part-time employee was charged with the responsibility of auditing the entire reserve base of the second-largest company in the largest industry on the planet.

Phantom Reserves: 4.35 Billion Barrels of Oil Instantly Consumed

A total of three write-downs since January 9, 2004 have resulted in the instant consumption, sans revenue, of 4.35 billion barrels of oil, reducing Shell’s total reserves by 22%.

Shell’s confession opened the floodgates. On January 27, Forest Oil (FST) publicly lit a match to 49 million barrels of oil previously attributed to its Redoubt Shoal field in Alaska’s Cook Inlet. The company finished its destruction of its phantom oil reserves with a revelation on February 12, which made an additional 23.8 million barrels vaporize. Nexen (NXY) chimed in on February 3, reducing its reserves by 67 million barrels of oil. The day after Nexen’s admission, Husky Energy (HSE.T) eliminated 275 billion cubic feet of natural gas reserves. El Paso Energy (EP) recorded a 1.8 trillion cubic foot negative revision to its gas reserves, about a 40% reduction, according to a February 1 SEC filing. Eighteen days later, the scandal-ridden Westar Energy lowered its Powder River Basin natural gas reserves by 123 billion cubic feet.

Someone should have told Anton Barendregt (and his counterparts at Forest Oil, Nexen, Husky, El Paso and Westar) about the events that took place in Texas and Canada in the mid-1990s…

Back in the mid-1990s, the Railroad Commission of Texas put all the gas fields in Texas on ‘absolute open flow,’ or AOF. That means that they were allowed to produce as much gas as they could sell, and weren’t subject to the monthly production limits. Prior to the announcement, they’d been on ‘full allowable,’ which meant that companies would have to lock in production for the following month – to work off the ‘overage’ – if the production limit had been exceeded in the current month.

Apart from the insanity in Texas maintaining its own microcosmic version of OPEC – the Railroad Commission – the real rub here is that Texas gas producers had been using their allegedly abundant gas and oil reserves to secure numerous revolving credit facilities.

Phantom Reserves: No Extra Gas Output

Imagine the chagrin of investment bankers when they realized that putting the entire Texas gas industry on absolute open flow did not increase the gas output one iota. The reserves were "phantom" reserves, just like those of Royal Dutch/Shell. The non-existent reserves couldn’t be said to be worthless, however…they had proven themselves to be excellent tools for acquiring cheap loans. It’s just that you can’t fill gas pipes with them.

Equally curious was the incident involving the Alliance Pipeline. The pipeline was completed about 10 years ago, solving a gas transportation bottleneck in the Canadian province of Alberta. Before and during the pipeline’s construction, Alberta gas producers had been complaining that they would’ve produced much more gas if it hadn’t been for a dearth of distribution infrastructure [i.e., pipelines]. Then you’d have seen some production, by God. Yet, once the Alliance Pipeline was completed, Alberta gas production levels didn’t rise dramatically…in fact, they didn’t rise at all. So where was all the gas that was allegedly sitting around, waiting for a ride to market?

The events in Texas and Alberta were simply write-downs that occurred at the wellhead, instead of during the audit process. Maybe Shell and the others are to be commended for ‘fessing up now. It appears that in writing down Shell’s reserves, too few drill bits and too many tool-bag bureaucrats seem to have been involved. As a result, who really knows how much oil and gas Shell has today, and how much Shell really had last year? Not me, and not anybody I trust.

Of course, none of this changes the fact that both Texas and Alberta are prolific gas-producing regions. It just shows you that investing in an oil and gas company is a statement of trust, and an acknowledgement – conscious or otherwise – of risk.

Anton, though culpable, was clearly under pressure as a part-time subordinate. He was inherently motivated not to challenge his superiors. One of the larger U.S.-based independent oil & gas producers, Anadarko Petroleum, does all its own internal reserve auditing, too, just like Shell. They’re probably good people doing honest work, but think about this for a minute. If a publicly traded company the size of Royal Dutch said it trusted the auditing of its financial statements to a lone, part-time underling, shareholders would tar and feather the CFO. And he’d deserve it.

Phantom Reserves: Outside Auditing

It only makes sense, then, that petroleum reserves – the one and only source of an oil company’s value – should be reviewed by an independent, outside auditor. And to avoid the development of Andersen/Enron levels of coziness, one might even employ several different audit firms over the course of several years.

Or you could go one better, like some other investor-conscious oil and gas companies do. To be quite technically correct, these select few do not use mere reserve audits or reviews. They provide the basic drilling and seismic data to outside consultants. The outside consultants then tell the oil companies what their reserves are, via complete, detailed evaluations from that basic data. Full reports are completed on all of the reserve properties every year. There are only a few large oil and gas companies where all of the published reserves are the result of reports by independent reserve evaluators, which themselves are rotated to further increase transparency.

In the post-Enron financial era, it is inexcusable for companies in any sector to be overstating the value of their assets. But for the world’s second-largest oil company to overstate its reserves by 22% goes beyond criminality…it’s downright incompetence, nothing less than shoddy, careless management. Thus, four Shell executives, including CFO Judy Boynton, have been replaced. Shell’s earnings will be reduced by $100 million annually – about 1% – 2% – for each of the past four years. I wonder how many 30-hour weeks Anton will have to put in to make up for that loss?


Dan Ferris
for The Daily Reckoning
May 18, 2004

Editor’s Note: Dan Ferris is the editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest shares in the market. Following the wisdom of original value investors Benjamin Graham and Warren Buffett, Ferris takes investors behind the numbers to learn the true value of a business – and to point out from a ‘bottom-up’ perspective which individual companies are trading at prices simply too cheap and safe to pass up.

We received a short missive from Bill this morning. Your fleet-footed editor is deep in the dense equatorial forests of Nicaragua. Unfortunately, he says, the gremlins have foiled all attempts at communication…even radio contact with the Baltimore HQ has been compromised.

Should we forgive him?

Well…since he has lapped the North Atlantic with a series of stops in Paris, London, Las Vegas and Managua – all in a matter of days – we might be persuaded to grant your verbose Paris editor the opportunity to think and rest…and enjoy complimentary airline alcohol.

In the meantime, allow us to introduce you to Tom Dyson. He’s the newest denizen of the Daily Reckoning Baltimore HQ…and proof of what happens to a man when he gets mixed up with our lot. When we first met him, he was calculating daily profits for bond traders at Salomon Smith Barney in London. But life at the DR appears to have sharpened his sense of adventure…yesterday, Tom scaled a drainpipe to get a look inside an abandoned building where H.L. Mencken was supposed to have lived.

But that’s not even the best part…wait ’til you see what he discovered when he got inside…


Tom Dyson, traveling back in time, but still in Baltimore…

– "No one in this world, so far as I know…has ever lost money by underestimating the intelligence of the great masses of the plain people." (H.L. Mencken)

– ‘The Sage of Baltimore,’ Henry Louis Mencken, is considered one of the greatest and most influential of newspapermen, political commentators, critics and authors in the history of the written word. As a columnist for the Baltimore Sun, Mencken lived in Baltimore until his death in 1956. On Saturday, we went to visit his home.

– The early-19th century mansion is now derelict. From the outside, the huge building looks neglected and disheveled. As such, it blends in perfectly with the adjacent buildings. We peered in through the enormous bay windows at a vast, bare front room – a grand reception room for guests or a library, perhaps. Our curiosity was piqued – by decay and dust – and we had to see more.

– We beat our way through a tangle of ivy at the back of the building, which, left to its own devices, had covered every window, wall, fixture and fitting from the basement to the attic. We shimmied up a drainpipe and onto a rusted-steel landing, at the foot of the rusted-steel fire escape. We climbed the ladder with soft steps – the iron had decayed, and most of the footplates were no longer welded to both edges of the ladder. One step broke off and fell to the ground, now three floors below.

– Combing back the ivy revealed an open window, and unable to resist, we clambered through into a crumbling, plaster-strewn bathroom. For the next two hours, we sifted through a network of corridors, stairways, rooms and doors, all devoid of any human attention. There was nothing here but rats, memories and ghosts…and a copy of Barron’s from October 17, 1988, lying in a discolored heap at the bottom of a closet.

– "Happy Anniversary…What Now?" The front-page headline asked, in reference to the imminent anniversary of the Great 1987 crash. On that fateful day, the Dow lost 508 points, making an intraday low of 1,616, and closing 23% lower. In April 2000, the Dow peaked at 11,600. $1 invested in the Dow at the low point of the crash would have been worth $7.18 at the bubble peak – a 13.1% annual return before inflation.

– But Barron’s also helps us calculate inflation…in 1988, our faded tabloid had been purchased for $2. Today, the identical paper costs $4…a 4.7% annual rate of price inflation. Therefore, according to our fatuous calculations, the Dow only yielded an 8.4% real return from crash bottom to bubble top.

– In hindsight, October 20, 1987, was a fantastic buying opportunity. So was October 18, 1988. In fact, it was one-way traffic for the rest of the ’80s and all of the ’90s…but investors weren’t to know that. They had all the same fears that we have now. Even Richard Russell was wary:

– "Russell believes stocks are still in the first phase of a long and tedious bear market," reported Barron’s in 1988, in a column called ‘The Trader’ by Jay Palmer, "a phase when stocks go down for no underlying economic reason. Still to come, he maintains, are the second stage, where deteriorating business conditions and declining corporate earnings push stocks lower, and the final leg, where panic rules the day. Says he: ‘In the third stage, people who are waiting for a rainy day find out it’s pouring.’"

– Yesterday, it poured. The Dow opened 100 points lower following news that a car bomb had killed the head of the Iraqi governing council. It closed the day 106 points further south, settling at 9,907 for a loss of 1%. The S&P lost an identical percentage, closing 12 points lower to 1,084. But it was at the Nasdaq, as usual, where the rain fell hardest…it lost 1.45%, or 28 points to round out the session at 1,877.

– The dollar was unable to find any shelter, either. Trouble in Iraq means bigger bills in Washington…and less valuable bills in your pocket. Initially the buck fell hard, dropping a cent to 1.205 or thereabouts versus the Euro and 113.30 versus the Yen. But as the day progressed, so did the dollar, climbing back to 114.5. Gold opened $5.50 an ounce over Friday’s close, but settled at $379.5, just $2.50 higher.

– Will Richard Russell still be bearish in 2019? Are investors overestimating their expected stock market returns? Did Henry Mencken underestimate the intelligence of investors? Only time will tell…more from Barron’s tomorrow…


Addison Wiggin, back to the future…

*** Police in Britain foiled a $140m gold heist in London yesterday.

The Flying Squad was already lying in wait when the gang burst through gates at Heathrow airport. The prize? 11,500 lbs of gold bullion and $70m in cash.

"The gang threatened staff with at least one firearm, knives, cudgels, hockey sticks and lumps of wood…" reports BBC News.

They then forced their way into a secure area and loaded the goodies into the back of a van. As they drove away, police fired specially designed bullets that deflated the vehicles’ tires. One officer was injured. The goldbugs are in custody.

*** Here in Baltimore, the goldbugs have not yet put in an appearance. No one seems interested in gold, in fact. Instead, our neighbors and fellow citizens pay homage to green paper of dubious value…which is getting dubiouser by the minute.

We preferred the colorful euros that lined our pockets when we were in Paris. But then again, how different is one fiat currency from another? Anything that can be manipulated, will be manipulated, we venture…even, as Dan Ferris points out below, things that don’t actually exist…


Addison Wiggin
The Daily Reckoning

The Daily Reckoning