Oil

by Tom Bower

  Still scorched by Brent Spar and Nigeria, Moody-Stuart sought to rebrand Shell as honest and transparent. The company, he acknowledged, needed to establish “public trust,” values of “sustainable development” and “social responsibility.” Acknowledging that such matters concerned Europeans more than Americans, he added that “Analysts do not value those things highly, but some major shareholders definitely do.” Exxon and Chevron, he knew, did not suffer the same burden. Doggedly, he persevered. To hasten the “internal merger,” Shell’s country chairmen had been disempowered, and responsibility for taking major decisions on exploration had been centralized in The Hague and London.

  The turbulence was not welcomed by the 8,000 dismissed employees, particularly those who had been enjoying perks in the abolished hierarchies, or by the axed country barons in Britain, Holland, Germany and France, but the reforms did improve the company’s effectiveness. The profits in 1999–2000 would increase by 38 percent to $7 billion, compared to 1998, when profits in the third quarter had fallen by 56 percent. But the financial improvement glossed over Shell’s failure to find new oil and gas. Negotiations had started with the Nigerian government for a five-year development program worth $8.5 billion in more stable areas away from the delta to produce an additional 600,000 barrels a day, and there was also the Brutus field in the Gulf of Mexico, which would produce over 200 million barrels of oil and gas; but those projects were insufficient to replace Shell’s annual depletion.

  Brutus, a cutting-edge development that involved drilling 20,000 feet into the rock from a rig a mile above on the sea surface, was being supervised by 43-year-old Walter van de Vijver, Shell’s chief executive in the United States. Although talented, “the Tall Angry Dutchman” had been summoned to The Hague to receive informal warnings about his manner. Moody-Stuart had ordered him to negotiate a collaborative venture between Shell and Enron, a major international electricity and gas supplier. After lengthy meetings in Houston with Ken Lay, Enron’s chairman, van de Vijver reported to Moody-Stuart, “I can see no sense in their model.” Renowned for spontaneity and impetuosity, van de Vijver concluded that Moody-Stuart’s enthusiasm for the Enron deal exposed him as another Briton prone to pursue unreliable market trends and following the last man’s flawed advice. Van de Vijver was equally prejudiced against Phil Watts, Shell’s head of exploration and production. Brazenly, he told John Hofmeister, the director of human resources, that he regarded Watts as an obstacle rather than a boss; and he similarly dismissed Jeroen van der Veer, responsible for Shell’s chemical industries, as “useless.” His contempt for his colleagues mirrored the fractured relationships among Shell’s directors during 2000 as they decided on Moody-Stuart’s successor.

  Jeroen van der Veer was favored by van Wachem, but was regarded as too young. The second candidate was Paul Skinner, the head of downstream, criticized by some as “a legend only in his own mind.” Resistant to the new requirements of diversity and inclusivity, Skinner was rejected on Moody-Stuart’s suggestion in favor of the 55-year-old seismologist Phil Watts. Watts’s candidacy was opposed by Chris Fay, the recently retired chairman of Shell UK, who mentioned his suspicions of a “geological mafia cover-up” to Moody-Stuart. Fay suspected that Watts’s reduction of the exploration budget, his unsuccessful search for new oil and gas, and Shell’s recent reinterpretation of its existing reserves to increase the amounts of oil and gas under its control was concealing the actual depletion of the company’s assets. His protest was ignored, and subsequently Watts took issue with Fay’s comments. Moody-Stuart had no doubts about Watts’s integrity. “He is a good Christian and very thorough,” he said. Although Watts could occasionally be a bully, Moody-Stuart felt his energy and ability were what was needed to destroy “the bureaucratic monolith.” Others believed he was too aggressive. Contrary to Shell’s gentlemanly traditions, Watts enjoyed playing hardball, and could be abrasive with those who failed to match his standards.

  Those who doubted the wisdom of Watts’s appointment as chairman in December 2000 were equally nervous about the promotion of van de Vijver to head of exploration and production. The intemperate Dutchman’s dislike of Watts was unlikely to foster a collegial atmosphere, especially as he spoke of himself as having been chosen to inherit the chairmanship. Moody-Stuart decided to ignore how the mutual dislike between van de Vijver and Watts would be aggravated by the inherent tensions among Shell’s management. According to Shell’s unique constitution, Watts, although the chairman, lacked any authority over the Dutch directors, including van de Vijver. Unlike Lo van Wachem, Watts’s personality would undermine his attempts to impose his authority, which was certain to give rise to difficulties in the future, considering van de Vijver’s disdain for Watts. The mutual distrust was interpreted by van de Vijver as confirmation of his eventual succession. Initially, Watts was uninterested in van de Vijver’s dreams. His own ambition was to revive Shell, and he could cite his success in Sakhalin, the huge development on Russia’s Pacific coast, as evidence of the repairs that had been made to the company’s international reputation since Ken Saro-Wiwa’s execution.

  In the early 1990s Watts had identified the production and sale of natural gas as profitable. His “Walls of Gas” strategy was built on Shell’s mastery of the complicated technology shared only by ExxonMobil. Years earlier, Watts had been enthusiastic about Shell’s LNG ambitions in Brunei, Malaysia and Australia, but nationalization in Malaysia and government-inspired delays in Australia had frustrated the company’s schemes. But Shell’s development at Sakhalin 2 offered potential profits from LNG.

  The bid for a license to develop the oil and gas deposits at Sakhalin 2 had been won by Marathon Oil in 1990. Knowing that the costs of exploiting the reserves were too daunting for his company, Vic Beghini, Marathon’s president, identified Shell as the only major oil company that was suitable to become its partner. Teo Oerlemans, a senior Shell engineer, stressed Sakhalin 2’s principal advantage to Shell’s directors: LNG could be shipped directly to Japan without using Russia’s pipelines, and Mitsui had contracted to buy the natural gas. Accepting Oerlemans’s advice, Shell became Marathon’s junior partner in 1992. By 1994, Shell’s engineers had condemned Marathon’s technical competence as “bad” and their relationship with Marathon’s employees as “terrible,” but Beghini resisted pressure from Sakhalin’s governor to replace Shell with Exxon. On June 22, 1994, witnessed by US vice president Al Gore and Russian prime minister Viktor Chernomyrdin, the $10 billion contract to develop Sakhalin 2 was signed in Moscow. The agreement, said Gore and Chernomyrdin, proved that Russia would abide by international law and would regularize its tax policies. Under the first PSA agreement with the Russian government, Marathon had 30 percent of the venture, Shell 20 percent, and the remainder was divided among other Western companies. The development of the project was slow, expensive and beyond Marathon’s finances. On December 13, 2000, after Beghini’s retirement the previous year, Watts flew to New York and bought out Marathon’s interest. Shell now owned 51 percent of the company, with Mitsui and Mitsubishi owning the remainder.

  Watts’s success was significant. Since finding oil in 1958 on the West African coast, Shell had barely added to its portfolio. It had gained a share of the oil in the North Sea and the Gulf of Mexico, but had failed miserably in South America. $300 million had been wasted drilling dry wells in Alaska, forcing Shell to abandon some exploration in the Gulf of Mexico and reluctantly to accept BP’s investment to continue exploring in the Mars field. Sakhalin 2 ended those barren years. Within the company there was jubilation. Potentially, Sakhalin was a cash cow, but only after engineers had overcome unprecedented difficulties to build the first $3 billion “train” to produce the LNG. Veterans of the North Sea boom were recruited to build two offshore platforms and pipelines to produce 90,000 barrels of oil a day, all year round. Limited production of oil had started, albeit restricted to the six warmest months of the year, and the first tanker had left Sakhalin for South Korea on September 20,
1999. Watts had good reasons to celebrate.

  Watts’s self-congratulation concealed his artlessness about Russia. He had bought Marathon’s share of Sakhalin 2 without adequately considering the reaction of the Russian government, assuming that his negotiations and Marathon’s payments, as requested by Valentin Fyodorov, Sakhalin’s governor, to improve the region’s infrastructure, had secured Shell’s position. Disdainful of Moscow’s control, Fyodorov encouraged Watts’s conviction that any deals made locally were beyond the Kremlin’s control. Russia’s internal turmoil seemed to encourage that belief. The chiefs of Gazprom expressed no interest in Shell’s plans, not least because, without any money or expertise, the Russians could contribute nothing to the project. Observing the unlimited powers exercised by Fyodorov until 1993, and by Igor Farkhutdinov, the governor after 1995, Watts assumed that everything would be agreed upon locally. Shell was providing Farkhutdinov with the finance to split from Moscow, but neither Watts nor the company’s directors in Europe considered the implications of encouraging his autonomy. Unlike in Nigeria, where Shell could rely on the British Foreign Office for advice, it was short of the diplomatic support in Moscow enjoyed by Exxon, Chevron and BP. Shell’s executives thought a close relationship with Farkhutdinov would suffice. “We don’t need to consult anyone in Moscow,” said Watts, slightly troubled that the contracts agreed to with Farkhutdinov were “a little too splendid.” Critics of Shell mentioned their impression that Russia appeared to be being equated with Nigeria, and that the Russians were regarded as vodka-drinking idiots. The more malicious suggested that the appearance of a black Nigerian engineer in Sakhalin, and of a female project manager, had irritated those Moscow bureaucrats who did not appreciate Shell’s diversity programs. More seriously, the bureaucrats in Moscow did resent Shell flying local Sakhalin officials to The Hague for “indoctrination.” To Watts, distant Moscow was easily forgotten. He had found penetrating the small clique governing Russia impossible, and the PSA agreement was watertight.

  To protect Shell’s $10 billion investment in Sakhalin, the LNG had been presold in Asia as a guarantee for loans from banks, to order the special tankers and hire thousands of skilled engineers to build the production facilities. Watts knew that Shell’s directors would never have committed the company to a $10 billion project before “placing all those ducks in a row” and without owning 51 percent of Sakhalin. He also knew that Shell’s investment was impossible without a flawless PSA agreement, guaranteeing profits and limiting taxes. The Russians had no wiggle room in the future. But most important, with oil prices between $10 and $15 a barrel, Shell’s skeptical directors had only approved the project after being reassured that the costs would be low. Forcefully, Watts had persuaded his budgetary staff to shoehorn the project within the $10 billion budget. Few involved in the calculations visited Sakhalin, and even those who did derided the higher estimates by the “elephant riders” in the Far East before producing a precise estimate of $9.624 billion. Watts’s assertion that Sakhalin 2’s profits would be considerable, and the costs contained within the budget, had assisted his selection as chairman. With unconcealed self-praise, he rated Shell’s PSA agreement as superior to Exxon’s for Sakhalin 1. After five years of negotiations, finalized between 1995 and June 1996, Exxon had been compelled to accept a 30 percent stake, and to include two Russian companies with a total stake of 40 percent and other partners in the $15 billion project. Further down the food chain, after five years Mobil, Texaco and Exxon were still waiting at the end of 1999 for an agreement to develop Sakhalin 3.

  The mega-mergers and low-priced oil had placed additional pressure on Watts, when he was head of exploration and production, to meet Moody-Stuart’s targets to increase Shell’s profits and size, especially after the horrors of 1995 and a poor exploration record, which included Shell having successfully bid for the worst acreage in Angola. Like BP, Shell was focused on increasing dividends to improve its share price. The stock market value of oil companies was partly dependent on the amounts of oil they owned and had available for production. To achieve growth without risking money meant producing more oil, and the cheapest way to do that was to improve engineering at existing wells. An alternative was to increase the amount of oil and natural gas categorized as “reserves.” The valuation of reserves was determined by a combination of industry guidelines and experts’ estimates, and a formula devised by the American Securities and Exchange Commission. The guidelines for booking reserves were first published in 1936 by the American Petroleum Institute, and changes to reassure shareholders about their company’s value, requiring “reasonable certainty” of production, were implemented in 1978. A company could not book reserves until money had been allocated for drilling and production was anticipated. As technology improved through horizontal drilling, the oil companies agreed that the SEC’s interpretation was unreliable, and that its interference should be rejected. Presuming that the SEC would accept the companies’ own estimates of their reserves, each oil major adopted its own individual criteria.

  Shell’s standard changed in 1997. Moody-Stuart was under pressure to prove the company could grow without a merger, and his desire to “improve efficiency” extended to enhancing its reserves of oil and gas. Shell’s “Leadership and Performance Group” was ordered to issue a directive to “create value through entrepreneurial management of hydrocarbon resource volumes.” In future, Shell would book reserves without allocating any money for production: the reserves would be increased simply by relaxing the guidelines. In the past, reserves had been decided locally by each country chairman, and it seemed each country had used different rules. To achieve uniformity, Watts endorsed the company’s decision to reinterpret the rules, assessing reserves upon a “reasonable expectation” of an available market rather than using the SEC’s gauge of “reasonable certainty” of producing and selling them. The change of policy had started in 1995, when Nigeria’s rulers, to improve their ability to raise loans and channel more money into their Swiss bank accounts, had encouraged Shell to increase its oil reserves by four billion barrels. To justify the increase, Shell and other oil companies were offered more acreage for exploration. This had coincided with Shell’s own initiative, the Reserves Addition Bonus. Embarrassed by its falling share price, Shell’s directors had asked Tim Warren, the head of technology in exploration and production, to investigate whether its reporting of reserves was too conservative, and could be increased by relaxing the accounting guidelines.

  By that time Watts had become director of strategic planning and sustainable development. Although he was not directly responsible for Nigeria, he and the local country chairman were induced to increase Shell’s reserves, and to agree to the Nigerian dictators’ request even though chaotic conditions in part of the delta prevented exploration. No one in The Hague questioned the abandonment of the company’s natural conservatism and its policy of “If in doubt leave it out.” In 1997 Shell booked the Gorgon field in Western Australia as reserves in its official accounts, although the plan for production had not been approved by the government and no sales contracts had been signed. For those reasons Chevron, Shell’s partner at Gorgon, had not booked the reserves. Similarly, in Oman Shell booked some oil reserves where extraction was not yet possible. At Ormen Lange in the North Sea, off northern Norway, Shell booked reserves in 1999 after drilling two exploration wells but before complicated technical problems had been resolved. BP, Exxon and Statoil delayed booking the same reserves. All those bookings assumed that the reserve numbers would eventually prove to be accurate and would be approved by the SEC. Shell was renowned as the gold standard for honest reporting, so no one doubted that its oil and gas reserves were growing. Nor was a paradox noticed: while the reserves increased, the exploration budget was cut. The conundrum was how, at a critical moment, Watts could deliver his promise of 5 percent growth. Combined with incentives, it appeared that “self-interested optimism” alone would increase the reserves. “Oil men can play to any rules they are as
ked to play,” observed John Jennings, a former chairman of Shell. “Oil breeds arrogance because it’s so powerful.”

  The increase in reserves, and Watts’s arrival as chairman in January 2001, coincided with an unexpected surge of oil prices from $11 to $30. Across Europe and America, cheap oil had become an unchallenged assumption. OPEC had been dismissed by many as impotent, and oil as irrelevant as cotton. In 1980 the US had spent nearly 9 percent of its GDP on oil; by 1999, it had fallen to 3 percent. Oil, it was assumed, was not a growth business. Investors were unconvinced that the oil companies needed reserves, and felt that rather than invest in finding new oil, they should return their profits to shareholders. Fearing repeats of oil gluts, OPEC countries, burdened by debt, had also not invested. The cushion of spare production had dwindled from 15 million barrels a day in the mid-1980s to 2.5 million (18 percent to 5 percent). World production of crude had fallen from 67.2 million barrels a day to 63.8 million, mostly in OPEC countries, which, despite abundant reserves, could not instantly expand production.

  Reports of a new shortage rattled those who had supported America’s embargoes against Iran, Libya and Iraq. Fearing a threat to the economy, President Clinton sent Bill Richardson, the energy secretary, to tour OPEC countries and appeal for a 10 percent increase of production. Richardson was partially rebuffed. To reduce prices to the $22 to $28 range, Saudi Arabia’s petroleum minister Ali al-Naimi agreed to increase production by 5 percent. Next, Clinton protested that Mexico’s prices were too high. He was told that the increase of prices from $8 in December 1998 to $24 was good for the country. Washington warned President Tellez not to be “too pushy. The big players of the oil market have already said there needs to be more oil. The message has gotten through. Heavy lobbying could backfire.” By September 2000, some were speaking of an “oil crisis.” Middle East oil was being sold to Asia rather than the West, and OPEC was resolutely united to keep prices high. In Congress, which had been asleep about oil for many months, there were sudden demands for punitive action against OPEC and Mexico.