Michael Harrison's Outlook: An oil giant's road from Rajasthan to ruin

Fortunes; Failure; Scramble

It is a long way from the arid deserts of Rajasthan to the Shell Centre on London's South Bank. But two events this week provide a link.

It is a long way from the arid deserts of Rajasthan to the Shell Centre on London's South Bank. But two events this week provide a link.

One was the announcement by Cairn Energy that it had made yet another significant oil discovery in a region of India hitherto better known for its sumptuous pink palaces and backpacking tourists. The other was the disclosure that Shell's former head of exploration and production, Walter van de Vijver, is to receive a £2.5m pay-off after being sacked for his part in the company's reserves scandal.

The link is this: the oil fields in India where Cairn has struck black gold were sold to it at a knockdown price by Shell. Cairn was a small independent exploration company when it paid Shell £6m for the exploration block in Rajasthan two years ago. It is not so small any longer. Since Cairn made its breakthrough discovery in the region in January this year, its stock market value has risen by 275 per cent or £1.7bn. Not a bad return on investment.

Fortunes

By a coincidence of timing, Cairn's first Rajasthan discovery was announced just 10 days after Shell had shocked the oil and financial markets by slashing its proved reserves by 3.9 billion barrels or a fifth.

Since then, the fortunes of the two companies could not have diverged further. Cairn is now valued at slightly less than £2.4bn, putting it on course to join Shell in the blue-chip FTSE100 index. Shell, by contrast, has endured the most humiliating, torrid and damaging period in its 100-year history. It is hard to think of a more spectacular fall from grace or a more abject example of management failure. Its three most senior executives have been fired and it is or has been under investigation by five different regulatory bodies on either side of the Atlantic.

So far it has paid £83m in fines but it faces unquantifiable claims for damages in the civil courts from aggrieved investors. It is now poised to give in to shareholder demands and abolish its historic dual-board structure and perhaps even merge its British and Dutch halves altogether.

But the links between Shell and Cairn go deeper than just the fact that one company sold the other an exploration block in some far-flung part of the world. In many ways, Shell finds itself in its current predicament precisely because of decisions like the one to quit Rajasthan.

For a great many years, Shell has had a very poor record of finding new sources of oil and gas in comparison with its rivals such as BP and Exxon-Mobil. It is that which is the root cause of the scandal that has now enveloped the company.

Shell's innate conservatism - it is not known as the civil service of the oil industry for nothing - meant that it always felt safer pumping production from mature, established fields and thereby keeping the dividend gusher turned on rather than exploring for oil in high-risk, but high-reward, parts of the world.

Curious really, considering that the one thing an oil major such as Shell can afford to do is take risks. Unlike small independent exploration companies, it is not betting the farm each time it sinks the drill bit. Shell's risk averse approach is perfectly illustrated by its decision to get shot of Rajasthan, a region which, on the face of it, was not the most promising territory for exploration but had bags of potential for anyone who was brave enough.

Failure

Initially, cairn must have thought that it had been sold a pup because it spent the best part of two years sinking holes in the ground and using up investors' money without a single success. It was only when it tried its luck 50 miles further north that it finally struck gold. Cairn's gamble is matched only by Shell's conservatism. But in the oil industry, it does not pay to be too cautious. For Shell, it has resulted in a reserves-replacement ratio which is vastly inferior to those of its rivals.

Replacement ratios - the rate at which production is replenished each year by new discoveries - are an important yardstick by which markets value oil companies because the volume of reserves they have under the ground is an important measure of their future worth. Most oil companies regard a replacement ratio of anything less than 100 per cent as failure. At Shell, it was consistently well below that level.

Scramble

This meant that every year, just before the filing of its regulatory accounts, there was an unseemly scramble to book as proven every barrel of oil it could lay its hands on. In the words of one former Shell executive: "We told all the operating companies to look in the cupboard and see what they could find."

As is now painfully clear, some of Shell's operating companies joined the search a little too enthusiastically. In some cases, reserves were booked as proven when at best they were probable - an important distinction as far as investors and financial regulators are concerned because it indicates the likelihood of recovery. In other cases Shell chose to book reserves in jointly owned fields even though its partners felt they were not able to do the same. The deeper it dug itself into this hole, the more Shell was forced to lie to cover the tracks leading up.

Shell is now paying dearly for that odd combination of ingrained conservatism on the one hand and gung-ho, purblind optimism on the other. The extent to which Shell's arcane corporate structure and lack of accountability or clear lines of communication perpetuated an environment in which such misjudgements could occur has been argued over long and hard.

Shell insists the two are not connected but the fact that it is now about to tear up its structure and start again suggests otherwise.

Momentous and traumatic as that process promises to be, in some ways it will be the easy bit. The harder part will be to change the mindset and culture which has permeated Shell for longer than anyone can remember. More than that, it will have to develop a new business model which puts much greater emphasis on riskier, frontier exploration. The payback should be a business with better quality reserves.

In the short term, Shell's replacement ratios are likely to be flattered. The perverse effect of the massive recategorisation of reserves that the company has been forced to make is that over the next few years, its replacement ratio will improve markedly as those reserves are moved back again from the probable into the proven category.

But that is unlikely to fool anybody. Shell's investors will demand hard evidence that the leopard really has changed its spots. After the destruction of trust and value presided over by Shell, that promises to be a much longer journey, even than Rajasthan to the South Bank.

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