[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]





                         SHELL GAMES: CORPORATE
                       GOVERNANCE AND ACCOUNTING
                        FOR OIL AND GAS RESERVES

=======================================================================

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                             JULY 21, 2004

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-105


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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSSELLA, New York              CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey            CHRIS BELL, Texas
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    July 21, 2004................................................     1
Appendix:
    July 21, 2004................................................    27

                               WITNESSES
                        Wednesday, July 21, 2004

Dharan, Bala G., J. Howard Creekmore Professor of Accounting, 
  Jeese H. Jones Graduate School of Management, Rice University..    13
Duchac, Jonathan E., Associate Professor of Accounting, Wayne 
  Calloway School of Business and Accountancy, Wake Forest 
  University.....................................................    11
Knight, Eric, Managing Director, Knight Vinke Asset Management 
  LLC............................................................     5
Simmons, Matthew, Chairman and Chief Executive Officer, Simmons & 
  Company International..........................................     8

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    28
    Gillmor, Hon. Paul E.........................................    30
    Dharan, Bala G...............................................    31
    Duchac, Jonathan E...........................................    51
    Knight, Eric.................................................    55
    Simmons, Matthew.............................................    96

 
                         SHELL GAMES: CORPORATE
                       GOVERNANCE AND ACCOUNTING
                        FOR OIL AND GAS RESERVES

                              ----------                              


                        Wednesday, July 21, 2004

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to call, at 2:20 p.m., in Room 
2128, Rayburn House Office Building, Hon. Michael G. Oxley 
[chairman of the committee] Presiding.
    Present: Representatives Oxley, Feeney, Sherman, Inslee, 
Lucas of Kentucky, Clay, Scott, and Bell.
    The Chairman. The committee will come to order. I apologize 
for being late.
    I understand you offered to chair, Mr. Sherman.
    Mr. Sherman. Yes.
    The Chairman. We will take that under advisement.
    Nearly 2 years ago, this committee passed the most critical 
securities legislation enacted since the 1930s, the Sarbanes-
Oxley Act of 2002; and with the Act's corporate reforms and 
rigorous measures taken by the Public Company Accounting 
Oversight Board, it helped rebuild investor confidence in our 
capital markets.
    The corporate governance failures that led to the passage 
of the legislation have not completely disappeared. Tomorrow 
this committee will hear reports from a panel of experts on how 
the Sarbanes-Oxley Act has benefited the American investor and 
helped to restore accountability in the governing bodies of 
publicly traded corporations. Today, we examine some 
unfortunate examples of why that reform was necessary.
    The abuses of corporate insiders who contemptuously 
disregarded the interests of public shareholders while seeking 
their own personal enrichment unfortunately were not limited to 
any one industry. However, the problems that have recently been 
alleged at El Paso and Shell, among others, raise some 
compelling questions about accounting practices and internal 
controls at energy companies. There has been growing unease in 
the industry about a widespread tendency to overlook reserves.
    Regulators cracked down on energy companies in the 1970s 
when it appeared they were being cavalier with their reserves 
disclosures. A report by Energy Consultancy in 2001 noted the 
pressure on managers of publicly traded energy companies, 
quote, ``to push the envelope of credibility in efforts to buoy 
investor confidence and thus increase stock value,'' end quote. 
The consultants blame the overbooking on incentive programs 
that offer bonuses for big reserves estimates.
    Financial statements of energy companies like those of all 
public companies necessarily include estimates that may not 
ultimately prove to be accurate. In the oil and gas industry, 
the most important number which is an estimate is a company's 
proven reserves, the oil and gas in the ground that a company 
claims to own. If reserves estimates are made in a way that is 
biased, for example, because bonuses are tied to high reserves 
estimates, this obviously compromises the financial statements 
of any company.
    I understand that Shell has since removed reserves bookings 
as a component of executive performance reviews that are used 
to calculate bonuses. We will examine whether additional steps 
should be taken to ensure that oil companies' reserves 
estimates are not compromised by improper incentives. We will 
examine the accounting rules themselves to ensure that the 
rules that the SEC has put in place have kept up with 
technology to provide investors with the most accurate possible 
information about a company's true reserves and, accordingly, 
its financial position.
    Some critics contend that the rules of the Commission, that 
currently apply to whether reserves can be treated as proven or 
not, are outdated. We will learn more about these concerns 
today.
    And we will examine questions of appropriate governance in 
light of the unusual corporate structure at Shell. Some experts 
have attributed the lack of transparency at Shell to the 
company's unique corporate arrangement, which consists of two 
separate boards charged with overseeing the company.
    I am encouraged by reports that Shell has already 
undertaken a review of its corporate structure in response to 
this criticism. I believe there is significant opportunity for 
Shell to repair some of the confidence that has been lost by 
remaking its corporate structure to reflect the image of 
transparency and candor that is embodied in the majority of 
publicly traded corporations as a result of the Sarbanes-Oxley 
Act.
    I look forward to hearing testimony from our distinguished 
panel of witnesses, and the Chair's time has expired. Are there 
further opening statements?
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 28 in the appendix.]
    Does the gentleman from California seek recognition?
    Mr. Sherman. First, Mr. Chairman, thank you for the 
brilliance in deciding to hold these hearings, first, because 
it gives us a chance to talk more about accounting issues, and 
second, because it helps illustrate our cooperative role with 
the Committee on Energy and Commerce, where we are engaged in 
protecting investors in securities markets and they focus on 
industrial regulation.
    I have spoken often at this committee of the need to have 
verifiable information that goes outside the four corners of 
the financial statements. Over the last century and-a-half, we 
have developed a system for reporting historical, completed 
transactions in an organized way and in a way that, in the 
absence of truly egregious behavior, is reliable. But we have 
been forwarding the same information, that is to say, only if 
it is a transaction with an outsider from the company, it is 
financial, it is completed, then it affects the income 
statement or the balance sheet. And we have discovered how to 
do this, how to give investors reliable information.
    You need GAAP, and you need what I would pronounce ``GAAS. 
That is to say, you need generally accepted accounting 
principles or some other system that defines what you are 
reporting--that is to say, define what is a proven reserve 
barrel of oil.
    Second, you need Generally Accepted Auditing Standards. And 
you need some system whereby a third party comes in and 
verifies that a particular fact meets the definition.
    Now, we do that with financial information. We do that for 
a balance sheet and income statement, which we have been doing 
for well over a century. They added a funds statement, which is 
just a recapitulation of the information on the income 
statement. The balance sheet, that is recent, only 20, 30 years 
old.
    We haven't done anything for a long time to expand what 
accountants and auditors do. But we all know that very 
important for investing in oil companies is, what are the 
reserves; if you are investing in a manufacturing company, what 
is their back order. That would be the first question I would 
ask at Boeing before I cared what their earnings per share 
were. If I were looking at a retailer, I would like to know 
what their same store year-to-year sales were.
    But the fact that this information is quite relevant to 
investors has been ignored by an accounting world that reports 
only the irrelevant, verifiable information. And so we need a 
system, either from this committee or from the SEC, that 
defines the information that investors deserve--and it will 
vary from industry to industry--that has a system for defining 
the terms whether you are defining a dollar of income on an 
income statement or a barrel of reserves on a reserves 
statement, and defines and has some profession--perhaps the big 
four would want to do this; they haven't done it so far; I am 
sure there are other entrepreneurs that can get into the 
attestation business--but defines how you are going to have 
professionals verify that the information in the report is 
reliable.
    If we--either our committee should do that or the SEC 
should do that, or the SEC should appoint an outside body 
similar to the FASB or the ICPA, or perhaps those 
organizations, to define this information that we need, 
describe the professional qualifications of those who will 
verify it, define materiality standards so we know what 
standards to hold the verification of professionals to.
    Until then, we will have verifiable, audited information 
about Shell, about what their financial transactions were, and 
we will have to guess whether their statement of oil reserves 
is accurate. We will not have any verification of it.
    And, oh, by the way, that might be more important than the 
information that is verified.
    So I think that the Congress was wise in getting this 
committee involved in the investor protection area. We have had 
that responsibility for less than 2 Congresses. And it is now 
time for our committee to prod, or legislate, and make sure 
that all the important information to investors, or as much as 
possible, is laid out in the SEC-filed statements with 
definitions that are established with a verification profession 
that investors can count on. And perhaps the first place to 
start is that oil companies should publish a statement of 
reserves with some attestation professionals signing an opinion 
indicating that we can rely upon it.
    The Chairman. The gentleman's time has expired.
    Mr. Sherman. I thank you for your indulgence.
    The Chairman. Other members seeking an opening statement?
    The gentleman from Georgia.
    Mr. Scott. Thank you very much, Mr. Chairman. Let me 
congratulate you as the winning manager of the congressional 
baseball team. You did an astounding job and did it in the 
Casey Stengel way, with grace, style and charm.
    The Chairman. The gentleman can have as much time as he 
wants.
    Mr. Scott. I want to thank you, Chairman Oxley and Ranking 
Member Frank, for holding this hearing today on corporate 
governance and the accounting for oil and gas reserves.
    The Royal Dutch Shell group had unique corporate 
structures, which have led to accounting inconsistencies. In 
addition, the company had perverse incentives for corporate 
executives which led them to overstate energy reserves. This 
corporate combination finally came to a head when Shell had to 
restate its oil and gas reserves statement by 20 percent. As a 
result, Shell had to admit that it overstated profits by $276 
billion over several years.
    The El Paso Corporation also had to restate its reserves by 
41 percent.
    The chain of events at Shell may have been prevented if 
third-party certification of a company's energy reserves was in 
place. This committee should consider whether or not additional 
corporate governance rules may be necessary to better account 
for our energy reserves.
    I look forward to hearing from this distinguished panel. I 
am very interested in a few issues, such as third-party 
verification of energy accounting, the SEC investigation into 
the Shell accounting procedures, and a discussion on successful 
methods versus full cost methods of accounting reserves and 
whether they are accurate and dependable. I look forward to a 
very informative hearing.
    Thank you, Mr. Chairman.
    The Chairman. The gentleman's time has expired.
    Does the gentleman from Texas seeks recognition?
    Mr. Bell. Thank you very much, Mr. Chairman. I am not going 
to engage in the shameless sucking up, as demonstrated by my 
colleague from Georgia. I do appreciate your holding this 
hearing and putting together such a distinguished panel that 
features not only one, but two individuals from Houston, I am 
very proud to say.
    I represent a large part of Houston, which many consider 
the energy capital of the world. We will probably hear more 
about that today. My perspective may be a little bit different 
since the industry employs hundreds of thousands of people in 
the Houston area. So it is vitally important to me and my 
constituents that we avoid any suggestion of scandal or taint 
in the industry, that we avoid any further corporate collapses 
in the energy industry. As everybody here knows, we have 
suffered through Enron in a very up-close and personal fashion 
in Houston, along with the rest of the country.
    I believe what we are here to discuss today could point to 
looming problems in the industry, and if we continue to see 
similar problems on a wider level in the energy industry, I am 
anxious to hear how that might translate to the hard-working 
men and women in the field. Could we be looking at heavy job 
losses, and just what might the impact be to investors?
    So I look forward to the testimony. And thank you, Mr. 
Chairman, for holding this hearing.
    The Chairman. The gentleman's time has expired.
    The Chair now turns to our distinguished panel and let me 
introduce them from my left to right: Mr. Eric Knight, Managing 
Director of Knight Vinke Asset Management LLC; Mr. Matthew 
Simmons, Chairman and Chief Executive Officer of Simmons & 
Company International; Mr. Jonathan E. Duchac, Associate 
Professor of Accounting, Wayne Calloway School of Business and 
Accountancy from Wake Forest University, the Demon Deacons; and 
Dr. Bala G. Dharan, J. Howard Creekmore Professor of 
Accounting, Jesse H. Jones Graduate School of Management from 
Rice University, the Owls.
    We are glad to have you all with us, and we appreciate, on 
relatively short notice, your ability to appear before the 
committee. And Mr. Knight, we will begin with you.

STATEMENT OF ERIC KNIGHT, MANAGING DIRECTOR, KNIGHT VINKE ASSET 
                         MANAGEMENT LLC

    Mr. Knight. Before I start, since we have had little 
advance notice, maybe you haven't had a chance to read the 
materials attached. I want to bring to your attention a couple 
of the exhibits which I am going to refer to.
    After my biography, there is a letter which we and CalPERS 
wrote publicly to the boards of Royal Dutch and Shell 
Transport. There is an editorial which I wrote for the 
Financial Times in March. And there is something I wanted to 
point out, which is the agenda for the Royal Dutch meeting, 
which I am going to refer to because it brings up an 
interesting point.
    My name is Eric Knight, and I am the Managing Director of 
Knight Vinke Asset Management, a New York-based asset 
management firm registered with the SEC as an investment 
advisor under the Investment Advisers Act of 1940. Our 
investment strategy involves investing in fundamentally sound 
public companies where suboptimal stock market performance can 
be attributed in some way to poor governance structures and 
practices which we interpret in the broadest sense. In such 
cases, we work with the company's institutional and other 
shareholders to overcome or redress these governance problems 
and aim, thereby, to obtain a rerating of the stock and make a 
profit on our investment.
    Through Knight Vinke Institutional Partners, an investment 
fund which invests in European equities, we hold approximately 
1.32 million shares of Royal Dutch Petroleum with a market 
value of approximately $70 million. CalPERS, who have a $200 
million commitment to invest in our fund separately, also have 
holdings in Royal Dutch Petroleum and Shell Transport & 
Trading, amounting to stock with a combined market value of 
approximately $580 million.
    We have been working with CalPERS and other institutional 
shareholders of the Royal Dutch Shell group, both in Europe and 
in the U.S., with a view to pressing its boards and management 
into reexamining their unusual governance practices and 
accepting a more orthodox corporate governance framework.
    Why are we interested in governance at Shell? Although as 
recently as 2002, the boards of the Royal Dutch Shell group 
declared that they prided themselves in upholding the highest 
standards of integrity and transparency in their governance of 
the company and that they aim to be at the forefront of 
internationally recognized best governance practice, we believe 
that reality presents a different picture.
    In light of the multiple reserves restatements over the 
past few months and the astonishing revelations of the Davis 
Polk report, shareholders can perhaps be forgiven for being 
skeptical. The group concedes that the framework within which 
the boards operate is conditioned to some extent by Royal 
Dutch's unique relationship with Shell Transport, and this 
results in some special arrangements which may not be 
appropriate to other companies. We felt it necessary, 
therefore, to look carefully into these special arrangements.
    During the course of our due diligence, we asked our 
counsel in the Netherlands, the U.K., and the U.S. to prepare a 
report on the Royal Dutch Shell Group's governance structures 
based on publicly available information, and a copy of this 
report is included in the attached materials.
    By way of background, the Royal Dutch Shell Group of 
companies is 100 percent owned by two holding companies: Royal 
Dutch, which owns 60 percent, is the largest listed company in 
the Netherlands; and Shell Transport, which owns 40 percent, is 
one of the 10 largest in the U.K. Royal Dutch is managed by a 
supervisory board and a management board, as is usual in the 
Netherlands, whereas Shell Transport has a unitary board 
comprised of executives and nonexecutives which is the 
structure most commonly found in the U.K. It is important to 
realize, however, that both Royal Dutch and Shell Transport are 
pure holding companies with no operating activities of their 
own.
    The following is a summary of some of the more surprising 
facts which emerged from our analysis.
    The operating companies of the Royal Dutch Shell Group, 
i.e., a group of companies below the two parent holding 
companies, are managed on a day-to-day basis by an informal 
committee of senior managers, the so-called ``Committee of 
Managing Directors,'' and not by a chief executive officer. 
Substantial power and autonomy is given to the CEOs of each of 
the Group's four main operating companies. And although there 
is a chairman of the CMD, none of these executives reports 
formally to this person.
    The boards of Royal Dutch and Shell Transport are comprised 
of different groups of individuals responsible to separate 
shareholder constituencies, and it is unclear, therefore, 
exactly to whom the CMD and its chairman report or are 
accountable. The two parent company boards come together on a 
regular basis in a large gathering known as ``the Conference,'' 
and this is yet another informal body vested with no formal 
powers and unaccountable directly to the shareholders of either 
holding company.
    The Royal Dutch supervisory board, which is perhaps the 
most powerful of the different Shell governing bodies, as it 
controls the majority shareholder in the operating companies, 
is effectively a close-knit self-perpetuating body. This 
results from the existence of a class of so-called ``priority'' 
shares which have the exclusive right to nominate board 
representatives at Royal Dutch and to reject nominations by 
shareholders.
    As of now, the members of the Royal Dutch supervisory 
management boards hold or control 100 percent of these priority 
shares and have the ability to control their own nominations. 
This self-perpetuating mechanism is wholly inconsistent with 
internationally accepted principles of good governance.
    Despite mounting evidence of poor internal communication, 
inadequate controls, lack of accountability and unclear 
reporting lines Shell's management and board members still 
maintain that the reserves debacle had nothing to do with 
structure.
    We disagree.
    Shell's management has operated for years, indeed decades, 
with none of the basic building blocks of modern governance. 
Its divisional management did not report formally to a group 
chief executive; its divisional CFOs did not report to a group 
CFO. The person presented as the chief executive, the chairman 
of the CMD, apparently lacked either the authority or 
responsibilities or the accountability normally associated with 
a chief executive. He reported to two boards comprised of 
different individuals and so, effectively, to none. And the 
boards of Royal Dutch were shielded from shareholder 
intervention through the priority share mechanism, which made 
them effectively a closed shop.
    The Royal Dutch Shell Group's unusual board and management 
structures may not have been entirely to blame for the 
misstatement of reserves, but we believe that they and the 
corporate culture they foster certainly contributed to the 
problem.
    Royal Dutch, as a foreign private issuer, is currently 
exempt from the proxy rules under the U.S. Securities laws, 
despite the fact some $25 billion in market value of its shares 
are represented on the U.S. markets. Nevertheless, in the 
build-up to this year's annual meeting, Royal Dutch employed a 
permanent U.S. proxy solicitor to obtain support for a 
resolution giving a shareholder discharge to its supervisory 
and management board members. I refer to the third exhibit, 
which is the agenda for the Royal Dutch annual meeting.
    In itself, this would not be remarkable were it not for the 
fact that the resolution was strongly opposed by the mostly 
European shareholders who attended the annual meeting and that, 
despite this opposition, the resolution was passed thanks to a 
large block of proxies coming mostly from the U.S., these 
proxies held by the board coming from mostly the U.S. 
shareholders.
    Approximately 25 percent of Royal Dutch shares are held in 
the U.S. in the form of ADRs; and in this context, we ask 
ourselves:
    Did U.S. shareholders know, or were they made aware, that 
item 2 of the agenda, covering approval of the accounts, 
payment of the dividend and discharge of the board members, all 
presented as a single item, were in fact separate resolutions 
each to be voted on separately?
    Did they know that shareholders could have voted in favor 
of the accounts and the dividend, of course, which is 
important, but against the discharge?
    Had Royal Dutch not been exempted from the provisions of 
the U.S. proxy rules, we believe that the SEC could have asked 
for clarification on these points; and in light of recent 
events, the votes could have gone the other way.
    In conclusion, if Shell and other multinationals want 
substantial access to the U.S. capital markets, it seems 
anomalous that they should be held to lower disclosure 
standards than their U.S. peers, EXXON, for example. This 
applies to proxy solicitation just as it does to reserves 
accounting.
    The Chairman. Thank you, Mr. Knight.
    [The prepared statement of Eric Knight can be found on page 
55 in the appendix.]
    The Chairman. Mr. Simmons.

  STATEMENT OF MATTHEW SIMMONS, CHAIRMAN AND CHIEF EXECUTIVE 
            OFFICER, SIMMONS & COMPANY INTERNATIONAL

    Mr. Simmons. I am honored to address the accounting and 
financial disclosure of the oil and gas industry. I believe the 
topic is timely and extremely important, as I feel that our 
entire energy reporting system, globally and in the United 
States, is badly in need of reform.
    The Chairman. Mr. Simmons, could you give a little bit of 
background of your company?
    Mr. Simmons. For the last 30 years, I have chaired and 
founded a company called Simmons & Company in Houston. We are a 
specialized investment banking firm that concentrates entirely 
in energy. We are a research-driven firm, and I am a member of 
the National Petroleum Council and the Council on Foreign 
Relations and the Atlantic Council of the United States. We 
have about 150 employees and have completed 550 transactions at 
a value of about $60 billion.
    I do believe that our energy reporting system is badly in 
need of reform. I think our current system lacks the 
reliability and transparency that should be mandatory for 
something as important to our economy and way of life as 
energy.
    Until Shell Oil Company shocked the world with its 20 
percent reserves reclassification, followed by a litany of 
other reserves, I think too many energy industry observers 
casually assumed that the information presented by our publicly 
held oil and gas companies was quite accurate.
    In fact the system has always had numerous flaws, and these 
flaws grew in magnitude in recent years as fewer appraisal 
wells were drilled, as new oil and gas exploration and 
exploitation projects became increasingly complex, as decline 
rates in existing oil and gas fields accelerated and as new 
projects got increasingly smaller in terms of potential 
reserves.
    A tell-tale sign that the reported oil and gas results were 
askew was the wide number of public companies who have 
routinely reported additions of 120 to 150 percent, compared to 
the annual gas and oil production each year, while fewer and 
fewer of these same companies were showing any meaningful 
growth in production volumes.
    In reality, a host of time-tested measures to assess 
reserves and their potential recovery dwindled as the price of 
oil and gas stayed too low to commercially afford the standard 
tests. The industry ended up using far fewer outside third-
party reserves engineers. The number of appraisal wells that 
always follow a new field discovery fell. The use of coring to 
test a new reservoir's rock properties started to be dismissed 
as becoming obsolete. Instead, the industry began relying far 
more heavily on less costly geophysical data and computer 
modeling. And while the geophysical technology has improved by 
quantum leaps, as have computer techniques to interpret this 
data, neither of these data can begin to determine the limits 
of where the producible reserves lie.
    In a low price environment that the industry struggled 
through for too long, pressures also mounted to declare proven 
reserves status as early as possible so all additional costs 
could be capitalized, and too often, the proved declaration 
status was probably premature.
    This led to a widespread industry bias of booking 
aggressively high levels of proven reserves while spending far 
less money to create these reserves than would have occurred a 
decade ago. This not only created a cushion of proved reserves 
that might or might not ever get produced, but it also led to a 
possible illusion that the cost of finding and developing a 
barrel of gas was actually less than the amount of money that 
needed to be spent.
    These are not the only deficiencies in our energy data 
system. Today, the single biggest factor to begin estimating 
the company's or country's future oil and gas production is to 
properly assess the decline rates in the company's existing gas 
and oil production base. Yet these decline rates are now 
accelerating through the use of modern technology that draws 
reserves out of the ground far faster. Yet there are no reports 
issued by any public company, any private company or any 
national oil company that even hint at the annual decline rates 
for the entire production base, let alone the decline by 
production region or on a field-by-field basis.
    Reserves estimating will never be a precise science. It is 
a series of complex estimates. But even if the reserves 
estimates could be found to be precise, the data would still 
not provide an analyst with any reliable tool to begin 
assessing field-by-field production declines or provide 
information on the degree to which a reporting company possibly 
is being overly conservative or overly aggressive.
    The data deficiencies extend to the global oil and gas 
systems. In fact, the lack of quality data is far worse for all 
national oil companies, particularly the OPEC member companies.
    We have now evolved into a systematic ``trust me'' era for 
energy providers. With the capital intensity of the industry 
now starting to soar with the world's remaining spare oil 
capacity slim to possibly now becoming nonexistent, with our 
petroleum inventories now operating on a just-in-time basis, 
this ``trust me'' era needs to end. The time has come for all 
key oil and gas producers to join in a reform of how reserves 
and current production is reported.
    The Energy Information Agency in the United States has 
recently requested that all natural gas producers begin 
supplying timely current production data to our government. 
Today, the best natural gas supplying information lags real 
production by as much 6 to 24 months. We can no longer tolerate 
such a time lag. While company-by-company reporting of their 
production data to the EIA would be costly, I would argue it is 
too costly to our economy's well-being to not have such timely, 
accurate production data.
    This fall, the National Energy Agency will be calling for a 
mandated new set of proven reserves reports and a detailed 
field-by-field production report by all key global oil 
producers. I applaud the EIA and the IEA's data reform efforts. 
But as the IEA, in particular, begins pressing the national oil 
companies and, in particular, the OPEC producing companies for 
this new data reform, it is critical that our leading U.S. oil 
and gas producers join in and take the lead in this data 
reform. Otherwise, it will be easy for any OPEC producer to 
balk at reform if Exxon Mobil, BP, Shell, et cetera, are not 
held to the same standards.
    In my opinion, the single best data reform is to require 
all significant oil and gas producers to begin timely reporting 
of field-by-field daily oil production or production from key 
producing units, and accompany this new disclosure by the 
number of producing well bores from each production unit so 
analysts and public policy planners can begin assessing field-
by-field production declines. Absent such data, there is no way 
to guess at future supplies by company or by country.
    On the proven reserves side, an important change would be 
to begin reporting, by key production unit or field, three key 
reserves estimates. First is the current estimate of the 
original hydrocarbons in place, second is the current estimate 
of the ultimate recoverable reserves, and third is the 
cumulative amount of reserves already produced. The remaining 
recoverable reserves can then be broken into proven, probable 
and possible.
    With this added layer of disclosure, it is not so crucial 
that every producer meet the same 90 percent probability test 
embedded in proved reserves. Analysts can gauge the quality of 
layers of reserves left to produce and then dig out better 
answers through follow-up analysis. Today there is so little 
data that is disclosed that such analysis is either difficult 
or impossible.
    These new reforms also need to have some form of third-
party expert certification to ensure that the data is being 
accurately reported. Third-party reserves engineers do not need 
to calculate proven reserves, just as CPA firms do not need to 
produce a company's financial statement; and it adds a degree 
of comfort to have an independent expert certify that the data 
was properly prepared.
    The beauty of enacting the detailed breakout of key 
production reserves data by key units is that all companies 
already possess this data. It is the data that a lender 
requires when a company wants to borrow funds against reserves. 
It is what any company wanting to sell reserves needs to 
furnish to knowledgeable buyers. If it means a company has to 
add 20 or 30 more pages to its financial reports, this is a 
small cost when compared to today's system, which leaves too 
many shareholders or potential shareholders in the dark. Why 
should shareholders not have the same access to the same data 
any lender or reserves buyer demands?
    If this data reform happens, and it could happen quickly if 
all stakeholders join in the request for such key data, the 
whole world would be better off. We will begin a new era when 
genuine analysis of our energy system's reliability and true 
profitability can be ascertained. The time for this reform is 
at hand, and this committee can play an important role in 
helping this reform be effective.
    Thank you for the opportunity of addressing this issue.
    The Chairman. Thank you, Mr. Simmons.
    [The prepared statement of Matthew Simmons can be found on 
page 96 in the appendix.]
    The Chairman. Professor Duchac.

  STATEMENT OF JONATHAN DUCHAC, Ph.D., ASSOCIATE PROFESSOR OF 
ACCOUNTING, WAYNE CALLOWAY SCHOOL OF BUSINESS AND ACCOUNTANCY, 
                     WAKE FOREST UNIVERSITY

    Mr. Duchac. Thank you, Mr. Chairman.
    The accounting for oil and gas reserves has a long and 
tumultuous history and has been periodically the subject of 
considerable debate in Congress, the accounting community and 
the financial markets. The recent reserves restatements by a 
number of companies in the oil and gas industry have once again 
placed increased scrutiny on the calculation and determination 
of oil and gas reserves information and prompted this committee 
to consider the current accounting rules for oil and gas--
whether the current accounting rules for oil and gas reserves 
should be revisited.
    Oil and gas reserves are, by definition, an estimate and 
subject to considerable uncertainty. The amount of oil and gas 
reserves that are disclosed in a company's financial reports 
are determined by two factors, the definition of reserves and 
the reserves estimation process.
    The definition of reserves for companies listing on U.S. 
securities exchanges is established by the Securities and 
Exchange Commission and provides a conceptual foundation for 
the reported estimates. This definition focuses on proven 
reserves and attempts to limit the variability of reported 
reserves information. While the SEC's definition is not 
flawless, it is widely considered to be one of the more 
rigorous and conservative reserves definitions in place.
    The reserves estimation process is a complex process 
whereby companies use a wide array of data to develop an 
estimate of a company's crude oil and gas reserves. Because the 
process is complex, uncertain and relies heavily on estimates, 
the resulting reserves values are subject to considerable 
uncertainty and estimation. The use of estimates such as these 
is not uncommon in financial accounting as estimates are 
frequently relied upon when financial information, subject to 
uncertainty, provides relevant data points for the users of 
financial information.
    Central to the accounting estimation process is the 
presumption that these accounting estimates will be unbiased 
and made in good faith. Random error is an inherent and 
unavoidable aspect of the reserves estimation process and 
cannot be eliminated. However, for reserves estimates, to be an 
effective source of information for external constituencies, 
this information must be free of bias or intentional error.
    Because of the uncertainty associated with reserves 
calculations, additional information often becomes available 
that prompts subsequent adjustments to reported reserves. If 
that information is incorporated in the reserves estimates in a 
timely and unbiased fashion, the adjustments are treated 
prospectively. However, if the reserves estimates are known to 
change and a company fails to adjust reserves estimates to 
reflect these known changes in the underlying fact pattern, the 
disclosed reserves are problematic because they do not portray 
the best estimate of the company's reserves at the time they 
are reported. Thus, the most significant challenge associated 
with oil and gas reserves estimates lies not in the use of 
estimates but in ensuring that the estimates are made in good 
faith and accurately reflect the most recent information about 
a company's reserves. If the disclosed reserves do not meet 
these constraints, then the value of the information is 
significantly diminished.
    When reserves estimates are biased or not made in good 
faith, correction of these estimates may lead to the 
restatement of reported reserves, as we have seen in recent 
months. In these situations, the accounting rules have little 
influence on the ultimate outcome because the errors were the 
result of a breakdown in the reporting process for the reserves 
estimates, as opposed to a poorly functioning accounting rule. 
The more salient question to consider in this case is, what 
steps could have been taken that would have reduced the chances 
of presenting reserves estimates that did not accurately 
reflect the underlying data, data set and fact pattern.
    I would argue that the most effective remedy for this 
problem is not to focus on the accounting rules for reserves 
estimates, but to improve the procedures surrounding the 
reporting and determination of those reserves estimates.
    While there is no question that expanding the detail on 
reserves disclosures will provide relevant information to the 
users of financial information, such additional information 
would not directly address the problems underlying the recent 
reserves restatements. Rather, process-oriented improvements 
would have the greatest impact on reserves disclosure quality. 
This can be accomplished through several possible actions, 
including ensuring the companies have in place a well-developed 
and well-functioning internal control system for the 
calculation and reporting of reserves estimates; two, 
conducting an independent review of oil and gas reserves 
estimates that follows closely along the lines of an audit; and 
three, limiting the amount of performance-based compensation 
that is tied to reserves balances.
    Focusing on process-oriented solutions such as these would, 
in my opinion, have the greatest impact on improving the 
quality and usefulness of oil and gas reserves information.
    The Chairman. Thank you, Professor.
    [The prepared statement of Jonathan E. Duchac can be found 
on page 51 in the appendix.]
    The Chairman. Professor Dharan.

 STATEMENT OF BALA G. DHARAN, J. HOWARD CREEKMORE PROFESSOR OF 
ACCOUNTING, JESSE H. JONES GRADUATE SCHOOL OF MANAGEMENT, RICE 
                           UNIVERSITY

    Mr. Dharan. Chairman Oxley, Ranking Member Frank and 
members of the committee, I want to thank you for this 
opportunity to present my analysis of the accounting and 
disclosure issues related to oil and gas reserves. I am a 
professor of accounting at the Jesse Jones Graduate School of 
Management at Rice University, Houston, where I have taught 
since 1982. Given the time available for my oral testimony, I 
will present here only the summary of my analysis, and my 
written testimony has been submitted to the committee.
    The Chairman. Without objection, all of the statements will 
be made part of the record.
    Mr. Dharan. Having useful and reliable information on oil 
and gas reserves is enormously important to the U.S. 
policymakers, managers of the companies, investors and the 
public. Over 150 publicly owned U.S. oil and gas producers 
filed reserves data in recent years and the reported total 
reserves for oil and gas is valued at over $3 trillion.
    Companies currently are required to provide unaudited 
estimates of proved reserve quantities to the Securities and 
Exchange Commission, using definitions provided by the SEC. In 
theory, since the SEC definitions are conservative and, in this 
era of rising oil and gas prices and improving recovery 
techniques, it is hard to envision scenarios where companies 
could report significant downward ``technical revisions'' in 
proved reserves. In practice, however, recent large downward 
revisions in proved reserves by Shell and El Paso, and smaller 
restatements by a handful of other companies, have shown that 
the reserves data are indeed vulnerable to disclosure quality 
risk. In fact, as investors learn more about how reserves are 
estimated and reported, it might come as a shock to them that 
items on a company's balance sheet such as cash and receivables 
are subject to far more external audit and internal controls 
than proved reserves estimates.
    Some in the industry argue that we just need some small 
fixes to improve the usefulness and reliability of reserves 
data. Others are calling for more disclosures. However, I think 
it is really a case of a larger credibility gap that affects 
the reserves disclosures, and it requires potentially new 
regulations or at least new industry action to address the 
problem.
    The credibility gap is caused by what I call two related 
factors, quality credibility and reporting credibility. The 
quality credibility which affects the relevance of the reserves 
information is caused by a lack of common technical standards 
and lack of training and certification programs to propagate 
the standards among all evaluators. There is also no industry-
wide peer review or monitoring program.
    The reporting credibility which affects reliability is 
caused by the fact that reserves disclosures are not audited by 
external auditors or by external or independent reserves 
evaluators. Despite this lack of any auditing requirements, it 
is indeed a credit to the hard work and dedication of the 
industry's engineers and evaluators that the reserves numbers 
they produce are generally stable and are subject to very few 
downward adjustments overall.
    Rather than relying on continued luck, it is preferable for 
the industry to seriously consider proposals for certification 
and reserves audit. The five proposals I am going to outline 
here, if accepted, would make reserves data more reliable and 
subject to the same level of auditing standards as other key 
items on the company's financial reports.
    The first proposal is to require a certification program 
for reserves evaluators. Several industry leaders have called 
for certification requirements. Also, ethics education needs to 
be part of the training. Such a program should be easy to 
implement, given the highly talented work pool that constitutes 
this expected technical field and the technical nature of the 
reserves estimation process.
    The second proposal, to improve the reliability of the 
reserves is to require an independent reserves audit. The term 
``reserves audit'' refers to the use of independent external 
evaluators to audit the reserves report prepared by the 
company. If a reserves audit requirement is to be adopted, the 
SEC would need to work with the new auditing regulator and the 
petroleum industry to go over the technical auditing standards.
    The third proposal is for the separation of the reserves 
auditing function from the reserves consulting. As we learned 
from the recent corporate scandals involving the mixing of 
auditing and consulting, the SEC should require a strict 
separation between reserves auditing and reserves consulting 
functions by a firm for the same client.
    Fourth, the industry and the SEC need to adopt a 
principles-based approach. The SEC and the industry tend to 
rely on a rules-based rather than a principles-based approach. 
Instead, they should, along with the FASB, allow a principles-
based implementation of the disclosure requirements, while at 
the same time imposing strict internal control and external 
audit requirements on the industry.
    Finally, the SEC should work toward common international 
standards for reserves disclosures by working with the IASB. 
Despite the highly technical nature of the reserves estimation 
process, both preparers and users of reserves information know 
that reserves estimation is not an exact science. This makes 
reserves disclosures inherently subject to information quality 
problems.
    I had mentioned that the current credibility gap is a 
product of quality gap and the reporting gap. In my testimony, 
I will outline five proposals for regulators for closing the 
credibility gap of the disclosed data. These changes which I 
support will lead to a significant improvement in the quality 
and reliability of reserves data for all users, including the 
management of energy companies.
    Thank you for the opportunity to present my views. I will 
be glad to respond to your questions.
    [The prepared statement of Bala G. Dharan can be found on 
page 31 in the appendix.]
    The Chairman. Thank you and thanks to all of our panel 
members. Let me begin with a question for all of you.
    First of all, I would like each one of you, perhaps 
starting with Dr. Dharan: Why are so many companies at fault 
for overstating reserves? Is there one particular cause? Is it 
the incentive to do so, or is it just simply incompetence or is 
there a bad intent?
    Succinctly, where do we stand on that whole issue?
    Mr. Dharan. Chairman, I think the low oil prices that we 
had in the late 1990s was part of the problem, along with the 
lack of attention to internal controls that would have caused 
and prevented many of the conflicts that came over the last 6 
months. The Sarbanes-Oxley Act clearly has allowed companies, 
or forced companies, to focus on these issues today, but they 
should have been doing this all along for the last 5 or 10 
years.
    Mr. Duchac. I would agree with Professor Dharan. I think 
the real issue here is that there has been a lack of internal 
controls in terms of getting the information from the 
estimation process to the financial reports. And there seems to 
have been--at least if you look at the big restatements, there 
has been a big breakdown in the internal controls between the 
estimation process and what shows up in the financial 
statements.
    So really, especially if you look at the big breakdowns we 
have had, it is an internal control problem; and hopefully that 
is being resolved by the Sarbanes-Oxley Act.
    The Chairman. Thanks for the advertisement. Actually, we 
are having an oversight hearing tomorrow on that very subject, 
and obviously internal controls will be a major function. This 
dovetails very well with what we are going to go after 
tomorrow. So I thank both of you.
    Mr. Simmons.
    Mr. Simmons. I agree with what both of the previous 
speakers have said, that the lack of oversight and the lack of 
attention was the problem.
    But I think the heart of the issue was that the collapse of 
oil and gas prices basically didn't commercially allow these 
companies to actually collect the same data that they used to 
be able to do. And we then coincidentally developed a suite of 
technology that essentially convinced too many people that you 
didn't need to do these tests.
    So it wasn't any sort of a systematic way of overstating 
our reserves. These are decent companies, by and large, but we 
ended up trapping the industry into a system of not being able 
to afford to do the data collection that has effectively set 
the limits to what the reserves were. We created the illusion 
that costs were coming down and the whole thing ended up 
creating a house of cards. So it was low price.
    Mr. Knight. I can only speak about Shell, because I have 
not looked at the U.S. companies. But what I can say about 
Shell is, I think the reason for the problem is really two 
reasons. The first is there was a lack of resources allocated 
to this issue internally. And the other issue is, I think there 
is a cultural disregard for the need to satisfy reporting 
requirements within the company that were just felt not 
important enough.
    I would like to illustrate, because what I am saying, I 
think, is quite important.
    With respect to the resources which were allocated, 
information has been coming out in dribs and drabs over the 
last few months about how Shell has been organized, how it is 
organized internally. And one of the things that struck me was 
my understanding that they only had one part-time reserves 
accountant working within a group of this size, responsible for 
collecting this data. The data was not being collected 
annually; it was on a sporadic basis.
    One person for a group of this size, it just gives you some 
idea of just how little regard internally, within the 
organization, there was for the issue of reserves reporting 
under the regulatory definition. And the reason, I think, is 
that, throughout the organization, Shell has for years prided 
itself on its technology with respect to deep-water drilling, 
seismological testing and so on. It has been at the forefront 
of this technology. And I think what permeates from this is, 
the organization had far more confidence in its own estimates 
of what it regarded as proved reserves than anything else.
    It is striking when one reads the annual reports to see the 
preface to this unaudited reserves data section, which always 
starts by saying that ``We don't believe any of this stuff. It 
is not important. No one in the industry cares about it.'' I am 
paraphrasing a little bit, but that is what they say.
    The first point is that within the organization, which is 
where the resources are necessary to collect the data, it 
wasn't given enough importance. And the second thing is the 
question of culture. And what perhaps better illustrates this 
is something that came out of the annual meeting of Royal Dutch 
2 weeks ago. I was there. What I can tell you is that the 
supervisory board chairman, Mr. Aad Jacobs was being questioned 
by shareholders pretty hard as to how this whole reserves issue 
could have happened. Why weren't the board members aware of 
this? And why were they not paying more attention to reserves? 
After all, this is an oil company.
    And the response was, We do meet with the management very 
frequently, and we have breakfast with them.
    And the next question was, When did you last meet with the 
head of exploration?
    And the answer was, I think October or November, 2 full 
months before this whole issue started coming out in the public 
arena.
    And what emerged at this breakfast meeting, the head of 
exploration did, in fact, mention to Mr. Aad Jacobs, the 
chairman of the supervisory board, that there was a problem 
with reserves.
    And when one of the shareholders asked, Well, what did you 
say to the head of exploration?
    I asked him whether he had spoken to his boss.
    And the next question was, Well, did you discuss this with 
any of your other board members?
    And the answer was, I didn't feel it was necessary.
    So I think that gives you some idea as to how groups such 
as Shell treated the issue of reporting.
    Now, I think all of this is changing, of course, and it is 
now becoming evident that in order to have access to the U.S. 
capital markets there are certain rules which need to be 
respected regardless of whether or not you think this is 
important. This is changing, but that gives you some idea as to 
what was behind all of this.
    The Chairman. Let me start with you, Mr. Knight, and go 
back here.
    And that is SEC accounting standards, they need to be 
updated. If so, how?
    Mr. Knight. If I can give you my answer as an investor, we 
are an investor in Royal Dutch. We do a lot of due diligence. 
We didn't give a lot of importance to the SEC reserves data in 
our analysis. We looked at the data, but we did an analysis 
which went far beyond.
    Essentially, what we were looking at was a company which 
had a very long tradition of planning for not the next year or 
the next 5 years, but the next 2 or 3 generations. That was the 
tradition of Shell and that was the reason why one bought stock 
in Shell. You bought it because of the dividends. You knew the 
dividends were going to increase and you could count on Shell. 
That was the tradition and the reason for investing in Shell. A 
little bit like gilt.
    What was important to us, therefore, was to establish 
whether or not the company had the reserves, the long-term 
reserves in order to continue paying this dividend and in order 
to continue producing an increase in production and so on.
    Clearly, the other thing which struck us was the fact that 
this company until the last year was doing all of its planning 
with an oil price not--unlike in the U.S., it was planning on a 
$16 oil price. This is at a time when the oil price was already 
over $30. They were doing their capital expenditure based on an 
assumption. It was clearly a long, long, way short.
    This is the only industry which basically does its 
projections on the basis of their price, which is half of what 
the current market price is. And the reason that they did that 
was because they were all so shocked when the oil price went 
down to below $10 a barrel. They started planning on that 
basis; and therefore, that is what led, I believe, also, to a 
reduction in capital expenditure for about 2 years, which led 
to the Group's falling behind in terms of exploration and led 
also to what we regard as a temporary drop in its reserves 
replacement ratio.
    To answer your question, I think--what I believe is 
required is that the rules, I think today, need to reflect the 
fact that many companies are exploring, producing an 
environment which is no longer the onshore environment of 20, 
30 years ago. The cost of proving continuity of pressure 
between two wells is not $20,000 a hole or $50,000 a hole, it 
is $20 million a hole, and there are environmental risks 
associated with every hole that is drilled. That needs to be 
taken into account.
    Companies such as Shell are able to make commercial 
assessments to develop these reserves on the basis of 
seismological and other data, which today I believe is not 
fully taken into account in the SEC rules. So I think that does 
need to be taken into account and the rules need to be changed. 
And if they are changed, it will be easier for the companies to 
follow the rules; and I think it will be more useful for 
investors because at least then the reserves data will more 
closely match the commercial data.
    The Chairman. Mr. Simmons.
    Mr. Simmons. I actually applaud the SEC's efforts in this 
area. And I think there are some flaws within the system that 
need to be addressed, but I actually take issue with a lot of 
my friends in the industry that argue that the standards are 
outmoded, the technology is removed. I believe actually that is 
part of the problem.
    But I also think that the reality is in deep-water areas. 
It is hard to do flow meter tests. It does cost a lot to core a 
well. So I think the issue is far more complicated.
    The standards are not outdated. I think we have kidded 
ourselves as an industry that technology created some knowledge 
it didn't.
    Mr. Duchac. Consistent with what I said in my opening 
testimony, what you have got with the SEC's definition of 
``reserves'' is an estimate; and the question is, does the SEC 
rule accurately reflect that estimate and would it change in 
the SEC rule, kind of narrow the level of uncertainty 
associated with it? Because estimates are going to be 
uncertain; they are inevitably going to be wrong. But as long 
as they are not wrong in a biased fashion, then you can't 
really say that the rule is outmoded.
    The question is, can you reduce that level of uncertainty 
by changing the SEC rule? Possibly, but the question is, how 
much can you narrow the distribution on the uncertainty of 
these estimates and what are the costs of narrowing that 
uncertainty? And I guess, at the end of the day, the problems 
we have seen are not problems with the accounting rule.
    The problems we have seen in these recent restatements are 
internal control problems. So a different accounting rule would 
not have generated a different result in these situations. And 
I am not necessarily sure a change in the accounting rule will 
get us any further down the road to more reliable or more user-
friendly data. So I would tend to argue that the accounting 
rule per se is not the problem here.
    Mr. Dharan. The SEC rules are fairly strict and 
conservative as they stand right now with respect to the 
definition of proved reserves, and I am very comfortable with 
them. There is no reason to change them at this point. However, 
having said that, the rules are really a function of the audit 
process.
    The reason why the SEC rules are as conservative as they 
are now is because it is rules-based as a result of the lack of 
audit requirement at the user end. And as companies adopt 
certification and external audit requirements, then we can 
expect or we can anticipate that the SEC would be more flexible 
in allowing companies to understand the principles behind the 
rules rather than trying to use the rules as bright lights.
    At this point, I would not change the SEC rules until I set 
up those additional control mechanisms.
    The Chairman. My time has expired.
    The gentleman from Georgia, Mr. Scott.
    Mr. Scott. Thank you very much, Mr. Chairman.
    I would like to talk with you for a moment, Mr. Knight, on 
the governance issue of the Royal Dutch Shell Group. Could you 
explain to me the significance of the certain percentage, 25 
percent, I think, of the Group's shares are exempt from U.S. 
proxy rules. And why is that and what is the downside of that 
in the governance issue?
    And the other part is that in your testimony you mentioned 
that the CEOs of individual energy companies comprising Shell 
are powerful and they are autonomous, but it is yet unclear in 
terms of their boards of directors, who they report to, who 
they are accountable to.
    For example, it points out that the parent company boards 
meet at a conference, but this is an informal group and is not 
vested with any authority, and they are not accountable to the 
shareholders of either holding company. And it is somewhat 
confusing, but if you could clear up for us this rather 
roundabout way of the governance issue, the board of directors, 
the CEOs, and who is accountable to what; and why, given the 
fact that you have U.S. investors investing in 25 percent of 
the companies, they are exempt from U.S. proxy rules?
    Mr. Knight. Let me answer the second question first.
    The--in any normal, large organization, you would expect to 
find the head of exploration, for example, the CEO of the 
exploration division, the exploration subsidiary, reporting to 
the group chief executive. That is what you find at any large 
company.
    In the case of Shell, that is not the case. The CEO, 
Exploration, does not report to the Group CEO. Mr. Malcolm 
Brinded, who is the head of Exploration, does not report to van 
de Vijver, who is the Group chief executive.
    The question is, who does he report to? There is no real 
answer. I believe he does what he wants. I think that is at the 
heart of the problem.
    The question is then, who does the Group chief report to? 
There isn't a real answer to that. The way they have operated 
is a way which is totally informal. There is this committee 
that is described probably as the best way to run a club. But 
to run a major multinational company this way is astonishing.
    The analogy I use, Shell is like a big oil tanker. And at 
the helm, you don't have one person who is responsible for 
getting the tanker to the destination; you have a committee of 
people, all of whom are sitting around the helm. The chief 
engineer, continuing my analogy, the head of the Exploration 
Department, does not report to the bridge. He does what he 
likes, goes forward, backwards. They have tremendous autonomy.
    There are cases where Shell has been competing--different 
departments of Shell have been competing against each other for 
acquisitions using their own departments, their own finance 
departments and legal departments. It is really, truly 
astonishing that a group of this size and this importance can 
be managed in this way. The conference, which is the informal 
group on these two boards, informal committee, and an informal 
group of people. So once again the whole structure is 
unaccountable to any one group of shareholders.
    So, under these circumstances I think it is--is it 
surprising, really, that you don't have any strong central 
guidance as to what the basic values of the group should be?
    My answer is that under these circumstances, there is--it 
is not surprising at all, and the first thing shareholders and 
regulators and others should be doing is to ensure that these 
things are tidied up to ensure that this isn't going to happen 
in the future, because they can beat their breasts and be sorry 
about it, but, frankly, I don't see anything which is going to 
prevent this from happening again at the moment, unless these 
very basic governance issues are sorted out.
    Mr. Scott. Well----
    Mr. Knight. Now if I may turn to the first question. Royal 
Dutch, which is the holding company and owned 60 percent of the 
group, and is the largest public company in the Netherlands, is 
owned to a very large extent by U.S. institutional 
shareholders. Twenty percent of its stock is held in the U.S. 
in the form of ADRs, stock which is traded in New York, which 
is just held by U.S. institutions. In fact, of the top seven 
shareholders of Royal Dutch, four are American institutions. 
Only one is Dutch. It is not as if it is a quasicompany 
controlled by Dutch, you have a number of other German 
institutions and so on. So this group has a very strong, a very 
strong tie with the United States. When I say that 25- or $30 
billion of stock is traded every day in the United States, that 
is what I mean; a quarter of the company is held by U.S. 
investors.
    It just seems strange, therefore, that under the current 
rules which applied with respect to the private issuers means 
that foreign companies which come to the United States and have 
access to the U.S. capital markets are not obliged to publish a 
proxy statement, for example. When they hold their annual 
meeting, they are not obliged to publish information which they 
may be giving to ISS and others, for example, for the case they 
are making in favor of voting for or against a specific 
resolution. There is nothing which shareholders can find out 
about in the public domain which will tell them what the 
company is doing until they get to the annual meeting and they 
discover there is a large block of proxies which is held by the 
shareholders and makes any vote by the shareholders completely 
a waste of time.
    Mr. Scott. Let me ask you this. This is the final minute of 
my time.
    Mr. Feeney. [Presiding.] Without objection, the gentleman 
has an additional minute.
    Mr. Scott. Thank you very much.
    How prevalent is this when you look at what they are doing 
as compared with what other international energy companies are 
doing? Is this the standard operating procedure with these 
loose governance and lack of accountability?
    Mr. Knight. My experience with most non-U.S. companies 
which have shares traded in the U.S. is that generally speaking 
they don't bother to solicit proxies, because they don't really 
need to. Shares in Europe, for example, are mostly held in 
bearer form. It is very difficult for institutions to again 
actually vote their stock.
    In this case Shell had a very good reason for doing this. 
They wanted to get their shareholders to give the board members 
and the management members a clean slate. They wanted them to 
give them an absolution. They were looking for what is known as 
a legal discharge, and they got it, and they got this through 
the mechanism, by using this, by using this exemption. I just 
think that under the circumstances, as a shareholder who voted 
against giving the discharge, it is a little--is perhaps--is 
perhaps a little bit irritating, to say the least.
    Mr. Scott. So you have 60 percent of the shareholders of 
the United Kingdom, another 30 or 40 percent with the 
Netherlands, and 25 percent with the United States?
    Mr. Knight. Excuse me, if I may correct you. There are two 
companies. Royal Dutch, which owns 60 percent of the group, 
Royal Dutch is a Dutch company. You have Shell Transport, which 
is an English company, which owns 40 percent of the group. Each 
of these has its own shareholders and has its own board 
members. So you have two companies, public companies. The Dutch 
company, which owns 60 percent of the group, has a very large 
U.S. component in the shareholders.
    Mr. Feeney. The gentleman's time has expired.
    Mr. Scott. Thank you.
    Mr. Feeney. Mr. Duchac, you suggest that it is not simply 
the accounting issues at Shell, but it is an industry wide 
epidemic of overreporting reserves. One of the things that you 
touch on, I didn't hear you speak to, but in your written 
testimony, is the incentives and bonuses that are delivered to 
officers based on the amount of reserves.
    Can you describe in greater detail what those incentives 
and bonuses look like across the industry, and how we could 
disincentivize overreporting by the executives?
    Mr. Duchac. I would probably put a disclaimer there. I 
don't think I was quite that aggressive in my comments.
    Mr. Feeney. We are inviting you to be as aggressive as you 
like.
    Mr. Duchac. But one of the issues that I think surfaced was 
that as part of the bonus compensation or as part of the 
compensation schemes for some of the management teams was that 
they were compensated at a number of factors, one of those 
factors being an increase in the amount of the reserves, which, 
you know, intellectually, at least, up front makes sense.
    If you are an oil company, you want to expand your reserve 
base, so you want to incentivize your managers to have 
successful drilling exploration efforts. The downside of that 
is that when you put that incentive into the bonus scheme, you 
are now in a situation where you may provide an incentive for 
many engineers to not report downward or revisions of that 
number because of the impact that it will have on their own 
personal compensation schemes.
    Different companies have different plans. I can't really 
speak to across-the-board generalizations, but there are 
certain--different companies have different plans. But to the 
extent that those reserves are used as part of their bonus 
schemes, it is a--it is a potential factor that will contribute 
to reserve estimation problems.
    Mr. Feeney. Mr. Simmons, in light of Mr. Duchac's testimony 
about the incentives, your testimony includes the notion that 
there is no such thing as proven reserves until the well runs 
dry essentially. You don't know until you are tapped out how 
much is down there. So, with respect to reporting requirements, 
and in light of the fact that some or most companies want to 
encourage the accumulation of reserves, understandably, how can 
we best define actual reserves, or what term would you use and 
how would you go about diagnosing? You suggested independent 
auditors, for example, but give us some suggestion about how we 
can more accurately define these things.
    Mr. Simmons. Well, I think at the heart, at the heart of 
the issue is forcing or suggesting or voluntarily getting the 
disclosure standard so enough key data is in the company's 
reports that analysts can basically dig into it and analyze the 
data. Which is why I come back so strongly to field-by-field or 
key production-unit-by-production-unit reports on production, 
on number of well bores and on these three variations of 
reserves, the amount that you think the structure totally 
holds, because that is the starting point of coming to finally 
P1 or 90 percent, the amount you think you can ultimately 
recover, and both of those should change over time as you find 
more data, go up or down, and then finally the amount that has 
been totally produced so that you know what the residue is.
    Whether you want to go out and further break out P1, P2 and 
P3, which is proven, probable or possible, it is a good idea. 
But I would say just breaking the data out, it is the 
equivalent, or maybe a little bit towards the equivalent, of 
towards the tail end of the conglomerate era who finally decide 
that it was really sort of crazy to have a company just total 
their sales and total their earnings, because analysts actually 
couldn't tell whether LTV was an aerospace company or sporting 
goods company, and out of that came the business segment 
reserve report, business segment reporting.
    I think until we get to some form of unit-by-unit breakout, 
we can do all sorts of changes, we can do all sorts of 
government issues, and we are still going to leave analysts in 
the dark. I think until analysts have the right data--my sense 
is that there are still smart analysts around that will dig 
into the data. It is just when you don't have the data, we 
basically have the blind leading the blind.
    Mr. Feeney. Mr. Knight, speaking about the blind leading 
the blind, you have talked about the governance problems at 
Shell and the fact that they basically report to themselves. It 
is a very closed organization, based on your testimony. But we 
do have sort of an industrywide issue about overreporting, 
according to the other testimony.
    So have you looked at the other companies in the industry 
and what has motivated them to overreport, since you have 
concentrated on Shell's governance structure? How does Shell's 
governance problems relate to the industrywide aspect of this 
overreporting problem?
    Mr. Knight. Well, Shell has some very particular problems 
of its own, which I have talked about, and which I don't think 
I need to repeat. I think it is quite interesting with the data 
which has been coming out on reserves. There is a field in 
Norway called Ormen Lange, which is a field on which there is 
very little hard data available. I think I was talking to one 
of my colleagues on the panel here. I understand there are only 
four wells that have been drilled in this field, but there are 
a number of companies, reporting companies, which have shares 
in this field.
    The percentage of the total of the overall--the overall 
reserve part, if you like, which they are reporting as proven 
is very different from one company to the other. It goes as low 
as 25 or 35 percent in one case or as high as 80 or 85 percent 
in another for the same field, same--the data in theory should 
be identical.
    I think that to the extent that the information is made 
available, analysts, as Mr. Simmons was saying, being perfectly 
skeptical about this company's submission because they can 
compare it with some other companies'--other companies' data 
with regard to a specific field--it becomes very difficult, 
when the world is broken down into four regions, and you really 
don't know which fields we are talking about. We don't even 
know which countries we are talking about in some cases.
    Mr. Feeney. Thank you.
    The gentleman from Texas. Mr. Bell. You are recognized for 
5 minutes.
    Mr. Bell. Thank you, Mr. Chairman.
    Mr. Simmons, I wanted to go back to something you testified 
about earlier, just to be clearer about the data being 
unaffordable, and you talked about some of the data collection 
techniques. Is that what made it unaffordable, because the 
technology involved in collecting the data was so expensive, or 
did I not follow that correctly?
    Mr. Simmons. Let me take the example of cutting the core on 
an appraisal well. I sat next to the senior vice president of 
exploration of one of our major oil companies in charge of 
Latin America about 6 or 8 weeks ago, and I said, let me ask 
you about your impression about coring. Has that become kind of 
obsolete? Because if I ask about 100 people, I would get, oh, 
yes, we just don't do that much in boring. He said, you know, 
when we are operating the field, I would not dream of not 
cutting the core and flow-testing, he said; it can cost 20- to 
$40 million more, but it is the only insurance of saving a $2 
billion mistake. But the longer we had this low-price 
environment, you literally--you basically turn a project into 
being uncommercial if you did that.
    Mr. Bell. If you cut the core.
    Mr. Simmons. If you basically drilled the multiple number 
of appraisal wells. So out of necessity, as opposed to a 
conspiracy, company after company started tossing the towel in. 
That is one of the reasons that the independent reserve 
engineers started not getting hired. It was a cost-cutting 
measure. People started all getting comfortable that we really 
didn't need to do that anymore, and, in my opinion, that was 
wrong and led to an enormous potential overstatement of 
reserves as a systemic problem.
    Mr. Bell. Dr. Dharan, I see you shaking your head.
    Mr. Dharan. Well, not that I disagree or anything, but I 
was just also commenting, thinking about the fact that with a 
large energy company, there is always competition for 
resources, and when the oil prices were as low as they were--
even hard to believe now--but just 6, 7 years ago, the 
competition within the companies was such that the exploration 
side was usually getting the least amount of budget.
    And some of the problems that the other panelists have 
mentioned really are the result of those internal problems. But 
at the same time, I totally agree with Mr. Simmons that none of 
that should have permitted companies to cut down on the 
necessary validation process that they needed to do to evaluate 
the reserve quantities. I think that should have been the 
number one budget item regardless of the other commitments the 
companies had.
    Mr. Bell. Mr. Simmons is someone who is intimately involved 
in the financing of energy companies and projects. What do you 
see as the best route for regulators to take in the wake of the 
Shell case? And also, should we be concerned with the reactive, 
overreaching policy that could perhaps hamper long-term 
production?
    Mr. Simmons. I think the worst long-term thing that could 
happen to our entry into the oil and gas business in the United 
States is a crisis of confidence in the whole reserve issue. We 
have just had the convergence, market-to-market accounting, and 
this is a totally different deal. But I think if we have a 
litany of reserve writedowns, we are asking for a crisis of 
confidence in an extremely capital-intensive industry, in a 
risky industry, and there is nothing capital hates more than 
geological risk and disclosure risk.
    So I really think it is really important that the key 
stakeholders in this area realize we have a badlyflawed energy 
system. We will never get perfection on 90 percent. Trying to 
get any 5 companies to try to agree on what is 90 percent 
certainly is a joke.
    But there are so many strides we could be making. I go back 
to my remarks that I made in my oral and my written is watch 
the efforts of IAA in Paris, because they are really going the 
same 9 yards and trying to get the same disclosure of OPEC, 
where we have no data.
    One of the reactions that they are getting from the key 
OPEC members is why should we have to report things that we are 
not insisting on U.S. public companies? I say, no, everybody 
ought to be held to these standards.
    So I think data reform is extremely important. Whether, 
again, field-by-field is the best answer or not--the nice thing 
about it is everyone should have the data so you are not 
talking about a whole new generation of accounting. But I just 
think we need to move quickly into that area, or we are going 
to have a crisis of confidence, and it will badly hurt our U.S. 
energy supplies. This is too capital-intensive an industry to 
scare capital away right now.
    Mr. Bell. Whenever you are talking about perhaps more 
regulation, there is always a fear of overreaching, and I would 
like to pose this to the whole panel in closing: How do you 
think we will best avoid overreaching?
    We will start down here and just move down the line.
    Mr. Dharan. I think as long as we focus on the quality of 
disclosures and not the quantity of disclosures, we could first 
improve the existing disclosures; make sure that is working 
before imposing additional cost of new disclosure. So to some 
extent we should always, of course, be concerned about 
potentially regulating to prevent the problem that has already 
gone away in some ways.
    I am not saying that it has happened here, but I just feel 
that by first focusing on the quality of disclosures by helping 
the industry implement an auditing system, we could then set up 
the environment where we could ask questions about do we need 
more information, and if so, what is the cost of collecting it, 
what are the downsides, and have those kinds of discussions, 
without somebody also questioning the validity or usefulness of 
even existing information.
    Mr. Duchac. I would probably agree with that and say that 
the focus really needs to be on process rather than product. If 
at the end of the day--I am not sure adding to the disclosure 
base right now is really going to do anything right now, 
putting four pages in an annual report with more detail will 
really help the external constituents.
    I think what will help them is focus on improving the 
process that generates that estimate so that that process is 
more consistent across companies. So if you are comparing two 
or three companies, you know that the reserve estimation 
process is done in a rather consistent basis for each company 
so that you are comparing apples to apples, and that the 
process is thorough so that the estimates that are ultimately 
generated are the numbers that end up in the finance reports. 
So I would argue more focused process in which those numbers 
are generated.
    Mr. Simmons. And I would just conclude, among my whole 
field-by-field reporting, that if the industry actually had 
this, it would actually help the industry run itself infinitely 
better, so I think everybody wins. And, yes, it is a bit more 
complicated, but, again, analysts are actually smarter than we 
give them credit for if they have stuff to analyze, but not 
right across the board, and right now we are in the dark, and 
something has to change.
    Mr. Bell. Mr. Knight.
    Mr. Knight. I would like to put a slightly different 
perspective on this. The idea that you publish proved reserves 
lends--leads me perhaps to think what is not proved reserves 
just isn't there. The truth of the matter, it is there.
    Frequently the only difference between what is proved and 
isn't is how much is budgeted by a company to take it out of 
the ground. It is a question of budgeting. I think companies 
need to be free to allocate capital as they see fit. The idea 
of trying to impose on that company a standard which is 
presented in a way as being an all-encompassing measure of 
reserves is, I think, slightly--is, I think, difficult to 
apply.
    I think the reality is that most people who invest in this 
industry, particularly when they invest outside of the U.S., 
whether it is less consistency of data, if you like, we are 
looking at companies which operate in different areas and 
regimes and so on, you need to look at other data.
    What I think is important is to get the data out there. 
There is maybe a slight cost in the sense of getting 
consistency of that data may be difficult, but actually having 
the information out there and allowing people to form their own 
views as to what are probably reserves or possible reserves.
    What do I think of allowing people to make investment 
decisions on the basis of their own assessment and on the basis 
of more complete information? By focusing solely on proved 
reserves, which are only a small part of the iceberg since 
companies have projects which last decades, if you like, and 
which are going to create reserves in the future, I think 
misses a large part of the equation. I think, therefore, what I 
would like to see is more information, less focus on what is 
proven and what is not proven, because, frankly, the idea of 
what is proved is slightly artificial.
    Mr. Bell. Thank you. Thank you very much.
    Mr. Feeney. Thank you.
    Congressman Scott, do you have additional questions?
    Mr. Scott. No thank you, Mr. Chairman.
    Mr. Feeney. Congressman Bell.
    Thank you, gentlemen, very much for your testimony. We 
appreciate your view, and it is an interesting insight.
    With that, Congressmen Scott and Bell, we adjourn.
    [Whereupon, at 3:40 p.m., the committee was adjourned.]


                            A P P E N D I X



                             July 21, 2004


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