Free Essays

Complex market structure

Both the oil and gas industry has a complex market structure. Global oil supply is being controlled by just five big players in the industry namely BP, Texaco, Royal Dutch Shell, TotalFinaElf and Exxon Mobil. For investors in oil industry, accounting of oil reserves plays a vital role. For oil companies, or any corporation that has its sales, product capped by limited supply with large market demand, investors always look for the long term oil deposits or reserves that will generate future income while deriving their expected revenues on the investment made in the oil companies.

Hence, if an oil company declares that it has potential vast amount of reserves of oil or gas, then it will have impact on its stock price. Royal Dutch / Shell Group on 9th February, 2004 declared that it had overvalued its oil reserves by 20% or higher by 3. 9 billion barrels. Due to this anomaly, Chairman of Shell, Phillip Watts and another top executive, Walter van de Vijver, forwarded their resignations. The company’s head of chemical division, Jeroen van der Veer, had replaced Mr. Watts. (Weirauch 2004).

Estimation of oil reserves is a crucial financial indicator for an oil company. Due to this overstatement, the company was under investigation by prosecutors and regulators both in Europe and in the United States. Overstatement of oil reserves is first exposed by the company’s draft audits exposing serious reserves problems in Oman and Nigeria. Mr. Vijver explained his stand through the issue of a statement asserting that he warned the top executives of the company as early as 2001 about the requirement to re-evaluate ‘potentially non-complaint reserves.

” Further, Mr. Vijver report also exposed that the corporation’s filing with the SEC [Securities and Exchange Commission] might have over reported by about 2. 1 billion to 3. 5 billion barrels of oil. (Multinational Monitor 2004). Due to overvaluation, Shell’s stock price fell down about 12% causing huge monetary losses to investors. The stock price never recovered till the end of 2004 and it had shaken the confidence of Shell’s investors on the company.

It is to be observed that oil companies can account their oil reserves in their books only if it is from proven resources and that too the oil well is currently under production process and it is essential for the oil company to demonstrate that it is not only economical but also legally possible to produce oil under present scenarios. Hence, it should be proven resources rather than probable reserves, recoverable reserves or recoverable resources as these are more uncertain in nature.

Investors of an oil company will take only the proven resources for calculating their return on equity in the long run. However, there are many arguments that even unproven resources can be turned into proven resources by the employment of new, advanced technologies. The controversy corners around as there is no proven method or accounting standard to arrive at proven resources by oil companies. Normally, oil companies follow certain inbuilt guidelines for the calculation of proven resources or oil reserves.

It is to be observed that SEC never insists that a certificate should be obtained from a third party for the accuracy of oil reserves declared by an oil company. Hence, the oil company has to adhere some guidelines while arriving at reasonable numbers when categorising the oil reserves as proved. SEC of USA has the rigorous requirements around the globe regarding the method of arriving at proven resources but it demands only “rational certainty “ and this no doubt results in giving scope for subjective assessment by an oil company .