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Royal Dutch/Shell Merger, Earnings Counteract Another Possible Reserves Reduction
In an effort to provide greater accountability and streamline corporate governance since its reserves reduction scandal earlier this year, Royal Dutch/Shell last Thursday announced that it will merge its two holding companies, The Hague-based Royal Dutch Petroleum Co., which owns 60% of the company, and London-based Shell Transport & Trading Co. Ltd., which holds 40% of the company.
The company also announced that its earnings more than doubled in the third quarter. However, the good news for investors also came with some bad news. The company also said that another 900 million boe reserves reduction is possible because its assessment so far has only covered 55% (8 billion boe) of its reserves.
Shell shares soared on the London Stock Exchange Thursday, hitting a 2004 high before closing. Royal Dutch shares were up 1.37% on the Euronext exchange. And in trading on the New York Stock Exchange, U.S.-traded Shell shares were up 1.4% to $47.41, while Royal Dutch shares were up 0.52% to $54.11.
Analysts said the changes announced with the merger would go a long way toward meeting the demands of investors who have been angered by the reserves crisis. The crisis has led to three senior executives being ousted, almost $150 million in fines imposed by U.S. and British regulators and a 23% drop in the company’s total oil and gas reserves so far.
Since January, Shell has reduced its reserves estimation by 4.47 billion boe. It admitted Thursday that it may have to cut its reserves yet again. However, the company also reported that its third quarter profits were up 120% to $5.4 billion from $2.4 billion in 3Q2003.
“These are again satisfactory results and I am pleased with the progress we’re making,” said CEO Jeroen van der Veer. “I am of course disappointed that the more rigorous review and audit process we have put in place has identified potential proved reserves reductions.”
Standard & Poors placed the AA+ long-term credit ratings on Royal Dutch/Shell Group and its fully owned subsidiaries on CreditWatch with negative implications. At the same time, the A-1+ short-term ratings on all of these companies were affirmed. The CreditWatch placement was in response to the potential additional downward reserves adjustment. The overall reserves revision would represent an additional 6.3% reduction in Shell’s current proved-reserves base, S&P noted.
“This latest warning about Shell’s reserves represents the fifth such announcement about the company’s reserves base this year. When Shell’s ratings were last affirmed on July 8, Standard & Poor’s did not expect that further significant adjustments to the company’s reserves base would be required. The potential 900 million boe volume adjustment could reduce Shell’s proved-reserves life to less than 10 years, and the reserve-replacement rate for 2004 is expected to fall short of the already low 60%-80% range forecast by the company earlier this year. Moreover, the volume adjustment could be even higher than the announced 900 million boe.” S&P also noted more than six billion boe of Shell’s reserves still have to be audited.
However, S&P also said that the company’s current weaknesses — its exploration performance and internal control issues related to reserves booking — are counterbalanced by its conservative financial profile and policies, its profitable global downstream operations, its broad portfolio of upstream assets and its competitive, though increasing, development and production costs.
The company’s exploration and production earnings were up 18% in the third quarter to $2.4 billion. However, production was flat at 3,608 boe/d. The company reported an 11% drop in U.S. natural gas production to 1,294 MMcf/d from 1,455 MMcf/d in 3Q2003. U.S. gas production was down about 33 MMcf/d from the second quarter of this year, and for the first nine months of the year U.S. natural gas production was down 14.6%.
A 97-Year Engagement
Under the merger proposal, the two parent groups, which have been managed as a unit since 1907, will merge and form the supervisory board of the new company, to be named Royal Dutch Shell PLC. The consolidation is expected to take place in the second quarter of 2005, with the new company to be nominally based in London but with its physical headquarters and tax home in The Hague, Netherlands.
If the deal is approved by stockholders, they will receive shares in the new company on a one-for-one basis. Dividend payments will be shifted to a quarterly basis from their current semiannual frequency.
Van der Veer, the current chairman of the Royal Dutch/Shell Group’s board of managers, will continue as the new company’s CEO. Additional reforms in management and governance structure are also planned.
The company said the restructuring will provide “clarity and simplicity, one listed company, one board, one chairman and one chief executive.” It pointed to “greater efficiency, streamlined decision-making with clear lines of authority and an empowered CEO,” as well as “accountability — clarity in governance, reporting relationships and responsibilities.”
“We shall move from the complex governance and corporate structure that people found difficult to understand,” said Royal Dutch Chairman Aad Jacobs. “We have been listening hard to what the world had to say.”
Analysts welcomed the announcement of the new structure and earnings improvement, but were disappointed in the new reserves restatement. “As a result of strong 3Q earnings and our improved outlook for the chemicals segment, we are raising our 2004 ($5.10/share), 2005 ($4.65-$4.70), and 2006 ($4.25-$4.35) earnings estimates [on Royal Dutch Petroleum],” said Freedman Billings Ramsey analyst Jacques Rousseau.
“However, our thesis remains intact: with a much lower upstream production volume growth rate than its peers and a mid-cycle return on capital employed that should decline in the coming years due to rising capital investments, we believe that it will take a number of years before RD can become competitive with other major integrated oils in terms of financial performance and shareholder returns. We maintain our ‘Underperform’ rating on Royal Dutch, preferring ExxonMobil and Total.”
However, Deutsche Bank upgraded Shell to “buy” from “hold” after the announcement. Merrill Lynch analysts said they would have expected the company’s shares to be sharply lower Thursday had it not been for the announcement of unification of the two holding companies into a single entity.
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