Royal Dutch/Shell Group reportedly came under the increasing scrutiny of federal prosecutors last week following the release of a long-awaited report that confirmed some top-level executives lied about the company’s reserves for nearly two years. The group, responding to the shocking findings in the report, cut its oil and natural gas reserves for the third time in as many months, and announced that Judith Boynton stepped down as chief financial officer.

One former official went as far as to say he was “sick and tired about lying” about reserve numbers. Investors, apprised the reserve change would mean less than 1% difference in net earnings, appeared oblivious to the news as the company’s stock price remained relatively steady throughout last week. This could change, however, if jolting revelations about the group continue.

The disclosure prompted reports that the Department of Justice has made its criminal probe of the reserves’ deception a key priority, and that it could lead to criminal charges being brought against former executives and/or Royal Dutch/Shell. The Securities and Exchange Commission (SEC) is carrying out a civil investigation of the unfolding reserves’ restatement.

The 463-page report by the group’s audit committee, which reviewed 90% of Royal Dutch/Shell’s proven oil and gas reserves, estimated that 4.35 billion barrels of oil equivalent (boe) that were booked prior to the end of 2002 need to be downgraded, resulting in a 22% reduction of overall proven reserves. The latest recategorization was 5%, or 200 million boe, more than the previous two restatements (4.15 billion boe combined) that were announced in January and March.

The group, which is 60% owned by The Hague, Netherlands-based Royal Dutch Petroleum and 40% owned by Shell Transport & Trading in London, also reported that its proven reserves for 2003 will be reduced by approximately 500 million (boe).

The news of the third reserves restatement was accompanied by the release by the law firm of Davis Polk & Wardwell (DPW) of revealing and biting e-mails and notes exchanged between former Royal Dutch/Shell Chairman Philip Watts and the company’s ex-chief of exploration and production (E&P), Walter van de Vijver. They strongly suggested that the two knew the company’s reserves were inflated for years.

Both men “were alert to the differences between the information concerning reserves that had been transmitted to the public…and the information known to some members of management,” concluded a report of DPW, which was hired by the audit committee to carry out an independent probe of the circumstances that led to the reserves’ overstatement.

“Bottom line was that both reserves replacement and production growth were inflated. Aggressive/premature reserves bookings provided the impression of [a] higher growth rate than realistically possible,” the report continued.

In a Nov. 9, 2003 e-mail, van de Vijver told Watts that he was “sick and tired about lying about the extent of our reserves issues and the downward revisions that need to be done because of far too aggressive/optimistic bookings.”

Starting in 2001, van de Vijver tried repeatedly to bring the matter to Watt’s attention, the DPW report indicated. “Mr. van de Vijver consistently pressed the position that reserves booked during Sir Philip’s term [as head of E&P] were ‘aggressive’ or ‘premature,’ non-compliant with Shell guidelines for booking and, implicitly, SEC rules,” it said.

The Royal Dutch/Shell boards, after reviewing the findings of the report, concluded that none of the managing directors bore “material responsibility for the difficulties created by the reserves issue.”

Taking into account the latest restatement, Royal Dutch/Shell estimated that the closing balances for its 2002 and 2003 proved reserves were 15 billion boe and 14.5 billion boe, respectively. This put the company’s reserve replacement ratio for 2003 at around 60% and its reserve life at the end of 2003 at 10.2 years, according to the company.

It estimated the impact on net earnings will be just over $100 million per year from 2000 through 2003, which the company said would amount to less than 1% of net earnings over the four-year period. This includes the negative impact on earnings of $86 million that was included in the 2003 earnings announced in February, the company said.

The explosive details in the report appeared to have had little effect on Royal Dutch Petroleum stock throughout last week, which traded at $49.25 per share at mid-day Friday. Shell Transport & Trading stock hovered between $41-$43 during the week. Immediately following the release of excerpts of the report by the group’s audit committee, Standard & Poor’s cut Royal Dutch/Shell’s credit rating to “AA-plus” from its top-tier “AAA,” and indicated that a further reduction may be in store. The other two credit ratings agencies followed suit.

Although Shell directors noted the report revealed “disturbing deficiencies” in the company’s past reserves’ reporting practices, current Chairman Jeroen van der Veer emphasized that “Shell is a sound and profitable group,” and he said that controls now in place would be “rigorously enforced” to avoid inflated reserve numbers in the future.

Boynton was the third executive to step down since the news about Royal Dutch/Shell’s inflated reserves surfaced in January. The first casualties were Watts and van de Vijver. Tim Morrison, company controller since mid-2002, will succeed her as acting CFO. Boynton will remain with the company in an advisory capacity reporting to van der Veer.

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