by Steve Coll
Exxon’s rates of return on capital rose sharply during the 1990s, declined as oil prices fell late in the decade, and then recovered to a record level of about 20 percent by the decade’s end, superior to any competitor. Raymond was only partly successful in persuading others to embrace his math—although no other major industry adopted his ideas about R.O.C.E.’s centrality as a metric, Exxon’s major oil company rivals did start to report their own R.O.C.E. numbers, to Exxon’s benefit. R.O.C.E. was, in any event, a somewhat arbitrary figure by which to compare oil giants. The measure favored ExxonMobil’s relative strengths as an operator in low-margin downstream and chemical divisions; for investors, all companies highlighted the numbers that made them look best. Certainly R.O.C.E. was a long-standing and valid way to measure a corporation’s ability to maintain profit discipline across many projects over many years. Still, “about two thirds” of an oil company’s R.O.C.E. is typically explained by “commodity prices,” as James J. Mulva, the chief executive officer of ConocoPhillips, once remarked. (His company’s R.O.C.E. scores lagged.) That is, the most sparkling annual R.O.C.E. numbers, in comparison with returns seen in other industries, often reflected factors in the global oil market beyond any one company’s control. That was apparent in ExxonMobil’s own yo-yoing numbers. Yet within the oil industry, R.O.C.E. scores did provide a basis to compare operating and capital efficiency. Raymond understood the distortions caused by swings in oil prices, but he thought the number was as good a way as any available to judge management’s long-term investment discipline. “Our competitors hated it,” Raymond recalled. “The reason they hated it is that it’s a report card, and while everyone can talk about individual projects and how attractive they may appear to be, ultimately, over time, you have to look at, ‘Well, how do all of those individual projects add up?’”11
Raymond’s relentless proselytizing about R.O.C.E. was part of a larger pattern of his leadership: He chose his own metrics; he declared that other metrics were wrong; he delivered profits; and he ignored criticism.
That worked well enough when the subject was Exxon’s increasingly strong quarterly profit performance, in comparison to peers. It worked less well when the subject was Exxon’s ability to find enough new oil and gas to replace the hundreds of millions of barrels the corporation pumped and sold every year. As profitable as Raymond was making Exxon by the late 1990s, he struggled increasingly with a challenge that had never shadowed John D. Rockefeller: how to keep the corporation’s oil reserves—the foundation of its business—from shrinking.
The cold war’s end initially promised new bounty for Western oil corporations. Vast reserves did initially open for bidding in the former Soviet Union, Africa, and elsewhere. But it did not take long for the opening to become constricted. Raymond concluded by the late 1990s that while there was plenty of oil in the ground worldwide, the amount that Exxon could access might make it difficult over time to replace the vast quantities the corporation pumped each year—Exxon produced about 585 million barrels of oil and gas liquids in 1997. The reason involved the persistence of “resource nationalism,” or the inclination of governments that owned oil and natural gas to maintain control of their treasure.
The business models of the major international oil companies such as Exxon, Chevron, Royal Dutch Shell, and British Petroleum—and the prices that their shares commanded on Wall Street and on the London exchange—depended in part on the size of the underlying trove of oil and gas the corporations could claim to own. “Booked reserves” or “equity oil” referred to those proven reserves that a corporation controlled legally and could exploit for sale in future years.
In the world’s wealthy free-market political economies—the United States, Norway, the United Kingdom, Canada, Australia—virtually all of the oil available was “equity oil” in the sense that any company that found it and acquired it could own it legally under contract, in a manner akin to property rights. Exxon and its peers could display such equity reserves to shareholders as “proved” or “booked” oil under regulatory and accounting rules enforced in the United States by the Securities and Exchange Commission. The size of these booked reserves allowed shareholders to estimate future profits with relatively high confidence; equity oil was fundamental to Exxon’s stock market valuation, just as the number of shopping malls or office buildings owned by a real estate company would be fundamental to its market value.
Before the 1970s, Exxon, BP, and other large oil companies owned and operated large oil and gas fields in Saudi Arabia, Iraq, Iran, Venezuela, and elsewhere. Rising anticolonialism and nationalism stoked a period of upheaval that caused them to lose major properties. The twin anti-American oil embargoes of the 1970s signaled the arrival of the new era. The embargoes coincided with the rise of a price cartel, the Organization of the Petroleum Exporting Countries (O.P.E.C.), which served the interests of oil-producing governments. In 1979, the Iranian Revolution’s philosophy of Islamic self-determination advanced the spread of anti-Western political attitudes in Middle Eastern capitals. Populist leaders of oil-producing governments competed to prove themselves as resource nationalists—proud owners of their own geological wealth and unwilling to allow foreign corporations to possess a single barrel. Saudia Arabia, Iraq, Iran, Venezuela, Algeria, Libya, and other governments all seized back oil and gas fields from Western corporations, including Exxon. The expropriations decimated Exxon’s holdings and rates of daily oil production. By the late 1990s, Exxon and the other large private oil and gas companies based in the United States and Europe owned less than 20 percent of the world’s oil reserves. In 1973, Exxon had produced just over 6.5 million barrels of oil and gas liquids per day from its worldwide properties. By the late 1990s, that figure had fallen by more than two thirds.12
The corporation spent much of this period “struggling with the issue,” Lee Raymond recalled. “We lost our equity position in the Middle East,” where 60 percent of the world’s proved oil reserves were located. The most fundamental question facing the corporation was, “What’s that mean for the company?”13
Even the most nationalistic governments might welcome Western companies as technology partners and hire them strictly as contractors to drill, produce, and refine oil and gas, as a homeowner might hire out a contractor to renovate a house. Such fee-for-service contracts could be the basis of a profitable business—Schlumberger and Halliburton were examples of companies that built lucrative franchises in this way. But deals of this kind stopped short of allowing the contractor to own any oil beneath the ground. Exxon’s business had always been premised on owning oil, which required greater risk taking but promised much higher profit than a contractor could hope to earn.
By the 1990s, virtually all of the oil in the Middle East was off-limits to corporate ownership because of resource nationalism. The strategic problem facing Exxon was that apart from new frontiers in offshore ocean waters or above the Arctic Circle, there did not seem to be much new oil or gas to discover in territory controlled by wealthy, free-market countries. Elsewhere, in Africa, Asia, Latin America, and the former Soviet Union, oil geologists advised, there were still major discoveries to be made, but inconveniently, much of this new oil seemed likely to be found in places where governments would be skeptical about allowing Western corporate ownership. Notwithstanding communism’s fall, many politicians in developing countries, responding to popular feeling, still held that it was neither just nor necessary to give away ownership of oil and gas reserves, least of all to Western capitalists like Lee Raymond.
Although Exxon jockeyed for position as the world’s largest privately owned oil company, by the late 1990s it ranked only fourteenth or lower on a worldwide basis if the list included government-owned companies such as Saudi Aramco, Kuwait Petroleum, Gazprom of Russia, Petrobras of Brazil, or Sonangol of Angola. These state-owned giants not only showed large inventories of booked reserves, they also increasingly prowled outside their borders to compete with Exxon to capture next-generation oil re
serves in Africa, Asia, and Latin America.
Exxon’s strategy was to emphasize its superior record of project execution, budget management, and cutting-edge technology. Its executives tried to persuade oil-owning governments that Exxon’s efficiencies could deliver an enormous cash windfall over the long life of a project, in comparison with what a less-efficient state-owned company could deliver. Computing power had started to remake oil exploration techniques. Three-dimensional imaging and algorithms that sorted reams of seismic data into patterns transformed the ability of Exxon’s geologists to find oil and gas. Many state-owned oil companies lagged behind. Not all oil-endowed countries had the capacity or the political and economic stability to build and manage a state-owned oil company that was competent in all sectors of the business. These were the openings Exxon tried to seize. Yet Chinese and Russian competitors could make offers to African or Latin American or Central Asian host governments that Exxon couldn’t touch—government-to-government loans, arms transfers, and political favors.
All this placed unprecedented pressure on Raymond and his peers to show Wall Street that they could find or buy new oil and gas reserves to replace what they produced annually. If an oil company failed to replace production for a sustained period, it would be on a path to liquidation. Under U.S. Securities and Exchange Commission–supervised accounting rules, the oil and gas reserves Exxon and its peers reported to shareholders were not carried on corporate balance sheets, but they were reported each year in S.E.C. filings. The reserves were among the most important assets oil companies described to investors because they suggested the scope of a particular company’s potential future profits and its sustainability. The sheer size of a company like Exxon or Shell increasingly made the math of annual reserve replacement daunting—more than a billion barrels had to be found and booked as new equity reserves each year if the company did not want to appear to be shrinking.
The temptation for Wall Street to fudge the numbers was powerful, as events at Shell would soon bear out. Yet the management of annual reserves reporting—having in-house geologists count up “proved” holdings, field by field; reviewing those counts at higher levels of management annually; and applying objective standards that could hold up if the S.E.C. inspected them—was a relatively new priority. During the long history of Standard Oil and its successor companies, down to offspring Exxon, executives had not had to worry much about reserve counting or replacement. There was plenty of oil to drill worldwide, and because Exxon, in particular, had owned stakes in Saudi Aramco and Iraqi and Iranian companies with massive reserves, the issue seemed of little material importance. It was only after the nationalization waves of the 1970s that annual reserve replacement became precarious, and counting methods drew attention from regulators. Gradually, Wall Street analysts and investors focused down on the question of which oil companies were renewing their reserves healthily each year and which were struggling and even in danger of spiraling smaller. Raymond took up the challenge of reserve counting with characteristic aggression and disdain for Washington regulation.
He had cause for concern: Between December 31, 1996, and December 31, 1997, the proved reserves of oil and liquid natural gas that Exxon reported to the S.E.C. fell from 6.34 billion barrels to 6.17 billion barrels, a decline of more than 2 percent. The amount of that decline was the equivalent of 465,000 barrels of oil production per day, annualized, a sizable amount by industry standards. During the same year, the corporation’s reported proved natural gas holdings increased slightly, but not enough to offset the fall in oil reserves. Judging by the rules enforced by the S.E.C., then, Exxon’s total oil and gas reserves shrank during 1997.
The news that Exxon had retracted a bit, at least temporarily, was hardly shocking: All of the major oil and gas companies struggled during the 1990s to replace produced reserves. To the public and Wall Street, however, Lee Raymond made no such admission. On February 5, 1998, Exxon announced in a press release that it had replaced 121 percent of its 1997 production by adding new proved reserves—in other words, its reserves had grown, not shrunk. “This year’s strong performance is the fourth year in a row that we’ve exceeded 100 percent replacement,” Raymond declared.14
How could Exxon tell the public and Wall Street one thing and the S.E.C. another? The answer involved a catalog of legalese known as S.E.C. Rule 4-10, the binder of regulations that governed what oil and gas companies could and could not report as “proved reserves.” A purpose of Rule 4-10 was to prevent oil companies from puffing up their reserve numbers to lure share buyers and bolster their stock market prices.
One of the rule’s provisions held that “oil and gas producing activities do not include . . . the extraction of hydrocarbons from shale, tar sands, or coal.”15 Tar sands refer to bitumen, a thick form of oil that usually has to be dug out of the ground by techniques that resemble mining, after which it is mixed with chemicals to create a liquid suitable for transport by pipeline to an oil refiner. Canada holds some of the world’s largest tar sands reserves. Exxon, through local affiliates, had been buying into these holdings under Raymond’s spur. Raymond believed it was wrong for the S.E.C. to exclude tar sands from proved oil reserve counting—and so he simply ignored the commission’s rules when he issued press releases.
The S.E.C. had enacted the tar sands rule because it wanted investors to know when a company was engaged in mining and when it was engaged in oil production—for one thing, the expense of mining was typically higher than the expense of oil drilling, so the value of tar sands reserves over time might be less than an equivalent amount of purer oil. Raymond thought this was wrong, too: The purpose of S.E.C. regulation was to ensure accurate documentation of resources, not to force companies to dance around in outmoded categories devised by bureaucrats. There was no doubt that Exxon owned the Canadian tar sands resources it claimed—outright fraud was not the issue. In any event, if Exxon’s Canadian tar holdings were included with other oil and gas holdings, the corporation’s total proved reserves had indeed gone up during 1997, not down—and this is what Raymond chose to emphasize to Wall Street and the public.
Did his defiance of the S.E.C. rules matter? Raymond might disagree with the regulations on the books, but the purpose of S.E.C. regulation was to ensure that all investors had accurate information about the companies whose shares they owned. Through fraud-inflated bubbles, Wall Street reminded the world every ten or twenty years why such regulation was vital. Raymond declared publicly each winter in press releases and Wall Street presentations that Exxon enjoyed smooth, year-to-year reserve replacement when, in fact, no such picture existed, according to S.E.C. regulations. And the corporation’s spinning did help to mask a strategic issue at Exxon, the challenge of resource nationalism and reserve replacement, which was of genuine and enduring importance.
On December 31, 1996, Exxon stock traded at $24.50 per share. On February 6, 1998, the day after the corporation issued a press release boasting of “the fourth year in a row that we’ve exceeded 100 percent replacement,” Exxon shares closed at $31.00. Exxon’s profitability was unchallengeable, but it could be questioned whether all of that 10 percent plus annual gain in stock price, which benefited Exxon executives and employees as well as ordinary shareholders, was honestly earned.
Raymond’s defiance of the S.E.C. was not illegal—the corporation’s annual 10-K filings to the commission appeared to be carefully parsed, and they broke out tar sands (or “oil sands”) as a separate reserve figure, in fine print. Rule 4-10 enforced disclosures in official filings to the commission, not in press releases or oral statements to Wall Street analysts.
Exxon’s practice of reserve spinning to the public reflected a broader mind-set of chutzpah toward Washington. The commission staff was by far the weaker party in this particular contest; for many years the S.E.C. did not have a single oil geologist on its payroll to assess the “proved reserve” claims made by the oil corporations it oversaw.
Exxon’s argumentative press release
s also signaled how heavily the reserve replacement conundrum weighed on Raymond and his colleagues. The underlying challenge of reserve booking did have far-reaching consequences: It would draw Exxon to far-flung corners of the earth in pursuit of reportable reserves the corporation might previously have ignored on the grounds that they involved too much political and economic risk and dragged the company into dictatorships and other violent settings for which it was not well prepared.
“What is the one item that concerns you most, that disturbs your sleep?” the Wall Street oil industry analyst Fadel Gheit recalled asking Raymond over a meal.
“Reserve replacement,” Raymond had replied.16
John Browne ascended to become chief executive of British Petroleum two years after Lee Raymond took over Exxon. As individuals, their personal interests could hardly have been more disparate—Browne, the Soho-inspired gourmet; Raymond, the duck hunter and country club golfer. As business competitors, they faced a common challenge. As Browne put it later, “We believed governments of oil-producing nations would increasingly prefer to work with very big and influential oil companies. They did not think small was beautiful—that was clear when you spoke to them. They wanted to see a big balance sheet, global political clout, and technological prowess, and they wanted to be sure that you would be around for a long time.”17
Moreover, the geographical distribution of Exxon and British Petroleum’s oil holdings increasingly isolated those two companies from the regions with the most promising new opportunities. Exxon’s reserves and those of British Petroleum were the most heavily weighted toward the politically safe, economically free but geologically mature oil regions of the West. About 80 percent of Exxon’s reported proved oil reserves lay beneath the United States, Canada, and Europe. British Petroleum had struck out aggressively in the former Soviet Union after communism’s collapse, but about three quarters of its assets remained in Britain and the United States. Chevron had acquired sizable reserves in Kazakhstan and Africa. Mobil owned large holdings in Africa and Asia; the majority of its reserves lay outside of North America and Europe.18