Energy royalties: responding to the critics
Gary Lamphier
The Edmonton Journal
Saturday, October 20, 2007
Oil and gas companies have waged a furious assault on the recommendations of an independent royalty review panel since it submitted its report in September. Gary Lamphier sat down with panel member Evan Chrapko and royalty expert Pedro Van Meurs -- who was retained by the panel -- to get their responses to the industry's charges.
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Q: Alberta is widely known as a stable place to invest. By raising royalties, won't this put Alberta on par with places like Russia or Venezuela?
A: "The vast majority of countries change their fiscal terms regularly. I take great exception to Alberta being compared to Venezuela or Russia, countries that rip up existing contracts. Alberta is absolutely not doing that," says Van Meurs.
Wood Mackenzie, a global energy consulting firm, says 18 countries have altered royalty rates since 2001, transferring $260 billion US to government coffers, Van Meurs adds.
Q: Instead of gaining $2 billion (Cdn) a year in royalties, as the panel suggests, won't Alberta lose billions as companies like EnCana slash spending?
A: "I've assisted in changing the fiscal terms in at least 20 jurisdictions around the world. Every time terms change, companies say they'll go elsewhere," says Van Meurs. "Yes, some oilsands projects will be deferred. But Alberta needs a slower level of development" to curb inflation and maximize its oilsands resources, he argues.
Q: With natural gas prices down, the Canadian dollar above $1 US, drilling levels depressed and foreign LNG (liquified natural gas) supplies rising, isn't this a terrible time to raise royalties?
A: "The panel recommended lowering royalties at low natural gas prices. With lower royalties, there's more support for industry," says Van Meurs.
"At $7 (Cdn) per gigajoule, all royalties would be higher. At $6, 82 per cent of all gas wells would pay lower royalties. And at $5, royalties on all wells would be less."
Q: So how much would industry save from these lower royalties?
A: "At $6.20 gas prices, the royalty savings on low productivity wells would be about $227 million," says Chrapko.
Q: The energy sector is already grappling with the end of the Accelerated Capital Cost Allowance and the elimination or scaling back of several royalty programs. Why didn't the panel take this into account?
A: "We did extensive analysis on this. There are practically no countries in the world that permit a 100-per-cent writeoff for major capital expenditures. So ACCA was an unusually rich program that was no longer in keeping with Alberta's healthy oilsands industry," says Van Meurs.
Q: Even if most gas wells pay lower royalties at low natural gas prices, what does it matter if, as some say, the entire basin is now uneconomic?
A: "Drilling is down, but we had very active drilling going on, even at $5 (per gigajoule). So are all these companies dumb? To say the whole basin is uneconomic at $5 makes no sense," says Van Meurs.
Q: According to Tristone Capital, five per cent of Alberta's gas wells account for 50 per cent of production and generate about 40 per cent of all provincial royalties. Under the panel's recommendations, won't these critical wells -- mainly in the Foothills -- take the biggest royalty hit?
A: "We don't deny that at all. The most profitable wells will bring in most of the (additional) royalty revenues," says Van Meurs.
According to the panel's report, higher royalty rates on such wells would generate more than $900 million a year in additional royalties, roughly half the projected $2-billion total increase. However, even at a gas price of $9 per thousand cubic feet, Tristone reckons returns on such wells would be cut sharply.
Q: Won't the panel's recommendations, if implemented, kill any incentive to drill these high-cost wells?
A: "Some of the reaction of the industry, particularly EnCana, was I think largely related to the deep well (royalty incentive) program. It's true the panel recommended cancelling a number of royalty programs. But it never recommended cancelling that one," says Van Meurs.
Q: Ziff Energy estimates that "full cycle" natural gas supply costs in Alberta have doubled to $7.90 per thousand cubic feet (Mcf) since 2000. If so, isn't there very little incentive left to drill expensive deep-basin targets in Alberta?
A: "Under the current royalty terms, deep gas wells are paying as much as a 20-per-cent royalty. These wells are being drilled today at $6 per Mcf. So this argument doesn't make sense. And remember, the (deep-basin gas) royalty holiday only applies to the first $500,000 of royalties," says Van Meurs.
Q: But if full-cycle costs are really $7.90, as Ziff says, why does the panel recommend that all wells pay higher royalties at just $7?
A: "The full-cycle view means you account for everything, not just the successful wells. So you factor in all the costs of exploration, and the denominator is your total production," says Chrapko. "But it's the commodity price that's the key to profitability. Royalties are not a magic wand that are meant to address all ills. In the capitalist system, every inefficient operator isn't entitled to a profit -- especially in an industry that's already one of the most subsidized in the province."
Q: Sure, there's drilling even at low gas prices. But aren't lease holders forced to drill their prospects while gambling that prices will rise?
A: "Each well has a different break-even price level. As the price declines, more wells are less economic. Do some companies drill because their leases are running out? Of course. But I can't think of anybody who would actually deliberately lose money by drilling a well," says Van Meurs.
Q: Let's turn to the oilsands. CAPP president Pierre Alvarez says today's high oil prices are somewhat meaningless. Yes, light crude is now above $88, but bitumen is worth less than half that. More importantly, it is returns that matter, not commodity prices. Your response?
A: "The answer is very simple. In all the economic analyses we did, the panel assumed bitumen prices would be 45 per cent of light crude oil prices. So that's the basis of all the economic analysis," says Van Meurs.
Q: OK, but what about the returns from these projects?
A: "First, I suggest you take a look at the market values of these companies, if you don't think these oilsands projects are highly profitable," says Chrapko.
"Suncor's stock price just hit an-all time high. So did Canadian Oil Sands Trust, and Canadian Natural Resources (CNRL) shares are just below their all-time high."
Q: But oil prices are up about $7 a barrel since the panel's report came out, close to a record high. Doesn't that explain it?
A: "In part. As I like to say, it's the oil price, stupid. That's always the key factor. And that's why these companies are racking up record profits. But on top of that, let's talk about the sweetheart deal these producers get under the current generic oilsands royalty regime," says Chrapko.
"They not only deduct their startup capital costs, they also deduct their R&D costs and their operating costs, as incurred. And on top of that, they get another six per cent on their capital invested," he adds.
"During this whole period, they pay a one-per-cent royalty until all such costs, plus six per cent, are recovered. That's the sweetheart deal. If that's not looking at returns, I don't know what is."
Q: But what about the huge cost overruns companies have absorbed?
A: "The reason they're able to absorb the multi-billion dollar hits is that you and me, all of us, are paying for it. That's why they can agree to 24-per-cent increases (over four years) in their labour agreements, as Suncor and CNRL just did."
Q: Still, the panel proposes two major increases to current oilsands royalties, including a hike in the ultimate net profit payout to 33 per cent, and a bitumen tax tied to oil prices that scales up to a high of nine per cent at $120. Won't this severely impair returns for oilsands projects?
A: "My work for the panel was precisely to measure, to ensure, the linkage between profitability and royalty rates. So in all my reports I analyzed the rate of return, the profitability ratio, and the net present value per barrel of oil equivalent for every feasible price-cost combination for oilsands as well as conventional natural gas and oil wells," says Van Meurs.
Q: All right, but as you know, J.S. Herold, an industry consulting firm, says returns from the oilsands aren't as high as other jurisdictions, correct?
A: "J.S. Herold makes a basic mistake in calculating returns. They only looked at a five-year timeline, instead of the entire lifespan of a project. The economic rent -- or royalties -- have to be looked at when the project is done, not just in advance. Otherwise you end up with a castrated view of the revenues," says Chrapko.
Q: Suncor and Syncrude operate under special Crown Agreements that don't expire until 2016, and which enable them to opt to pay royalties on lower-value bitumen in 2009. Isn't it wrong to recommend tearing up these contracts?
A: "The panel under no circumstances recommended any ripping up of contracts. The current agreements with Suncor and Syncrude are there, and all the forecasts in the panel's report are based on those agreements," says Van Meurs.
"You can see that even in the forecasts on page 17 (of the report). Clearly, oilsands royalty revenues are projected to drop to $1.7 billion from $2.2 billion by 2010, under the current system."
Q: But what about other oilsands producers that have made big investments, such as CNRL, which falls under the current generic oilsands royalty regime? Even if royalties are changed, shouldn't CNRL be 'grandfathered?'
A: "The oilsands division of the Ministry of Energy and its utter incapability of monitoring the current system -- as shown in the recent auditor general's report -- would suggest that you don't want to start setting up two sets of rules when they can't even monitor one," says Chrapko.
"But I want to make it clear that our problem is with the oilsands division, not the whole energy department. Dave Breakwell and his team, including Barry Rogers and Matthew Foss, were beyond exemplary. Our whole report could not have been done without them."
Q: You say you're not in favour of ripping up the current agreements with Suncor and Syncrude. Yet, they'd be subject to the proposed new bitumen tax.
Isn't that the same thing?
A: "No. The Suncor and Syncrude agreements only apply to royalties, not absolute fiscal stability in the province. So any tax -- whether it's a bitumen tax, a water tax, or a carbon tax -- can be imposed, just like any tax. That's not ripping up an agreement," says Van Meurs.
Q: OK. But isn't a bitumen tax just another name for a royalty?
A: "No, they're two different things. As we've said, Suncor and Syncrude won't be subject to any new rules on oilsands royalties, yet they account for about 50 per cent of all bitumen production. So that's one reason why we introduced this new bitumen tax," says Chrapko.
"Ideally, you always like to work towards a level playing field for all investors," says Van Meurs. "The bitumen tax does that."
Q: Let's get back to oilsands project costs. As you know, the industry says costs have skyrocketed, and the panel's numbers are outdated. Any response?
A: "In January, Wood Mackenzie updated all of the cost estimates for all the major oilsands projects. Their study was widely distributed, and I was conservative in interpreting their data. The energy department assured me subsequently they have reconfirmed that Wood Mackenzie still believes the cost data is reasonable," says Van Meurs.
"Since then, Wood Mackenzie has stated that yes, some new projects are 25 per cent more expensive than those we had studied, and these are projects that are on the drawing board, so they're just estimates. Well, give me a break. These are just fantasy numbers that are now being thrown around."
Says Chrapko: "In January, on a conference call we had with Wood Mackenzie, they were estimating oilsands capital costs ranged from $50,000 to $80,000 per barrel, depending on the project.
"Since our report was issued, they're saying it's now $100,000. Well (bleep), whose pocket are they in?"
Q: Wood Mackenzie says the panel's recommendations, if implemented, would reduce the value of current or future oilsands projects by some $26 billion, or 13 per cent of the sector's value. How does that serve the province's interests?
A: "Please understand what this means. It means that if you bought all of the oilsands assets today from all the companies there, you would pay $26 billion or 13 per cent less than you would have paid before," says Van Meurs.
"Why is this in the interest of the province? Because this value is going to be transferred from the companies to the province (in the form of higher royalties). That's the benefit. Alberta will be $26 billion richer on a net present value basis."
Q: But doesn't this imply that some marginal oilsands projects will be killed? Isn't that part of the rationale for the $26-billion figure?
A: "No. Let me put it this way. It's as if you bought a house. Previously it was worth $400,000, but the municipality comes in and says, from this day forward, there's a further $10,000 in property tax on that house. So now, maybe you're only willing to pay $370,000 for it. That's basically what's happening here."
Q: Why didn't the royalty panel include land-lease sales to determine whether Albertans are getting their fair share? Wasn't that a key omission?
A: "No. The panel's task was to determine a fair share of resource revenues, and fair share has to be determined based on a relative comparison with other jurisdictions in the world," says Van Meurs.
"A lot of nations have payments that look like bonuses, but are very difficult to determine and aren't normally taken into account, like import duties. So that's why, by taking these figures out of it, we get an apples-to-apples comparison."
Q: You admit some marginal oilsands projects are likely to be scrapped if royalty rates are raised and a bitumen tax is imposed. Shouldn't the industry decide how fast development occurs?
A: "It's the government's function to create a sustainable rate of development for the oilsands. That's not an industry function. The mandate of the department of energy is to maximize the value of the resources," says Van Meurs.
"If you let the free market completely decide what happens, then every time oil prices go up, more expensive projects get built, which jacks up the rate of inflation even more. So using the revenue minus cost royalty formula that applies to oilsands projects, you wind up collecting less royalty revenue," he adds.
"Since it's the mandate of the department of energy to maximize the value of the resources, therefore, one of the ingredients in maximizing the value of the resources is to establish a sustainable level of development. In a boom scenario, you're destroying that value, rather than maintaining it," he adds.
Q: Some critics say the panel didn't adequately consult industry, and therefore the data you used is dated or incomplete. Your response?
A: "That's nonsense. In many countries, fiscal changes or hydrocarbon tax changes are passed with far less consultation, or no consultation at all. There aren't many places in the world as open to consultation as Alberta. The industry had six months time to make its case," says Van Meurs.
Adds Chrapko: "Now -- after repeatedly hearing from industry, 'If it ain't broke don't fix it' -- we're suddenly hearing 'Well, there's room to move.' Well, I don't know how to put it elegantly, but that just takes the cake. About two-thirds of the public hearings, and probably 90 per cent of the written material, was from industry. We needed wheelbarrows to carry it around."
Q: What are your views on the closed-door meetings the government has had with industry representatives since the panel's report was issued?
A: "What I regret is that this is not part of the official process, where we could have sorted out all these debates about costs in public, rather than behind closed doors.
"That is of course somewhat disconcerting" says Van Meurs.
Q: So have you been asked to comment on industry's objections to the report by the premier and the energy minister?
A: "Four panel members, including myself, Bill Hunter, Andrew Plourde, and Judith Dwarkin, met the premier and the energy minister for about two hours, on Thursday. But we weren't given the data that was being used against us," says Chrapko.
"We were asked only to comment in generalities. So we just made the point that the debate should be based on data that's open to third-party verification, like our own. So the conversation was at a level that didn't offer an opportunity to do a proper analysis."
Q: Any comments on Dwarkin's involvement in the report issued Thursday by her firm, Ross Smith Energy, or her subsequent statements?
A: "It doesn't surprise me if the industry got to her. Her employer's bread is buttered directly by investors in the conventional energy sector. But she advanced the recommendations we adopted as a sector champion of that part of the report."
Q: The hints we're now getting from the premier suggest he'll announce a "balance" between the panel's recommendations and the position that's being expressed by industry, behind closed doors. Your thoughts?
A: "Therein lies my problem. The energy industry has succeeded in leaving the impression that the panel produced some kind of communist-Marxist document that was egregious and outrageous. I think that's the biggest problem now. In fact, we were more pro free enterprise and conciliatory in the industry's favour than much of the independent advice and international comparables indicated we needed to be."
glamphier@thejournal.canwest.com
© The Edmonton Journal 2007
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