Royalties: As Big Oil pumps Alberta

COMMENT: This is an excellent essay on Alberta’s royalty review, with a bad sub-heading. Too bad you can’t read it from the bottom up, because many of the reasons why royalties should be increased, appear later in the report.

The 2006/07 forecast oil production is from MEMPR’s 2005/2006 Annual Service Plan Report
http://www.em.gov.bc.ca/DL/GSBPubs/AnnualReports/AR2005-2006.pdf

As Big Oil pumps Alberta for profit, the province's royalty take is shrinking.
Is it time to get greedy?

DAVID EBNER
Globe and Mail
August 18, 2007

Royalties have existed as long as humans have spun wealth from the world's underground riches, digging and drilling to produce personal and collective fortunes. The first royalty believed to have been collected occurred in ancient Greece, creating great wealth for Callias, a top aristocrat whose home was the finest in Athens and was the setting for one of Plato's dialogues.

Callias owned silver mines at Laurion, which is now a suburb of Athens but was once the chief source of revenue for the Athenian city state, where slaves mined the ore. Callias received royalties on the production and the mine operators took their slice. This division of wealth became the foundation of a fiscal system for the sharing of dollars generated from the extraction of natural resources that is generally unchanged more than two millennia later.

The owner of a resource, be it silver in Greece or oil and natural gas in Alberta, receives a royalty as a right of ownership from the person producing the resource and aiming for their own profits. But what the rate should be is a difficult debate, as the arguments are relative in the absence of absolutes – reflected in the fact that there are a thousand or so royalty systems for energy around the world. The question is also clouded and confused by the word at the heart of the argument: Fair.

Royalties paid on oil and natural gas production in Alberta are one of Canada's most crucial economic calculations. Within two weeks, the provincial government receives an extensive report from a six-member panel that conducted a public review of royalties, taxes and other fees paid by energy producers – with a core mandate to determine if citizens are getting their fair share. The report, and what rookie Premier Ed Stelmach's government does with it, could have significant repercussions across the Canadian economy.

“This is a critical issue,” said Frank Atkins, an economist at the University of Calgary.

Hitting the right note on royalties helps spur development, bringing wealth to Alberta and to all Canadians. But getting it wrong means kicking over an economic domino with countrywide repercussions. The energy business obviously has enriched Alberta but it has also very much made the nation wealthier, starting with federal taxes that get shared east, centre, west and north, to things such as auto sales, with Alberta recently underpinning record domestic vehicle sales, an engine of the Ontario economy. The oil sands, in fact, pay more corporate income taxes to Ottawa than Edmonton.

In sleepy sessions from Grande Prairie to Medicine Hat, the unprecedented public review started in late April and ended mid-June but occurred beyond the attention of many Albertans and most Canadians. The panel heard more than 100 public presentations, with roughly half of those made by industry players. Another 224 submissions were made on paper.

Greg Stringham, a vice-president at the Canadian Association of Petroleum Producers, was one of the people near the heart of the debate helping lead the industry lobby, but he made his points without thumping his chest or threatening impending doom, as was the case with so many other Alberta oilmen. Mr. Stringham knows there isn't one easy answer.

“Our answer to the question of whether it is fair, we'd say yes,” Mr. Stringham said in an interview. “But fair is a nebulous word, it's hard to define.”

Figuring out fair is critical for Alberta because royalties aren't just one little thing in a much bigger picture: They are the thing. Resource revenues are the province's No. 1 source of income, ahead of corporate and personal income tax. In 2006-07, Alberta collected $9.8-billion in oil, natural gas and oil sands royalties, as well as $2.5-billion from the sale of new exploration rights – accounting for one-third of the province's income.

Without energy, Alberta's gross domestic product would be about half the size, according to economists Robert Mansell and Ron Schlenker of the University of Calgary, who added that without royalties, a provincial sales tax of 16 per cent would be needed to make up the revenue. And they said the calculations were probably understated, alluding to the fact that without energy, there'd be hardly any economy at all in Alberta, with no need for all the engineers, lawyers and accountants, never mind all the restaurants and Canadian Tires.

It is this dependence that backstopped the don't-choke-the-golden-goose argument issued by industry, which is powerful in sound bites, because who dares ruin a good thing? It was these comments that gained the most attention in the local media. Jim Buckee, the gruff retiring chief executive officer of Talisman Energy Inc., employed rhetoric when he sat before the panel in May in Calgary, saying a zero per cent royalty generates zero dollars and a 100 per cent royalty also produces zero, as it drives all activity elsewhere. “The current regime has worked and it's best left alone,” Mr. Buckee declared.

Also in Calgary, Steve Laut, president of Canadian Natural Resources Ltd., the country's No. 2 producer, said: “What we have to be very cognizant of is any significant change – or any change – to the royalty system could [produce] a drastic – I mean drastic – reduction in activity in Alberta.”

The review looked at all aspects of oil and gas in the province but the focus was clearly on the oil sands. The giant resource, concentrated in the remote boreal forest of northeastern Alberta, has commanded the energy world's attention after being recognized several years ago as the second-largest reserve of oil after Saudi Arabia.

It is a huge change from a decade ago when the oil sands languished unloved, considered a fringe resource with the price of crude at a quarter of today's level.

Industry, hoping to jump-start the near-dead business, sponsored a national task force to find ways to overcome development challenges to seize the alluring promise of enormous long-term potential. A key idea, proposed in 1995, was an enticing royalty regime, quickly adopted by Alberta. The province takes just 1 per cent of gross revenues until an oil sands plant has recovered the billions of dollars it took to build the operation, a rate that then rises to 25 per cent of revenues minus costs.

The system, then and now, is among the world's most generous regimes.

And it worked: Oil sands production reached one million barrels a day in 2004 – a milestone that had been forecast for 2020. According to current projections, by 2020 the oil sands could produce four million barrels a day, which would make Canada the No. 4 oil producer in the world behind Saudi Arabia, Russia and Iran.

While the royalty regime was a spark for the boom, it is one of several important factors that attracted billions of dollars of investments. The most important element was the price of oil, which has surged fourfold. Among the other important changes is markedly improved oil sands technology, as well as fewer opportunities for large projects elsewhere.

For global oil companies, royalties are one component in a complicated equation with the key variable – oil prices – in constant and often extreme flux. Given this, even with Alberta looking at royalties, some of the world's biggest oil companies have made major moves since the review began. Statoil ASA of Norway, looking to expand beyond the North Sea, an oil region in decline, spent $2.2-billion in April for an undeveloped oil sands project, making Alberta its top international expansion priority. Royal Dutch Shell PLC has pinned much of its future growth on the oil sands, spending $8.7-billion this year to buy the part of Shell Canada it didn't already own, and this month it announced it is looking to spend an additional $27-billion to build a giant new upgrader to process raw oil sands output.

In May, Brian Straub, Shell's senior vice-president of oil sands, added his voice to the chorus of industry warnings but conceded higher royalties won't stop Shell. “They're not going to drive us out of the province,” he said to reporters after presenting to the review panel, “but certainly our ability to invest is put in jeopardy.”

CHAPTER ONE

FROM BUST TO BOOM … TO BUST TO BOOM

When Alberta became a province in 1905, natural gas had already been discovered around Medicine Hat, in the southeastern corner of the young jurisdiction. There was also an oil strike near Calgary in 1914 that sparked a mini-boom, but the frenzy fizzled quickly. However, for the fledgling province, most of the resources were still owned by Ottawa, as well as a small portion held by private hands.

It was not until 1930 that the federal government relinquished its ownership of regional natural resources to Alberta and the other western provinces.

At the onset of the Depression, Alberta was sparsely populated, mostly poor and dependent on agriculture. The initial royalty rate was set at a flat 5 per cent, not that it particularly mattered, as the province produced little oil and gas. The birth of the province's modern industry, and its launch to “have” province from long-time “have not,” came in the late 1940s, when a gusher of crude, and then another, were discovered near Edmonton.

The royalty rate was tinkered with several times and by the 1960s, the province had used its newfound status as a significant oil producer to demand more from energy companies, which at the time were mostly American. Royalties had been raised but the high end was capped at 16.7 per cent of gross revenues – which was undone in the early 1970s by then-premier Peter Lougheed as the price of oil jumped far higher after the Middle East flexed its new muscle.

Having unseated a government that ruled for more than three decades, Mr. Lougheed, a left-leaning Conservative who began the dynasty that still exists today, tied royalties more closely to the price of the commodities and jacked up the maximum rates past 30 per cent. Ron Ghitter represented downtown Calgary in those days and recently recalled the reception from oilmen in a radio interview. “They cried bitter tears,” he said, half-joking that he had to use back alleys to avoid confrontations.

But higher royalties didn't deter industry from chasing growth and riding soaring commodity prices. In the six years after royalties were raised, before the global energy boom of the '70s peaked, oil and gas production in Alberta remained strong, the number of wells drilled each year doubled and money spent to acquire new exploration rights exploded tenfold. The industry only came undone when commodity prices collapsed.

During the 1980s bust, the royalties scale began to tilt back, with programs created to encourage activity as the price of oil and natural gas remained low. In the early 1990s, desperate to spur new exploration, the government of then-premier Ralph Klein cut royalties, charging less than 10 per cent when prices were low or, significantly, when a well's output was modest.

Even with the last overhaul, a goal of taking 20 to 30 per cent for royalties was in place, and the province's take bounced around the low end of the range, averaging 22.4 per cent from 1995 through 2003. In 2002, seeing that 30 per cent was out of reach with the system as is, the province reduced its ambitions, cutting the range to 20 to 25 per cent.

The take continued to fall, slipping below the bottom end of the goal to 19 per cent in 2004, where it remains three years later. A senior Alberta Finance official warned in April that the figure could fall further. Industry says Alberta needs to recalibrate the goal, lowering it to align with what it says is the reality of a changing business.

This year's provincial budget acknowledged that the system as it stands will return citizens less each year, warning royalties could fall by a third to $6.6-billion in 2009-10 from the $9.8-billion received in 2006-07.

Part of the story behind the numbers is the fact that explorers have carefully combed over the Western Canada Sedimentary Basin since Leduc No. 1, the first big oil discovery in February, 1947. All of the easy oil and natural gas and most of the big hits have been uncovered, leaving each new find smaller than those in years past. Even just a decade ago, the typical oil or gas well was relatively prolific and many generated a high rate of royalties. But as the years passed, the average well's output fell. Initial production of a natural gas well today, for instance, is less than half of what it was in the mid-1990s.

So as the system Mr. Klein's government put in place sees more oil and gas wells paying citizens less, energy companies are still chasing profits furiously, emboldened by high commodity prices and testified by the more than 17,000 or so wells drilled in Alberta last year.

Even this year, during a slump, almost 13,000 holes are expected to be cranked into the earth. This slowdown, due to low natural gas prices and high drilling costs, is much less brutal than crashes of the past – and record oil prices has ensured the search for crude remains robust.

Compounding the money situation for the province is that royalties were capped at prices that are far lower than current market rates, though the cap was well above the market when the system was drawn up. Further exacerbating Alberta's new reality is the emergence of the oil sands and the low royalties paid there, steadily replacing higher royalties previously paid on conventional crude and natural gas.

CHAPTER TWO

THE MYTH OF PROFITABILITY?

While Alberta's royalties take sits at 19 per cent now, energy companies are making the biggest profits they have ever enjoyed, led by EnCana Corp., the sector's No. 1 player, which in 2006 made $6.4-billion, the largest profit in Canadian corporate history. Add on Suncor Energy Inc.'s $3-billion profit, and two large oil and gas companies made about as much in profit as the entire industry paid the province in royalties last year.

All in, the five most profitable energy companies in Canada saw their bottom lines shoot up more than 50 per cent in 2006 from 2005. And despite rising costs and other challenges, the trend is still very much intact.

PricewaterhouseCoopers, in its annual Canadian energy survey in June, said the positive trend is one that “we don't see changing any time soon.” EnCana's operating profit this year is up about 50 per cent from a year earlier and cash flow has climbed more than 20 per cent.

Canadian Natural in early August said its cash flow has surged 35 per cent higher to a record of $3.1-billion.

These results contrast with the main argument of industry, that energy companies are hardly as profitable as they appear to be and are in fact struggling with soaring costs and worried about eroding profit margins – so they simply can't afford an increase of royalties, adding that such a change would ruin Alberta's reputation as a dependable place to do business.

“It's a myth out there that this is a hugely profitable business,” Mr. Laut of Canadian Natural told the royalty review panel.

Mr. Laut routinely presents a different picture to investors. Canadian Natural next year will begin production at a $7.6-billion oil sands mine. In every presentation marketing the company, Mr. Laut said its Horizon project will produce a “wall of cash flow” of nearly $1-billion annually (with oil at $45 [U.S.] a barrel) that will be “sustainable for decades.”

Mr. Lougheed, whose blue eyes still sparkle, remains a champion of the people. At a luncheon at Rouge, a restaurant housed in the home of one of Calgary's founders, Mr. Lougheed – who as a boy watched his family lose his grandfather's home due to debts in the Depression – worried about the average person: “People are not having an easy time in this province that aren't tied into the oil industry.” Over a meal, he gave a primer to a group of British journalists visiting to tour the oil sands. Mr. Lougheed began with 1930, stressing that Albertans are the owners and oil companies lease rights to do their work.

He was specifically skeptical about the many costs deducted from gross oil sands revenues to produce the net number from which royalties are calculated. “My instinct,” he said, “tells me they've been allowing a system where the operators, the lessees, have been deducting too aggressively – and that has been hurting the royalty flow to the people of Alberta.”

Suncor Energy, the second-largest oil sands miner, estimates that with oil at $60 a barrel, it will pay as little as 6 per cent in royalties on its gross oil sands revenue in the coming years.

Sensing widespread skepticism, the Canadian Association of Petroleum Producers midway through the review tried to bolster public support, issuing two short books outlining the benefits of the oil sands and conventional production, and the message was simple: Without us, there is nothing – don't dare touching the goose at all.

The association also put out the results of two poll questions conducted for it by Ipsos Reid, one of which asked whether the billions of dollars collected from the energy industry was too low, about right or too high. The question, posed to 800 Albertans, did not mention that the province's percentage take was in decline. Half of those surveyed said the money collected seemed to be “about right.”

Asked whether the lack of context in the question was unfair to those surveyed, Pierre Alvarez, president of the industry association, was aggrieved and invited The Globe and Mail to conduct its own poll, asserting the results would be the same, concluding: “Is any poll perfect? No.”

The second question was about the oil sands, where by industry and government calculations, about 50 per cent of revenues, after costs, goes to governments, a figure that includes royalties, taxes, cash to get mineral rights for exploration, and other levies. Asked whether the 50 per cent number was fair, but without any further context, more than half of those surveyed said “about right.”

However, the oil sands question did not mention that the industry-led national task force on the oil sands in the 1990s that created the 1 per cent/25 per cent royalty regime envisaged the overall take, royalties, taxes, et cetera, at 60 per cent, not 50. The take has been whittled lower because of corporate tax cuts in Edmonton and Ottawa.

Pedro van Meurs, a top consultant on fiscal matters in energy, considers government takes of less than 60 per cent to be low, though in a report to the Alberta government in April he added that low doesn't necessarily mean unfair. Industry argues that a lesser take from the oil sands is necessary because it is expensive to build and operate projects around Fort McMurray.

Mr. van Meurs, however, noted that an important issue underlying the oil sands royalty is that it doesn't generate a higher percentage for the state when prices are high, that the take is essentially “flat” regardless of high or low oil prices. The price of oil is at about $70 a barrel currently and has been at more than $60 for most of the past several years.

“At $60 a barrel or higher, oil sands projects generate unusually high total profits for investors,” Mr. van Meurs wrote. “This makes these projects very valuable. There are few projects in the world creating such attractive total values to investors at these price levels.”

Because of the corporate tax cuts, Canada is the only major energy jurisdiction in the world to actually reduce its take from oil and gas in the past five years, according to Wood Mackenzie, another leading energy consultancy.

A similar picture was inadvertently painted by Mark Nelson, head of Chevron Corp.'s Canadian arm, when he spoke at the review's stop in Edmonton. One presentation slide showed a list of 16 countries, including the United States and the United Kingdom, and all 16 had increased their take since 2002.

His point was that Alberta has to be careful to position itself competitively but also showed that all other jurisdictions have capitalized on high energy prices while only Alberta hasn't.

Afterwards, while Mr. Nelson said he would like to see the existing system unchanged, he said higher royalties would not deter Chevron's expansion plans in Canada, though he did say it could slow the influx of money.

“We are committed regardless of the outcome of the royalty review. We have to be. We have to get our customers oil and energy.”

CHAPTER THREE

ALL THE MAKINGS OF A CASH MACHINE

In Russia, where the Kremlin late last year seized control of a large development from Royal Dutch Shell for a pittance, the state takes 90 cents of every dollar when oil is above $29 a barrel.

In Venezuela, which produces less oil than Canada, President Hugo Chavez in June officially seized control of several developments similar to those in the oil sands. Multinational companies, such as Statoil and France's Total SA, acquiesced, deciding it was a better to stay in an onerous situation rather than depart altogether. Others, including Exxon Mobil Corp., said forget it: And by doing so will take billions of dollars in income statement writedowns as they walk away from their investments.

In Alberta, where the state takes less and less and energy corporations make more and more, the Finance Minister of less than a year, small-town doctor Lyle Oberg, adopted the arguments of industry in May, telling The Globe and Mail that he worried that the time was not right to ask oil companies to pay more given various stresses, higher costs and such (which in fact are seen around the world).

Mr. Oberg is the arbiter of the question of fair in Alberta, as the panel's report goes to him at the end of August, with a fast decision expected in the fall – to limit the amount of “uncertainty” industry frets over. Mr. Oberg has been skeptical about the need for a review. At a speech to investors last month in Calgary, he apologized for the uncertainty created by the review, saying he had to do it because of political pressure.

Watching Venezuela and Russia, Fadel Gheit, a leading energy analyst on Wall Street at Oppenheimer & Co., said the world's energy producers will have to reassess their futures as the political skies darken almost everywhere.

Mr. Gheit said the oil sands are obviously one of the best opportunities in North America, offering big reserves and long-term sustainable production – in short, a cash flow machine.

“North America, the world's largest energy market, is also the most profitable,” Mr. Gheit told his clients in a report after Mr. Chavez waved goodbye to Exxon (which has stakes in two of the oldest oil sands operations and is developing a new $8-billion [Canadian] oil sands mine).

“We expect [that] restricted access to large energy resources and unstable fiscal and political regimes to force major oil companies to reshape their business strategies with increased focus on North America,” Mr. Gheit said in a report.

This dynamic, for many Albertans, is clear. “In Alberta, we have safe oil. Industry should be paying for that,” said Carolyn Kolebaba, an official with the Alberta Association of Municipal Districts and Counties, representing all the small towns that see energy companies use their civic resources but wonder where the riches go as roads are worn down from the heavy truck traffic and hospitals strain to serve under the severe demands of the boom.

The oil companies all urged Alberta to maintain its reputation for fiscal stability. The argument was made straight-faced, as though the rest of the world was a peaceful and predictable place where stability is the defining theme, and industry presentations often were underpinned by quiet threats: Should Alberta dare to raise royalties, it would be Alberta that would become the planet's black sheep.

Lino Ramirez rejected this view.

Mr. Ramirez, a computer science graduate student, came to Alberta from Venezuela eight years ago, leaving as Mr. Chavez became president, watching from afar as his home country exercised its power. Mr. Ramirez, a quiet man with a big smile who doesn't endorse the expropriation of Mr. Chavez, wants his adopted home, where he hopes to start an energy services firm, to start “speaking up.”

“Where are these companies going to go? We have the opportunity here and when we know what's happening in the world, we have to use it for our benefit,” Mr. Ramirez said in an interview after a thoughtful presentation making the same, strong point to the panel in Edmonton.

CHAPTER FOUR

EVEN IF IT'S FAIR, IS IT FAIR ENOUGH?

The public review visited six Alberta cities and the six-member panel works through the summer to produce its report. Chaired by a retired forestry executive, the panel also included two university economists, one industry economist, a technology entrepreneur and a former oil executive. The group has been alternately praised and criticized. Some say it is too much in the pocket of industry; others say the members have the right mix of smarts and experience, as this is not easy territory to navigate.

Throughout the review, the sextet has mostly appeared as impartial as could be, asking the same probing and skeptical questions of all that came before them. And spending a summer sifting through thousands of pages of information is an unenviable task, attempting to quantify fair. Their pay was not disclosed by the government but it is likely not the most profitable way to spend one's time – they are doing duty as citizens, as Albertans, as Canadians.

“The Premier's mandate is he wants to find out what Albertans think,” Bill Hunter, the panel chair and self-described “simple logger,” said in an interview as the review began. “We're going to put a lot of effort to make darn sure we collect that.”

Mr. Hunter is a man with a warm, bearded face, carrying a happy girth, never in a tie, a man who sincerely thanked every presenter and reserved particularly warm thanks for the average Albertan. But how to mull the mix of opinions, as the panel sits for the summer to calculate a conclusion? Every piece of information would be weighed seriously, he promised, from the numbers of industry experts to the evocations of those that spoke from the soul.

In Newfoundland, the state is wrestling with fair, too, but does so with more boldness than Alberta, where politicians since Mr. Lougheed have been leery of offending industry. Newfoundland Premier Danny Williams, knowing of the riches off the shores, last year refused to sign a deal with Exxon, Chevron and others on the proposed Hebron project when the corporations wouldn't agree to allow the province to take a small equity stake – and Big Oil walked.

At the time, Mr. Williams, a Conservative in the tradition of Mr. Lougheed, was lambasted by all corners, unflatteringly compared with Mr. Chavez, a socialist, and accused of a disastrously aggressive negotiation strategy that would forever drive away companies with so many great opportunities elsewhere.

A year later, Exxon and Chevron are back, ready to restart negotiations. Mr. Williams' government, meanwhile, is close to introducing new legislation that would require state participation in all developments, fairly sharing in the ups, and downs, of oil and gas.

A local Newfoundland economist, Wade Locke of Memorial University in St. John's, this year published a paper trying to answer whether his province is getting its fair share. “At best,” he wrote, “it is a value judgment or opinion that can neither be refuted nor proven.”

Thus, on his main question, whether his home is getting what it deserves, in a presentation he said: “That is not a question an economist can answer. It would simply be an opinion.”

In the nebulous world of relatives and no absolutes – where just about the only absolute is that Russia and Venezuela are rougher places to do business than Alberta – Don Gunderson may have had the most incisive observations among the Albertans who made public presentations.

Mr. Gunderson, an auditor with no energy industry experience, sat down in Edmonton, beginning by saying: “I'm here just as an ordinary citizen. … What you're going to get here is just opinion and impressions.”

He settled in, growing more confident, made a wry joke before delivering the best assessment of fair heard during the public review in its two months and six stops.

“I think the most solid evidence that the current royalties are too low is the fact that the oil companies are happy with the current rates,” Mr. Gunderson said with a quiet smile.

“[This] may be simplistic but I think [it's] accurate,” he continued.

“We don't want a fair price; we want the best price.”