Alberta’s oil sands royalties are just fine

September 22nd, 2006
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This is my first “Open Range” column in Alberta Venture magazine, September 2006 (original version):

Alberta’s rollicking boom has triggered calls for higher energy royalties. Oil and natural gas companies are accused of withholding the “fair share” that Albertans – through their provincial government – expect and deserve. Oil sands producers, in particular, are portrayed as contributing virtually nothing despite obscene profits and ongoing subsidies.

The facts tell a different story. In fiscal 2006 the province hauled in $14 billion in resource-related revenues. That’s an astounding sum. Economists had previously estimated Alberta’s resource sector could generate just $3-$4 billion per year on a sustained basis.

Rates are structured to cash in on high commodity prices. The natural gas royalty rises to 28 percent – straight off the producer’s top line, revenues. That can be equivalent to 50 or even 70 percent of profits. As for “subsidies”, tax credits to encourage certain types of drilling were a mere $113 million last year.

Royalties from oil sands do seem low. Until recently, they were low. Alberta’s “generic” royalty structure, approved in 1995, was designed to encourage the massive investments needed to build those monumental oil sands plants, which take years to construct and years more to recover their investment costs. Even a casual glance at oil sands investment, jobs or production suggests this approach was wildly successful.

Before cost-recovery, an oil sands project pays only 1 percent of its gross revenue. But this is temporary. After pay-out, its royalties shoot to 25 percent of net revenue (roughly, cash flow, or revenue minus direct costs). The low initial rate, in fact, hastens the day the government can apply the higher rate.

The trend is highly encouraging. Suncor’s Inc.’s oil sands royalties went from $21 million in 2003 to $261 million the next year. In just the first quarter of 2006, Suncor paid $285 million. The province’s haul from one company in one quarter was more than the entire oil sands sector paid in any year before fiscal 2005.

The massive Syncrude project had been paying next to nothing as it underwent a multi-phase, multi-billion-dollar expansion. But this year its royalty shot from 65 cents per barrel of production to $6.68 per barrel – about $1.7 million per day, or $620 million per year. The new CNRL Horizon project should generate $2-$4 billion in annual cash flow beginning in about 2012. It will add further royalties of $500 million to $1 billion.

So far about 32 of 55 oil sands projects are past payout. Provincial oil sands royalties grew from $197 million in fiscal 2004 to $1.2 billion last year. They’re budgeted at $1.7 billion this year, but last year’s receipts were almost triple the budget. By 2020 they should be $5-$7 billion per year. They’ll neatly replace the long-term decline of royalties from conventional production. These rates will have to be reduced over time to maximize recovery of this maturing resource. In the end, government revenues will be highest if we can maximize industry production and profitability. If there’s no production, there’s no tax or royalty revenue at all.

Still, some have wondered whether we might need to apply the brakes – gently – to our out-of-control boom. By, for example, raising energy royalties. Wouldn’t slightly slower growth ease the labour shortage, pull back unaffordable housing prices and limit runaway industry costs? Not just left-leaning critics but even a prominent candidate for the provincial PC leadership have mused along these lines.

The risks would be enormous. Most economic forecasts are wrong most of the time. Alberta’s boom may seem permanent, but the unexpected happens all the time. If commodity prices suddenly fell, any neo-Keynesian royalty policy would quickly go from applying the brakes to skidding off the road. You can’t manipulate an already-cyclical industry.

And at bottom, you simply can’t hoard opportunity. From the 50s through the mid-90s, decades went by when nothing happened in the oil sands (Suncor’s plant nearly closed). Alberta seized a singular opportunity, exploiting a confluence of factors to build among the world’s most prosperous societies. Oil prices are high – right now. Investors worldwide are salivating to get in on the oil sands – right now. The U.S. is desperate for energy security – right now. Oil sands production is leaping – and so are royalties. Rewriting royalties would be pointless – and profoundly self-destructive.

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