Lower royalties = bigger pie

November 22nd, 2010
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My “Letter from Calgary” column from the mid-November issue of Investment Executive magazine. Here’s the link to the published version.

Alberta’s 2007 royalty regime never made sense. Now that it is gone, both oil and gas drilling and land sales are soaring

Well, well. Miracles of a sort do occur. Oil and natural gas drilling across Western Canada will be up by almost 25% in 2010 over 2009, and total rig-days — a measure of average well depth and complexity — will increase by an even greater ratio, according to a report by the Cana-dian Association of Oilwell Drilling Contractors released in late October.

Two main factors are at work: technological advances in horizontal wells completed with multiple hydraulic fractures; and Alberta’s return to a royalty structure that rewards success.

When Alberta premier Ed Stelmach and his then-energy minister announced the New Royalty Framework back in late 2007, they had claimed that if drilling activity decreased, it would only be because of lower commodity prices. Don’t blame us, in other words. Their claim was always gibberish.

Today, the proof is in hand. Oil prices are basically flat, while natural gas prices are far lower than they were when the royalty hikes were announced and lower this year than last. Yet oil drilling is booming while natural gas drilling, hammered over the past three years, is staging a modest revival.

Stelmach’s royalty hikes had placed Al-berta’s overall fiscal regime far below that of Saskatchewan or British Columbia in support for new exploration drilling. Now, Alberta is a friendlier jurisdiction than Saskatchewan and is competitive with B.C.

In an aging resources basin that’s thousands of kilometres from main markets, in which the oil and gas industry faces high labour costs and heavy regulation, the only remaining controllable variable is the fiscal regime. It had to give. And the changes have done wonders. Since late last year, auctions of mineral leases have soared, totalling almost $1.9 billion by the end of September.

Alberta’s competitive, auction-based approach to leasing mineral rights had long functioned as an effective proxy for capturing economic rents during periods of high commodity prices. It was a subtle approach with a light touch that had avoided the ruinous effects of outright higher royalties. Stelmach’s populist demand for “our fair share” of natural resources wealth — as if Alberta’s No. 1 industry was somehow stealing it — was already being accomplished through the mineral-lease auction system.

But that was something Stelmach and his ministers had failed to understand. When they increased royalties, they killed everything — drilling, investment and land sales, which plunged to near zero in Alberta. The drop in land sales vastly outweighed the government’s own forecasts for increased royalties, which never materialized because drilling also collapsed. The policy became a punishing and inexcusable social science experiment.

Have Stelmach & Co. learned anything? Hard to say. Their discussion of the new incentives still includes talk about how much money the government was losing or giving up as a result of the reduced royalties. With land sales soaring, while thousands of extra wells are being drilled, the new approach is already generating new public revenue. Nobody is “losing” anything. IE

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By George Koch