​Concocting a new resource revenue recipe won’t be easy for Alberta’s rookie premier

Oil and gas producers in Alberta at least have an “industry-friendly” face heading up Rachel Notley’s royalty review panel, even if they don’t yet know the panel’s terms of reference, its specific timeline or even who might be called on to sit on the panel.

Dave Mowat, president and chief executive officer of ATB Financial, was named June 26 to head the review, but he and Energy Minister Marg McCuaig-Boyd still have to consider who will sit on the panel and what its terms of reference will be.

“We have talked about the process, and one of the things that I am anxious to do is get the right people on the panel and then put together those terms of reference,” Mowat said following his appointment. “I think it is very important to make sure you are working towards a consistent outcome.”

Asked specifically whether the oil and gas industry would be represented on the review panel, Mowat suggested the panel doesn’t need to be representative of all stakeholders to be effective.

“I think what the panel is is smart people who understand the issues, and inquiring minds who are creative and who have the ability to engage and allow people to have substantive input,” he said. “I don’t think you need to be from anywhere to have a good review of things, and so we will be really looking for calibre people who are exactly that.”

Among Notley’s critics—and possibly even some of her defenders—there are few who would want one of the review panelists to be Gil McGowan, president of the 160,000-member Alberta Federation of Labour (AFL), who makes no secret of his view that royalties are too low.

“If you strip away the rhetoric, the industry is saying the public should give the resources away for a handful of jobs,” McGowan says. “You can only sell the resource once, and one of the most important jobs of government is to set a reasonable rate of royalties on production.”

While McGowan won’t venture a guess at what that reasonable rate should be, he leaves no doubt royalties should be higher than they are.

Billions left on the tableThe AFL head cites a report released in late April by the left-leaning Parkland Institute, Billions Foregone: The Decline in Alberta Oil and Gas Royalties, to substantiate his claim that successive Tory governments have been “blind cheerleaders for the industry” rather than “stewards of the resources.”

That report was authored by Jim Roy, the senior adviser for royalty policy for the Alberta Department of Energy between 1985 and 1993, a long-serving provincial senior civil servant in finance and other departments, and widely believed to be under consideration for a spot on the commission.

In the report, Roy claims a new royalty formula introduced from 2009 to 2011 by the Conservative government in the wake of oil and gas price collapses caused by the Great Recession was a multi-billion dollar error.

He claims the adjustment, which undid changes brought in to correct the “unintended consequences” of former premier Ed Stelmach’s controversial Our Fair Share royalty program in 2007, was nothing more than a giveaway to the industry that cost the province $13.5 billion between 2009 and 2014.

“Some say it was bad luck, the [previous Tory] government points to the [lower prices received for oil and gas produced] and claims nobody can control it,” Roy writes in the report produced by Parkland, which is affiliated with the University of Alberta. “However, the average annual value of production was $83 billion in the five years before 2009 and $82 billion in the five years after—this is not an overall drop in price.”

While the report points to lower natural gas prices as a contributing factor to royalty income for the province that was about $5 billion/year lower after 2009, there were other factors that could have been mitigated if the royalties collected from the late 1970s to the early 1990s had prevailed, Roy argues.

In those years, he writes in the report, the province collected a 15 per cent royalty on a well with average production and a 23 per cent royalty on a well with double the average production. However, that had declined to just a five per cent royalty on a well with average production by the 2002-14 period, while it was the same for wells with double the average.

Roy claims that adjustment has cost the treasury billions of dollars.

McGowan, who sits on the Parkland board and is very familiar with Roy and his work, argues that in the years following Peter Lougheed’s Progressive Conservative, in power from 1971 to 1985, successive Tory governments strived to “appease their friends in the energy industry.” Roy was a Lougheed appointee.

“[Lougheed] created a strong energy department because he understood the energy industry and the interests of the people don’t always align,” Roy says.

Roy’s critics say he is far removed from royalty policy, having left the Alberta government over 20 years ago, but he counters that he continues to be actively involved as a consultant (with his firm Delta Royalties) in helping to set energy tax and royalty policies worldwide.

“I haven’t been involved in setting Alberta royalty policies for some time, but I’ve helped set policies in Bolivia, Pakistan and on behalf of First Nations [in Canada],” he says. “I’d have a better understanding because I’ve been involved in setting royalty policies in administrations in British Columbia, Saskatchewan, Alberta, Yukon, Maritimes and worldwide.”

How Alberta stacks upRoy argues that the royalties and taxes the industry pays in Alberta and other producing provinces in Canada are among the lowest in the world, no matter what the price level happens to be and that the quality of reserves here is as good as or better than virtually every other major oil-producing jurisdiction—most of which extract much more in taxes and royalties than Alberta does.

“Alberta’s oil reserves compare with world-scale reserves in Iran, Iraq, Saudi Arabia and Venezuela,” he says. “Iran doesn’t even allow private sector investment, Venezuela has a 40 per cent royalty rate, Saudi Arabia imposes an 85 per cent tax, and Iraq has a 66 per cent tax.”

Closer to home, he says, oil and gas companies pay much more to operate in the U.S. than they do to operate in Alberta, largely reflecting the fact that many mineral rights are privately held by landowners, rendering the tax/royalty structure much more complex.

North Dakota, for instance, has private lease payments that, on average, represent about 12.5 per cent of revenue, although those payments can be higher in many areas depending on production. In addition, the state collects two severance taxes that total 11.5 per cent.

That totals 24 per cent, which is much higher than in Alberta.

In Texas, the rate paid by the industry is much the same, with state taxes totalling 12.85 per cent and payments overall averaging 25.3 per cent.

Roy argues that the overall take in Alberta over the last decade has dropped from about 20 per cent to 10 per cent, similar to overall rates in B.C. and Saskatchewan, creating what he calls a “a race to the bottom” that robs provincial treasuries of potential dollars.

“Industry knows royalties are too low, and they know they’ll be raised,” he says of the impending royalty review.

But even if the review leads to no adjustments, it’s only responsible for governments to conduct royalty reviews every so often, especially given that a new party is now in power, Roy adds.

One area where Roy believes the new government could easily argue for higher royalties is the so-called post-payout royalty that oilsands developers are charged.

Oilsands developers pay only a one per cent royalty during the early years of production, until they have recovered their investment, which led to the flurry of oilsands development that has sustained economic activity in the province for much of the last decade.

“That’s a very generous royalty,” he says.

The post-payment royalty, which is imposed after producers have recovered their initial capital investment, is set at 40 per cent.

“It should probably be higher than that,” Roy says, advocating a 50 per cent royalty.

A better wayBenjamin Dachis, a senior policy analyst with the Ottawa-based C.D. Howe Institute, extends Roy’s argument, advising the Alberta government to adopt the same cash flow–based approach to all oil and gas resource royalties as it has with the oilsands.

That was the think tank’s argument in a little-noticed, September 2011 report, Rethinking Royalty Rates: Why There is a Better Way to Tax Oil and Gas Development.

The report, which goes into extensive detail regarding bonus bid revenue and royalties in the three western provinces, recommends changes to the bonus bid systems in the provinces (bonus bids have represented as much as 40 per cent of total resource revenues in the past), with a suggestion that the provinces coordinate their systems to counteract possible collusion among bidders.

Dachis says the governments now impose what he calls a gross royalty on conventional oil and gas, which doesn’t create an incentive for producers. Instead, he says they should adopt the same initial low royalty rates as those paid by oilsands producers, with the rates rising substantially and with the imposition of a cash flow tax, after the developers have recovered their costs.

He says a similar approach is taken toward non-oilsands mining projects in Canada, and it provides an incentive to develop even when commodity prices are low.

If Alberta adopted such a model, government resource revenues would be lower when oil and gas prices decline, but correspondingly higher when prices are higher and producers are generating positive cash flows.

However, a spokesman for the organization that represents most major producers in Canada says this is no time to tinker with the existing royalty structure.

“The Alberta royalty system is very complex,” says Alex Ferguson, vice-president, policy and performance, Canadian Association of Petroleum Producers (CAPP). “It’s a pretty massive effort to do a top to bottom review.”

He says CAPP has no major problem with the government conducting a review of the current structure, which would be done by competent people in the Alberta government bureaucracy.

As it is, he says the current royalty structure, with different rates set for coalbed methane gas production, deep wells, shallow wells, the oilsands and other resources, provides the appropriate levers to encourage development.

Alberta and other resource-producing provinces benefit from the relative simplicity of the model in Canada compared to the models in place in Texas or North Dakota. However, he disputes Roy’s claim that the total take by governments and private landowners in those states is significantly higher than it is in Alberta.

“If that was the case, we wouldn’t be seeing any oil and gas development in the western U.S.,” he says, noting that the opposite is the case: several Alberta-based producers have committed much of their new capital investment to the U.S.

Roy, McGowan and others who argue royalties should be hiked are ignoring other factors that erode the competitiveness of Alberta for producers, such as its distance from markets, cold climate and high wages.

“Canada is seen as a high-cost regime,” Ferguson says, adding that those costs will increase dramatically when the higher per-tonne fees the NDP have suggested would be levied under planned changes to the Specified Gas Emitters Regulation are implemented. In fact, CAPP says, the planned increase in the carbon levy under SGER to $30 per tonne in 2017 from $15 per tonne this year will add an estimated $800 million to industry costs over the next two years.

Blame natural gasWhile the focus these days is on the impact lower crude oil prices are having on government revenues from the oil and gas industry, it is actually the collapse in natural gas prices and production over the last several years that is to blame for the government’s royalty collection problems, Feguson suggests.

“If gas royalties are going to increase from $500 million a year to $2 billion, it will have to be as a result of rising production or rising prices. Is anyone expecting there will be a tripling of natural gas prices or production?”

In the previous Tory government’s proposed budget, released in late March, the impact of lower commodity prices was highlighted by an expected 70 per cent plunge in non-renewable resource revenue. It expected resource revenue to drop to $2.87 billion this budget year, down from $8.79 billion in 2014-15.

The previous government forecast natural gas royalties, once the major contributor to government resource revenues, would decline to $450 million this budget year, down from $960 last year and $5.8 billion in 2008-09, when gas prices and production were much higher.

Oilsands royalties were forecast to decline to $1.36 billion from $5 billion last year, while crude oil royalty revenue was expected to fall to $594 million this year from $2.16 billion in 2014-15.

Land sale revenue was also seen plunging in the Tory government’s budget, down to $315 million from $484 million last year (it has been well above $1 billion in the past).

“If gas prices were at $10 [per gigajoule], we wouldn’t be discussing royalties,” Ferguson says.

The previous government predicted gas prices will average $2.94/gigajoule this year, down from $3.53 last year, while production will climb slightly to 4.74 tcf from 4.7 tcf last year.

It saw oil prices averaging $46.33/bbl for Western Canadian Select at Hardisty, down from $69.86.

Gary Leach, president of The Explorers and Producers Association of Canada, questions the knowledge base of critics of the current royalty regime, such as McGowan and Roy.“We were intimately involved in past discussions of royalties,” he says. “Where were they?”

He agrees with Ferguson that low natural gas prices will continue to plague the government.

Even if some major LNG export projects go ahead on the B.C. coast, he says producers are unlikely to see prices move much above $4 anytime soon.

More to the point, he says any royalty and tax system “has to fight for that next dollar of investment,” and if Alberta’s royalties are unrealistically high, those dollars will go elsewhere.

Leach says the government needs to take into account that the economic benefits from oil and gas development aren’t only reflected in direct royalties and taxes it collects from the industry.

“Half of Alberta’s economy is related to the oil and gas industry,” he says. “[The government needs to take into account] additional dollars it gets from corporate taxes and personal income taxes [directly or indirectly related to energy development].”

CAPP, meanwhile, wants the panel to keep four key points in mind as it goes about its review, association president Tim McMillan said in a statement following Mowat’s appointment.

“An appropriate royalty structure attracts investment, creates jobs, generates government revenue and builds Alberta communities,” he said. “The current royalty structure, put in place just five years ago, has helped achieve those goals by being responsive to the ups and downs in the industry – and that’s been good for Alberta and Albertans.”

Going forward, McMillan added, the industry would like to see four principles included as part of the royalty review:

1. A government commitment to a vibrant and competitive oil and gas industry;2. Confirmation any royalty changes will be forward looking;3. Be stable and predictable to minimize uncertainty and maximize investment in Alberta; and4. Consider royalty changes in the context of all the mounting costs from new government policies such as climate change and corporate taxes.

Judith Dwarkin, chief economist at ITG Investment Research, was a member of the Alberta Royalty Review Panel, the six-person group that in 2007 produced a report that recommended hiking royalties across the board—Stelmach’s doomed Our Fair Share royalty plan that would have increased government revenues by $2 billion/year.

Today, she hints that she would not favour any increases in the provincial royalty rates.

“The competitive environment faced by the industry has evolved since this was last examined,” she says. “It’s a different picture than it was 10 years ago.”

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