BLAW 628 Alberta Oil Sands Royalty Regime

By Ashutosh Garga

Submitted to: Prof. Stan Rutwind December 3, 2009

TABLE OF CONTENTS EXECUTIVE SUMMARY...................................................................................3

General Background of the Alberta Oil Sands Regime............................................................. 4 Origins of the Alberta Oil Sands Royalty Regime .................................................................... 4 Generic Oil Sands Royalty Regime ......................................................................................... 6 Current Alberta Oil Sands Royalty Regime ............................................................................. 7 Key Considerations for Implementing a Royalty Regime......................................................... 8

CONCLUSION ...................................................................................................13 REFERENCES ...................................................... Error! Bookmark not defined.4

EXECUTIVE SUMMARY
On October 25, 2007, the Alberta government announced its new policy on the oil and gas royalty structure in Alberta. The new policy represents the first major overhaul of the provincial royalty regime in over thirty years. A comprehensive review of the royalty system was necessary due to a significant increase in oil prices and the perception that Albertans were not receiving their fair share from energy development. From 1998 to 2005, oil sands production exceeded forecasted expectations. There was an 80% increase in total conventional oil and natural gas wells, a 74% increase in overall expenditures on oil and natural gas, and finally, a 300% increase in investment in the oil sands.1 Furthermore, royalty rates and associated formulas were not keeping pace with changes in the resource base, world energy markets, and conditions in other energy-rich jurisdictions. Clearly, the onus was on the government to re-balance the royalty and tax system to ensure a fair share is collected both currently and as future circumstances change. With some exceptions, the province of Alberta forecasts a 20% increase in royalty revenues due to anticipated increases in royalty rates.2 The announcement has been mired with disappointment by industry and scepticism regarding government estimates of the size of increased royalty revenues. The purpose of this paper is to provide a general background and origins of the Alberta oil sands royalty regime, discuss the generic and current royalty regimes, and recommend key considerations in implementing a royalty regime that is fair and equitable for both Albertans and the oil and gas industry.

General Background of the Alberta Oil Sands Regime

The Alberta government does not currently own, operate, or participate in oil sands projects even though the provincial Crown still retains title to the vast majority of oil sands resources. Instead of direct participation, the Crown operates under a royalty system, whereby it leases the rights to produce oil sands to private entities, and collects rent from the production of the resource. This rental system is commonly known as the Alberta Oil Sands Royalty Regime and is designed to maximize and capture a fair share of the value of mineral and energy resources for the benefit of Albertans. The Crown's share is paid by way of a royalty credit against other oil sands gas production and the bitumen producer's share is paid via an advance from the Crown in the way of a royalty credit, with recovery coming from increased future bitumen royalties after payout of the project. The total value of the settlement is estimated to be $85 million.3

Origins of the Alberta Oil Sands Royalty Regime

The origins of the oil sand regime are quite astounding. In an effort to accelerate oil sands expansion beyond 1 million barrels per day by 2020, the Alberta government established the oil sands royalty regime in 1997. Extremely low royalties (25%) were effective in overcoming barriers related to high capital costs and encourage the large investments needed to develop the oil sands. Since 1997, capital investments in oil sands projects have increased more than 400%, oil production has increased 130%, and the price of bitumen has increased 256%.4 The production goal of 1 million barrels of oil per day from the oil sands was surpassed sixteen years ahead of schedule in 2004. During the 1960s, the complex extraction process and subsequent upgrading of bitumen into a marketable product was not well understood. Eventually, the first large scale commercial oil sands project was launched by the Great Canadian Oil Sands plant,

owned by a syndicate of companies who later became oil sands giant Suncor. To encourage innovation and private investments in oil sands projects in the face of these early challenges, the Alberta government imposed a royalty regime in which the Crown shared the inherent risks by accepting a minimum royalty until these projects began to realize profits. Minimum royalty rates on gross revenue ranged from 1% to 5%. Royalty on net revenues ranged from 25% to 50%.5 Specific development, operating and capital costs were permitted and some gas royalties were waived. However, as more projects prospered, royalty terms for significant oil sands projects were negotiated on a project-by-project basis and specified in individual Crown agreements. This project-by-project royalty approach was relatively manageable in the formative years of the oil sands sector due to few commercially viable operations. Furthermore, this flexible royalty arrangement proved useful in accommodating the unique requirements of each project, addressing project-specific concerns, and providing the foundation for building institutional knowledge and experience that formed the basis of current oil sands legislation. As oil sands development progressed, research and technological innovations contributed to increased returns on investment and reduced operating and production costs. Inevitably, additional companies became involved in oil sands development and world oil prices and global market forces governed their investment decisions. A different royalty regime was needed to address the different circumstances and needs of a growing oil sands sector as this individualized royalty arrangements clearly began to outgrow its utility. Maintaining the status quo resulted in an inconsistent royalty system in which potential investors lacked a transparent and predictable royalty structure on which existing oil sands companies were unsure about the type of royalty structure new investments or expansions might be confronted with. Eventually, a more comprehensive and consistent approach to the collection of royalties was required to address the

increased investment and development interest in the resource driven by technological advancement and stronger world oil prices. In 1993, the Alberta Chamber of Resources constituted the steering committee for the launch of the joint industry-government National Task Force on Oil Sands Strategies. The National Task Force on Oil Sands Strategies was comprised of representatives from the oil sands industry and the Alberta and federal governments to assess the technical, socio-economic, environmental and marketing aspects of oil sands development and recommend strategies to address these issues. The Task Force identified Albertas ad hoc, project-specific royalty structure as a barrier to oil sands development. Rather than evaluating royalties through individual Crown agreements, it was concluded in their 1995 report that a generic royalty regime founded in statute with the same standardized royalty provisions (e.g. based on a specified percentage of net project revenues after cost recovery) should apply for all oil sands projects. The Government of Alberta accepted this recommendation and began work to develop legislation and policy to support the proposed generic oil sands royalty regime. Fortunately, such a system was already present in a number of pre-existing individualized royalty arrangements and provided the basis from which to create this new generic system.

Generic Oil Sands Royalty Regime

The generic oil sands royalty system consisted of two royalty rates applicable before and after payout. Before payout, a royalty rate of 1% of the projects gross revenue applied before the oil sands developer realized profit equal to the capital invested in the project, plus an allowance equal to the long term government bond interest rate to recognize financing costs during the course of the construction period. After payout, the royalty rate is the greater of either 25% of the projects net revenue (gross revenue minus allowable costs) or 1% of the projects gross revenue. As of September 2006, 33 of the 65 oil sands projects under the generic royalty regime were in
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post-payout and were paying the 25% royalty. While at 25% the actual royalty rate is flat, the post-payout royalty regime provides an element of price sensitivity as profits are correlated with oil prices.6

Current Alberta Oil Sands Royalty Regime

The Pembina Institute, a not-for-profit environmental policy research and education organization eventually released a report indicating that the transition from a project-by-project royalty system to a generic regime has introduced unanticipated complexities for project operators (e.g. the interpretation of the regulations, guidelines and policies used to calculate royalties). Furthermore, the Pembina Institute insisted that the generic royalty regime led to the royalties on a barrel of bitumen declining by 32% from $2.92 per barrel in 1997 to $1.97 in 2005.7 Additionally, the current royalty regime leaves 53% of net revenue with companies while Albertans retain only 32% of the revenue available from oil sands developments. In contrast, oil and gas companies in Norway retain 22% of the revenue, while Norwegian citizens, the owners of the resource, received 78% in revenues. Additionally, significant cost overruns associated with many of the projects led to many of them remaining at the 1% royalty rate for extended periods of time resulting in Albertans waiting longer to be compensated and receiving less total compensation.8 The report advocated an increase in royalty rates to levels determined through a comprehensive and public review of current rates. These rates should be set to ensure maximum compensation to the citizens of Alberta who like Norwegian citizens, are the owners of the oil sands resource and should avoid leaving excess profits with corporations. In light of these recommendations, a new royalty regime was implemented on Oct 25, 2007 to ensure that Albertans enjoyed a greater share of oil sands revenues. The base rate starts at 1%, and increases for every dollar that the oil price is above $55 per barrel, to a maximum of 9% when it is priced at $120 or higher. Instead of
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a net post-payout royalty of 25%, the new regime starts at 25% and increases for every dollar that the oil price is above $55 per barrel to 40% when it is priced at $120 or higher.9 This adjustment to the base and net royalty rates ensures that all major components of the royalty system are sensitive to oil prices. Additionally, existing oil sands projects will not be grandfathered and hence, subject to these adjustments. In fact, the Alberta government is already engaged in discussions with Syncrude and Suncor, whose Crown agreements expire in 2016, to participate in the new oil sands royalty regime. Historically, the Crown negotiated transitional arrangements (i.e. partial grandfathering) with Suncor and Syncrude setting out the terms under which these two projects would be brought under the generic royalty arrangements. Consequently, the terms of those transitional arrangements will afford Suncor and Syncrude a right to some, or even complete grandfathering.

Key Considerations for Implementing a Royalty Regime

The implementation of a royalty regime is complex and future revisions to an existing one are always possible. The following key considerations are realized: y The royalty panel intends to develop a policy that is fair to industry and government, one that strikes an equitable appropriate balance between the competing interests of all parties involved. These vague words communicate a soothing emotive purpose rather than identifying strict objective criteria for developing policy. If industries utilize such wording in as an example, their mission statements, they would be greeted with a great deal of skepticism. Instead, mission statements containing phrases such as maximize return to shareholders convey more honesty and directness. This paradigm also exists in the vision of the Department of Alberta Energy: Optimize the sustained contribution from Albertas energy and mineral resources in the interests of Albertans. Once again, it
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is strongly recommended that a more direct approach of the objective that will win the respect of both the industry and Albertans be taken such as Maximize the net benefits to Albertans from their energy resources. y While the proposed royalty regime should be well-defined, it must contain sufficient flexibility to be applicable under unusual market conditions, allowing for overrides during emergencies. In October 2009 for example, the Gulf of Mexico received a severe hurricane and at the same time, hostilities occurred in the Middle East. As expected, the economic impacts were devastating. Rationing was imposed and the price of oil, in particular, rose to extremely high levels. Under such an event, industries and governments holding oil supplies in North America are in a favourable position to realize substantial profits. Any royalty structure that operates under such an upset market condition should be taken into account by the Panel, namely, suitable caveats should exist in the royalty regime to address such an upset condition. If not, this would be a further subsidy to an entity that is already reaping exceptional profits. It might be useful to define the conditions that would trigger such emergency royalty reviews. Ideally, royalty policies would remain in effect over extended periods of time, but the inevitable volatility of supply and demand balances make it desirable to have a policy with as much reasonable flexibility to reduce the frequency of royalty reviews. y The political impacts of the optimal royalty regime on the quality of life of Albertans using specific measures such as workforce demand, hosing requirements, inflation, GDP, and infrastructure should be emphasized during panel reviews. It may turn out that the optimal royalty regime that maximizes return to Albertans may interfere with a political optimum which also requires maximizing the quality of life of Albertans. Additionally,

the review panel should be aware that high levels of oil production are creating a great deal of inflation and other stresses in Alberta. Polls suggest that the majority of Albertans feel that the quality of life has deteriorated. The political dilemma evident is that a reduction of royalties could very well escalate this situation while increased royalties might alleviate or defer this condition. y The production of resources should never terminate due to the implementation of a royalty regime. In particular, the incorporation of the word conservation should never have been omitted from the previous Energy Resources Conservation Board to the current Alberta Energy and Utilities Board. The conservation of energy implies accessing and producing as much of our resources as possible. The rate of production or the period of time over which a resource is produced is not a component of conservation except if it impacts the total resource recovered from a deposit. A producer will obviously halt production when it is economically not viable in the producers interest to continue to do so. As a result, conservation should remain a vital area of focus for royalty takes. y If operating costs converge to revenue, royalty rates should equal zero. In particular, companies with low operating costs per unit of production such as smaller startup companies and those who by virtue of enhanced recovery techniques can extend the life of a well should benefit from any royalty re-structuring. y The royalty rate for companies that choose to include an upgrader and hence, add value to the bitumen by processing it should be subject to a lower royalty rate compared to those companies who prefer to send it elsewhere for processing. The major issue to overcome however is the fact that a bigger project implies greater time to recover the costs and hence, such companies would enjoy a lower royalty rate for a longer period of time.

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However, this reward may be warranted because for Alberta, there is more economic value added to the natural resource by upgrading it rather than sending it elsewhere. y The royalty rate must not be too high so that the upside is lost and Alberta becomes uncompetitive. Nor should it must so low that an increase in rates would result in increased revenues to the government. The reviewing panel should take into account the elasticities between royalties and other sources of revenue such as corporate taxes and land sales. In determining the optimum royalty regime, the panel should take into account the time value of money and resources through standard net present value economic analysis. A royalty structure that discourages current industry activity in a world of rising oil and gas prices may initially seem like a positive strategy. However, this strategy could backfire if prices fall due to the development of new, cheaper energy sources. It is recommended that various future world energy market scenarios be examined and tested to forecast how proposed royalty regimes would respond. In arriving at the optimum royalty regime, the incorporation of some probability measure on the frequency of each market scenario may be required. y Due to high levels of capital already invested in oil sands development, a royalty structure sensitive to the concerns of companies providing raw materials to construct the underlying facilities is also paramount. For example, Shaw Group Protection Ltd is one of the largest international applicator and supplier of anti-corrosion coatings, concrete weight coatings, thermal insulation coatings, and specialized coatings to the oil and gas pipeline industry. Currently, they have invested 38.2 million in a new coating facility in Camrose, Alberta designed to provide new products and solutions for customers operating oilsands projects.10 Significant changes in the royalty structure could force

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customers to abandon or delay these projects resulting in stranded assets in Camrose, Alberta. y Companies should develop sound work habits and policies that reduce the environmental damage of the oil and gas industry so the bills of the future will be decreased. It is critical that companies engage in forward-thinking investment decisions that are mindful of the long term prosperity of Albertas economy and environment. In particular, the combined cumulative impact of accelerated oil sands development in Alberta is difficult to quantify and must be made a priority by the Alberta government while slowing the development pace to provide ample time to gather baseline data and evaluate project impacts. During the interim, a fund could be established and used on a cost sharing basis as an incentive with companies for carbon sequestration pipeline, membrane water treatment, water recycling and land reclamation projects to develop and otherwise encourage experimentation with these technologies.

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CONCLUSION
Albertas oil sands are undoubtedly an enormous economic and strategic advantage for Canada. As a global energy leader, the Alberta government has a responsibility to develop a royalty framework through the deployment of policies to ensure that emerging technologies are developed and brought to market in a manner acceptable to Albertans. Royalties are clearly an important part of Alberta's overall fiscal framework. They ensure that Albertans, represented by the government, receive a portion of the benefits arising from the development of the provinces resources. They are also an important policy tool that can shape economic and resource development. It is clear that determining an appropriate level of government take within any royalty system is a complex task. Economic theory provides some insight, but the ultimate decision depends on the values and priorities of Albertas government and citizens. Moreover, the social, political and economic context in which these decisions are made changes over time. As a result, Albertans must continuously examine the policies and programs executed by their government. Oil companies are always striving to reduce royalty rates due to their claims of shrinking investments and development in oil sands if changes are implemented. They express a variety of concerns including environmental costs, a high Canadian dollar, and increasing construction and operating costs as reasons to reduce royalty rates. However, they also vouch that the oil sands are an attractive place to do business due to high shareholder returns, large reserves, long project lives, political stability, and a lack of viable prospects in other areas of the world. Clearly, the implementation of a fair and stable royalty regime ensures long-term expansion in the oil sands for industry while continuing to provide value to Albertans.

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REFERENCES
1

Government of Alberta, Royalties in Alberta, 25 November 2007, <http://www.albertaroyaltyreview.ca/more_info/background.pdf > (26 November 2009).

William M Hunter, Our Fair Share, 18 September 2007, <http://www.albertaroyaltyreview.ca/panel/final_report.pdf > (26 November 2009).
3

Alberta Department of Energy, Alberta Oil Sands Tenure Guidelines: Principles and Procedures, 15 June 2006, < http://www.energy.gov.ab.ca/OilSands/pdfs/GDE_ost.pdf > (29 November 2009).
4

Amy Taylor, Royalty Reform Solutions, 20 September 2006, < http://www.albertaroyaltyreview.ca/public_meetings/submissions/2007_0522_amy_taylor_pemb ina_institute03.pdf> (26 November 2009).
5

Government of Alberta, Alberta Oil Sands Royalty Guidelines, 30 November 2006, < http://www.energy.alberta.ca/OilSands/pdfs/GDE_osr_chp1.pdf> (28 November 2009).
6

Alex G Macwilliam, Investing in Canadian Tar Sands: Tenure, Fiscal, Commercial And Political Issues, 16 February 2007, <http://www.fmclaw.com/upload/en/publications/20052006/Energy_Investing%20in%20Canadian%20Tar%20Sa nds.pdf> (30 November 2009).
7

Alex G Macwilliam, Investing in Canadian Tar Sands: Tenure, Fiscal, Commercial And Political Issues, 16 February 2007, <http://www.fmclaw.com/upload/en/publications/20052006/Energy_Investing%20in%20Canadian%20Tar%20Sa nds.pdf> (30 November 2009).
8

Fraser Milner Casgrain LLP, Investing in Canadian Oil Sands, 17 March 2007, < http://www.prac.org/materials/2007_March_eBulletin.pdf > (1 December 2009).
9

MacLeod Dixon LLP, New Royalty Structure, 28 November 2007, <www.macleoddixon.com/documents/New_Royalty_Structure.pdf> (29 November 2009).

Matthew Stewart, Shaw Pipe Protection, 19 June 2007, <http://www.albertaroyaltyreview.ca/submission_summaries/2007_0619_matthew_stewart_sha w_pipe_protection_ltd.pdf> (29 November 2009).

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