Royalty check
To which my friend Terry Corcoran has already written a trenchant reply: Maybe the oil belongs to the government, but not the people. And it belongs to the government not by some divine right, but because, well, "they took it." In which case, they should presumably give it back....
Or, if that's too radical, then sell it -- instead of charging a royalty to drill on crown lands, the state could simply sell the land itself, capitalizing the discounted stream of future royalties into the sale price.
Well, that's not going to happen. But it does suggest a better way of setting royalty rates than at present.
Terry takes issue with the panel's claim that royalties are different from taxes, but let's say they are. What are they, then? They're a price. A tax is the government's way of saying, "you've got money and we want it." A royalty is the oil companies saying, "you've got oil and we want to drill it."
As the owner of something, I have two ways of putting a price on it. I can just pick a number, and tell everybody to take it or leave it. That's more or less what the premier has just done. Or I can put it up for auction. Why has this option not been considered?
If I set the price by fiat, I always have to worry about whether I've set the "right" price. Too low, and I'm giving it away (the Panel's argument.) Too high, and I scare off potential buyers (the oil companies' argument). The situation's even worse in a political setting, where uncertainty is compounded by demagoguery. Which is precisely where Alberta is at now.
But in an auction, you always extract the most that a buyer -- any buyer -- is willing to pay. No more and no less. There's no sense getting in a political argument about it, and no need: the highest bidder determines the "right" price.
So if Stelmach really wants to be sure of getting full value for the people's oil, without killing the goose that laid the golden egg, why not auction it off?
10/24/2007
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24 Comments
Except that there already is an established market rate for this "price". Jurisdictions around the world charge resource based royalties. Each "price" needs to be adjusted for certain other realities - political stability, estimated cost of extraction in relative terms, local infrastructure, local tax code (apart from royalties), etc... Which is to say that the royalty rates in, say, Tanzania will likely be lower that those in Alberta.
I very strongly suspect that if there was some kind of auction, you would get a price that a thoughtful observer could independently determine with considerable ease.
I don't follow Alberta politics too closely, but it seems to me that the determination of a proper royatly rate would be one of the simpler things a government should be able to do.
Except that's not an established market price at all, but rather an established political process. I've known people in the private capital markets who have a fiendishly difficult time coming up with a "correct" price for any limited resource, and use a huge battery of statistical/financial tests and procedures to try and find such a price, say during the pricing of options on a resource.
Auctions are much simpler than any "rational" attempt at setting the price of a limited resource. And, at least at the margin, you always extract the maximum amount of cash which any group of bidders is willing to pay. There's no point in trying to set a price which is higher than what the highest bidder's willing to pay — the resource goes unused, and the auctioneer (presumably the government) foregoes 100% of the potential revenue from the resource.
And governments always run that risk when unilaterally setting royalties on a resource.
“Each 'price' needs to be adjusted for certain other realities - political stability”
Where’s the political stability in the government of the day changing the royalties to whatever it feels is “fair”?
Where’s the property rights? Oh, I forgot, we have no property rights in our glorious Charter. Does Tanzania have property rights?
Not sure what Canadian Charter property rights provisions (or lack there of) has to do with this. At least as far as the point being that the real political risk in the resource business is that the government will unilaterally expropriate your resource rich land. Not a terrible risk in Alberta, I would say. Certainly more so in Africa. History argues this rather persuasively.
As far as political stability goes, if you do have a government that changes the price too frequently that will inevitably short circuit their own desires - the market will place a risk premium on whatever price they receive. That would only reduce business activity (assuming, of course, the change is an upward change).
In terms of the established price - check it out. It does exist. You can find one for every resource rich jurisdiction in the world. In most cases it will be a bit different and that will owe itself to the adjustment factors to which I speak. It is no different than a corporate tax rate (which, I might add, is also subject to a political process). The corporate tax rate in Alberta is set relative to their competitors (other provinces, USA, etc...) adjusted for certain advantages and disadvantages that Albertans feel they can offer a corporation (eg. robust infrastrucure, state financed health care, political stability, etc...).
Should we auction off the corporate tax rate?
In a global economy , we de facto auction off corporate tax rates. Look what happened in Ireland.
Regarding property rights, I think what AC is driving at is that if the property was auctioned off, there would be a set value established upon which discounted cash flows could be used for investment decisions.
But when investors are dealing with royalties instead of owned property then things are subject to whims of politicos. The same is true with stumpage fees instead of the forest industry owning the property and looking after it in the optimum way for future cash flows.
"But when investors are dealing with royalties instead of owned property then things are subject to whims of politicos."
Things are always subject to the whims of politicos. If they weren't able to make the cash grab through the royalty structure then they probably could have done it through the tax code by creating some kind of polluters tax.
I still like the idea of the auctioning off of land over royalties, mainly because I agree that it would likely lead to extracting the most value from the land, but let's not kid ourselves that it would somehow eliminate political interference.
1. The on-the-ground story that is being poorly reported esp. outside of AB is that the Gas sector has come to a screeching halt.
Imports of LNG from Saudi and Siberia have now begun in the US and they will increase. Thus, the price of gas has been capped - pardon the pun - at a point that is now below the cost of exp. and dev. of potential reserves along the eastern slopes of the Rockies. And there is little chance that the price will rise for a continuous period above the break-even mark for many years to come time.
Most of the current royalty streams are coming from gas not conventional crude or tarsands, so look for a drop in those revs for the next few years. Needless to say there is little tolerance in the industry for talk of higher royalties as a result.
2. As for the industry as a whole in the past three years labour costs have at least doubled in cdn $ while the US$ - the currency that the producers get paid in has fallen from a 1.25 to .96 CDN with little sign of a reversal in the trend. And whatever profit is earned is taxed at 50%. The attractiveness of AB as a place to develop more oil and gas production has been seriuosly eroded over this interval.
3. Increasing royalties essentially reduces the amount of income that can be paid to employees, service companies and shareholders - many of whom are Canadian and all of whom pay taxes.
Increasing royalties is an attempt by the provincial gov't to get at the head of the income stream instead of being at the end of it. To believe in Royalties is to believe that big central government is better than small diverse government.
And to call Stemach a conservative is an obscene abuse of the term's meaning.
There _is_ an auction system, not in royalties, but in acquiring first the rights to explore a parcel of land, and second, _if_ one finds an economic pool of oil or gas, there is another auction for the rights to produce it. These auction payments (into the $billions most years) were specifically _excluded_ from the royalty review, are are the main beef the industry has with that review. That money is not a 'royalty' but it is company money that goes into the government pot.
Looking forward to the future columns on Dutch Auctions vs English Auction :-)
Auctions are actually a well studied area of economics.
Here is a good Wiki entry on auctions
http://en.wikipedia.org/wiki/Auctions
Joey Smallwood, for all intents and purposes, followed the process Andrew prescribes for the Upper Churchill Falls development, that subsequent Newfoundland gov'ts have decried. It was a 65 yr deal where Newfoundland would receive a prescribed schedule for the hydroelectric output (in 1976 it received three tenths of a cent, per kilowatt hour, by 2016, the price will drop to two tenths of a cent). Obviously, Joey Smallwood and his advisors never accounted for inflation or the increasing price of energy over the life of the contract.
http://www.empireclubfoundation.com/details.asp?SpeechID=590&FT=yes
This parallels, to some limited extent, what has happened in Alberta wrt royalty rates. The current rates were set in the 1990s when the outlooks for oil and gas prices were bearish. It appears that neither the gov't nor industry had anticipated the rapid rise of oil prices in the last few years, due to increased demand from India and China, and political risk overseas.
Had the royalty structures from the 1990s allowed for increasing royalty rates as the world prices increased to today's levels, this review would probably have never been needed.
Would anyone purchasing an oilsands lease or rights as Andrew suggests in the late 1990s, on an asset that will last 50 yrs, have factored into their evaluation the forecast price of oil rising from $20 to $90 today in their NPV calculation, and even higher for future years? Doubtful.
I think energy prices are just too volatile and uncertain for the province to get full economic benefit by auctioning off their ownership.
Say the Alberta gov't today picks a royalty rate that is too high, and its coffers suffer accordingly in subsequent years due to lower activity. There is nothing preventing them from adjusting them downward in the future, as they had done in the 90's.
Good arguments Derek. I would add this - how would the government know how much resource is in the land? They will know how much can be extracted at what price under current conditions. What they will not know is how technology will impact extraction techniques in the future. It is very common for resource properties to have their lives extended once extraction commences.
I just don't see how an auction makes practical sense. There is no need (because a market already exists) and it ties the governments hands into the future.
Derek: The "Generic Royalty Regime" that applies to the tarsands is as follows:
"- A minimum 1% royalty payable on all production;
- Royalty on production equivalent to 25% of net project revenues after the developer has recovered all project costs, including research and development costs, and a return allowance (after "payout");
- The return allowance is set at the Government of Canada Long-Term Bond Rate;
- All projects cash costs including capital, operating, and research and development are 100% deductible in the year incurred;
- No gross up of operating and capital costs; and
- No gas royalty waivers."
Unlike the moronic deal that Joey signed (and Clyde Wells resigned over, if memory serves) there is a built-in inflation clause as the rates are a percentage of revenues.
Gord,
Yes, I understand the existing royalty regime for oilsands. My comparison to Joey's deal was wrt Andrew's suggestion of a lump sum payment up front (NPV) for ownership of the petroleum assets. Joey could have taken his fixed contract for the next 65 yrs with a set income stream and sold it to a financier for a lump sum, rather than receiving payments in the form of an annuity. So, same thing.
The first part of the existing royalty arrangement (under 1%) is not unlike the regulated rate of returns that utilities receive - guaranteed and no risk.
The real issue in the royalty debate is what happens with "windfall" profits?
If a company, say Suncor for example, made an investment decision to expand production in 1998 or earlier (as it had to for its Millenium project) under a very conservative price forecast, (and under the royalty regime at that time), and world events change significantly, as they have, should they be entitled to 75% of the windfall (beyond prices that they had expected), while Alberta continues to receive 25%?
True, they undertook the investment risk (mitigated to a great degree by the 1% royalty holiday and regulated returns at BofC rates). But is that enough justification for them to capture 75% of the upside?
Since I wrote my original post, Stelmach has announced, by 2010, additional royalty revenue of $1.4 billion, with limited details.
Assume, for the moment, that all of the new revenue comes from the oilsands. According to CAPP, in 2010, total oilsands production is forecast to be 2.15 million barrels/d (785 million barrels/yr).
see table 1 : http://www.capp.ca/raw.asp?x=1&dt=NTV&e=PDF&dn=103586
So, less than $2/barrel, in 2010. On this very crude analysis, the increases don't seem as draconian as some are now suggesting on BNN and elsewhere, post Stelmach press conference. I've seen crude prices jump this much in one day. Who knows where it will be two plus years from now?
"But is that enough justification for them to capture 75% of the upside?"
For current projects, absolutely. Tarsands looked like a hell of a crap shoot ten or more years ago, particularly in areas where Steam Assisted Gravity Drainage (SAGD) was the proposed and at the time unproven extraction technology. Now that SAGD is 'proven' the argument can be made that the % after expenses have been covered of should be higher ON NEW projects, and even that the 1% rate should be increased.
This is of contrary to the proposal of another moronic Newfoundland premier - Danny Williams -who wants to revise the terms of development on leases that were started 20 plus years ago.
As for the "less than $2/barrel" argument, the impact on tarsands will not be and currently isn't the primary issue, it is the impact on conventional Oil and Gas production where the margins are much, much thinner.
And in response to the "Who knows where it will be two plus years from now?" I think that in 2004 US$ we will more likely see oil at $40/bbl before we see it at $100/bbl. The combination of a global economic slowdown, huge new production coming on from almost every corner of the globe, and peace and elevated production from Iraq agur for a turn in prices in the next couple of years, as long as the mullahs in Iran are dealt with in a pre-emptive fashion.
Gord,
A couple of reply points. It appears that you are for grandfathering of existing royalty rates for existing projects. Let me make a counter argument for no grandfathering.
First off, prior to the 1996/1997 royalty regimes for oilsands projects in Alberta, royalty rates would be negotiated on a one-off basis per project, depending upon the technical risk and forecast prices for oil and gas etc. It was only through a joint negotiation with gov't and industry that this standard 1%/25% arrangement came into existence.
Prior to the new arrangements, according to an Eric Reguly column, Suncor had paid 30% royalty. As I understand, this was not grandfathered (it dropped 5%), even though the new lower rates were to encourage further investment.
Similarly, when the Alberta Gov't in a recent budget cut corporate tax rates to encourage further investment, the older higher rates for existing businesses were not grandfathered.
So, on a general basis, if it is acceptable to not grandfather when taxes/royalties are being decreased, why is it not acceptable when the reverse is contemplated?
There is nothing magical about the 1%/25% formula. It was a negotiated arrangement based upon a forecast of costs, production rates, prices, and rates of return. No doubt, had the price of oil collapsed, or returns not been sustainable, industry and government would have been back at the table renegotiating terms, as they had in the 90s. If I'm not mistaken, it was expected at that time (1996)that the government's total take would be in the order of 60% (including taxes, royalties etc.) As it turns out, it has ended up being 47% or thereabouts. If industry could renegotiate on the downside, why can't the gov't?
It appears that if oil drops to $40/bbl as you suggest, the new royalty rates won't come into effect - ie they are price sensitive, kicking in above about $65 or thereabouts, as I recall reading somewhere.
This from today's National Post:
-- The government take from oilsands projects will increase from the current 1% before project payout, to a range of 1% to 9%, depending on oil prices.
When investment is recovered, projects will see royalty increases from the current 25% to a range of 25% to 40%, depending on oil prices. At current oil prices, that translates into a government take of about 65% of net revenue, up from the current 47%.
http://www.canada.com/nationalpost/financialpost/story.html?id=482c819e-ee15-4b7d-aa0c-f75d07a251f2&k=91335
But, it appears we agree that oilsands are not the real issue - it is conventional oil and particularly gas production as you had earlier pointed out. Without knowing the details, I understand that some concessions have been made in the Stelmach proposal for gas development, so I'll hold off commenting further on that issue for now.
The only observation is that huge inflation in the costs for conventional exploration, development and production have definitely been adversly affected by unfettered oilsands development.
Gord "huge new production coming on from almost every corner of the globe"
Please be more specific and advise any new projects able to offset the massive decline in production in the next few years.
An auction is good for capturing the maximum price at a particular time.
The thing is, oil and gas are resources that are both going to increase in value over time. So sure, Alberta could auction it all off now, and then in 20 years be relying on handouts from Saskatchewan when their higher royalty rates are no longer a deterrent to the industry due to the increase in prices from the coming increase in demand.
So lets look at the larger picture. Alberta's economy is too hot to handle right now, with thousands of people moving in, being unable to find homes, and the infrastucture beginning to fail under the weight.
The inflation rate of Canada as a whole is being propped up by Alberta, leading to our interest rates and dollar both being higher right now than they would under an Alberta with sustainable growth.
Increasing the royalty rates -- even beyond what some energy producers are willing to pay -- may not be a bad thing, as the cooling of the Alberta economy is best handled while we have a surplus and while there are still energy reserves in the ground for future generations. After all, it's not like the oil left undrilled is going to go down in value. In the meantime, we use the increased royalty rates to promote sustainable growth and give us the opportunity to make the needed fixes to our infrastucture and increasingly diversify our economy so as not to be so dependant on resource extraction. The inflation rate in Canada would then drop, prompting the bank to lower interest rates and the dollar to sink to levels more appropriate given the slowdown in our largest trading partner. This would in turn provide some needed support to everywhere *else* in Canada to invest and to export.
auctions only work if the bidders don't collude
look at what happened when alberta privatized their power distributors
the idea was that the increased efficiency from the supposed competition would be enough to drive down the prices for consumers
instead the 'competition' never materialized and the alberta government has been paying the private shareholders of these companies every winter since so that alberta voters dont realize how badly they got screwed
It would do Andrew and Terry to get out of Toronto on occasion, and into the real world.
Alberta has an inflation problem and no central bank that can raise interest rates. Inflationary economic growth is of no benefit to anyone. The only way to stop the inflation is to raise the taxes or in this case royalties on the economic activity that is causing the inflation, so the economic growth remains, and the inflation is eliminated.
It is all economics 101. The average Albertan living amidst the inflation and the declining quality of life that accompanies it understands this, while the intelligentsia in Toronto don't.
Point #2. Oilsands inflation has caused the natural gas industry and production to go into decline in Alberta.
The oilsands have had a free ride while natural gas royalties paid the bills, but now the oilsands induced inflation is killing the natural gas industry, natural gas royalties are in decline, and thus, the free ride for the oilsands has to end, and bitumen has to start paying for some of the bills.
The royalties on most natural gas wells under Stelmach's proposal will decrease. The royalties for oilsands will increase.
Again...it would help if the smart people in Toronto actually knew the facts before expressing uninformed opinions.
Point #3: An auction is not feasible for several reasons, but primarily.
The value of the oilsands asset is such that no public company could afford the minimum reserve bid. The only way a public company can afford to pay for the oil is via a royalty system such as Alberta has in place.
Point #4: Alberta does auction off the right to exploit a certain piece of land with an adjustable future royalty. Check out those bid prices. If the companies had to actually pay for the discounted royalties streams upfront also, the price would be prohibitive.
I find it intriguing that no one here - and especially AC - has pointed out the consequences of any resource taxation (including royalties).
Taxes on non-renewable resources lead to high-grading, whether we're talking oil, gas, aggregates, precious or base metals. High-grading means less production, lower productivity, more scarcity and higher prices.
The effect of less abundance of economic primary resources is almost incalculably high, as it is multiplied many times in a highly service-based economy. Human advancement is greatly slowed, despite all indications that great leaps in ingenuity are needed more than ever.
From this perspective, except for recovering the costs of externalities, there is no place for resource taxation - it is thoroughly harmful.
Google, that is a fair point, but it does extend to all taxation - be it corporate taxation or any indirect taxation (eg. the need for a company to build its own roads, schools in the area, etc...). Anything that hits the bottom line will make low grade resource less economic.
The thing is this - if you want to carry you argument to its logical conclusion, then all forms of taxation should be eliminated. That will, necessarily, make much more of the resource economic. Franky, however, I don't see that as an option. At least not when the resource is still realtively abundant and in demand.