Alberta Premier Ed Stelmach made the promise from the show position down the stretch of a provincial leadership battle. He eventually won and soon followed through on his populist pledge to review Alberta’s oil and gas royalty structure.

Alberta’s current royalty structure is undeniably more favorable to private producers than arrangements in other jurisdictions. Even the companies generating headlines with promises to abandon Alberta projects acknowledge that adjustments should be made.

The uproar over the Our Fair Share report has its roots in the Conservative leadership contest, which brought Stelmach to power in late 2006.

The Alberta Tories’ leadership race devolved into a populist brawl that rapidly roused key elements of the electorate without imparting much information. In that campaign, every registered member in the Progressive Conservative Party of Alberta had a direct vote, and anyone could sign a membership card right up to the last minute. It became a popularity contest. Promising more money from oil and gas was an easy way for candidates to attract attention and win votes.

Stelmach won, and on Feb. 16, 2007, Finance Minister Lyle Oberg announced the appointment of a six-member panel of experts to complete the review. On Sept. 18, 2007, the Alberta Royalty Review Panel (the Panel) released Our Fair Share.

In its letter of transmittal to Oberg, the Panel proposes a “mitigating fiscal program,” cutting right to the chase before directly addressing the question it was created to answer. The Panel “was created to review whether Albertans are receiving a fair share from energy development through royalties, taxes and fees.” The Panel concluded Albertans don’t get their fair share and haven’t for a long time. It sees the upward adjustment as a positive factor in achieving “…Alberta’s rightful place in international competitiveness.”

The money quote, the foundation upon which the royalty regime report was based: “Albertans own the resources.”

Industry reaction has varied in intensity. The Canadian Association of Petroleum Producers (CAPP) described the Panel’s integrated recommendation as flawed. EnCana Corp said it may pull CD1 billion out of Alberta, and Petro-Canada, Talisman Energy and Crescent Point Energy Trust (CPG.UN, CPGCF) have also threatened to leave.

According to CAPP President Pierre Alvarez: “The panel low-balled costs faced by industry by billions of dollars and shrank the revenues paid to government by industry, again by billions of dollars. When you stick to and consider all of the facts, it is clear that the picture does not reflect our current reality.”

Citing numerous studies that have reached the same conclusion, Alvarez listed industry cost estimates used by the Panel and described them as outdated and far too low.

“When you understate costs by that much, and when the numbers are in the billions, well, that is an easy way to give the appearance of loads of room to raise royalties and taxes,” Alvarez said.

The question is, as usual, of degree.

The Panel describes its assessment of fairness by first measuring government’s total take and comparing that figure to those of other energy producing jurisdictions. If “total take” is too much, companies will move operations to places where the bite is smaller. EnCana has threatened such action. Others will follow.

If total take is too low, “Alberta gives away some of its fair share and “projects of marginal economic value are undertaken just because they are a bargain—i.e., because the ‘company keep’ amounts are too high.”

The deal-maker, from the Panel’s perspective, is that its recommendations and the Alberta Dept of Energy studies on which they are based were reviewed by Dr. Pedro van Meurs, an expert on the design and assessment of global oil and gas royalty systems.
 
Oil and gas industry representatives and executives cited Dr. van Meurs’ 1997 report on international government take rankings; a decade ago, Alberta’s oil and gas take ranked high. In Dr. van Meurs new, up-to-date rankings, Alberta’s take is low compared to other jurisdictions.

Energy royalties are like the fees songwriters get when a radio station plays their music: The owner of the product gets a royalty when it’s used for a company’s benefit. But energy resources can be used only once. The public, through the provincial government, owns mineral rights for 81 percent of Alberta’s nonrenewable natural resources, so producers pay royalties to the government when they extract oil and natural gas.

The Panel concluded the government doesn’t receive a fair share because Alberta’s system hasn’t been adjusted to reflect changes in the world energy market or the provincial resource base. The last revision of oil sands and royalties in 1997 was done when companies had little interest in developing in the remote north of Alberta, so the royalty system was changed to encourage more activity. Today, the oil sands is one of the world’s most coveted petroleum fields.

Dr. van Meurs’ new international comparison puts Alberta’s royalty share in various sectors dead last among systems in comparable US states and other countries. The Panel’s recommendations would put royalties in the middle of the pack on some oil sands types and gas, but still last on conventional oil.

Before the report, criticism swirled around oil sands producers’ 1 percent royalty rate on a new project’s revenues until it earned profit equal to startup costs. This deal was crafted in 1997, when the massive costs to build oil sands plants and upgraders made normal royalty rates too daunting. The panel decided royalties shouldn’t become an undue burden on operators that haven’t recovered their investment.

Oil sands companies that have recouped startup costs pay 25 percent of net revenues (revenues minus production costs), which the panel found unnecessarily low in today’s climate. It wants firms to pay 33 percent, so Albertans get a higher share that’s still internationally competitive.

The report also calls for a new oil sands severance tax, a tax imposed by a political subdivision on the extraction of natural resources, such as oil, coal or gas, that will be used in other political subdivisions. That rate would go up and down based on oil prices, from 1 percent when oil is at USD40 per barrel to 9 percent at USD120. At current prices of about USD80 per barrel, firms would pay 5 percent.

The Panel also recommended simplifying conventional oil and natural gas royalties. The current structure includes special programs that muddy royalty calculations; the Panel concluded that rates should be based on commodity price and how much a well produces. The new system would actually mean lower royalties for low-producing wells, which represent 57 percent of conventional oil wells and 82 percent of natural gas wells.

More productive wells would pay more.

Much like the income trust tax decision, the Alberta Royalty Review was forged in the burst of temporary circumstances. The Canadian October “surprise” was, of course, literally an overnight reversal, while the Our Fair Share report played out over many months. But it’s the product of a desperate political move; the letter of transmittal covering the report is courtly and compelling but reveals much by introducing a cure before it acknowledges a disease.

The review panel’s decision to leave the 1 percent rate untouched could provide Stelmach room to maneuver politically. By hiking the initial royalty rate for oil sands, Stelmach could reassure many voters concerning fairness. He’d also eliminate a statistic that will otherwise continue to generate popular indignation. And because the long-term outlook for crude oil prices is bullish, a higher initial royalty on new oil sands production isn’t likely to trigger capital flight.

Stelmach promised a royalty review, with the strong implication of higher public revenue. Once a darkhorse, Stelmach had to deliver on that commitment when he won.

Now he’s stuck between a fired-up public and a frightened energy patch.

Here are some things Stelmach will have to consider:

• Almost 40 percent of Alberta’s GDP is driven by capital spending. The most recent provincial government roster of capital projects totals CD225 billion, including CD148 billion related directly to oil sands.
• Capital costs were rising even while the Panel did its work, and the government must be clear that its decisions are based on reliable information.
• Many producers are earning good profits on oil and gas production, which was developed earlier when costs were lower. That profitability excites public attention, but it’s history.
• Fresh capital spending–the major driver behind Alberta’s economy–relies on expectations of future profit. Oil and gas operators, as well as investors, are well aware that the sector’s costs for new infrastructure have been rising rapidly in tandem with crude oil prices.
• The Panel recommends no grandfathering of existing projects. Changing the rules under someone who’s committed CD3 billion to CD4 billion to Alberta would be unfair.
• A serious misstep on royalties could lead to an overreaction from the industry.

We’ll know by mid-October what Stelmach will do with the Panel’s recommendations.