Yesterday I had a discussion with a friend concerning his holding in Canadian Oil Sands Trust (Toronto: ACOS.UN). He was and still remains upset about the Halloween surprise when the Canadian government provided its pronouncement on trust units. But now, he is concerned about more political risks—namely, potential changes because of Kyoto or similar protocols, a change in taxation, a change in royalties. Let us examine each one.
Environmental Regulation Changes and Costs
A minority party is leading the Canadian government. Most public opinion polls that ask Canadians for their largest concern indicate that the environment is number one. Thus, the Conservative government is likely going to act in some capacity. While no one knows what the outcome will be, you can be sure that it will be an additional cost to greenhouse gas emitters.
Oil sands companies (and mining companies) benefit greatly from a special capital cost allowance (CCA) classification 41. If an oil sands company's capital falls into one of the three buckets:
- Starting a brand new mine;
- Increasing production by 25% or more; or
- Spending capital in excess of 5% of gross revenue;
available for userule that delays the write off for two years or until the equipment is available for use, whichever is less. I am not completely certain on the exact mechanics of the last statement. (You can also read an alternate description at the Natural Resources Canada website.) When I last investigated the impact of the immediate capital write-off, it was a huge driver. It supercharges the returns to the developer (oil sands company or mining company). The reason why it is in place is because oil sands and mining developments require vast sums of capital and take many years of construction before the project begins to earn income. If the project is economic, then the developer; province through royalties and provincial tax; and federal government through federal taxes all earn their proportionate share. However, for oil sands developers, a strong case can be made that, with the current high prices, the developers no longer require this supercharged write-off. I believe the Liberal party has hinted strongly at removing some tax incentives for the oil industry if it were in power. Class 41 is a prime target.
For oil sands companies that are already in operation and are not planning major expansions, this CCA 41 is no longer of concern. But most, if not all, companies are planning on further expansions. Shareholders need to pay attention to this potential change.
The last threat is a change to the royalty regime. It might take one of several different forms. One potential change might be to assess royalties on synthetic crude oil rather than bitumen. Bitumen is a very heavy oil from the oil sands and by itself is not very useful. Bitumen needs to be upgraded so that it can be refined. If you like, you can think of a value chain with four steps:
- An undeveloped oil sands lease;
- A mined lease where the oil sands has been extracted to a bitumen state;
- Upgraded synthetic oil after upgrading; and
- Refined products after refining.
The value of bitumen compared to synthetic crude oil (SCO) varies over time. It depends largely on whether there is a shortage or surplus of upgrading capacity. At present, there is a glut of oil sands production with a scarcity of upgrading capacity. Thus, bitumen has a lower value, or equivalently, the light heavy spread is very large at present. In its desire to capture more value from the oil sands activity, the provincial government could levy its royalty against synthetic crude oil instead of bitumen. In fact, for many, many years the owners of Syncrude Canada Ltd. paid royalty on SCO, not bitumen.
Under normal circumstances, upgraders are simply a necessary evil. They are expensive and do not return much, if any, profits. Under this scenario, the price of bitumen is high, and the light heavy differential is narrow. But today, because of the explosion of the oil sands development, the opposite is true.
If you are running an oil sands company under normal circumstances, you would actually prefer to have the royalty levied against SCO. That is because when the differential is wide, the upgrader is making a lot of money, the company can afford to pay royalties, and the upgrader costs are part of the cost base for assessing royalties. And when the margins are small and upgrader is loosing money, the upgrader actually lowers the royalty payment because the upgrader costs are still part of the cost base. In effect, by placing the upgrader inside the royalty ringfence, the company has created its own hedge.
In today's environment, however, the differentials are wide and will remain so for the next few years at least. Thus, companies want the royalty levied against the bitumen. If the Alberta government were to change its royalty from bitumen to SCO based, that would negatively affect today's oil sands companies. With this current scenario, companies are not interested in the hedge. They are instead interested in maximizing their profits. If you assume a weighted average cost of capital of about 10%, then you know that the first 10 years are the important years. And thus, today's oil sands companies want the royalty assessed against bitumen, not SCO.
My friend wants to sell Canadian Oil Sands before any of these potential adverse political developments transpire. However, he is concerned about being hit with a large tax bill. One potential solution might be for him to short another oil sands company and effectively lock in the price for his Canadian Oil Sands trust units. Therefore, he is investigating that as an alternative to liquidating his position. If he were to short another oil sands company, he must compare the developments for both Syncrude and other company to see if they are and will remain good proxies for one another. He must also concern himself with Canadian Oil Sands distributions and changes to the trust as it approaches the end of its trust structure. He also has to investigate margin requirements. And while having a pair trade should work in theory, there is always some risk. He must weigh those risks against a potential tax savings today.
None of what I have written should be considered investment or tax advice. I am merely providing some commentary for those who might be in a similar situation.