As preparation for this article, I encourage you to read my prior article about Syncrude Canada Ltd. and Suncor Energy Inc. (SU) moving away from a synthetic crude oil (SCO) based royalty to a bitumen based royalty. In my prior article, I explained that I expected that Alberta would put a clawback measure in place to recapture the royalty sheltering that occurred when the companies used their capital spending on their upgraders as part of their royalty deductions. A reader wrote to me and highlighted a recent presentation by Canadian Oil Sands Trust (COS-UN.TO) at Scotia Capital's Energy Trusts Conference. On page 11 of their presentation, Canadian Oil Sands Trust states:
The outstanding issues that need to be resolved before making our determination is a methodology for valuing bitumen and how capital invested for the upgrader would be recaptured.
This quote is in relation to how Syncrude would move from an SCO based royalty to a bitumen based royalty. One challenge is to value properly the bitumen, which I will discuss in a future article, and other challenge is to recapture the lost royalty because of the prior upgrader investments. Knowing that Syncrude is already involved in negotiations, I assume that Suncor had or will have similar negotiations. Thus, my prior expectation appears correct in that the Alberta government will put a clawback mechanism in place for those companies that elect to move from a SCO to a bitumen based royalty.
Moreover, on page 15 of Alberta Review Panel Final Report (PDF, 2.25mb), the Panel states:
Upgrader Royalty Credit - Even though it cannot do so unanimously, the Panel recommends that a tradeable royalty credit be introduced at a rate of 5% of eligible capital expenditures on additional upgrading capacity in Alberta. This would only apply for projects whose application to construct and operate an oil sands upgrader is approved by the Energy and Utilities Board (or successor agency) after the bitumen valuation methodology is in place (30 June 2008 indicated above).
This recommendation is poor. I understand that the recommendation's purpose is to encourage upgrader construction in Alberta. In my view, that thinking is flawed. Upgraders are often poor investments. Upgraders and refiners to have production creep whereby upgraders and refiners to expand their production capabilities and reduce their cost structures such that the investments earn only a marginal rate of return. Because of the flood of oil sands production, there is currently a glut of heavy oil in the marketplace and thus a high differential between heavy and light oil. That glut, however, is not expected to endure. When glut of heavy oil is no longer present as new upgraders come on stream, the marketplace will become more balanced, and the high rates of return now enjoyed by upgraders will be diminished greatly.
With an anticipated balanced heavy oil and upgrader marketplace, imagine the following scenario: Oil prices are at record highs at over $100 per barrel yet upgraders are earning marginal but acceptable rates of return. Oil companies are enjoying record profits. Alberta consumers are feeling the pinch of higher energy prices. And those same consumers are subsidizing oil companies' investments in their marginal upgrader projects by virtue of granting those projects 5% royalty credits. Maybe it is just me—but I do not see why Albertans should be asked to subsidize an industry making record profits from a non-renewable resource.
In this article, I covered two topics: one, synthetic crude oil versus bitumen election; and two, upgraders and upgrader credits. Both topics involve upgraders and seemed to fit logically together. On the first topic, there are implications from moving from an SCO to a bitumen based royalty scheme. And in the second topic, the Panel tried somehow to allow companies to enjoy a bitumen based royalty scheme and enjoy a kicker from building an upgrader in Alberta regardless of their profitability. I find it odd that Alberta would want to recapture its lost royalty because of a switch from an SCO based royalty to a bitumen based royalty but would grant an incentive for building upgraders. The two actions seem at odds.
Disclosure: I am long Suncor stock and Canadian Oil Sands Trust Units.
Model Linda T is featured in the photograph, which is hosted at Flickr. If you click on the picture of Linda, you will be taken to where you can view a larger version and see even more pictures of her.
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