To set the stage, I quoted below from pages 14 and 13, respectively, of the Alberta Review Panel Final Report (PDF, 2.25mb):
Bitumen Pricing – As noted earlier, there are no well functioning markets for bitumen and the interests of Alberta bitumen producers are not all the same with respect to the price received for their product: production-only developers prefer high bitumen prices, while lower bitumen prices (relative to those for SCO) are in the best interests of integrated producers. "Let the market decide" appears unlikely to resolve this issue in the best interests of Albertans.
For hard-to-price commodities like bitumen, formula-based approaches based on published prices for correlated surrogate commodities are common throughout the world as price setting mechanisms. The Panel believes the Government's best option rests with such an approach to pricing bitumen.
A permanent, generic "bitumen valuation methodology" (BVM) applicable to all calculations requiring such a value, used by all participants in the exploitation of Alberta's bitumen resources where a bitumen price needs to be calculated, should be put in place by 30 June 2008. It would replace all current or intended uses of temporary BVMs and alternatives to the permanent BVM would not be allowed.
In very strong terms, the Panel recommends that a truly independent, unconflicted, world-renowned and highly experienced advisor be hired to consult widely, consider relevant international practices and then develop a permanent BVM. Consultation for this purpose, as a point of clarification, would not entail or imply negotiation nor is it intended to introduce any sense of 'veto' power or 'consent' requirement on the oil sands industry. As described above, there are simply too many competing interests, too little time left before a BVM is required, and resolving the issue is too fundamental to Alberta's economy (certainly in the sense of the Treasury of the Province) to continue to leave this issue in limbo or to put the province at risk of hitting an impasse with industry.
The Panel recommends, without limitation but by way of example, that the valuation methodology obtained from this process be applied to all bitumen produced in the province for purposes of determining Payout and for calculating base royalties, and OSST payments. Once a permanent BVM is in effect, the bitumen floor device described above for determining OSST can be lifted, in favor of the new methodology.
From page 13, the Panel states the following:
Oil Sands Severance Tax (OSST) – The Panel recommends strongly that a severance tax, applicable to all oil sands projects, be introduced.
The Panel views the OSST, applying to all Alberta bitumen production, as an absolutely essential component of a "fair" royalty system for Albertans. The Panel recommends:
- That, for each project, an OSST be levied against gross revenues from bitumen production, with a floor applied to the bitumen price equal to 40% of the price of West Texas Intermediate ("WTI") in Canadian dollars. This floor price should remain in effect until a permanent "generic" bitumen methodology is in place, as discussed below;
- That rentals, base royalty payments, and net revenue royalty payments be deductible from the base against which OSST is applied;
- That the OSST rate be linked to the price of WTI in Canadian dollars, as follows:
- Zero for WTI prices of less than $40/barrel;
- 1% at $40/barrel, and growing by 0.1% for each $1/barrel increase in the price of WTI;
- Reaches a maximum of 9% at $120/barrel, and stays at this rate thereafter;
- That OSST payments not be considered eligible expenditures for purposes of calculating Payout, revenues for royalty purposes, and income for corporate tax purposes.
At present, bitumen pricing is an opaque process. A buyer and seller come to terms for a quantity of bitumen with a specified quality to be delivered over a specified period. Those terms are confidential between the parties. The Panel wants to make bitumen pricing more transparent—in effect, make bitumen a fungible commodity.
The problem is that every project produces unique bitumen. Syncrude's bitumen is different from Suncor's which again is different from Shell's and so on. Each project's bitumen will be priced differently and is worth a different value to different upgraders. Some bitumen will contain more fines (sand and clay particles) than others, some will have more sulfur content than others, and so on. The upgraders receiving the bitumen will be configured to accept the known qualities of their purchased bitumen and thus will price it appropriately. In summary, there is tremendous challenge in trying to develop a transparent marketplace.
With that as a background, I will comment on the Panel's statements. I will begin by addressing a permanent, generic BVM. I have seen one version of a BVM by the Alberta Department of Energy. It was a complex multiple regression analysis equation. In short, it made no sense. Regression analysis always depends upon the factors thrown into the mix. And what might hold true today, might make absolutely no sense tomorrow. It does not explain cause and effect. Rather than a complex multiple regression analysis equation that practically nobody understands, a BVM should be transparent and understandable.
A transparent and understandable BVM is still overwhelmingly difficult. Earlier I discussed the different qualities of bitumen produced by each project. That is one hurdle. Another hurdle is that how would the fiscal regime manage temporary gluts and surpluses? For example, assume for a moment that Syncrude's upgrader had a huge fire—it has happened before—and that Syncrude's bitumen is now on the marketplace. Spot market bitumen prices in Alberta have just plummeted. Should those independent mines coupled with independent upgraders with long-term contracts be able to reset their bitumen prices for royalty purposes? Do integrated producers suddenly benefit? Should one party (independent mines and upgraders versus integrated producers) be treated differently than the other? Do smaller independent mines without long term contracts benefit? If any of these parties benefits, smart lawyers, accountants, and royalty specialists will create mechanisms that allows all parties to arbitrage from short term aberrations in the marketplace. If no parties benefit, then Alberta will be deeming unrealistic prices. There is no solution that satisfies everyone.
Moreover, I find it odd that Alberta could witness record highs in WTI prices, yet record lows in bitumen prices because of a plant upset. That upset then has the potential to cost not only the direct affected projects, but also cost Alberta less royalties from all projects.
Another solution is simply to set bitumen prices as a percentage of WTI. The challenge is a) to determine an appropriate percentage, and b) to recognize that upgraders do not cost a percentage of WTI prices to process the bitumen but rather a fixed and variable cost. That is, the cost to process bitumen might be $15 for Upgrader Z
regardless of the WTI price. Each upgrader will have a different cost structure. And each upgrader's cost structure will differ over time.
Another challenge with having a bitumen priced regime is that Alberta could find itself in a position whereby upgraders are marginal businesses, yet mines are highly profitable (see an earlier article). Developers would then be faced with the challenge of building an expensive yet marginal return upgrader in order to develop the mine and thus to make the whole project viable. In other words, without an upgrader, there is no project. Thus, with a bitumen based royalty, Alberta might kneecap future projects from building an upgrader simply because upgraders have returned to their normal marginal rates of return.
Under existing rules, a project can elect to use bitumen or synthetic crude oil (SCO) based royalty regime. Then, if upgraders do return to being marginal businesses, projects can elect to throw the whole mix into the royalty ring fence to reduce the overall risk of the project (thus, ensure viability) and to increase the project's return.
I will address the OSST in a separate article. I included the OSST quote in this article because the OSST is integral to the bitumen pricing. As we see from the OSST quote above, the Panel has chosen an arbitrary value of 40% of WTI price for bitumen as a temporary measure. The 40% of WTI price for bitumen is of pivotal importance, yet do we know if this value is appropriate or correct?
Moving on to a different segment, a truly independent, unconflicted, world-renowned and highly experienced advisor would be hired. Where would Alberta find such an esteemed individual? Oh wait, we have one working on the Panel. I wonder if he would be interested? Given some of the glaring problems with this report, I am not sure that a truly independent, unconflicted, world-renowned and highly experienced advisor is the best route to follow.
In summary, there are extreme challenges in developing a transparent bitumen market. Each project produces a unique quality of bitumen, and each upgrader has been configured to optimize its incoming feedstock. Different upgraders will value the same bitumen differently, depending upon their configuration and their other feedstocks. If Alberta resorts to using a multiple regression type analysis for pricing, the price will not be understandable or stable over time. Nobody will have a solid understanding as to how price was arrived at or when the inputs need to be reevaluated. Moreover, bitumen prices are volatile and can be affected by plant upsets. It is conceivable—indeed likely—that Alberta will at some point experience extreme high oil prices and low bitumen prices. The low bitumen prices would result from an extreme plant upset. If Alberta only applies spot pricing to those projects that are using spot prices, smart professionals will create arbitrage mechanisms. If Alberta deems a bitumen price, then Alberta might be providing an artificially inflated price for the industry. Using a bitumen based royalty regime, Alberta might kneecap future projects that require an upgrader when upgraders are earning normal marginal rates of return. As a temporary measure, the Panel recommends that a 40% of WTI price be used for bitumen valuation. Is this value fair and reasonable to all parties? And last, the Panel recommends a truly independent, unconflicted, world-renowned and highly experienced advisor to help solve this mess. Given the quality of the Panel's report, I am dubious that a truly independent, unconflicted, world-renowned and highly experienced advisor will provide the answers needed.
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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