I am critical of the Alberta Review Panel Final Report (PDF, 2.25mb). Over the prior articles, I have outlined shortcomings with the report. In this article, I will outline how I would have approached the same challenge of responding to their terms of reference. Below is a quote from page 101 of the Report.
Royalty Review Terms of Reference
An independent Panel of experts will review all aspects of the oil and gas royalty system, including conventional and oil sands. The Panel will also examine the tax regime faced by the resource companies, including income tax and freehold mineral rights levied on freehold mineral rights holders.
If, for a moment, we accept that the National Oil Sands Task Force (NOSTF) in the mid 1990s was correct in splitting the economic value pie into three approximately equal parts for the developer, province, and federal government, then how do we respond given that a) the federal rate was 29.12% then and is 21% now and falling to 18% by 2011 and b) provincial tax rate was 15.5% then and 10% now. In other words, the federal and provincial tax rates were about 50% higher then than they are now or soon will be. Surely, that has resulted in a transfer of the value from economic value pie away from citizens and toward developers. Without much further analysis, we citizens can conclude that our governments have not been safeguarding our interests by maintaining an equitable share of the economic value pie.
As a side note, throughout my discussion in this article, I am deliberately referencing economic value. I find undiscounted cash flow values present specious arguments and are not worthy of serious discussion.
What other key changes have happened since the NOSTF's work back in the 1990? Just thinking quickly, I would rattle off some differences:
- Oil prices have departed from their long run historical US$20 real per barrel pricing and have risen substantially;
- Oil rich provinces such as Venezuela and Russia are no longer welcoming foreign investment on easy terms;
- Brazil, Russia, India, and China (BRIC) are all racing toward becoming modern industrialized countries, soaking up vast quantities of all commodities, including oil and gas;
- According to Alan Greenspan, the United States is involved in a war in Iraq largely centered on oil issues;
- Geopolitical tensions have increased with terrorists waging war against democracies and western civilized world;
- Construction and material costs have risen around the world; and
- Conservation, greenhouse gases, and alternative fuels have become household words as people seek to lessen their environmental footprint and reduce their energy costs.
A lot has changed in only a decade. And, I am sure that I have not captured all the major changes. However, let us look at what I have mentioned and how it might influence our thinking.
Oil prices have increased. There might be the potential for windfall profits. How do we want to address huge profits that are earned by the industry through good fortune? When some of the oil sands companies purchased their leases, they did not foresee these generous prices, not even in their wildest dreams. They purchased the leases at then fair value then, but at bargain basement prices today. Do we want to moderate these windfall profits?
The Panel by recommending an Oil Sands Severance Tax has attempted to moderate windfall profits. While I understand why people might want to capture windfall profits, I remain unconvinced that windfall taxes are good public policy. I remain open, however, to the argument.
Oil rich provinces are not as accessible as they once were. If developers do not like Alberta, they can no longer readily leave and go to Venezuela, Russia or some other countries that are much more protective of their natural resources. Given that Alberta remains a friendly place with good government, adequate infrastructure, and the rule of law, developers should place a premium on working in Alberta compared to many other locations. This is especially true given the size the resource and the lack of geological risk.
BRIC countries and others are racing toward a modern society. As Jim Rogers has argued for a long while, commodities are likely to enjoy a bull run for several more years. Commodities were once considered irrelevant, because you could always easily and readily secure them. That is no longer true. Commodities have become scarcer and countries are hoarding their resources for themselves.
Wars and terrorism and oil. That almost says it all. Oil is no longer a cheap commodity in bountiful supply. There is a race to secure vast quantities of oil as oil becomes increasingly more difficult to find and produce. Much of the oil rich regions are located in more interesting places of the world from a risk point of view. Again, that bodes well for Alberta.
Costs have gone up dramatically. Perhaps surprisingly, this is a non factor for the NOSTF, because its recommendations were focused on economic profits. If a developer feared it would not be profitable, then its correct course of action was to not build. Period. If a developer believed that it would be profitable given the economic landscape, then the economic spoils (economic value pie) were split approximately equally among the developer, province and federal government.
Conservation, greenhouse gases, and alternative fuels all speak to the notion that we have to use fossil fuels wisely because they are scarce and because they do pollute.
Nothing has happened during the prior decade that motivates me to want to reduce the government take. Two larger questions are as follows: Should the government take be increased from the NOSTF's recommendations, and if so, by how much? These questions deserve public consideration and comment.
In addition to reviewing the current events, I would encourage others to compare and contrast alternative regimes in different jurisdictions, with a note of caution. Comparing different regimes is fraught with difficulty. Often, politics enter into the picture. The Gulf of Mexico has very generous terms because the United States wants to encourage exploration and production. Middle East countries have very harsh terms because of the geological risk is comparatively low and because those countries depend heavily upon oil and gas revenues to sustain their economies. Some countries have generous terms, but transportation costs are prohibitive. The key point is that if you torture the data long and hard enough, it will confess to anything.
So while I think it is important to look internationally for comparisons, I think it is equally or more important to look at the risk reward ratio for engaging in oil sands activity. Do developers earn modest, fair, or generous returns given all the risks? And, what defines modest, fair, and generous returns?
So, what have we accomplished thus far? We know that the provincial and federal tax rates were about 50% higher during the 1990s than they are today. (Equally true, I could write that taxes have fallen by about one third from 1990s level to today's level, but that does not sound nearly as dramatic.) So that alone motivates us to want to recalibrate the overall fiscal regime to bring the stakeholders' proportions back into balance. We have also acknowledged that major changes have occurred during the past decade, none of which to my mind would influence me to want to reduce the government take. We should, however, engage all interested parties—including the public and developers—to a vigorous debate as to what is a fair and reasonable government take. And we should probe whether that take should remain constant over a wide range of oil prices or whether the take should reflect oil prices.
Next, I would construct a sample of projects to evaluate. These projects would demonstrate how much the developer, province, and federal government received. The projects I would examine would be as follows:
- Greenfield mining project with and without an upgrader;
- Greenfield in-situ project with and without an upgrader;
- An upgrader;
- Expansion project (increase production by greater than 25%)
- Efficiency project (production remains unchanged, but costs decrease); and,
- Debottlenecking project (a variant of the prior two).
An initial step once these sample projects or scenarios were created would be to run each of these projects under two fiscal regimes with two parameters. Use the royalty and taxation regime that existed in the mid 1990s with the rates that existed in the mid 1990s. Next, do the same exercise, except with today's regime (there have been tweaks during the past decade) and today's rates. This exercise would clearly show how the values shares have shifted.
Then to arrive at a new fiscal regime to rebalance the proportional shares, various fiscal levers would be used to examine the percentage value shares (not the sum of undiscounted cash flows) to the developer, province, and federal government. If, by raising the provincial royalty, the federal portion decreased, then we know that is a likely nonstarter. I discussed this topic at length in a prior article.
Experiment and debate the relative shares to the different stakeholders until a satisfactory regime is reached. As part of that experimentation and debate, use the most efficient fiscal means possible. Recall that different stakeholders have different costs of capital. That allows some economic levers to be more efficient than others.
In summary, if I had been charged with the same assignment, I would have a) shown that the current sharing of economic value has shifted toward the developer and away from governments as the tax rates have decreased during the past decade; b) reviewed current events to set the stage for a dialog to determine the appropriate sharing going forward; c) reviewed risk and return profiles so that everyone has a common understanding of the risks taken by the oil sands industry with the expected net present value shares; d) use different fiscal levers to arrive a new regime that satisfies the agreed upon splits in the economic value pie value; and e) communicate to the public in a transparent manner throughout the entire process.
This is undoubtedly a difficult process to arrive at a fair and equitable fiscal regime. At the end of the process, not all parties will be satisfied. The key is to make the process as transparent and accessible to the public as possible. Given the increasing value of oil sands along with its environmental impacts, the public has right to have a full and open hearing. Creating a new fiscal regime is an extremely complicated process because of the need to consider the vast array of public policy issues and because of the importance to the economies of Alberta and Canada.
Calgary model Judith Aldama is featured in the photograph, which is hosted at Flickr. If you click on the picture of Judith, you will be taken to where you can view a larger version and see even more pictures of her.
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