The Panel in their document Alberta Review Panel Final Report (PDF, 2.25mb) proposed regime that is complex. More specifically, Panel recommended the following:
- During the prepayout period, the royalty is 1% of gross revenue.
- During the postpayout period, the royalty has two parts. First, the 1% of gross revenue from prepayout still applies. And second, the 1% gross revenue royalty is treated as a cost before an additional 33% net revenue royalty is applied. The net revenue is the gross revenue less 1% gross revenue royalty less operating costs and capital expenditures.
- Rather than attempt to summarize this last portion of the royalty, I will simply quote from page 13 of the report:
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.
I will review the three components above. First, the prepayout of 1% gross revenue is the same as the existing regime. As a matter of principle, I dislike gross revenue royalties because they are not tied to profitability. I would rather have no gross revenue royalty with a higher net revenue royalty percentage in the postpayout phase. Most people, however, feel that a developer should pay something during the prepayout phase and 1% of gross revenue is an amount that is palatable to both the developer and the province. In summary, the 1% gross revenue royalty during prepayout is the same as the existing regime and most accept a low royalty during the prepayout phase.
As an aside, I discussed in prior articles that prepayout and postpayout are not singular one time events. If a developer loses money in a given year, the project goes back into prepayout until it climbs back out of the hole and earns the long term bond rate again. Why would a developer lose money in a given year? Low commodity prices, expansion projects, debottleneck projects, efficiency projects, extreme plant upsets, and labor disruptions are some of the potential reasons why a project might reenter the prepayout phase again. To add further clarification, an expansion project creates additional production capacity. A debottleneck project also increases production capacity by removing one or more of the project's constraints, such as insufficient upgrader capacity. An efficiency project reduces the cost of the production. Perhaps by adding more pots and pans the project can reduce its natural gas requirements and lower its operating costs. In effect, the royalty terms allow—more accurately, encourage—developers to look for opportunities to increase the value of the project to both the developer and the governments.
Moving along to the second bullet point, the postpayout phase has two components: the gross royalty of 1% and net revenue royalty of 33%. Again, I am not a big fan of gross revenue royalties. I am even less of a fan of combining these two measures together. I think it adds unnecessary complications. How much is the total royalty? The answer is, I do not know. I would have to get a pencil and paper and figure it out. I would prefer that the royalty were simply 34% or 35% of net revenue during the postpayout phase. Eliminate the gross revenue number and slightly increase the net revenue percentage value. Now, it is easy to understand. If you need to explain to someone what the royalty percentage is, then you can simply reply that the value is 34% of the net revenue which is the gross revenue less all costs. The Panel made this section needlessly complex with a dose of poor policy thrown in for good measure.
In an earlier article, I warned about having royalties above 25% without having the federal government at the negotiating table. You might need to reread my earlier article as a refresher.
The OSST is a whopper. I have discussed the bitumen versus synthetic crude oil royalty in a prior article. In this article, I will focus more on the numbers.
The OSST is a sliding scale royalty that is sensitive to oil prices. As oil prices move above C$40 per barrel for West Texas Intermediate (WTI) benchmark, a 1% an additional gross revenue royalty kicks in. It increases at 0.1% for every Canadian dollar increase in the price of WTI. At C$120 per barrel, the gross revenue royalty tops out at 9%, meaning that 9% is the highest percentage. Interestingly, this royalty is not eligible for payout calculations or as deductions for provincial and federal taxes.
This last royalty measure is intended to be an enhancement to the government for reasonably high oil prices. As the price climbs higher, the enhancement grows. That is the reason why it is not part of the payout calculations. The lack of deductibility for corporate taxation requires more explanation.
While I am not positive why the Panel chose to make the OSST ineligible as a deduction against corporate taxes, I can make a good guess. As the overall combined royalty and taxation levels increase, there is an incentive to gold plate. To demonstrate the incentive to gold plate, I am going to create an absurd example.
Stepping away from the oil sands industry for a moment, assume that a company operates in Alberta with combined provincial and federal tax rate of 30%. That implies that when the company spends money, it receives a shelter equal to 30% of the expense. Suppose a manager wanted to take his ten person team to Banff for a week of team building. After checking costs, the manager learned that he would have to pay approximately $1,000 per day per employee. So five days, ten employees cost his company $50,000. That $50,000 is an expense, so the real cost to the company is $35,000 (=70% times 50K).
Assume that the same manager with the same company and location had a combined provincial and federal tax rate of 90%. The real cost of that prior $50,000 expense is only $5,000 (=10% times 50K). So for $5K, he can take his entire team to Banff for the week. Because the cost is so low, why stop at Banff? Perhaps Macau is a more interesting and exotic location. The average cost per day, including airfare and hotel, is $5,000 per day per employee. The total costs is $250,000, but the real cost to the company is only a paltry $25,000 (=10% times 250K). Just imagine after five fun filled days of gambling and entertainment, his team will have sharpened its business acumen and will be refreshed to enjoy the new challenges at work.
The point of this absurd example is that, with higher taxes (or government take), developers can spend lavishly almost without consequence. There is no need to operate efficiently. There can be exorbitant travel and training expenses. Employees get the newest and best computers every six months, with new PDAs every three. To help ease the staff shortage while the team is away on various team building and training sessions, the developer can hire additional staff, because the real cost is only ten cents on the dollar.
I am assuming that the Panel chose to make the OSST exempt from royalty payout calculations as well as provincial and federal tax to prevent the gold plating and foolish spending. The OSST is an after-tax, direct hit to the bottom line.
What is wrong with this measure? First, the tax is paid even during the prepayout phase. A developer might be unfortunate in its timing. After construction is complete, oil prices are high (normally a very good thing) and the project is paying high royalties with no offset to delay postpayout or tax relief. Furthermore, once a project is up and running smoothly and prices spike up, the OSST might discourage developers from undertaking expansion, debottlenecking or efficiency projects. Because the OSST is soaking up a substantial portion of the cash flow, developers are unable to create large nest eggs to undertake these projects.
Without having run the numbers for various hypothetical situations, it is difficult for me to provide much more insight. My initial reaction is that the OSST appears very punitive. It is also unbalanced in that if times are extraordinarily good, the government take is extraordinarily high. If times are poor, too bad, soo sad.
To provide more meaningful insight, we would need to examine a typical greenfield project under various scenarios. And then we would need to examine the same project with secondary projects such as expansion, debottleneck, and efficiency. Then we could evaluate the harshness of the OSST.
There are some other royalty provisions, such as a 5% royalty credit for upgraders and such. I either have discussed these provisions in prior articles or have chosen to ignore them for our discussions.
In summary, the new regime is more complex and likely much harsher. The 1% prepayout is the same as before. The postpayout of 1% gross revenue royalty and 33% net revenue royalty is significantly higher than the existing 25% net revenue royalty is. Moreover, there might be severe issues with the federal government with a royalty rate in excess of 25%, because a higher royalty rate eats into its share of the economic pie. The federal government might be forced to cap the allowed royalty percentage to maintain its share of the pie. The OSST is complex in that it is a sliding scale starting at 1% at $40 WTI and ending at 9% at $120 WTI. This royalty is not eligible for postpayout calculations or as deductions for provincial and federal corporate taxes. Without having performed numerical analyses, the OSST appears punitive.
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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