Alberta Royalty Review Part Two: Royalty Introduction

Before I begin commenting directly on the Alberta Review Panel Final Report (PDF, 2.25mb), I will outline in high level terms the National Oil Sands Task Force (NOSTF) Alberta Oil Sands Royalty. Ultimately, we need to consider how the oil sands royalty and taxation work together. For this article, however, I will focus on the oil sands royalty and in the next article I will focus on the taxation.

I should point out that there have been tweaks made regarding ringfencing and other provisions. I am not going to address the minutia. Rather, I will focus on the higher level topics that allow us to understand the Alberta Royalty Review.

I provided a table below with line numbers and item descriptions. Each line will be described in more depth shortly. Please note, the official terminology used by the Alberta government might differ from my presentation below. I am using the basic terminology that I used when I created the economic models for the NOSTF.

That table does not look too difficult to understand, does it? Let us look at each row and see what we learn.

Line 1: Gross Revenue. Gross revenue is the quantity multiplied by price. The quantity is either synthetic crude oil (SCO) or bitumen and the price is the price of the commodity. In the future, I will discuss the SCO versus bitumen. At present, I believe all integrated developers—that is, mining plus upgraders—use SCO pricing and mine developers use bitumen pricing. The mine producers do not produce SCO, so bitumen pricing is obvious. I will comment in the future on bitumen pricing too.

Line 2: Less. This line simply sets up the deductions.

Line 3: Operating Costs (Opex) Deductions. In a future article coming shortly, I will discuss operating costs and capital expenditures. For those unfamiliar with this terminology, operating costs are those costs for items that are used or consumed in a short period of time. Three large categories of operating costs are labor; energy; and supplies, such as huge tires for trucks, catalyst for the upgraders, and other consumables.

Line 4: Capital Costs (Capex) Deductions. Capital deductions are those expenditures generally associated with infrastructure. The costs of building the mine, extraction, utility, and upgrader facilities are all capital.

Line 5: Net Revenue Before Adjustments. This line is simply gross revenue (money in) less all costs (money out). During the initial construction phase, this number is negative. During subsequent construction phases, this number may or may not be positive, depending on how large the subsequent construction phase is relative to on-going operations and the current price environment. During normal, steady state operations, Line 5 should be positive, unless the pricing environment is extremely adverse.

Line 6: Less: Loss Carryforwards, if any. First we need to understand loss carryforwards. If Line 5 above is negative, it creates or is added to loss carryforwards. The loss carryforwards is carried forward to the following year and increased by the long term bond rate, which is about 6%. In effect, this loss carryforwards represents how much the developer is recently out of pocket. Why is it recently? During the initial construction phase, the developer creates a large loss carryforward as it builds its plants. After several years of normal operation, the loss carryforward is depleted. The developer then might earn several years of good profits. Then, if the pricing environment is extremely adverse for a year, the developer once again creates a loss carryforwards. Or perhaps the developer spends capital to expand its production or reduce its cost structure. Those too will often create a new loss carryforwards. They key point is that loss carry forwards is not a cumulative number for a one time event. Rather, it allows the developer to recuperate losses. When a developer has loss carryforwards, it is said to be in pre-payout mode. When the developer has depleted its loss carryforwards, it is commonly said to be in post-payout. What does the long term bond rate have to do with all this? The long term bond rate is an inflator. It partially compensates companies for their costs, both opex and capex. The long term bond rate is a proxy for debt costs but developers use both equity and debt for the development of their projects, so the long term bond rate is a partial compensation for their costs.

To summarize quickly the preceding paragraph: losses create loss carryforwards. Loss carryforwards can be created multiple times throughout the life of the project. Pre- and post-payout modes refer to whether or not the developer has loss carryforwards. And losses are carried forward at the long term bond rate.

Line 7: Net Revenue Before Royalty. Net revenue before adjustments less carryforwards is the net revenue before royalty. Similar to Line 5, during initial construction this line is negative. During normal, steady state, post-payout operation, this line is positive.

Line 8: Greater of 1% Gross Revenue OR 25% Net Revenue Royalty. This line compares the 1% gross revenue (Line 1) royalty against the 25% net revenue royalty (Line 7) and uses the larger of the two values. In effect, prior to payout, a developer pays 1% gross revenue and post-payout pays 25% net revenue royalty. The minimum value for Line 8 is zero. During the construction phase, gross revenue is zero and net revenue is negative. Thus, the larger of the two values is zero.

Line 9: Equals Net Revenue. This line represents the cash that a developer has after paying royalties.

Some key points to consider:

• 1% gross royalty is a small value; oil prices themselves often fluctuate at or more than 1% within a typical day;
• The developer is allowed to earn the long term bond rate, roughly the cost of long term debt, until paying meaningful 25% net revenue royalty;
  • The ability to earn the long term bond rate before paying substantive royalties greatly reduces a developer's risk;
• If the price environment is poor when the developer begins production, it might remain in pre-payout mode for an extended period of time;
• If the price environment is rich when the developer begins production, it will progress quickly to post-payout mode; and
• Because of the pre- and post-payout modes, a developer has an incentive to spend capital to expand its production or reduce its cost profile.

The oil sands royalty is straightforward. There are just two tiers of royalties, one for pre- and other for post-payout. The intent behind having the two tiers is to allow the developer to earn a return on its investment before paying substantive royalties. Oil sands projects are huge costly undertakings. To reduce a developer's risk, the NOSTF proposed having two tiers.

There are more subtleties that I have shown here. This information, however, serves as a good background for the rest of my commentary and the Alberta Review Panel Final Report. My next article will discuss taxation. The two items need to be considered in conjunction, because together royalty and taxation form the governments' take or their portion of the economic pie. The developer receives the remainder.

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.