Alberta is trying to correct its oil and gas royalty mistake of 2007. Citing market changes occasioned by North American shale gas plays, the provincial government is pruning royalty rates and considering other incentives for conventional oil and gas. While market changes are legitimate reasons to make the changes and deserve close attention, they don't erase the mistake and shouldn't obscure its lessons. Whatever the announced reasons, though, the response is commendable.
Like many governments at the time, Alberta's in 2007 increased royalty rates after watching oil and gas prices climb. The only consolation for producers was that the province might have grabbed for more. A provincial advisory panel had recommended larger royalty hikes, especially on unconventional production from Alberta's rich but costly oil sands. The government at least moderated the recommended increases, announcing in November 2007 that royalty on conventional production would rise to a maximum of 50% at the start of 2009 from 30-35% on oil and 35% on gas.
Bad timing
The timing was disastrous. Oil prices plummeted in the second half of 2008, and gas prices fell to well below energy parity with oil. Recognizing problems, the province tried to redress the damage, offering in March 2009 a royalty credit based on new drilling footage and a royalty cap of 5% for early production from new wells. Still, the Canadian rig count fell by 40% last year after declining in 2008. Most of the slump occurred in Alberta.
Meanwhile, development of shale gas reserves was gathering momentum in the US and British Columbia—a phenomenon on which the Alberta energy ministry understandably chooses to focus in its rationale for new drilling and production incentives. A strategy document by the ministry, citing US shale plays and their potential to lower US reliance on gas from western Canada, says, "Alberta's largest natural gas customer is now a significant competitor for natural gas investment." Furthermore, new and prospective supplies from shales have had "a structural effect on natural gas prices," the document says. "Prices are widely expected to remain in the range of $4-7/Mcf [US] for the foreseeable future, down from previous highs of $10-12/Mcf."
Declaring that "the hard truth is that Alberta has lost competitive ground," the government is responding with royalty cuts and hints about further relief. Starting next year, maximum royalty rates will fall to 40% for conventional oil and 36% for gas. Also, the maximum 5% front-end royalty rate adopted last year, which was to have expired in March 2011, becomes permanent.
Additional relief might come from adjustments to the front-end royalty rate's time and volume parameters "as the need arises." And the government will consider further royalty breaks "in recognition of the unique challenges facing natural gas development." It also will review the "broader fiscal regime, including taxes" and "continue to monitor the fiscal regimes of competing North American jurisdiction to ensure Alberta remains an attractive place to invest and do business."
Two messages
One of two clear messages emanating beyond Alberta from these changes relates to problems governments create when they overreact to elevated prices of oil and gas. The concept is simple: Raising the state share of the fruits of investment erodes the incentive to invest. Only slightly more complicated is the peril of basing permanent tax changes on transitory price levels. Oil prices high enough to coax governments into rewriting contracts never last.
The other important message is the burgeoning influence of shale gas, production of which remains in very early stages. The high promise of North American shale gas already is redrawing LNG trade maps, straining links to oil price indexes in LNG contracts, and delaying projects sensitive to competition from LNG, such as development of Shtokman gas and condensate field in the Barents Sea. Now shale potential has forced the government of a province vitally important to global energy supply to correct an error that proved very costly.
Harsh experience taught Alberta a lesson. Other governments should learn from the provincial government's responsiveness and understanding of what resource development means to prosperity.
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