Producers warn of harm from Alberta's royalty proposals

Proposals for increased taxation of oil and gas production in Alberta have come under specific criticism from the producing industry.

By OGJ editors
HOUSTON, Oct. 3 -- Proposals for increased taxation of oil and gas production in Alberta have come under specific criticism from the producing industry.

In an Oct. 2 speech to the Calgary Chamber of Commerce, Canadian Association of Petroleum Producers Pres. Pierre Alvarez challenged "the foundation of the report—the justification given by the panel for raising taxes and royalties and their assessment of the consequences of doing so."

In an Oct. 3 letter to Alberta Premier Ed Stelmach, Ron Brenneman, president and chief executive officer of Petro-Canada, said the report by the Alberta Royalty Review Panel "contains material flaws in its analysis."

And on Oct. 2, Jim Buckee, former chief executive officer of Talisman Energy Inc., Calgary, sent an "open letter" to Stelmach saying the company might cut its capital budget by $500 million/year if the panel's proposals are implemented.

The late-September report, asserting that Albertans failed to receive a "fair share" of benefits from oil and gas production, proposed royalty increases on most conventional oil and gas and an added severance tax on bitumen from oil sands (OGJ, Oct. 1, 2007, p. 25).

Earlier, Encana Corp. said it would cut 2008 capital investment in Alberta by $1 billion if the government enacted the proposals (OGJ Online, Sept. 28, 2007).

Justification, assessment
Alvarez faulted the royalty report for considering government take—the government's share of income from oil and gas production—in Alberta in comparison with other producing regions while ignoring return on investment, discovery size, production per well, and production costs.

He cited a recent Tristone Capital analysis that said, "We have found that a common theme in the panel's work is that the report understates capital and operating costs, which distorts rates of return and overestimates economic rent available to the resource owners and the producers."

For example, Alvarez said, the panel used historic rather than actual costs, which recently have soared. It thus estimated the cost of a typical oil sands project at $4-6 billion, while recent projects have cost $10-11 billion.

The panel similarly underestimated costs of gas projects and failed to account for lease bonus bids, which totaled $3.5 billion in 2005-06 and $2.4 billion in 2006-07.

Alvarez also faulted the panel for suggesting that the government can increase royalties and taxes by 20% without causing great economic harm.

"Of course there is going to be an impact," he said. "When government takes more there is less money to be reinvested in the economy."

Under the proposals, taxes and royalties would increase more for oil sands than for conventional production, which the panel said would stimulate conventional activity.

Alvarez challenged that view, pointing out that a panel assertion that royalty would decline for 82% of Alberta's gas wells would hold true only at prices below break-even levels. The wells represented by the 82% figure account for only 25-30% of the province's total production.

"The most immediate impact and slowdown will be felt in conventional gas," Alvarez said. "This is a sector that has already been rocked by soft prices and escalating costs. The downturn you are seeing in rural Alberta would be accelerated."

Fairness issue
In his letter, Petro-Canada's Brenneman disputed the judgment that Albertans don't receive a "fair share" of revenue gains accompanying oil and gas price increases.

In the past 7 years, he said, royalties on conventional production increased 128%, while industry revenue rose 133%.

Like Alvarez, Brenneman noted that the panel ignored lease bonuses in its calculations of government revenue, considered only royalty rates in its judgments of competitiveness, and used an uncompetitive base price as its reference point for claiming that royalty would decline for 82% of Alberta's gas wells.

He further said introduction of a nondeductible severance tax for oil sands projects "ignores the higher cost and risk of these megaprojects." The tax would have the effect of adding 2-15% to the base royalty rate, depending on the oil price.

"The severance tax would make in situ projects—the recovery method for 80% of Alberta's oil sands resource—simply uneconomic," he said. "Oil prices, which year-to-date have averaged $80/bbl, would need to be more than $100/bbl on a sustained basis for in situ oil sands investments to make sense with the proposed changes."

He recommended that Alberta increase royalty rates only when oil and gas prices exceed current levels; account for "unique aspects of Alberta's mature basin and the resultant returns for investors" in its royalties on conventional production; retain the net-profit structure for oil sands projects; and phase in royalty changes so investors have time to adjust.

Talisman's cuts
Buckee elaborated on the potential effects of the royalty proposals on natural gas, which accounts for "the vast majority of conventional drilling in Alberta."

The domestic gas price, he said, is about $30/boe, which provides little margin with finding and development costs at about $20/boe and operating costs near $10/boe.

Decisions based on the proposed royalty increase would affect future drilling, he noted, adding: "You can't get royalties from wells that are not drilled."

Before the panel published its recommendations, he said, Talisman had decided to cut next year's spending by $500 million "because as much as a third of our drilling program is marginal at current gas prices."

Buckee pointed out that "government take can only be seen in the light of costs and prospectivity." In a mature producing theater like Alberta, costs are high and discoveries are small. At present, moreover, gas prices are low.

"Typically, as basins mature, governments reduce the royalty burden to encourage activity and maintain revenue," he said.

Most of the money the industry makes in Alberta "finds its way back to the people of Alberta by way of capital expenditures, lease payments, taxes, salaries, or operating costs," he said. "To deter investment in the name of increasing government take hurts Albertans."

Buckee also disputed the royalty report's cost assumptions for high-productivity gas wells, which he said are too low.

"At current gas prices, I believe it will be difficult for anyone to grow their natural gas production in Alberta," he said. "If you implement these proposals we will see a significant loss of investment, jobs, taxes, and the loss of world-class technical expertise."

More in General Interest