Musings: Low Prices And Liberal Politics Change Canada's Energy Biz
As a result of the commission’s review, royalties for oil and gas in Alberta will be changed, but the changes will only be for conventional oil and gas wells drilled beginning in 2017. The existing conventional oil and gas well royalty structure will remain in place for ten years. The extension through the end of 2016 of the existing royalty structure has the potential to cause an acceleration in the pace of any industry recovery whenever commodity prices begin recovering as producers rush to lock in the existing royalty rate. That scenario assumes operators develop confidence that any increase in oil and gas prices is likely to be sustained and that the operator has the money to pay for the drilling the wells.
What operators know from the commission report is that the new royalty rate structure to be introduced in 2017 will, if adopted by the government later this spring, reflect a different concept about how royalties should be established. As the report states, "There will be new royalty rates under the [modernized royalty framework]. However, the new rates will be calibrated to match the industry returns and Albertans' share of value that are achieved under the current royalty framework." Establishing this rate structure will adhere to the doctrine of ‘fairness for the residents of Alberta,’ but it will also provide an incentive for operators to become more efficient. The royalty rate for conventional oil and gas wells will be 5% of revenues until the cost of the well has been recovered. This should reward the most efficient drillers.
The commission also concluded that the oil sands royalty structure put in place in 2009 that encouraged significant investments in new facilities will provide sufficient royalty income to the Alberta government without needing to adjust the rates. The oil sands business already contributes the most royalty income to the province, which makes the question of fairness moot. The recommendation to maintain existing royalty rates in the future is certainly welcomed by the oil sands producers as low bitumen prices have significantly squeezed their profitability, and given the current global oil oversupply, this condition is not likely to be remedied soon.
The day after the release of the royalty review, Deron Bilous, minister for economic development and trade for Alberta announced the Petrochemicals Diversification Program. The program provides up to C$500 (US$357) million in royalty credits designed to attract investment in new petrochemical plants in the province. The plan is designed to support construction of two to three new facilities that would use propane or methane, both components of natural gas, as feedstocks to produce products such as plastics, detergents and textiles. As Minister Bilous stated, the plan is designed to help offset the high cost of construction in Alberta. He believes this may attract C$3-C$5 (US$2.2 - US$3.6) billion in investment and create more than 4,000 jobs.
This program is being initiated in response to one of the recommendations of the royalty review commission that the province adopt a strategy of processing its natural gas into higher-value products. This would be consistent with what other oil and gas exporting countries have done, which is to try to upgrade the raw material produced in their countries into higher-value products.
Builders of these new plants will be able to apply to the Alberta government for royalty credits worth up to C$200 (US$143.9) million for a single facility. Royalty credits will be awarded once projects are completed and start processing natural gas feedstocks. Since petrochemical companies do not pay royalties, these credits can be traded or sold to oil and/or natural gas producers who can use them to reduce royalty payments to the Alberta government. We are unclear whether the payment mechanism for the credits could trigger a race to build petrochemical plants and get them into service in order to secure the credits before others. That scenario is somewhat scary as it could lead to over-investment in new petrochemical plants, with those plants at the end of the parade failing to secure any royalty credits. As a result, any plants that fail to gain royalty credits would be destined to operate at a competitive disadvantage to the royalty-advantaged plants because of the difference in the level of investment. Inefficient allocations of capital in building these plants would be expensive for the petrochemical industry at a time when competitive pressures are growing.
Despite potential concerns about the mechanics of the Petrochemical Diversification Program, the general structure of the royalty program review was praised by the oil and gas industry. "The grandfathering of existing projects, the fact that the new rules will only apply to projects starting in 2017 and maintaining the oil sands royalty regime are signals that the government is serious about encouraging investment in Alberta at this difficult time," wrote Tim McMillan, president of the Canadian Association of Petroleum Producers, in a statement. The fact that the NDP is not increasing the government's share of royalties may be tough for the party's supporters to accept, but in light of the decline in oil prices and the impact on the economic and employment health of Alberta, it still represents a good deal. The royalty review commission also suggested that a capital cost index for oil and gas wells should be published annually in addition to information about each of the oil sands projects including their costs and royalties paid.
As the Alberta oil and gas industry breathes a sigh of relief following the release of the royalty review report, the industry is now stressed by the recent announcement of new criteria for evaluating pipeline projects in the country. Two weeks ago, in a joint announcement by Environmental Minister Catherine McKenna and Natural Resources Minister Jim Carr, the government amended the criteria by which major pipeline projects are judged. It will now require these pipeline projects to pass a more stringent environmental review, including a climate test to determine how the pipeline would affect greenhouse gas emissions. This marks a major shift in Canada’s environmental policy after the nearly decade-long Conservative rule under Prime Minister Stephen Harper that emphasized making Canada an ‘energy superpower.’
The touchpoint in this new environmental mandate is TransCanada Inc.’s (TRP-NYSE) Energy East pipeline project. This project is a 2,827-mile pipeline to deliver 1.1 million barrels of oil a day from Alberta and Saskatchewan, through Quebec and onto a deepwater marine terminal in New Brunswick for export to the United States and/or Europe. This pipeline, which was initially conceived as a supplement to the Keystone XL pipeline for exporting western Canadian oil, has now become the prime pipeline export project. TransCanada has hopes the project will be approved in time for construction to commence in 2017. The company says the pipeline’s construction will create 14,000 full-time jobs and generate billions in tax revenue. It is supported by most politicians in Western Canada, but not those in the East.
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