So what if they threw a royalty party and no one came?

 

A little Alberta-centric this week as we had just a wee bit of big news last week with the release of the new Alberta Royalty Framework. The second bit of big news was the relatively muted reaction. Maybe it’s that market participants are shell-shocked, or maybe it’s that people have had bad news for so long that it’s difficult, all things considered, to know how to react to what is relatively speaking, a good news story.

 

For those not familiar with this whole process, the new provincial NDP government (I suppose they’re really not that new anymore), as part of their mandate had promised to review the royalties paid by energy producers in the province to ensure that the citizenry (i.e. the government) was receiving their so-called “fair-share”.

 

Of course, “fair share” means different things to different people. For example, a more progressive, big government person might read that and say “absolutely they aren’t paying their fair share, those greedy energy company fat cats need to pay more”, while someone in industry or in the right-leaning, market oriented chattering class will interpret “fair share” as industry targeting micro-aggression and a licence to shakedown the energy companies and chase investment out of the province. The answer of course is seldom that simple.

 

A little bit of history and context is always useful. While royalty rates are constantly being looked at and tinkered with as the makeup of the oilpatch has evolved, major undertakings such as this are rare. The last review was done in 2006-2007 by the provincial PC government at a time when oil prices were high, as were natural gas prices and the province was growing and dealing with a massive infrastructure deficit. The thinking at the time was, everyone is flush and will continue to be flush, rates need to reflect that.

 

The 2007 review resulted in generally higher royalty rates across the board, making Alberta uncompetitive compared to its immediate neighbours (BC and Saskatchewan), chasing investment out of the province and generally causing chaos all at a time when the wheels were starting to come off both the commodity and the credit cycle.

 

That this (in hind-sight) ill-advised hike in royalties occurred as the commodity cycle was peaking (especially in the natural gas market where developments in shale collapsed that revenue stream) and the global financial system was teetering on the brink made the walking back of many of the changes over the next several years a foregone conclusion.

 

It also set the bar for this review pretty low, particularly given the current market challenges.

 

At any rate, here we are. The provincial NDP with a mandate to review rates and get Albertans their fair share. A panel of experts convened by the Province. An industry on edge. Opinion makers making opinions.

 

Three months of hard-core consultation and data-crunching, endless submissions (even one from me!). More opinion makers making opinions.

 

Then finally, a month late, the report is released and… and… and…

 

What?

 

Royalty rates for existing wells and for wells drilled up to 2017 are unchanged. Oil sands royalty rates unchanged.

 

What!?!?!

 

So, were we getting our fair share all along? The PC’s sure think so and wasted no time in pointing that out, disingenuously glossing over the fact that before they got it “right” they first had to get it spectacularly wrong. The Wildrose was grudgingly accepting. The Liberal party questioned where the concern for the environment was (didn’t see that coming) and the Alberta Party thought it was OK.

 

But is this it? No change? Not really. There are key takeaways and there are changes coming.

 

Because there will be wells drilled after January 1, 2017 and they will pay royalties on a different platform. And existing wells are grandfathered only for 10 years (a lifetime in royalty tinkering).

 

New wells drilled post 2017 will be charged royalties on a fixed percentage basis until certain prescribed capital costs are recovered then revert to a presumably higher rate (aha!). But this higher rate is going to be based on a gross margin or profit as opposed to gross revenues (this is new). And there will be royalty incentives for efficiency (also new). Plus, it will be commodity agnostic (new again), as opposed to having some vastly complicated structure that takes into account whether it’s oil or gas, the production level and the current commodity price.

 

Simpler. Based on revenue less expenses. Kind of like a tax, more like economic rent – which is what a royalty is supposed to be – I am hiring you to develop this resource for me and this is what you have to pay me based on your costs, acknowledging a shared risk, as opposed to this is what the commodity price is, pay me, I don’t care if you aren’t making money and lose your shirt doing it.

 

So what message are we supposed to take out of this review?

1. Alberta is a high cost basin. The royalty framework needs to reflect that in order to attract investment. No one is going to drill here unless they can get a return on their investment. The structure appears to meet that requirement by incorporating costs. In addition, by making royalties product agnostic, many of the weird disincentives in the previous structure are eliminated.
2. Industry participants need some form of certainty. They got that in some measure with the grandfathering of existing projects. The time to deliver the post 2017 structure is tight, but the panel appears to have ideas on this and it should ultimately be more straightforward.
3. Alberta is in a dog-fight with other jurisdictions to develop and supply oil and gas. The royalty review found Alberta to be in the middle of the pack royalty cost-wise with respect to its peer group even after incorporating the new carbon tax. Given the size and diversity of the resource base, that was deemed sufficient to attract investment. Let’s face it, Alberta is not a one-trick pony energy wise. Between conventional and unconventional oil and gas, liquids rich plays, heavy oil and the oil sands and a robust petrochemical sector, there are few jurisdictions that resemble Alberta. If we are competitive, the investment will come, but we don’t have to give it away.
4. Market access poses a challenge but presents opportunity. Yes we have challenges shipping product to far flung market and we really have a single buyer that results in heavy discounting (who on the other hand, has reconfigured much of its refining to accept our output), but by the same token, we have a resource base that can be exploited to develop value-added production right here at home, complementing such world-class facilities such as the Joffre Petrochemical plant. In fact, just days after the announcement, the government announced a new royalty-based incentive program to attract more such development to the province and while the predictable parties pounced all over it, it actually isn’t such a bad idea.
5. A more transparent system of royalties will lead to increased confidence in the system and less need to fiddle with it down the road.
6. A royalty regime that shares in the value created by the resource will be more successful than one that simply tries to exploit higher prices.

 

So what about the NDP? How did they do in this review? Can we grade them? Why not!

 

I assign the grade both by the amount of hue and cry accompanying the release as well as by the content.

 

I can’t give them an A, because there are still holes in the review and cost data to follow up with and I can’t fail them because they obviously didn’t fail. So here is the view from the top down.

 

They scared the bejeezus out of the industry by first winning the election and then starting the review as the market was imploding, raising taxes, implementing new carbon pricing and generally not being PCs.

 

But they corralled the right experts to conduct the review, got out of the way and let them do their work.

 

Once the report was done, they reviewed it, looked at the context of the current market, listened to and accepted the recommendations of the expert panel they engaged to tell them what to do.

 

Some people on the fringes of industry hated it. Some people on the left are horrified that rates aren’t rising. People are calling the NDP hypocrites for not raising rates. Mostly though, the hue and cry was minimal. The NDP threw a royalty party and everyone thought it was OK.

 

My take? They got it mostly right, for the market, for the province, for now.

 

So a solid B. Fill in the holes and I might even consider revising that grade.

 

Prices as at February 5, 2016 (January 29, 2016)

• The price of oil ended the week down
  • Storage was up, finished product inventories remain high as refinery turnaround season is in force
  • Production was down marginally
  • Markets have been selling the storage story for most of the month, U.S. dollar weakness prompted a mid-week rally but prices ultimately gave way
  • The rig count decreased significantly
• Natural gas gained slightly during the week, as cold weather continued but ultimately couldn’t sustain the rally.

• WTI Crude: $30.83 ($33.58)
• Nymex Gas: $2.068 ($2.311)
• US/Canadian Dollar: $0.7202 ($ 0.7135)

 

Highlights

• As at January 29, 2016, US crude oil supplies were at 502.7 million barrels, an increase of 7.8 million barrels from the previous week and 89.6 million barrels ahead of last year. Imports spiked up again during the week.
  • The number of days oil supply in storage was 31.5, ahead of last year’s 26.8.
  • Production was down marginally to 9.214 million barrels per day. Production last year at the same time was 9,192 million barrels per day. Making the call here – production growth year over year will be negative next week. The marginal decrease in production this week came from the Lower 48.
• As at January 29, 2016, US natural gas in storage was 2,934 billion cubic feet (Bcf), which is 17.9% above the 5-year average and about 20% higher than last year’s level, following an implied net withdrawal of 152 Bcf during the report week.
  • Overall U.S. natural gas consumption decreased by 14.3% for the period led by residential consumption.
• Oil rig count at February 5 was down to 467 from 498 the week prior.
  • Rig count at January 1, 2015 was 1,482
• Natural gas rigs drilling in the United States were down to 104 from 121.
  • Rig count at January 1, 2015 was 328
• The massive decline in U.S. rig counts appears to be a somewhat overlooked story at present and is a sign of capitulation to prices which have failed to move decisively with rig count. It remains to be seen what happens when the count starts to rise.
• As of February 1, the Canadian rig count was at 209 (28% utilization), 133 Alberta (26%), 33 BC (40%), 38 Saskatchewan (29%), 5 Manitoba (30%)). Utilization for the same period last year was about 48%.
• US split of Oil vs Gas rigs is 82%/18%, in Canada the split is 54%/46%

 

Drillbits

• More companies are starting to report their Q4 and full year 2015 numbers and… it’s not pretty
  • Suncor posted a Q4 loss of $2.0 billion compared to Q4 last year’s profit of $84 million. Operating income (excluding unusual and non-cash items Q4 loss was $26 million versius a profit of $386 million in Q4-14.
  • Shell Q4 earnings fell from $3.26 billion last year to $1.83 billion, a 44% decline. In addition, Shell postponed its Final Investment Decision (FID) on its BC LNG plant until the end of the year.
  • ConocoPhillips posted a Q4 loss of $3.5 billion (adjusted $1.1 billion loss) compared with last year Q4 loss of $39 million (adjusted profit of $0.7 billion).
  • ExxonMobil reported Q4 net income of $2.78 billion compared to $6.57 billion last year.
  • Imperial Oil (the Canadian sub of Exxon) reported Q4 net income of C$102 million compared with C$671 million last year. The upstream division posted a loss of C$289 million
  • BP reported net earnings of $196 million in Q4, down from $2.2 billion in the same quarter last year. These results exclude the impact of non-cash items including ongoing charges associated with the Deepwater Horizon disaster in 2010
  • Oilfield services company Weatherford announced it was going to cut another 6000 jobs in 2016
• The National Energy Board has asked TransCanada to reformat its application for the Energy East Pipeline project as with all the changes that have been made the existing application was deemed too complicated
• Justin Trudeau came to visit Alberta to see for himself the inside of crappy boardrooms in government-owned buildings and meet with provincial government and industry bigwigs. My invitation only arrived today, so I was unable to attend
• Barack Obama proposed a $10/bbl tax on oil produced in the United States as part of his budget deliberations, a measure that has as much chance of happening as the Northern Gateway pipeline. Although, if it did happen, Canada would sure be competitive!
• Drumpf Watch – Donald Drumpf came in a disappointing second in the Iowa caucuses, losing to a Canadian (Ted Cruz) and barely holding off an upstart, career politician in Marco Rubio. In Drumpf parlance, he didn’t win, so he’s a loser. Of course he didn’t see it that way, claiming fraud and manipulation by Cruz. God forbid that when finally presented with having to make an actual choice, people found him somewhat wanting. At any rate, off to New Hampshire – Live Free or Die!