Alberta royalty review insight from a Calgary economist

Alberta's royalty review is now complete. For opponents, it was a risky ideological experiment; for supporters, a huge opportunity.

Whatever one's view, it was clearly a tough job.

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Some want royalties to extract more wealth from industry, while others want to maximize investment and jobs. Some want royalties to encourage refining and upgrading, while others want to maximize the value of our resources.

With so many contradictory interests at the table, the review panel was navigating a minefield.

So how did they do?

Don't fear reviews

With a report exceeding 200 pages, there will be much to digest in the coming weeks and months. Here's a first crack.

Is there is a wholesale upending of our current system? Nope.

Are royalties increasing? Not really.

What changes for the oilsands? Very little.

Should you keep reading? Yes.

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First, some small recommendations. The panel provides a guide for future reviews. This is welcome. Reviewing royalties regularly as markets and technologies change is sensible. Reviews aren't something to fear.

Another recommendation concerns exploring future diversification and so-called "value added" activities. This is more politics than economics, and is postponed to the future.

Let's move on to substantive changes. But first, some background.

A quick primer

Alberta's oil is (mostly) publicly owned. But the government doesn't extract the resource itself. Instead, it partners with industry. Royalties are the way we collect the value of our resources.

But what is a resource's "value"?

In 2014, revenue from Alberta's petroleum industry exceeded $115 billion. But this revenue does not come cheap. There are large costs of operating and constructing facilities. There are also investment risks to consider. Subtracting these costs from revenue results (roughly) in the "resource rent."

It's thatrent that we as owners want.

What will change?

Ideally, we would tax resource rents directly. In oilsands, we come (somewhat) close already, so the panel only recommends improved transparency in how costs are calculated.

For non-oilsands material (crude oils, natural gas, etc.), things are more complex.

There are so many wells, with so much uncertainty, that measuring rent directly is impractical. Instead, we recognize capital costs with a lower royalty rate at the beginning of a well's life. Eventually, a higher royalty rate kicks in.

The trick is to increase the rate only after investors earn back their initial capital costs, plus a reasonable return.

In the current system, the low rate applies for a certain period or number of barrels produced. If oil prices are low, this low-rate period is less valuable, even if initial capital costs are unchanged. That's a problem

The new system proposes to fix this by making the low-rate period a function of dollars earned, rather than physical production or time. In a low-price environment, this could spur more investment.

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As abonus, firms with capital costs lower than the allowance will come out ahead. This will shift resources to lower-cost firms and create an incentive to innovate and reduce costs all good things from the point of view of maximizing resource rents.

Our 'fair share'

Taking a step back, University of Calgary economists Jack Mintz and Duanjie Chen provide five criteria to evaluate a royalty system: the government's share of resource rents, the returns for private investors, and the system's efficiency, simplicity and stability.

The government's share of resource rents will remain unchanged under the proposed new system. The rates and structure for oilsands are unchanged, and the rates for non-oilsands will be calibrated to maintain the current division.

Are we getting our "fair share"? The report provides some data.

We seem to extract roughly two-thirds of the available resource rents. (Though this varies by price, resource, well characteristics, etc.) That's about the same as Texas and North Dakota. But it's double Saskatchewan's share. Seems fair to me; but that's subjective.

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Efficiency in royalties means not distorting private investment decisions. Atfirst blush, the proposed structure improves efficiency in some wayswhile lowering it in others. I detailed one big improvement above.

How does it lower efficiency?

As wells get old, they produce less and their resource rent falls. Royalty rates should fall, too. The new system has a minimum royalty rate of fiveper cent. So, a decade or two in the future, some companies might abandon wells too soon rather than pay the five per centrate.

On balance, though, efficiency is likely higher. This means, in time, more investment and higher rents. That's afinancial win for governments and investors alike.

Finally, the proposed formula is simpler than the existing one,and stability is there since existing facilities are given 10 years before they are covered. Only new investment is affected at first.

While this is a quick firstpass, the substantive recommendations do well on these five dimensions.

Partisan positions

Some will hold blindly partisan positions,either in support of or in opposition to,any royalty review.

In contrast to this partisanship, the panel recommends technical changes to a technical system. Reasonable people will of course discuss, and perhaps disagree with, each change. But reason, not rhetoric, is precisely how we will move forward.

CBC Calgary's special focus on life in our city during the downturn. A look at Calgary's culture, identity and what it means to be Calgarian. Read more stories from the series atCalgary at a Crossroads.