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Assassinating The Goose?
The Alberta Royalty Review Panel has released its recommendations on changes to Alberta’s oil and gas royalty regime. In our view, the report recommendations are very negative for the oil and gas business in Alberta, particularly the oil sands developments.
The report calls for widespread changes to Alberta’s existing royalty regime, which could increase royalty payments to the provincial government by up to 20% at current price and production levels. Conventional oil and natural gas producers could see the government’s take increase by roughly 5% on average. Oil sands developers could be hit the hardest with proposals forecast to increase the government’s share to 64% from 47% currently.
For conventional production, the report calls for a simplification of the existing system, which has been revised over the years through several programs and exemptions designed to compensate for the changes in the reserve base and the commodities involved. The recommendations indicate that 57% of oil and 82% of the natural gas wells in the province would actually see lower royalties, with royalties more equitably distributed across the production spectrum.
The oil sands sector would be the hardest hit with the 25% royalty rate that is applied to projects after payout increased to 33%. In addition, a sliding scale ‘severance’ tax would be introduced that would start at 1% for WTI of $40/bbl (CAD) and be capped at 6% in a $120/bbl price environment.
While the Alberta government will not release its formal response to the report until mid-October, we expect this report to have a significant negative impact on oil and gas equity values, especially oil sands developers. We estimate that if the all of the report’s recommendations are enacted by the government, it will reduce the value of a typical oil sands project by roughly 20%. Projects that are still in the planning stage may suffer the most. We recommend a cautious response to the report and would continue to emphasize exposure to existing oil sands operators such as Canadian Oil Sands Trust and Suncor over new entrants.
Summary
• An independent review panel, commissioned earlier this year to investigate Alberta’s royalty regime, submitted a surprisingly negative report for the oil and gas sector in the province.
• The report calls for widespread changes in the province’s royalty regime that, if implemented, would increase royalty revenue by 20% based on current prices and production levels. The panel suggests royalty increases for conventional oil and gas as well as significant changes to the oil sands royalty regime.
• The Alberta government has stated it will not respond publicly until mid-October. If fully implemented, these changes could have a negative impact of roughly 9% on our 2008 net asset value estimates. Oil sands producers who are still in the planning phases would be hardest hit.
• Given the uncertainty surrounding the government reaction to this report, we recommend a cautious response and believe a wide spread sell-off could present buying opportunities among select companies.
Sector Comment Energy - Oil & Gas
Page 2 • September 19, 2007 (Back to Index)
A Fair Share?
The Alberta Royalty Review Panel has submitted its recommendations to the Minister of Finance Lyle Oberg. An independent panel of experts was appointed in February 2007, to conduct a review of Alberta's royalty regime to ensure Albertans are receiving a fair share from energy development. The review focused on all aspects of the royalty system, including oil sands, conventional oil and gas, and coalbed methane.
The Panel is recommending significant changes to the province’s royalty regime, which could increase royalty payments to the Alberta government by 20% based on current prices and production levels. No sector has been spared in the review, with the government’s overall take from Alberta’s resources increasing to 64% from 47% in the oil sands, 49% from 44% for conventional crude oil production and to 63% from 58% for natural gas. The increased revenue from the oil sands sector represents a jump of 7% immediately; 38% by 2010, and 51% by 2016.
The generic oil sands fiscal regime has been in place since 1997 and applied to all oil sands developments with the exception of Suncor and Syncrude. Under the current structure, oil sands projects pay a royalty based on 1% of gross revenue until the project recovers its capital and a nominal return, after which the royalty rate increases to 25% of net revenue, defined as gross revenue minus capital and operating costs. The Royalty Review panel suggests that the 25% royalty be increased to 33%. In addition, the 1% ‘base royalty’ will still be paid after payout but will be deductible from revenues for calculating the net royalty at the higher 33% rate. Previously, companies paid either the ‘base royalty’ or the 25% royalty, whichever was higher, which in most instances with today’s pricing environment was the 25% royalty. As a partial offset, the panel does suggest a 5% royalty credit for bitumen upgraders that are built in Alberta, subject to certain conditions and capital limitations.
Suncor and Syncrude pose unique challenges for the Review board and also the government, if they choose to implement these proposals. The generic royalty regime doesn’t apply to these projects yet. These two projects have separate agreements in place, negotiated at a time when they were the only two oil sands operators and the industry was still in its infancy. These operators paid royalties on the upgraded synthetic oil, which is of much higher value. In 1997, when the modifications were made to the royalty scheme, Suncor and Syncrude had the option to choose, by a certain date, to base their royalties on bitumen or synthetic. Suncor has indicated that it would switch to the bitumen-based royalty regime in 2009. Syncrude has made no such decision. The Panel made special note of these Crown agreements and indicated that a change in royalty regimes for those producers could have legal ramifications but ‘strongly’ recommended a review of those Crown contracts.
Severance Tax
Perhaps the biggest surprise among the panel’s suggestions was the call for an oil sands severance tax (OSST). The OSST would be payable on every barrel of oil sands produced in the province. The OSST would be sensitive to oil prices, starting at zero for WTI prices below $40/bbl (CAD equivalent), 1% at $40/bbl and increasing 0.1% for each $1/bbl increase up to a maximum of 6% at $120/bbl. Using our current long-term crude oil price for WTI of US$55/bbl, the OSST would be roughly 2.8%.
Sector Comment Energy - Oil & Gas
Page 3 • September 19, 2007 (Back to Index)
In an attempt to provide a slight offset to some of these widespread increases, the panel, although not very convincingly, recommends an ‘upgrading credit’ for all future capital investments of 5%. This 5% royalty credit would apply to expenditures for new upgrading capacity in Alberta beyond what has already been approved. With the economics of an “outside Alberta made” solution to the integrated oil sands equation becoming much more attractive, it appears that some, not all, panel members would try to slow that trend. The credit would also provide some incentive for merchant upgraders to continue their capital programs as they could generate the royalty credits and either sell them back to the upstream producer or trade them among the oil sands operators.
Impact Varied
Not surprisingly, projects that are in the planning stages and many years from production will be the hardest hit if these changes are adopted. On average, our net asset value estimates would decrease by 9% in 2008 if all of the reports recommendations are adopted, with Synenco, UTS and Suncor potenitally hit the hardest. Our existing net asset value estimate for Suncor assumes a conversion to the generic bitumen based royalty after 2009. Eliminating this benefit and imposing the proposed severance tax results in a 15% reduction to our net asset value estimate. Individual projects such as Fort Hills, Horizon, Long Lake, Northern Lights and Sunrise could see their discounted cash flows decrease on average by 23%. Operating facilities such as Syncrude, Cold Lake and the Athabasca Oil sands project declined by 8–9%.
Table 1: Potential Impact on Net Asset Value TickerRatingPriceTargetBeforeAfter% ChgCanadian NaturalCNQOP79.75 77.00 82.64 68.54 -17%Canadian Oil SandsCOSOP34.04 35.00 22.25 21.39 -4%EnCanaECAOP63.85 69.00 82.36 80.07 -3%HuskyHSEOP42.49 50.00 47.18 44.38 -6%Imperial OilIMOMkt50.00 50.00 44.30 41.14 -7%NexenNXYOP31.39 41.00 59.19 57.46 -3%OptiOPCOP18.83 30.00 38.74 36.19 -7%Petro-CanadaPCAMkt58.98 62.00 56.57 53.32 -6%SuncorSUOP101.05 110.00 88.72 75.51 -15%SynencoSYNUnd(S)12.59 14.00 14.29 11.46 -20%UTS EnergyUTSMkt(S)6.19 6.00 5.26 4.35 -17%Western Oil SandsWTOMkt38.44 40.00 44.44 41.80 -6%Average-9%
Source: BMO Capital Markets, Company Reports
While the Alberta government will not release its formal response to the report until mid-October, we expect this report to have a significant negative impact on oil and gas equity values, especially oil sands developers. We estimate if the all of the report’s recommendations are enacted by the government, it will reduce the value of a typical oil sands project by roughly 20%. Projects that are still in the planning stage may suffer the most. We recommend a cautious response to the report and would continue to emphasize exposure to existing oil sands operators such as Canadian Oil Sands Trust and Suncor over new entrants.
Sector Comment Energy - Oil & Gas
Analyst's Certification
I, Randy Ollenberger, hereby certify that the views expressed in this report accurately reflect my personal views about the subject securities or issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
