Province may lose big-time in Hebron royalty give-away

According to the Telegram, the Hebron partners won’t be filing their development application for the project until December 2010.

That’s a full year behind the original schedule but the companies claim it won’t impact anticipated first oil in 2017.

This is the second change to the project in two months.  The full implication of cancelling pre-drilling still hasn’t been determined.  It appears to have been dumped to avoid significant challenges posed by dropping the gravity base structure onto a pre-drilled template.

But the wider implications are still uncertain.  Pre-drilling would have allowed the project to get to full production very quickly.  As it is, production wells will now be drilled from the single derrick planned for the Hebron GBS. It took Hibernia five years to hit full production and that was using two derricks.

Delays in hitting full production will affect the timeline for the project to hit payout and that will affect the provincial government’s royalty take over the life of the project.

In signing the Hebron deal, the provincial government agreed to a flat one percent royalty until the project recovers its development costs (payout).  The generic royalty and the regime used for Hibernia and Terra Nova used a sliding scale that saw the provincial share increase steadily to a maximum of 7.5% based on cumulative production.

In 2007, natural resources minister Kathy Dunderdale said the flat royalty was a way of giving the companies insurance against low oil prices:

“The rationale behind these changes was the companies needed some downside protection if the price of oil went very, very low,” Natural Resources Minister Kathy Dunderdale said.

“So, that was the tradeoff [sic] for us — to give them protection if oil prices really plummeted, to get a gain if prices were high, above $50. So, we traded off some risk on the low end for significant gains on the other end.”

The provincial government’s entire assumption about the royalty give-away seems to have been based on the idea that payout would occur quickly.

But if oil prices remain high, the period during which the basic royalty remains at just one per cent shortens significantly.

“Normally, in terms of the basic royalty, even under generic, you go through those stages pretty quickly,” Dunderdale noted.

However, even at relatively high oil prices, lower production rates would drag out the time needed to pay off development costs.  And – looking at it logically -  the provincial government would lose significantly more in the process. That’s a point Dunderdale didn’t mention in 2007.

Dunderdale did mention the price of oil, which appears to have been a huge factor in provincial government thinking.  In exchange for the flat royalty give-away at the front end, the provincial government banked on recouping its losses if oil stayed above US$50 per barrel.  As Dunderdale told CBC in August 2007:

"You know, it's going to be a long time by anybody's estimates that we're ever going to see oil less than $50 a barrel," Dunderdale said. "We gave something on the downside which is low-risk to us to achieve a very high gain on the upside."

The “long time” turned out to be two years. [Time Travel Update:  or is Mathematically Challenged?  Oil hit 50 bucks a barrel within a year or so of her  great pronouncement.  it was less than 40 bucks a barrel a few months after that.]

The Hebron changes in December raise once more questions about the assumptions used by the provincial government in negotiating the royalty regime.    Slower time to full production could stretch payout to 10 years or more.  The provincial government appears to have operated on the assumption that oil would remain high throughout the initial production and post-payout phases.

A decade to payout is one one of the implications noted in Bond Paper’s preliminary look at the Hebron royalty.  The following chart used a relatively low price for oil and assumed high development costs.  It didn’t consider any delay in getting to full production but did anticipate taking a decade to hit payout.

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