03 September 2007

Deconfusing the royalty confusion

In Friday's National Post, Premier Danny Williams said:
With regards to criticism of modifications to the basic royalty, it is important to note that the change is the difference between 2.5% and 1% -- not between 7.5% and 1% as reported by Mr. Coyne -- in addition, we still maintain the 5%, and in some cases 7.5%, level of royalty once costs are recovered.
For those familiar with the provincial generic royalty regime, this would create some confusion since the situation described by the Premier is not how the existing generic royalty regime works.

The generic royalty regime provides for a basic royalty that increases from 1%, through 2.5%, 5% to a maximum of 7.5% depending on when the project achieves simple payout. Under provincial petroleum regulations, simple payout occurs when cumulative gross revenue and incidental revenue exceeds the sum of allowable pre-development costs, capital expenditures, operating expenditures and basic royalty paid.

After simple payout is achieved, the royalty paid is the greater of the basic royalty rate (assessed on gross revenue) or the net royalty rates of 20% and 10% after an allowed rate of return.

In order for the adjustment to basic royalty in the pre-payout phase to be the difference between "2.5% and 1%" - as the Premier states - the Hebron project would have to recover its eligible costs within the first two to three years of production or less. His comment assumes an extremely optimistic scenario.

The Premier referred to total costs of between $7 and $11 billion in the 22 August announcement. Taking that as the amount to be recovered (pre-development plus development plus operating expenses and royalties fixed at 1% annually), and given the scenarios contained in two previous Bond Papers preliminary assessments, cumulative gross revenue would exceed $7.0 billion after about three to four years.

At that point, the basic royalty under the generic regime would likely about 5.0%. Thus the difference between Williams' Hebron and the generic regime would be the difference between 1% (Williams) and 5% 9generic). If costs are higher and the time to simple payout is longer, then the generic regime would likely reach 7.5%.

At the same time the Premier said that : "in addition, we still maintain the 5%, and in some cases 7.5%, level of royalty once costs are recovered". This is correct, however, under the existing petroleum regulations, those rates would apply - and the province would collect that revenue - only in a situation where the basic royalty produced more revenue than the Tier 1 and Tier 2 net royalties. Presumably under the Williams regime, this would also include the Tier 3 royalty.

In other words, in a scenario where the basic royalty was paid at 5% or 7.5% after simple payout, none of the much higher rates on net royalty - including the Premier's new Tier 3 - would be paid. This point is explained by provincial government documents.

The royalty regime appears to have been adjusted for Hebron as indicated in the 22 Aug news to a flat 1% royalty due at the commencement of production. This replaces the generic regime that started at 1% and would likely have increased to 5% or more by the time of simple payout. At the same time, the regime under the proposed Williams' Hebron regime is, to paraphrase natural resources minister Kathy Dunderdale, a decision to forego revenues (royalties) in the initial years of production for possible royalties in the later stages.

This is an understandable compromise given the cost issues in the project, but it does reduce the initial royalty accruing to the province likely by between 4% and 6.5%. Any revenue foregone in the initial phase of the project may be recovered subsequently but only as long as prices for oil stay above $50 per barrel for WTI (Tier 3 royalties apply). Again, depending on how the Tier 3 royalty works this may be an understandable compromise. Unfortunately there is insufficient information in the public domain to assess the potential performance of the Tier 3 royalty.

The revenue accruing to the energy company does not offset this royalty concession. in the initial stages of production, the provincial energy company will be recovering its own share of the development costs. it is also liable for operating expenses, provincial taxes, federal taxes and other costs.[Note: see below] Thus any revenue, it collects must be assessed on a net basis.
Royalties are received by the provincial government acting as the resource owner (100%), without any liabilities; the net and the gross are identical figures. The provincial government collects and retains 100% of royalties with no revenue from royalties accruing to the federal government.


Note: Under s. 41 of the 1985 Atlantic Accord, Crown corporations receive no exemptions or special treatment with respect to taxes and other payments to the federal and provincial Crowns.:
Crown corporations and agencies involved in oil and gas resource activities in the offshore area shall be subject to all taxes, royalties and levies.
As a result of the Hebron memorandum of understanding, the Government of Canada will collect revenues from the provincial government's share of overall revenues which it ordinarily would not collect. These come in the form of federal corporate taxes, for example.