Groundwork: The Hebron MOU deconstructed, as announced

To help in assessing the final Hebron deal, here are some notes drafted for a Bond Papers post last year:

Bottom line: Bond Papers said it about 18 months ago, and overall it remains true - a deal is good.

Both sides wanted it. The provincial government needed the deal, like they needed it 18 months ago. There are some implications of the delay as described below.

Even the memorandum of understanding takes a huge political monkey off Danny Williams' back.

The oil companies get to develop more oil than initially planned for about the same cost as originally proposed.

Much work needs to be done, especially on the local benefits package. The provincial government backgrounder contains conditional language that needs to be sorted out in the detailed negotiations.

As Williams said of Voisey's Bay, the detailed agreement are where the companies can find loopholes, escape hatches and off- ramps to avoid delivering on what they appear to have agreed to deliver.

Let's take a look at some specific issues.

1. Superlative language. Characteristically, the Premier and his energy minister used superlatives to praise their own memorandum of understanding.

Words like "tremendous", "historic" and "off the chart" were flowing easier than API 70 oil.

As a general rule, use of over-the-top language is an indicator of an insecurity in the announcement itself or an effort to offset some deficiencies. Hyperbole is a Danny Williams trademark.

2. What Danny originally asked for

Two of the three, depending on which April one considers.

- April 2005. [ram audio file] Better royalties, secondary processing i.e. a refinery, and better research and development funding.

- April 2006. Super-royalties, an "equity" stake, and better local benefits.

3. Equity. Total estimated cost: $360 to $660 million. 4.9%, costing $110 million plus an estimated $250 million of construction costs. The Premier also predicted an additional set of costs of some $2.0 to $6.0 billion over the 25 year life of the project; that would translate into additional costs from the equity position of $300 million.

Those costs must be recovered before the equity position yields any cash as net benefit to the provincial treasury.

Beyond that the province's energy company - that still exists only on paper - now holds a series of undisclosed risks and liabilities.

4. Larger field. The earlier negotiations involved only the Hebron field and its approximately 500 million barrels of heavy, sour crude. This project adds about 200 million barrels of light sweet crude in the Ben Nevis structure.

Ordinarily, this would add additional cash value to the project, but as noted below, the total projected revenue is not significantly better than that estimated for the earlier negotiation.

5. Tier 3 Royalties. Super-royalties that deliver a percentage based on oil above a certain dollar price? Not exactly.

What turned up in the news conference looks more like the Hibernia royalty regime.

From the official backgrounder:

The new super royalty for the province is an additional 6.5 per cent of net revenue at higher oil prices (>US$50 WTI/bbl) after net royalty payout;

From the Hibernia royalty regime:

The Net Royalty consists of a two tier profit sensitive royalty which becomes effective when Net Royalty Payout occurs.

• Tier 1

The Tier 1 Net Royalty is 30% of Net Revenue after a Return Allowance of 15% is achieved. Basic Royalty is a credit against this royalty. Therefore, the interest holders pay the higher of Basic Royalty or Tier 1 Net Royalty.

• Tier 2

The Tier 2 Net Royalty is 12.5% of Net Revenue after a Return Allowance of 18% plus the CPI is achieved. The Tier 2 Net Royalty is in addition to any other royalties payable.

Net royalty payout is "point in time when the costs related to a particular project are recovered plus a specified return allowance on those costs." A similar concept exists in the province's basic offshore royalty regime.

In all likelihood, the triggers to attain Tier Three royalties are such that they will not be achieved on Hebron until after other royalties have been triggered. There is no way to be certain since the language in the backgrounder is too vague to determine how the new Tier Three royalty relates to the rest of the royalty regime used for the Hebron negotiation.

One thing is certain: Tier Three royalties are only available after the project achieves simple payout. That means the possibility of collecting the additional revenue is contingent on the price of oil being above US$50 per barrel from the mid 2020s onward.

6. Other royalty regime changes. The provincial government's so-called generic royalty regime for offshore projects was developed in 1996. It clearly establishes the minimum royalty to be paid to the provincial government is 1% of gross revenue and increases progressively to 7.5% until simple payout occurs.

The backgrounder for the Hebron MOU refers to a change to royalty regime to "[p]rovide downside royalty protection by keeping the basic royalty rate at one per cent of gross revenue until project costs are recovered (i.e. simple payout)."

There is nothing in the provincial documentation to indicate why it would be necessary to introduce this new concept except that the progressive increase in the basic royalty rate is being eliminated.

As such, provincial government royalties will be a mere 1% until such time as the project achieves simple payout.

7. Revenues. The news release today provide a revenue estimate for the province of $16 billion over the 25 year lifespan of the Hebron project.

On the face of it, this figure appears to be nothing more than an adjustment to figures used by MUN economist Dr. Wade Locke that projected up to $10 billion, based on an assumed oil price of US$50 per barrel. Bond Papers noted this possibility in a pre-announcement post.

However, Locke did not anticipate a change to the basic royalty regime that reduces royalties to 1% during the entire pre-payout period.

There is also no indication from the Premier on the revenue flow anticipated from the equity position, thus, with the new lower royalty regime, this $16 billion is highly suspicious.

8. Research and Development. The commitment for $120 million over the 25 year lifespan of the project appears to be below the current standard set by the offshore regulatory board.

9. Timelines. The project may begin construction in 2010. This assumes that the complex negotiations for the development agreement are concluded successfully and quickly and that the development application to the offshore board is approved expeditiously.

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