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16 June 2009

Hibernia Southern Extension MOU Assessment, Part I: Royalty - some potential added cash plus a cap

While Danny William’s radio tirade/meltdown is rapidly eclipsing his own good news announcement nationally, there is interest in assessing the details of the Hibernia South Extension memorandum of understanding based on the official news release and news reports on the day of the announcement.

Caveats

As with Hebron, the final agreement may yield some details which were not readily apparent when the MOU was announced.   As well, and as with Hebron, key portions of the deal are likely to be hidden from public view.   With that said, we still have enough information to make some observations about the proposed development deal.  In this first post, we will look at the royalty regime.

General

Overall, this agreement represents a transformation from Williams Mod 1 to Williams Mod 2 in the government’s approach to offshore oil development.

Williams Mod 1 (pre-2o06) was essentially a variation pre-1984 provincial government thinking and emphasised:

  • increasing local benefits especially through forced development of refining and downstream production;
  • some additional revenue from federal transfers, and
  • an undefined “equity” interest which is essentially analogous to the old petroleum corporation.

Williams Mod 2 (post- 2006) places the greatest emphasis on additional government revenue through the most obvious source:  enhanced royalties. This is especially clear in the Simms encounter where the Premier states:

The reason we’re caught up in the oil, it’s not the oil, it’s the black gold that’s out there, it’s not the petroleum, it’s not the oil and gas, it’s the revenue that it brings to us, so that we can deal with problems in the fishery, so that we can take care of the Abitibi workers, so that we can build new hospitals and new long terms care facilities, so that we can build new schools, so that we can lead the country in poverty reduction, and it goes on and on and on. Surely you – presumably – run a municipality. You must know the importance of revenue, and where that revenue comes from – if it comes from business, whatever form of business it is, or if it comes from residential real estate, it goes into your coffers now so you can do all the wonderful things that need to be done. [Emphasis added]

Government-induced infrastructure has been effectively abandoned as evident in both Hebron and Hibernia South and the equity portion has also been capped artificially at 10%.  In Hibernia South, the second GBS or other production facility has been discarded for the most economical production method (slant drilling from the original GBS and tie-backs to the original GBS).

This effectively adopts the philosophy that guided resource development after 1985 and is best seen in the 1990 Hibernia agreement and in the subsequent developments at White Rose and Terra Nova.

As much as Danny Williams may like to complain about those who offer alternative views to his own, this basic approach has been noted before – including in this corner – as an alternative to Williams Mod 1. 

The easiest, most efficient means of enhancing government revenue is through adjustments to the royalty regime.   Revenue is needed to meet the demands for program spending and infrastructure development today. Regular readers of Bond Papers will recognise the refrain.

Hibernia Southern Extension Royalty Regime

The base for the three-part royalty is the existing Hibernia royalty regime as concluded in 1990 and modified in 2000

This sets the rate after simple payout (achieved a few months early) at 30% Tier 1 royalty with a further 12.5% Tier 2 royalty triggered by profitability.

This is the royalty rate – 42.5% -  that produces the bulk of the cash.

The royalty regime for the southern extension is cut into three parts.  There is no explanation as to why the rate is structured this way. The backgrounder provided with the news release does not explain the structure clearly.

Part I:    For the 50 million barrels or so that will be drilled directly from the Hibernia gravity base structure, there is the 42.5%  that already exists in the Hibernia royalty regime established in 1990 and modified in 2000.

There is no price trigger for this since the original royalty regime did not tie provincial government revenues to oil prices directly.

Part II:  For the portion of the project that is under the original production License 1001 (PL 1001), the basis is the original Hibernia royalty regime (maximum 42.5%, not tied to price).

In addition there is a further 7.5% royalty when prices for West Texas Intermediate (WTI) are above US$50.  Above WTI at US$70 there is an additional 5%. 

There is a cap on the royalty however: 

Should supplementary royalty payout be achieved under the terms of the original Hibernia contract be achieved, the top rate will be 50 per cent.

It would appear that once the project has triggered the Tier 1 and Tier 2 royalties (42.5%),  only an additional 7.5% is available beyond that irrespective of price. 

Part III:   There is a similar 50% cap in the new areas, i.e. the ones covered by PL 1005 and Exploration License 1093 (EL 1093).  The cap is achieved by reducing the incremental royalty tied to price (WTI at US$50) from 7.5% to 2.5%.

Observations

Overall, this represents a complex arrangement that modifies the existing royalty regime slightly. The complexity may be due in part to the highly diversified interests in the three licenses, especially EL1093.

In many pricing scenarios, then, the maximum available royalty from what is described here as Part II of the regime  would appear to be the same as under the existing Hibernia regime, i.e. 42.5%.

On the face of it, the Part II and Part III royalty structures offer an identical outcome.  Additional information would be needed to explain how the structure works and why it is in place.

The provincial government revenue figure offered in the announcement  - $10 billion – is apparently derived almost entirely by applying the existing Hibernia Royalty Regime to an environment in which oil prices are considerably above the average price that existing during the initial phase of the project.

-srbp-

Money Update:  Premier Danny Williams told CBC’s David Cochrane today that the estimate of $10 billion of provincial revenue from Hibernia South is based on an estimated average oil price of $83 over the next decade.

There is something suspicious about the government calculation though since Williams claimed on Tuesday that five times as much oil left in Hibernia as in Hibernia South would net the province only slightly less cash than Hibernia proper even though both projects use essentially the same royalty regime:

We expect a further $13 billion from the remaining main field production and this extension adds an estimated $10 billion more in revenue for the province…