29 December 2011

Undisclosed risk (September 12, 2007)

[Editor's Note:  This is a post originally scheduled for publication in September 2007.  For some reason, it never appeared. Here it is, as originally written.  Note that some of the links may not work].

Take a look at the energy plan consultation document released in November 2006.

Try to find any reference to changing the province's generic oil royalty regime.

You won't find one.

That's because there was no public discussion of changing the generic offshore oil royalty regime until Premier Danny Williams and natural resources minister Kathy Dunderdale unveiled the new energy plan on Tuesday.

The changes Williams and Dunderdale announced are described only in one paragraph of the colourful, glossy booklet; that's because the regime isn't finished. However, that didn't stop the Premier from describing it as a regime that will be applicable well into the future, as if the provincial government had not previously developed a robust, functional royalty structure in 1996.

Here's exactly what the energy plan says about the new regime (p. 22):
The Provincial Government will also establish a new Generic Offshore Oil Royalty Regime based on principles and structure similar to the Offshore Natural Gas Royalty Regime. In the case of satellite field developments that use existing field infrastructure, adjustments to the regime may be made to reflect the robustness of satellite field economics, including consideration of recoverable reserve size and the potential that costs of existing field infrastructure may have already been recovered.
That's all.

The generic gas royalty regime is described in some greater detail, and it is useful to quote sections of it whole in order to appreciate what the principles and structure will likely be:
Basic Royalty provides a revenue stream to the province at all stages of a project. The basic royalty rate is linked to realized prices, rather than volumes or project economics as under existing oil royalty terms. This means that the province’s percentage share of the gross revenue from each project will be largely driven by price. This approach leads to greater transparency and ensures that the interests of the Provincial Government and industry are well-aligned.
Let's look more closely at this first paragraph, correct the misrepresentations it contains and then discover the radical reform the Premier introduced. The provincial generic oil royalty regime's basic royalty is linked to gross revenues, i.e. realized prices. The royalty rate increases progressively based on several triggers, including cumulative production levels until the project development and some pre-development costs are deemed to have been recovered by the project proponents.

The existing generic regime ties the resource owner's rent - not share - directly to price  and production; the higher production is and/or the higher the price per barrel, the greater is gross revenue. Hence, even at the lowest basic rate of 1%, the resource owners - i.e. the people of Newfoundland and Labrador - realize greater royalty revenue. At the highest possible basic rate of 7.5%, the resource owner stood to gain significant royalties.

The existing regime is transparent since it is a matter of public record. Any reasonably competent economist or even a rank amateur with access to the Internet and a calculator could come up with a robust assessment of the regime's impacts on the provincial treasury.

The key to udnerstanding the scope of the Williams' royalty regime comes in the last sentence as well as reference to the royalty as a "share". The new regime, as with the publicly-owned oil company, is intended to "ensure that the interests of the Provincial Government and industry are well-aligned." That alignment means one thing: the assumption of risk.

The scope and nature of that risk has not been disclosed to the public.

The province's existing royalty regime is based on the understanding that royalties are the rent paid to the resource owner for the right to develop a non-renewable resource. The existing regime claims a return for the resource owners based on no assumption of risk: royalties are a fundamental entitlement that are varied only by factors such as production levels and market rpcie for crude. They do not represent a share, as if the owners were co-venturers in the project.

The structure of the 1996 regime provided rates of return to the oil companies in the period after payout. However, the resource owners received their entitlement from the start of production. Their revenues increased progressively wither as a function of price and production directly or in combination with the progressively increasing royalty rate. That basic rate regime also served as a positive incentive for oil companies to run cost-effective developments to forestall losing gross revenue. The faster the companies could escape the drain on gross (pre-tax, pre-cost) revenue, the faster they could obtain sizeable net profits.

A solid foundation

Consider as well, that the commitment of the current administration to obtaining the greatest benefit for the province is exactly the commitment of every administration since the 1960s. For example, Challenge and change, the strategic economic plan issued in 1992, stated that "[t]the current policy of the Province with respect to onshore and offshore petroleum resources is to encourage and promote development in a manner which maximizes economic benefits to the province."

Even the natural gas royalty regime, in development for most of the last decade, is still a draft pending industry consultations. those consultations began over the past year and the regime exists in draft form solely because the indutry has expressed strong reservations about its components, including the equity stake.

As well, it is important to realise the even the claim today by Premier Danny Williams that his plan would bring predictability and stability to the industry through a standard royalty regime is nothing new. Challenge and change committed that "[t]he Province will... develop and implement competitive generic royalty regimes for both onshore and offshore petroleum production." This commitment was fulfilled four years later with the release of two royalty regimes, one for offshore and one for onshore oil development.

Development of the gas regime began in 1998 and has neared completion on several occasions. However, it did not languish due to neglect any more than oil and gas resources offshore have lain undeveloped due to neglect, indifference, ignorance or a willful effort to leave them underground. Cost of development, the size of the resources available and international economic circumstances combined to make them commercially unviable - like Hebron - until relatively recently.

The considerable work of successive administrations, both Liberal and Progressive Conservative, laid the foundations on which the province's oil industry is built. That work, refined with experience, provides the financial resources with which the current administration has attained unprecedented heights of popularity.

The Newfoundland and Labrador Model

Since development of the offshore was first considered with Hibernia negotiations in the 1980s, the Newfoundland and labrador offshore has operated in an environment which balanced competing interests and appropriately separated the policy roles of the parties.

Overall policy on development, local benefits and taxation lay with the provincial government acting on behalf of the public, as the de facto owner of the resource.

The public interest in regulation of development, maximising resource exploitation, and protecting public health, safety and the environment has been the responsibility of the offshore regulatory board. It was established at arms length from both the federal and provincial governments to ensure the creation of a stable and predictable regulatory environment which is important to the oil companies exploiting the resource.

The board also served as a locus of government insight into the industry and into the geology and engineering of the public resource.

Development of the resource was undertaken solely by oil companies, some public and some private. They represented the source of capital and expertise needed to extract oil and gas and bring it to market.

Each of these interests worked in a balance, akin to the model followed in Norway.

A fundamental policy shift, a fundamental conflict of interests

The Williams energy plan proposes a fundamental change in provincial government oil and gas policy. The change and the consequences are found in the creation of a state-owned oil company oeprated directly by the provincial government.

In itself, creating a state-owned energy corporation to operate within the province would not alter the management model applied to date. Under the Norwegian model, state-owned enterprises are run at arm's length from government and are treated, for all practical purposes, as if they were entirely non-government entities. The contending interests are managed through the triangular balance between state, regulator and companies. Each exists in an open, transparent and predictable environment that has eveolved over 30 years.

However, the energy corporation created in 2006 and modified in 2007 is entirely controlled by the provincial government. Therein rests the problem; the provincial government itself has become, in effect, a subordinate partner in project development.

The effect of this situation has already been seen in the Hebron negotiations. The head of one of the equity partners (Newfoundland and Labrador hydro/energy company) served as the lead negtiator for provincial taxes and rents. This is fully in keeping with the energy plan which states that one of the purposes of the state-owned energy corporation, is to "ensure better alignment between the provincial interest and the partners in the projects."

Yet, in the process, transparency - one means of protecting the public interest per se - has essentially disappeared. The Hebron royalty regime is currently held secret at the request of the project proponents. However, under the MOU, the provincial government is, in effect, one of those project proponents. For the first time since oil development began in Newfoundland and Labrador, the owners of the resource have no idea on what basis they will be paid for the right to develop their resources.

Further impacts of the changed policy structure may be seen in the new generic royalty regime, described briefly in a single paragraph of the energy plan (pp.22-23) as being similar to the new generic gas royalty regime:
Net Royalty is based on project profitability and reflects the revenue and costs associated with a particular project. Where profitability of a project is higher, the province will share in that profitability. Where profitability is less or declining, the Net Royalty Rate will be lower and the province’s share will decline.

Both the Basic Royalty rate and Net Royalty rate will be determined by a smoothing formula, rather than the existing “step” based system. This enables the new system to respond quickly to falling or rising prices, sending a positive message to investors and demonstrating that the province is prepared to share in price risk. (p.23)
The generic royalty developed in 1996 established royalties based on defined percentages. It was robust and ensured "that if oil prices increase or the profitability of field otherwise increases, the royalties to the province also increase."

Both the public and the corporations shared in the benefits of a project which was well-run and therefore remained profitable, even in times of relatively low oil prices. Both parties shared the benefit of a well-run project in periods of high crude prices. The resource owners, however, assumed no risk nor should they. The regime functioned well for the provincial treasury across all but the most expensive, small projects in periods of sustained low oil prices.

By contrast, the new regime will tie net royalties - the rent paid to the resource owner for development rights after project payout - only to profitability in a way that appears to subordinate the owner interest to the corporate one. This comes from the assumption of risk.

Project profitability, after all, is a function of revenue and cost. The new regime will actually lower both the rate and the amount paid to the resource owner in a period of relatively lower profitability. A project can be or appear to be relatively less profitable depending on how costs are assessed. Thus, even in a period of high crude prices, the rent paid by the project to the resource owner may be lower than under the old generic regime.

The bird in the hand for two in the bush

By accepting risk, the public interest in the new regime bets on what some might call a reverse Churchill Falls assumption. In that 1969 agreement, the revenue for what became the energy producer was tied to a fixed price on the assumption of long-term low prices for electricity.

The new oil royalty regime based on risk best on low-cost projects in a period of high oil prices. In all other scenarios, including higher cost projects in moderate to high revenues, the royalty return to the province will likely be affected negatively since profitability would be affected. Under the regime, as described in the energy plan, the resource owners agree to accept not merely less money in absolute terms but a lower rate as well.

This approach certainly has the prospect of assuring investors, as the energy plan states, and it may well increase competitiveness of the local offshore. However, it clearly does so, as in the Hebron agreement, by guaranteeing the oil companies pay lower rents at the front and potentially over the life of a project. It trades the bird in the hand of the old generic regime for the two that may be in the bush two decades from now.

Unfortunately for the Premier, he stated the real nature of the risk inherent in an approach that ties the public interest with the corporate.