15 January 2013

The cost of not doing the math #nlpoli

Natural resources minister Jerome Kennedy admitted over the weekend that he had not done the calculation to figure out if the equity stake in Hebron was worth the cost compared to just a change in the royalty regime.

CBC’s David Cochrane put the question to Kennedy after seven minutes or so of Kennedy’s recitation of talking point after talking point about the Hebron project and the impact of the massive increase  in costs.  In response to Cochrane’s relentless, detailed questioning, Kennedy tried every folksy analogy in his arsenal of banalities.  He talked about putting away money for your children’s education.  He tried the bland admonishment that the government would look after the future, not just do what was immediately popular. 

Kennedy even tried to suggest questions about public finance  - and the impact of spending billions on resource projects – should go to Tom Marshall.  Since the provincial government struck a deal with the Hebron partners in 2007, the estimated cost of the project has tripled.  Cochrane noted the cash commitments.

And finally with his acknowledgement he hadn’t done the math himself, Kennedy blinked on a basic element of the provincial government’s strategic plan.

Duck Dodgers in the 21st Century

Kennedy also confuses a whole lot of information as he ducked and dodged  to get away from Cochrane. He says, for example, that the basic royalty rate on Hebron is one percent.  That works out to about $120 million a year.  He tossed out the $2.7 billion in cash from the equity deal and $23 billion overall flowing to the provincial government.  All the numbers show Hebron is a very good deal,  Kennedy insists..

Okay, well, Cochrane’s question was about the relative rate of return.  He wondered if you would have gotten the same or better from Hebron via royalties versus equity stakes and the cash.  We’ll get back to the answer in a minute, but let’s look at Kennedy’s comments and the initial royalty.

Kennedy is right.  The deal the Conservatives signed in 2008 gave the oil companies a flat rate at the front end.  Once the deal hits payout, the royalty regime that’s been in place for decades cuts in, giving the province 20% to 30%.  If West Texas Intermediate is above $50 a barrel, then the provincial government can collect some extra cash through the so-called super-royalty.

But Kennedy is also wrong.  The royalty has nothing to do with the equity stakes at all. He confuddles the two and in the process misleads people. 

Kennedy is doubly wrong because he credits the royalty cash to the super-royalty.  In fact, the bulk of the royalty cash comes as a result of provincial policy established a couple of decades ago.  The $23 billion in revenue over the life of the project that Kennedy talks about is pretty much all royalty and the bulk of it reliably comes from the pre-2003 royalty regime on which the Hebron deal is based.

The same is true for Hibernia South and the White Rose.

Now if you want to know the answer to Cochrane’s question, you can look at it three ways.

Making money without spending any is always better

First, consider that as the resource owner, the people of Newfoundland and Labrador collect cash from the offshore oil developments through royalties. They assume no risk. They do not have to pay out a single penny. They just collect money.

The way the provincial government set up the old generic royalty regime before 2003, the government got paid based on price and production.  The royalty system worked whether the price for oil was low or the price was high.  It divided the cash among the developers and the owners (the public) and gave the public a bigger share of the cash once the developers got their initial money back.

The Hebron equity stake forces the public, through Nalcor, to pay out money at the front end. They have to borrow it from the banks or, as Kennedy indicates, they have to take money earned from other oil projects to fund the next project. They don’t actually see a profit  - a return on their investment - until all that initial cash is repaid.

Basically, making money from Day One with no initial outlay is obviously always going to be a better position than one where you have to fork out cash up the front end and then recover those costs before you actually make money.

When you add in the new tidbit, namely that Nalcor is going to use White Rose and Hibernia to pay for Hebron, you really have to think long and hard about whether these equity stakes make any real financial sense.

Not half as good as Kennedy makes out

That brings us to the second way of looking at it.  Note that during the interview Kennedy kept talking about a $110 million cost producing $2.7 billion.  Cochrane rightly nails that for the bullshit it is.  The current cost of the equity stake will be roughly $800 million to $1.0 billion for Hebron over the life of the project. 

Let’s say that “life of the project”  is about 25 years.  The great return Kennedy is talking about works out to be about $108 million a year based on whatever assumptions went into making up that $2.7 billion.

Still looks good, right?

Well, taking that same cash today and wiping out $800 to $1.0 billion billion worth of debt would accomplish exactly the same annual return.

Then there’s the question of who gets the cash.  Nalcor isn’t the provincial government.   If oil stays at or above current prices, then the equity stake will make cash for Nalcor. In order for taxpayers to take that cash, the provincial would have to claim it as a dividend. 

That might not be as certain as you’d think.  After all, when did you hear about the plan to divert money from the other equity stakes to pay for Hebron?  People who didn’t watch the Kennedy interview still don’t know.

But you do, and that is not what people believed when the government fought for those equity stakes.  The money from White Rose and Hibernia South was supposed to help pay for schools and hospitals and all that other good stuff.  Over the next five years, the provincial government is going to have some pretty tight times.  Rather than having all that extra oil money to count on, we can just stand by and watch it go to fund Hebron.  Well, who knows what will happen with Hebron equity cash in the future?

Regular readers have heard this argument before, of course, back in 2008.  As it turns out, the objections SRBP raised back then have turned out to be valid.  The equity stakes don;t benefit the public directly.  They produce a benefit most obviously for Nalcor but the public interest and Nalcor’s interest are not the same thing, as some people assume.  The equity diversion makes that as plain as plain could ever be

Easier cash from royalties

To take a third perspective on the equity versus royalty issue, consider the amount of cash involved.  This is an old argument and it remains true because it is based on simple math.

The equity stake will produce about $108 million a year according to Kennedy’s figures.  That goes straight to Nalcor.  At the same time, he told David Cochrane that one percent royalty in the Hebron deal the Conservatives signed will produce about $120 million a year for the first five years.  That’s how long it will take the companies to pay off their development costs, according to Kennedy.

The old generic royalty regime started at one percent base royalty.  The base royalty jumped up in stages based on time and production. Based on the Hebron production forecast of about 50 million barrels a year, the old generic regime would have delivered one percent in each of the first two years,  2.5% in each of the third and fourth years, 5% in the fifth and sixth years and then 7.5% if it took that long or longer to hit payout (simple cost recovery).

You can see where this is going.  Four years at one percent works out to be $480 million in total.  Under the old generic regime, the provincial government would have earned $300 million in each of Years 3 and 4 on top of the $240 million for the first couple of years.  That’s $840 million for anyone skimming along.

Think about it.  Since the province assumed high oil prices all along, they assumed the project would recover development costs in five years or less. If they wanted to get easy cash, they could have offered a flat 2.5% base royalty.  Four years of that would have produced $1.2 billion in royalties in just four years of production.  A tweak at the back-end royalty and they’d have found the other $1.5 billion easily.

And all that cash would have gone to the finance minister, not to the coffers at Nalcor.  Incidentally, note that Jerome corrects himself at one point and candidly notes that when he says “we” benefit, he meant Nalcor.  Yes, and he could have added that “we” the provincial government is not the same as “we” Nalcor.

This is something SRBP went through in 2008.  You can see it in the link above and in a second post from around the same time.  The numbers from the old calculations may be lower but the math is the same.  Too bad Jerome, Kathy and Danny didn’t do some simple math before they signed onto these supposedly great deals.