31 December 2014

The Legacy of Faulty Assumptions: Hebron Revisited #nlpoli

Hebron is the last of the four, big, offshore discoveries from the 1980s.

It’s due to come into production in 2017 based on a development agreement reached initially in 2007 with the provincial government and finalised in 2008.  There’s a potential problem with current production schedule.  The topsides fabrication is delayed in Korea but we won’t know until the middle of 2015 whether or not there will be further delays that would impact the planned date for first oil in 2017.

Hebron plays a big role in the imagination of the people currently running the province.  Their reaction to the provincial government’s financial problems is based, in part, on the expectation that Hebron will bring huge amounts of new cash into provincial coffers.

But with oil prices down,  people are starting to consider that those assumptions about an imminent return to insanely fat oil royalties might be a bit off base.  With that in mind, let’s revisit the Hebron development agreement and see what turns up.

Setting the Table

For starters, let’s imagine that we are going to see relatively lower oil prices for a while into the future.  All the factors that led to the current collapse of prices – including the shale oil revolution – could well continue for years.  We’ve seen it before:  high oil prices in the early 1980s collapsed and the world wound up in a prolonged period of very cheap oil.

Besides,  we can’t do any worse by imaging low oil prices than we have listening to people who made the fatal mistake of assuming oil prices only went up. 

Second, for the purposes of our little exercise, let’s assume that the average price of oil for the next decade or so is around US$50 a barrel.  People can argue whether it is real or not, but hey, those same people likely believed oil prices only went one way.  Guess they got a big surprise.  And besides, this is just a thought exercise so that we can see the implications of Hebron development on the provincial government’s revenue.

The United States EIA short-term forecast puts oil potentially as low as US$51 a barrel in March 2015 with a potential high of US$89.  That’s based on their assumption of 32% variability using an average of the experience over five days of trading in late November and early December.

Based on that, you could believe that US$50 is a low-end estimate.   Just look at it this way:  if US$50 is the actual lowest price then the situation described here is the worst case.  Actual results will be better.  If you base planning on the worst case and allow for better circumstances,  you will always be better off.  problems come when – as with Muskrat Falls,  provincial government spending, and Hebron,  the government accepts the most optimistic scenario and makes no serious allowance for anything else.

Third,  let’s recall some of the Hebron project’s key characteristics.  Anticipated production is 150,000 barrels a day. The provincial government royalty at the front end is a flat one percent until the project hits payout.  After that,  the Williams agreement uses the generic royalty regimes two-tiered additional royalty.  Tier II royalties are 30% and Tier II royalties add another 12.5% on that.  If West Texas Intermediate is above US$50,  the provincial government gets extra cash.

That flat percentage at the front end of the project is a change from the province’s usual royalty regime.  For this deal, the Conservatives accepted a flat price rather than an escalating percentage based on cumulative production and time.  This is an issue SRBP first reviewed in 2007.

Kathy Dunderdale was the natural resources minister at the time.  She explained that the provincial government wanted to give the oil companies a protection against low oil prices.

"You know, it's going to be a long time by anybody's estimates that we're ever going to see oil less than $50 a barrel," Dunderdale said. "We gave something on the downside which is low-risk to us to achieve a very high gain on the upside."

In other words,  the provincial government didn’t think anything of the decision because they expected to make more money at the back end of the development, after the companies had recovered their development costs.  The assumed oil prices would always be high and that, therefore, the extra royalty they had negotiated would apply.  In 2008,  the provincial government based its royalties estimates on oil at US$87 a barrel.

Fourth,  the cost of getting the project into production will be at least $14 billion.  That’s based on a revised estimate issued in 2013 by the companies behind the project .Their development application to the offshore regulatory board projected a development cost of $8.3 billion, of which the platform alone will account for about $5.0 billion.


At a price of US$50 a barrel, and production of 150,000 barrels per day,  the project will take about five to six years to recover development costs of around $14 to $15 billion.

If first oil happens in 2017,  then the project will hit payout as early as 2022 and as late as 2023. 

Push back first oil,  lower the price of oil, and increase development costs and you push back the date of payout. That’s important because the extra royalties can’t cut in until the companies get their development costs back.

Provincial royalty for the first five to six years of the project will be $27 million a year, each year.


Rather than be a source of significant extra revenue starting in 2017,  Hebron will provide a modest additional increase in provincial government funds.  The cumulative total revenue would be $162 million over the six years until payout.

By contrast, the generic royalty regime established before 2003 would have provided two years at  one percent,  two years at 2.5% and another two years at five percent.  The cumulative total of that would be $709 million.

That pegs the up-front loss from the 2008 agreement at $547 million.  Add that to the other give-aways in the deal on local benefits and construction and you get a sense of what the provincial government gave up to cut a deal in time for the 2007 election. It all works out, if oil prices stay high, but only if they stay high.  Any other oil price scenario and the assumptions underneath the 2007 Hebron agreement don;t work so well for the provincial government, i.e. taxpayers.

Now look at the provincial government’s overall situation,.  Rather than looking at a couple of years until bags of cash start showing up, we are really looking at almost a decade before we see significant extra cash from Hebron. 

By that time, Terra Nova will be winding down.  Current estimates hold that Terra Nova will run out of oil in about 2027. Rather than add to current production, Hebron will merely wind up replacing Terra Nova by the end of the 2020s.

The provincial government would need new projects to come into development in the 2020s and beyond to produce a significant increase in its revenues comparable to what happened purely by accident in 2007-2009.

Otherwise,  the provincial government is facing decades of slowly declining oil production.  Oil revenues will go down accordingly.  If we assume that oil stays around US$50 on average into the future,  we’d be looking at a provincial government with oil royalties from around 2006 but with other costs from the teens and twenties. Other revenues would have to increase at amazingly insane levels to offset the oil decline.

Some people will look to Muskrat Falls to replace that oil revenue.  Well, there’s absolutely no evidence that will happen.  The only source of revenue Nalcor has identified publicly for the entire project is local taxpayers. There may be export sales but that remains a matter of speculation based on Nalcor’s assumed ability to manage the water flows on the river.  That hasn’t been settled yet.

The Legacy of Faulty Assumptions

What that shows you is just how foolish it has been for the provincial government to spend all the oil money that flowed after 2006 while saving nothing.  It also shows the intellectual bankruptcy of the so-called “Prosperity Plan” and the same fundamental assumption of high oil prices that underpinned it.

If oil prices remain relatively low over the next decade, the provincial government won’t be able to balance the books, on average.  The “Prosperity Plan” assumed that there would be some years of surplus and some years of deficit, as oil prices fluctuated.  The fundamental strategic assumption of high or generally increasing oil prices was the plans main weakness.

It’s second weakness had to do with the nature of government spending.  The plan responded to drops in revenue with a simple formula:  spend money when you have it.  Don;t spend money when you don’t.  if government spending was built around discretionary spending only, then that would be not only possible but easy. 

The second flaw in the “Prosperity Plan” was that the spending increases it included were to core operating budgets.  Those are the things like jobs that are very hard to cut, especially in the year before an election.  The result is that the provincial government’s “prosperity plan” will involve spending money when the government has it, and borrowing more money to spend when the revenues aren’t there.

The result is an increase in debt on top of the already massive public sector debt.  The provincial government currently spends almost $1.0 billion paying the interest on the public debt.  Even if we accept the optimistic deficit number of $500 million assumed by the prosperity plan,  about $1.5 billion each year goes to either paying for old debt or adding new debt.  That’s 20% of spending, the largest part of which isn;t going to provide services to Newfoundlanders and Labradorians.  Spending beyond your means continuously – as the Prosperity Plan assumes - is never smart.  Ever.

Bear in mind, as well, that we have known for decades that provincial government costs would be increasing around now.  That’s because the aging population will require more health care services, for example. We’ve also known that the dependent part of the population will be greater than the productive part.  That’s a problem for government revenue and government spending. And thanks to provincial government decisions over the past decade, the problem is likely to be much worse than anticipated, not much better.