Thursday, October 25, 2007

Where is Alberta? Why Should You Care?


A barrel of crude oil supplies more than energy. It is also a building block for petrochemicals and other goods.
By Peter McKenzie-Brown
Can it really be true that - oil at $90 per barrel notwithstanding - the Canadian petroleum industry is facing an economic downturn? It is true, and you should care. Traditionally ignorant about Canada, Americans in particular should understand the implications of the critical economic issues now roiling the sector here. Canada is by far the largest source of imported oil for America, and one of the few large oil producers with the potential to increase production well into the future. The US Energy Information Administration has identified Canadian reserves as being second only to those of Saudi Arabia. So if you worry about peak oil and the world’s energy future, you would be foolish to ignore the geopolitics and energy economics that are racking Canada today. Canada's petroleum industry is facing a perfect storm. Five main factors are at play. First, the Canadian dollar is at its highest level against the US dollar in 30 years. Second, the natural gas industry is in the tank. Third, environmental issues are getting critical. Fourth, industrial inflation is rocketing out of sight. And finally, governments have become greedy - very greedy. Together, these developments augur ill for oil supply. Let’s look at them, one at a time.
 1. Exchange Rates: In 2001, the Canadian dollar's value was just over 60 cents per US dollar, and Fortune magazine famously dubbed our loonie the "northern peso". Today it is worth $1.04 US. During that period, oil (priced in US dollars) has tripled in value. These parallel movements have had some curious effects. Oil prices for Americans have more than tripled, based on nominal (US dollar) prices. In Canadian dollar terms, however, they have "only" doubled. That's a big increase, of course, but it's more modest than in the rest of the world. Consumers have been hit much harder in the United States than in Canada - that's on the one hand. On the other, American oil companies have benefitted far more from oil price increases than those in Canada. And since Canadian oil companies have profited much less, they have less capital for exploration and development than you might expect. Put another way, foreign exchange movements have made crude oil less profitable to develop and produce. The industry thus has less incentive to develop it.

2.The Natural Gas Sector: Forecasters now commonly suggest that western Canada's conventional gas production has peaked and will continue to decline. The reasons are complex, but part of the reality is that Canadian producers can’t sell their gas at the prices American producers command. The $7 futures contract for gas on the NYMEX is not reality in Canada. In Western Canada, our producers get $5 per thousand cubic feet for their gas, while the cost of finding and developing the stuff is in the $7-$9 range. Once again, this means less capital for investment in domestic reserves. And yet, as this article discusses below, that sector has just been hit with higher royalties. That's just what you need when new production is marginally profitable at best.

 3. The Environment: Global concern about climate change is leading to higher taxes on crude oil, most of it imposed at the retail level. In Canada, this includes transit taxes in the cities of Vancouver and Montreal, and – effective this month – a carbon tax in Québec. Retail taxes are not a concern for the oil producers, except to the extent they are inflationary. However, tough environmental rules in the upstream are creating a lot of problems. They increase costs and they delay project development. No one disagrees with the importance of good environmental regulation, but good regulation does not come cheap. It costs both time and money. Environmental regulation is adding to inflation and delaying the onset of oil production that is increasingly critical.

4. The Boom: The general boom in Alberta is also contributing to oil patch inflation. The province hosts most of Canada’s petroleum production, and is the North American jurisdiction with the lowest unemployment rate. In this province the petroleum sector faces rapidly escalating costs in almost every area. Office space in Calgary, the industry’s geographic centre, has quintupled in five years. Labour for oil sands development is astronomical. Productivity is declining. How can there be an economic boom when the basic economics of conventional oil and gas production are in decline? The main reason is that conventional reserves, which were drilled in an era of lower costs, are now getting produced and sold as quickly and profitably as possible. High prices for oil are accelerating the resource’s depletion. Costs for drilling and mineral rights have declined in the last year, but that is hardly cause for celebration. It has happened because the industry is less inclined to drill. From an all-time high of almost 25,000 wells in 2005, drilling has dropped precipitously. Estimated drilling this year will total only 17,650 wells this year and a mere 14,500 wells next. Most of the drop is in the area of natural gas drilling, but it is still something to worry about. If you don’t drill, you don’t find oil or gas.

5. Government Greed: The final piece of this puzzle is the matter of royalties and taxes. In Canada, oil and gas resources are mostly owned by government, and governments get revenue from producers in a variety of ways – primarily economic rent (royalties), sales of mineral rights, and a variety of taxes. In response to voters who are convinced high oil prices mean high profits for oil producers, Canadian governments are finding ways to increase their take from the sector.

This is their right and privilege, of course. However, the more the industry has to pay, the less oil it is going to produce. Today, things took a decidedly ugly turn for the petroleum industry in Alberta, the province that produces more than 90 per cent of Canada's oil. The province has no debt, has no sales tax and yet runs a huge fiscal surplus. This year alone the province projected the surplus to be $2.2 billion, based on lower oil price assumptions.

Its great wealth notwithstanding, this afternoon the provincial government announced a much-dreaded new royalty framework that will boost royalties by $1.4 billion per year (20 per cent) in 2010. The new rates, which will increase maximum royalties from current highs of 35 per cent to 50 per cent for conventional oil and natural gas, won't take effect until 2009. In the critical area of a regime for oil sands development, the system also changed. The current royalty is 1 per cent per year on gross revenue until a project recovers its multi-billion dollar investment. The royalty then rises to 25 per cent of revenue minus operating and other costs. Under the new regime there will be a sliding tax which starts increasing at $55 a barrel. Assuming current prices, oil sands royalties will be about 5 per cent before payout and 33 per cent thereafter. The maximum rate will be 40 per cent.


Outcome: The chart projects Canadian oil production based on the first of these two royalty regimes - the one that has so successfully encouraged development in the past. Rest assured that, under the new arrangement, future oil production from both conventional and oil sands resources will be less than the volumes projected. In a world anticipating peak oil, making oil production less profitable is a serious matter - and, by definition, the new fiscal regime will make oil and gas production less profitable in Alberta.

Love ‘em or hate ‘em, oil companies are governed by the rules of capitalism. They put their money where it will generate the best return. Canada, which has a strategically vital place in the world petroleum industry, is the world's seventh largest oil exporter, but also the seventh largest importer. In most of eastern Canada, the refining side of our industry is happily importing oil from overseas. Because they pay for it with our strong currency, it costs less. This is great for Canadian consumers.

When you have a strong currency, you have more options. Canadian producers will increasingly invest in production from riskier but lower-cost and therefore more profitable exploration provinces overseas. (One great under-explored region, for example, is Southeast Asia.) But they will do so at the expense of secure investment in Canada, including development of the vast oil sands deposits. We should worry about this, and worry a lot.
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