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Is investment in the oil sands slowing the industry down?

Why more isn’t better when it comes to the oil sands – and how embracing that view could save the province, and industry, billions of dollars

Dec 16, 2013

by Max Fawcett

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Investment in the oil sands seems like a self-evident good for industry and government alike. In fact, the opposite might be true
Illustration Graham Roumieu

Imagine that you’re an investor, and the government offers you a tax credit worth as much as 50 cents on every dollar you invest, provided those dollars are invested in factories that built, oh, let’s say yellow tricycles. Chances are you’d take them up on that offer. Indeed, you might be inclined to accelerate the construction of those yellow-tricycle-making factories, and be willing to pay a premium for that shortened timeline. You might not even care if the tricycle-making factory is particularly well-built, or if the people building it are doing a good job. You’d probably have to pay them more than they would otherwise be worth, and that, in turn, would drive up the cost of labour for those who built factories that made, say, red tricycles. But it wouldn’t really matter in the end – all that would matter was cranking out as many tricycle factories (and, by extension, tricycles) – as possible.

Welcome to Alberta, 2013. No, we’re not making yellow tricycles, but the government’s approach to regulating, incenting and taxing the oil sands is having a similarly distortive effect. It’s why, despite their best efforts, companies like Imperial and Suncor can only dream of bringing a new oil sands project in on budget. It’s why, despite oil prices that are significantly higher than forecasts made just a few years ago, the government is in deficit. And it’s why a growing chorus of economists, academics and even the odd politician here and there believes it’s time for the Government of Alberta to do something about the situation. More specifically, they’d like to see steps taken that would slow development of the oil sands.

The problem, according to those who take a critical view of the situation is that the economic incentives in place for the oil sands are misaligned with the government’s current and future interests. When the oil sands were a marginal, capital-intensive play, offering companies a heavily discounted royalty rate until their project reached payout (that is, until it had returned an amount on the original capital investment needed to build the project equivalent to that offered by a Canadian government bond) was an effective enticement. But with nearly two million barrels a day coming out of the oil sands, that enticement is no longer necessary – and may well be doing more harm than good.

“Any sort of outside, objective analysis would suggest you’re going to derive maximum value from this resource by doing it at a measured pace and doing it right.” – Andrew Logan, oil sands economist, CERES

One need only look at Imperial Oil’s recently completed Kearl project for evidence of what that harm looks like, and how much it adds up. The first phase of the megaproject came in more than 60 per cent over budget, costing the company $12.9 billion instead of the expected $7.9 billion. That’s five billion dollars extra that the government will have to wait for the company to earn back before it starts paying out the full royalty rate. Because the government’s new(ish) royalty structure sets rates based on global oil prices (the higher they are, the more companies pay), it’s impossible to put a precise dollar figure on how much cost overruns like the one at Kearl cost taxpayers. But that doesn’t mean we can’t get a figure that puts us in the ballpark, and some, like Andrew Leach, the Enbridge professor of energy policy at the University of Alberta, have tried to do just that. Based on the U.S. Energy Information Administration’s 2013 reference case, along with a $15 differential between West Texas Intermediate and Alberta bitumen, Leach calculates that for a 110,000-barrel-per-day mine like Kearl, each additional billion dollars spent on startup costs equates to between $525 and $560 million fewer dollars in taxes and royalties over the 40-year life of the project. As such, the cost overrun at Kearl will cost Albertans $2.5 billion by the time the first phase of the project has run its course. And guess what? There are still further phases to come, which will, if history is any guide, come online complete with cost overruns of their own.

Leach isn’t alone in his calculations. Pedro van Meurs, a Dutch royalty expert and consultant to the 2007 Alberta Royalty Review panel, has suggested that for every dollar of cost overrun during the construction phase of an oil sands project, the province effectively forfeits 40 to 50 cents in royalties and tax revenues. André Plourde, who sat on the 2007 Royalty Review panel and now teaches at Carleton University, says those figures are a reflection of the fact that the current royalty system effectively places increased production ahead of increased productivity. “You’re basically pushing too much activity into a relatively short period of time, and so you have companies competing with one another to attract what are fundamentally the same types of labour,” he says. “You can always pass on the cost, in part, to the owner of the resource, through lower royalties, and to taxpayers in terms of lower tax receipts.” In other words, companies are less likely to exercise restraint when building oil sands projects when they know they’ll get a substantial portion of those dollars back. They are, as Plourde says, “not spending dollar dollars – they’re spending 40- or 50-cent dollars at best.”

Andrew Logan, an oil sands economist with international consulting firm Ceres, says these constant cost overruns serve – or ought to, anyways – as a wakeup call for the province and its biggest energy companies. “What’s particularly cautionary about Kearl is that Exxon and Imperial have a reputation as being extremely disciplined from a capital and project planning standpoint, and if they can’t bring in a project anywhere close to budget, I’m not sure anyone can.” And while, as Leach’s math suggests, these chronic cost overruns on new oil sands projects are particularly bad news for the province’s coffers, they’re hardly good news for the companies commissioning them either. Phase 1 of Kearl, for example, is now expected to deliver a measly seven per cent return on investment for Imperial/Exxon – not a disaster, but not what you’d expect from a project that ties up so much capital.

“Any sort of outside, objective analysis would suggest you’re going to derive maximum value from this resource by doing it at a measured pace and doing it right,” Logan says. “That’s what’s going to maximize value – not a rush to build projects as quickly as you can. That would be best for the province, best for the industry and best for everyone who lives nearby and downstream.”

That’s certainly ATB chief economist Todd Hirsch’s view of the situation. “When it comes to the overall economy, faster is not always better. I think sometimes economists and politicians fall into the trap of wanting growth to be X+1 from what it was last year. But if you look at Alberta’s economy, particularly in 2011 and 2012, faster was not always better. We were getting close to overheating.” And when the economy does overheat, as it did in 2006 and 2007, the rest of the province’s businesses tend to suffer. “All the other bits of diversity we have in the province struggle, because they’re competing,” Hirsch says. “Take office staff: I lost my economist in 2011 to the energy sector because I couldn’t back up the money truck like energy companies could at the time.” No, Hirsch says, slowing growth in the oil sands wouldn’t magically lead to a more diversified economy, that holiest of grails in Alberta, but it could create the conditions needed for that to happen. “I think if there was a moderation, and a way to orchestrate a slowdown, I think there would be benefits that would ripple across the rest of the province.”

The problem is that the government doesn’t appear willing to even consider the possibility. Energy Minister Ken Hughes is resolute in his view that the government has no interest in looking at, much less changing, royalty rates in the province. “As an entrepreneur, I can tell you that stability is more important than almost anything else to investors in projects,” he says. “As a result, there is no consideration to change the royalty regime in Alberta.” And as for the corrosive effects of cost-inflation in the oil sands and what the government can do to stop it? “The most effective people to run projects and to build projects are people who actually have experience doing it,” Hughes says. “The Government of Alberta would not be well-equipped to play a role in that, other than to try and find ways to ensure there’s an adequate supply of workers in Alberta.”

Instead, he says, it’s up to industry to constrain their costs and control their budgets. “Industry has to exert as much discipline as is possible,” he says. “They have to approach the workforce challenges in a way that doesn’t drive up costs of labour and services, if they can. Not all of it is within their sphere of influence, obviously, but if industry was able to work together more effectively to address industry-wide shortages of labour, that would be, I think, helpful.” And would the government help them suppress their appetites, perhaps by constraining the number of new projects it grants permits to? Not a chance. “I can’t think of a single proponent of a development in northeastern Alberta that’s asked us not to have it go ahead,” Hughes says.

The good news is that it looks like some of the biggest players in the oil sands are starting to appreciate that need for restraint. Some have partnered on major projects with competitors to reduce the competition for scarce resources. Others have turned to improving and expanding existing operations. Logan says that could be the beginning of an industry-wide change in attitudes. “You look at Shell, Chevron, Exxon, BP, they’ve all seen production basically plateau or decline in the last five years, and yet they’re all actually worth more if you look at their market cap,” he says. “There’s been a realization that value can be driven by things other than top-line revenue growth. In a way, Suncor is following that lead, but they’re also establishing an important precedent within the oil sands that there’s a need to be more thoughtful about where capital goes and why it goes there.”

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But such a consensus is unlikely to last. A significant rise in oil prices, or a substantial reduction in costs, would incent a company to rush in and try to capture the newly available profit, a situation exacerbated by the existing royalty structure. There’s also the all-important human factor. “In theory, everyone’s incentives should be aligned,” Logan says, “but there are three different time-scales at work here. There’s the resource time-scale, which is quite long, obviously. There’s the CEO life span time-scale, which is much shorter. And then there’s a political time-scale, which is even shorter than that. Those three things are what are in conflict, and they’ve brought us to where we are.”

Even if prices and costs stay where they are and the human factor doesn’t conspire to spoil the whole thing, that’s still not an ideal situation. Indeed, as the Parkland Institute’s David Campanella suggests, it might be a whole lot worse than that. “The worst-case scenario for the public is what seems to be happening right now, which is that the government continues to try to incentivize more production through subsidized royalty rates while at the same time the oil companies are deciding, on their own, to slow down production and investment,” he says.

That’s why, if there was a time to have this conversation, it’s now. There are presently 2.17 million barrels a day worth of bitumen attached to projects that have received regulatory approval, with a further 1.23 million barrels a day under regulatory review. That’s in addition to the over 780,000 barrels per day that will come from projects that are already being built (a figure that doesn’t include the 180,000 barrel per day Fort Hills project that Suncor officially gave the go-ahead to in late October) and the 2.6 million barrels a day that get churned out of the oil sands right now. That is not the recipe for a steady and gradual buildup – it’s an invitation to another boom, and potentially a disaster for both the Government of Alberta and even the companies involved. And when you add in the tens of billions of dollars that are expected to get spent just across the B.C. border to develop the natural gas stored in its Montney shale, the resulting chaos could make the last boom look like a quiet day in the countryside.

Having that conversation would benefit just about everyone, too. For the province, it would allow it to reconsider its long-term vision for the oil sands and what it could do for Albertans. “Do we see this as a long-term resource, in the sense that we’re going to be in this business for the next 100 years, or do we think it’s really important to get it all out right now,” Plourde says. “I think that’s a call for the people of Alberta, and the Government of Alberta, to make.”

Part of that conversation, Plourde says, should involve the province reviewing how it thinks about, and measures, its objectives when it comes to the oil sands. “The future of Alberta is really tied to the successful exploitation of the oil sands, and I think we tend to measure success by expenditures. But I’m a cheap economist – I really would like to see these resources produced at the lowest possible cost, and so at the smallest possible investment per unit of production,” he says. “Production and dollars of investment are not the only measures that people should look at in terms of assessing the success of the development of the oil sands.”

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It might be time for industry to do the same. Back when many of the projects that are still in the planning and permitting stages were being drawn up in the mid-2000s, the prevailing view was that demand for oil would increase for the foreseeable future while supply would remain constrained. That’s changed, both because of the shale oil boom in the U.S. and falling demand in the developed world. A number of major financial institutions, including HSBC, Citibank and Deutsche Bank, have suggested that global demand could peak within a decade. “If you’re operating the marginal barrel, as the oil sands are, that’s a huge, huge concern,” Logan says. “If you’re in the position of having to commit tens of billions of dollars to a project, I’d think you’d want to have a bit more certainty about future demand before you moved ahead with that. Once that capital is sunk, it’s sunk.”

Unfortunately, the odds of the Government of Alberta acting on these imperatives, either by restricting new permits to the oil sands or eliminating the two-tiered nature of oil sands royalties, are slim. “It just seems so fraught with danger, because if there is any bungling or industry backlash, then the opposition can hold that up and say, ‘See, look, this government can’t be trusted with anything,’ ” ATB’s Todd Hirsch says. “So, sadly, it might be one of those situations where the government is reluctant to take what could be a very sensible step because they’re afraid of the fact that if it doesn’t work out well it could get crucified.”

History Lesson

It stands to reason that much of the reticence on the part of the Redford government to discuss changing the royalty and permitting structure in the oil sands is a reflection of the damage the last such conversation did to her predecessor, Ed Stelmach. But ATB chief economist Todd Hirsch, for one, thinks Stelmach was more a victim of circumstances than the author of his own demise. “Everyone blamed the royalty regime,” he says. “You can’t lay all of this at the feet of the royalty regime, but industry did anyway. It was bad timing. I’d like to see how the experiment would have gone if oil prices would have stayed at $147. My guess is there would have been grumbling and complaining, but you wouldn’t have seen this outflow of capital from the province, and the government would have been heralded for having done the right thing and having foresight.”

The Parkland Institute’s David Campanella agrees. “I think it’s a total myth that there was some big flight of capital resulting from the royalty changes,” he says. “Look at what happened in Saskatchewan and B.C. – they had massive drops as well, and they didn’t change their royalty rates.”

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