Monday, February 8, 2016

How Royalties Work and What It Means When Canada Restricts Alberta's Access to Energy Markets

The following remarks, attributed to an Alberta business executive, are interesting for two reasons: 1) They give a helpful overview of how Alberta's oil & gas royalties work for those who don't know, and 2) they explains clearly how Canadians are hurting themselves by essentially embargoing Alberta's energy resources over pedantic (and often contradictory) opposition to pipelines. 

This is worth reading for anyone interested Alberta's oil and gas industry, Canada's energy resources, and the ongoing debate over pipelines:

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I am writing this post in an attempt to inform and educate anyone who wants to understand the basics of how the Alberta government receives royalty money from Oil and Gas production in our province.

I will also explain how Alberta has lost BILLIONS of dollars in royalties over the last five or so years (remember this is money that could have paid for new schools, healthcare, social programs, or “insert government funded program of your choice”).

Lastly I will touch base on the impact this discussion has for all of Canada, and what we can ALL do about it.

I will try to keep this high level, but provide enough detail to help understand the basics.

So first: The Oil and Gas industry is divided into 3 main sectors:

  1. UPSTREAM - raw production from wells or open-put mining (this is the only area where Alberta gets paid a royalty).
  2. MIDSTREAM - transporting raw production or refined products -- pipelines, trains, trucks, barge, storage tanks, etc.
  3. DOWNSTREAM - refining of hydrocarbons (oil and gas) into end-use-products -- gasoline, jet fuel, heating oil, lubricants... the list goes on and on.
In regards to royalties, Alberta only receives a royalty on raw production that takes place in the Upstream Sector. This is because the majority of Oil and Gas reserves in Alberta (80%) are located on Crown Land (the government and people of Alberta own the surface/mineral rights). We allow companies to invest money (billions) and establish their operations here to extract that Oil and Gas. We do however set a specific percentage (royalty) that companies must pay to us for every barrel of oil that is produced (I’m really just going to focus on Oilsands because that is where the majority of our Oil and Gas royalty money is generated from. We also receive royalties from natural gas, crude oil and liquids ).

 There are two basic formulas for Oilsands royalties:

  • PRE-PAYOUT - this is when a company has not yet recovered their initial investment. While the company is still working to make their money back on their startup costs, we charge a royalty between 1-9% of their gross revenue. This percentage is dependent on the price of oil (the higher the price of oil, the higher the percentage we take).
  • POST-PAYOUT – at this point the company has recovered their initial investment, so now we (Alberta) take between 25-40% of the company’s net profits. Again – this percentage is dependent on the price of oil. The higher the price of oil, the higher the royalty percentage we take.

This is a very high level explanation of royalties, but I hope it at least helps you to understand the basics about how we make money as a province from our Oil. To give you an idea – in 2014 and early 2015, Alberta was paid approx. 8.3 BILLION in royalty money ... That pays for a lot of government funded services.



Now, I mentioned that I would also explain how Alberta has lost BILLIONS in royalty revenue over the last five or so years. I think many of you will be very shocked to hear the following facts:

Alberta oil production has been growing quite fast over the past 15 years. In the year 2000 we were producing approx. 600K barrels/day. Now in 2015 we are producing around 2.3 Million barrels /day. That’s almost a 400% increase in production!

Unfortunately, while we have increased production, we have NOT built the infrastructure (pipelines) to help transport this increased production to end markets. I’ll try to provide an analogy to make my point: you know how at the end of the year when a clothing store has excess inventory, they throw a massive clear-out sale to get rid of their excess inventory? (They have too much inventory, so they sell it at a discount to get rid of it).

This is essentially what is happening to Alberta Oil! We have more product than we can fit into pipelines, so we sell it at a significant discount to help get rid of it. The price discount applied is anywhere from 10-40%! Remember, we get paid a royalty based on gross revenue (pre-payout), or net profit (post-payout).

Alberta is losing royalty dollars because our oil is landlocked, causing a dramatic discount when we sell it! 

That 8.3 Billion in royalty revenue I quoted should have been substantially greater, but we sold our oil at a discount because we don’t have the infrastructure to ship it to end markets. I hope this makes sense how we have truly taken away money from ourselves by challenging pipelines (the safest method of transporting oil, a product we ALL use every single day). I don’t think that many people understand this.

This discussion of royalties and pipelines has implications for ALL of Canada as well. If what I have mentioned above does not move you, I hope the following facts will:

Canada has the third largest oil reserves in the world, yet we DO NOT provide our entire Country with oil!

Eastern Canada imports millions of barrels of oil every year from countries like SAUDI ARABIA, NIGERIA, IRAQ, VENEZUELA, and ALGERIA.

People claim to fight pipelines in Canada because they are protecting human rights and the environment. Yet we’re completely okay with importing oil from overseas countries that have atrocious human rights violations, and next to no environmental regulations compared to Canada. This is mind boggling and completely illogical. Again – I don’t think that many people understand this.

By protesting pipelines (specifically Energy East), Canadians are saying they would rather import oil from countries with atrocious human rights violations, and little to no environmental regulations compared to Canada (taking away jobs from Canadians and losing additional income tax).

And back to royalties – by protesting pipelines we are losing BILLIONS in royalty dollars, because we can’t ship our products to end markets, so we sell it at a discount (which lowers the royalty we receive).

If you’re a true environmentalist and humanitarian, you would push to buy ONLY CANADIAN OIL! Canada’s Oil industry has some of the tightest environmental regulations in the world! We’re also a world leader in renewable energy (which many people don’t realize).

Please support Canada today and tell our governments (Federally and Provincially) to approve pipelines... OR... your could continue to support foreign oil interests -- the choice is yours!

Thanks for listening.

Please like and share this post to help others understand the basics about this conversation. This topic has implications for all of Canada, regardless whether you work in the industry or not.