Alberta Oil and Gas Royalty Review 2015: Understanding the Province’s Royalty System – Part 1

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I have lived by one crucial principle since I was 24 years old. I don't blame or complain about things like the economy, the government, taxes, employees, gas prices, or any of the external things that I don't have control over. The only thing I have control over is my response to these things.- Jack Canfield

 

The new Alberta government under the New Democratic Party is currently reviewing the province’s oil and gas industry royalty system. While many industry observers wait with bated breath, I thought a series of blogs that may help the uninitiated (like myself) gain even a basic understanding of the system could be interesting.This first installment lays a broad framework that will lead to more specific discussions.

How to Define Royalties?

According to the Alberta Royalty Review 2007 Royalty Information Series: Royalty Information Briefing # 1 – What are Royalties -- “Royalty is the price [payment] that the owner of a natural resource charges for the right to develop the resource.”

I must quickly add that the subject of this series of blogs is the royalty regime as applied to the Alberta government’s legal and regulatory rights to receive royalties and related revenues from developers and producers of natural resource products in Crown lands. Alberta Energy’s website has this to say in regard to how mineral rights are distributed in the province:

·         81%  are owned by the Crown and directly administered by Alberta government.

·         19% are “freehold” mineral rights further distributed into a) owned by federal government on behalf of First Nations, b) located in national parks, and c) owned by private individuals and companies.

 

What Royalties Are Not

Because of the many similarities in the way they behave, many people tend to view royalties as a form of taxation. However, certain fundamental differences distinguish royalties and taxes from each other. The main difference is the rationale for levying royalties as opposed to taxes.

Royalties emanate from ownership. The right to payment of royalties in general proceeds from the right of ownership over natural resources, copyright, patents and other proprietary assets – whether owned by the state, corporations or private individuals. For instance, as mentioned above, Crown mineral rights in Alberta confer on the provincial government the legal right to manage such natural resources within its jurisdiction on behalf of its citizens. In exchange for the contractual rights to develop, extract and profit from natural resources Alberta levies royalty payments from corporations, partnerships, private individuals - domestic or foreign - who have acquired rights to natural resource development and production.

Taxation arises from the need to finance government services and affect economic and social development. The Canadian Encyclopedia states – “Taxes are compulsory payments by individuals and corporations to government. They are levied to finance government services, redistribute income, and influence the behaviour of consumers and investors.”

Covering the costs of services to the society, communities and individuals is the primary reason why business entities and individuals are legally obliged to pay taxes. Taxation primarily arises as a legal compulsion to contribute to financing government services.

Royalties and the Fiscal System

The preceding paragraphs centering on royalties and taxes are a good introduction to the larger framework that affects oil and gas development and production in the province. That larger system, which significantly impacts the health of the province’s oil and gas sector, is known as the Oil and Gas Fiscal System. In Alberta this system consists of the following components:

a.      Royalties;

b.      Corporate Income Tax (both Federal and Provincial);

c.       Freehold Mineral Tax (a.k.a. Severance Tax in Fig. 1);

d.      Bonuses; and

e.      Land Rental Fees.

 

This framework, with its different components and interactions (particularly royalties and corporate income tax rates), greatly determines how competitive, robust and strong the sector could be.

While the focus of this blog and its expected sequels is Alberta’s ongoing review of the oil and gas royalty structure, it behooves us to be at least familiar with the other fiscal system components. After all as our main reference here  (i.e., Royalty Information Briefing # 1 – What are Royalties) says, “In determining the appropriate level of royalties, the full fiscal system must be taken into account in order to ensure that the combination of royalties, taxes, and other fiscal levies contribute to the health of the oil and gas sector and to that of the economy as a whole.”

Characterizing Alberta’s Oil and Gas Fiscal System

Aside from knowing the components of Alberta’s Oil and Gas Fiscal System as enumerated above it is good to know the defining characteristics of Alberta’s system. After all, different jurisdictions (countries, states, provinces) tend to evolve their own systems. But globally a general framework and classification system have been derived based on the laws, rules and regulations and overall structure of fiscal systems in place in either developed or developing nations. Figure 1, below, courtesy of a document from Alberta’s Department of Energy and enhanced by my own colour highlights and letter-bullets, defines the present components applicable to Alberta as listed above.

 

Figure 1 – A General Illustration of Petroleum Fiscal Systems Used Around the Globe (Highlighting Components Currently Applicable to Alberta)

 

Alberta’s oil and gas fiscal system can be characterized using the classifications and categories shown in Figure 1.

Regressive” versus “progressive” systems.  Alberta’s fiscal system has a combination of regressive and progressive components. Regressive systems emphasize elements such as bonuses, rentals and fees that are paid to government before achieving “project payout”, i.e., before project costs incurred by lessees are recovered. Hence, they are not at all tied to the success or profitability of a given project or operation. As such these components are risk-free as far as the government is concerned. Progressive elements, on the other hand, are tied to profitability of a project or operation.

Fixed versus sliding royalty scales.  Royalties may either be in fixed terms or based on sliding scales determined mainly by changes in production levels and product pricing. The actual government take is based on formulas that factor in changes in price and production levels.  They pose a great risk to government and, by the same token, potentially great rewards or returns. Alberta’s royalty regime is based on a sliding scale which I will take up in a later blog.

Service fee systems vs. production sharing systems vs. concession systems.  A jurisdiction’s fiscal system will fall under any of these three categories, described briefly as follows:

a.      A service fee system is used chiefly in jurisdictions that do not allow foreign ownership of production. Foreign oil companies are compensated in terms of a guaranteed rate of return on their investment without regard to actual production or price changes. Good examples are Iran and Mexico.

b.      Production sharing systems use legally binding, international-court-actionable agreements known as production sharing contracts (PSC’s). Typically production sharing is used in jurisdictions with perceived unstable legal systems. Foreign petroleum companies and entities enter into such agreements with the appropriate government/state/Crown corporation giving both parties a measure of security and stability.

c.       Concession systems, also referred to as royalty/tax systems, are used in most jurisdictions judged to be under strong, well-developed legal systems. Alberta uses this system.

By way of summary we may say Alberta’s oil and gas fiscal system  is characterized by  its (1) having both regressive and progressive components, (2) using sliding royalty scales tied to profitability (i.e., interaction of production, costs and pricing), and (3) being based on a concession system.

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This discussion has barely scratched the surface of the topic. At a number of sequels I will cover in as much detail applicable the following questions and other similar concerns:

1.      What are the particular components, this time, of Alberta's royalty structure? Did you know for example that there are currently different royalty subsystems for conventional oil, oil sands, and natural gas?

2.      Why the need for a review of the royalty system, and what are the forecasts by pundits regarding the direction of expected changes in Alberta’s system?

3.      How does our royalty system compare with other jurisdictions’ fiscal regimes?

Until then I would highly recommend the motivated to review the references mentioned here as well as other sources of information and insight.

 

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