On January 29, 2016 Alberta’s NDP Government announced a summary of a Modernized Royalty Framework (MRF) that it intends to implement.

During last spring’s election campaign, the NDP had promised to review the Province’s royalty system. The objective of this review was to design a royalty system that Albertans could trust. The promise was made in response to the concerns of some Albertans that the royalty systems designed by the previous Government (the energy industry-friendly Progressive Conservative Party) were not giving the Province its fair share of the value of its oil and gas resources.

The Royalty Review Advisory Panel

In August 2015, the Government appointed a Royalty Review Advisory Panel to conduct the review. The Review Panel’s process included public engagement and technical reviews. The public engagement involved online and face-to-face dialogue with a broad cross-section of Albertans. The technical reviews included the use of three expert groups that examined the specific mechanics of the royalty framework. To support the technical reviews, the Review Panel retained energy analytics firms Wood Mackenzie and GLJ Petroleum Consultants.

The Review Panel’s recommendations were originally to be proposed to the Government by the end of December, but were delayed by a month in order to ensure that they “got it right”.

As the Review Panel was conducting its process, the prices of oil and natural gas were falling to their lowest levels in the past 10 to 15 years. The nose dive in prices resulted in:

  • Significant reductions in capital spending and mounting job losses in the Province by an industry struggling to survive through the downturn.
  • The Government’s non-renewable resource revenues being cut in half.

At the same time, the U.S. - Alberta’s biggest energy customer – emerged as a significant new competitor in the markets for the Province’s oil and gas.

Against this backdrop, the Review Panel realized that the focus for Albertans should be less on “are the rates right”, and more on what changes needed to be made to the royalty framework to put Alberta and its oil and gas industry in a position to address the challenges of a very different and competitive environment. The Review Panel rejected submissions that the current framework should be left alone or that only minor tinkering to the existing system was needed. They concluded that doing nothing or just making minor changes to the existing system would result in a flight of investment out of Alberta.

The Recommendations

Accordingly, in its Report to the Government the Review Panel presented recommendations, including the implementation of the MRF, to address the new reality that Alberta faces in securing value for its oil and gas resources in a highly competitive world where a return to higher prices is not a given.

The intent of the Review Panel’s recommendations was to create a simpler, more transparent and efficient system that:

  • Encourages investment, creates jobs and enhances economic activity.
  • Rewards innovation and cost-efficiency. Under the MRF, producers will have economic incentives to drill and complete wells at less than the applicable prescribed costs.

Although the NDP had been concerned about whether Alberta was getting its fair share, the worsening economic conditions and the NDP’s growing understanding of the industry resulted in changed priorities.

The Review Panel’s recommendations were accordingly accepted by the Government in whole, with no added provisions (unlike the Climate Change policy announcement, where the Government added a 100MT/year cap on emissions from the oil sands on top of the environmental review panel’s recommendations).

Key Conclusions

Some of the Review Panel’s main findings and recommendations include:

  • Overall, Alberta’s royalty rates are comparable with other jurisdictions, but changes are needed to simplify the system in order to make Alberta more attractive for future investment.
  • The oil sands royalty framework implemented in 2009 provides Albertans an appropriate share of value. This framework, combined with the last decade’s substantial investments in oil sands projects, is poised to generate increased royalty revenues in the near future.
  • Regarding the royalty system for oil, natural gas and natural gas liquids:
    • Existing wells will continue to be governed by the current royalty system for the next 10 years, during which period existing royalty rates will be grandfathered.
    • The MRF will apply to wells drilled starting January 1, 2017.
    • For wells to which the MRF applies there will be three separate phases.  Companies will pay a flat 5% royalty until well payout based on a revenue minus cost structure.  A Drilling and Completion Cost Allowance formula administered by the Province that will include any applicable carbon levies will provide the capital costs of wells for payout purposes.  These costs will reflect the depth and, for horizontal wells, the length of the wells drilled and will be calibrated annually. Royalties paid based on revenues on all production streams (oil, natural gas and natural gas liquids) are harmonized under the new program.
    • Post-payout, there will be two other phases:
      • The Mid-life phase where royalties are strictly tied to commodity prices.  These post payout royalty rates will be higher than the 5% flat rate that applies before payout and will be intended on average to yield the same IRR as under the current royalty system.  The post payout royalty rates will not be announced until the end of March.
      • When a Maturity threshold is hit (20 bbl/ d for oil and 200 mcf/d for natural gas) royalty rates will move to a sliding scale (based on volume and price) with a 5% minimum acknowledging that lower rate older wells have higher unit costs. This arrangement is intended to delay premature shut-ins of wells that are no longer economic under Mid-life period royalties.
  • A “distortion” that discriminates on the basis of the type of hydrocarbon found will be eliminated. As a result, companies will not end up assuming the same risk of loss or inefficiencies when, for example, they drill for oil but instead locate dry gas.
  • Current drilling incentives that were set to expire in 2016 will be extended and built into the MRF. The effect of those drilling incentives will diminish in a high price environment.
  • The Government should look into creating incentives for EOR and high risk experimental drilling.
  • There should be “an unprecedented level of transparency”, including information on an easy-to-use website. A new capital cost index will be published regarding oil and gas wells.  The Province will also give prices, production volumes and allowable costs used to determine oilsands royalties.
  • An annual detailed report will compare returns to Albertans with those of competing jurisdictions while measuring job creation, investment, production costs, value-added development and environmental performance.
  • Alberta should seize opportunities to develop a value-added natural gas strategy including fostering the establishment of more downstream industries in the Province.  The Province should provide financial support to accelerate the development and commercialization of partial upgrading technologies for bitumen, in order to better utilize a resource that is unique to Alberta.

Details of the MRF, including applicable royalty rates, are to be finalized by the Government in consultation with stakeholders by March 31, 2016. There is an opportunity during this period to identify and address any unintended negative effects or other adverse consequences arising from these proposed changes.

The Industry’s Response

Industry’s preliminary reaction to the Review Panel’s Report has been positive. Although many important details remain to be worked out, the Government has clearly signalled a desire to assist the energy sector through a challenging time.

However, Premier Notley’s recent comments that  “[it] is not the time to reach out and make a big money grab. That just is not going to help Albertans overall right now,” leaves open the unsettling possibility that the NDP may revisit the royalty rates when prices do recover.

It remains to be seen, however, whether any cash that left the Province as a result of the royalty review will find its way back in the near or long-term.