On March 17, 2011, Raymond Bachand, Quebec Minister of Finance, announced the creation of a new royalty regime applicable to the Quebec Shale Gas Industry as well as a number of other measures including a gas development plan, the replacement of the exploration tax credit and new compensation measures for municipalities.

Transition from the current royalty regime to the new regime

The new royalty system will be put into place upon completion of the strategic environmental assessment announced by the government on March 8, 2011. Until the completion of this assessment, operators can choose to remain under the current royalty scheme or participate in the new regime.

Operators who have completed wells at the time when the new royalty scheme is introduced can benefit from the current royalty regime throughout the production life of these wells, notwithstanding the entry into force of the new royalty regime.

Operators participating in the strategic environmental assessment can apply to have the new gas development program apply retroactively to their wells.

The new shale gas royalty regime

The current royalty regime is based on a fixed rate of either 10% or 12.5% depending on the production level of a well. This two-tier system will be replaced with an escalating rate system that takes into account both the value of the resource and the production level of an individual well.

The new rate will vary from 5% to 35% and the price used to fix the royalty rate takes into account market price, transportation cost, processing cost and other items which will eventually be specified in a regulatory framework to be adopted later. Production volumes will be calculated on a monthly basis taking into account average daily production volume. The precise formula is detailed in the appendix of the Budget Paper A Fair and Competitive Royalty System For Responsible Shale Gas Production (http://www.budget.finances.gouv.qc.ca/Budget/2011-2012/en/documents/Schisteen.pdf)

Example of the evolution of the royalty rate at a selling price of $4.00 [table]

Example of the evolution of the royalty rate on average volume per day of 250 000 cubic feet [table]

Examples of levels of production/selling price where the maximum rate of 35% would be applicable [table]

The new non refundable royalty credit

When the new royalty system takes effect, the current tax credit for resources with respect to shale gas exploration will be eliminated and replaced by a new non refundable royalty credit for exploration. The specific details will be announced by the Ministère des Finances at a later date.

The amount of the new credit will be up to 15% of eligible exploration expenses. It will apply as a credit to royalties payable with respect to individual wells, however, the credit cannot have the effect of reducing the royalty rate below 5%. Unused portions of the credit can be carried forward to subsequent years for the same well.

Review of duties applicable to rights and permits required for shale gas exploration and development

The government will be reviewing all of the duties and licences pertaining to exploration and production activities. This review is intended to modernize the legislative and regulatory regime applicable to the shale industry in Quebec. More specific details of this review will be announced at a later date.

Estimated impact on the yields from a standard well

The government has performed an analysis of the estimated impact of the proposed changes to the royalty regime over the lifespan of a standard well having an initial production volume of 2.25 million cubic feet per day. Under the current-day scenario, where well costs are estimated at $10 million per well and upon the assumption of a selling price of $4.25 per thousand of cubic feet ($4.00/mcf NYMEX price plus a mark-up of 0.25$/mcf to account for market proximity), the current regime results in a shortfall for the government evaluated at $400,000 per well with a net loss for the industry evaluated at $1.5 million per well. If the new regime were to come into effect today on such a well, government revenues would then represent $1 million per well whereas net losses for the industry are estimated at $2.9 million per well.

At a selling price of $6.25/mcf and in a situation where well costs fall to $6 million, government revenues under the current regime are estimated at $2.2 million per well whereas under the new regime they are estimated at $3.1 million per well, net profit for the industry being reduced from $4.4 million per well under the current regime to $3.5 million per well under the new regime.

Finally, based on a selling price of $9.25/mcf and well costs of $6 million, government revenues under the current regime are estimated at $4.5 million per well which the new regime would increase to $6.8 million per well all while decreasing net profits for the industry from $8.9 million per well under the current regime to $6.6 million per well under the new regime.

The government has also estimated revenue allocation at both a selling price of $6.25/mcf and $9.25/mcf. Under the current regime, the government's share of revenue is estimated at 33% and 34% respectively whereas under the new regime this would rise to 47% and 51% respectively.

Compensation for municipalities

Contrary to the recommendations contained in the Bureau d'audiences publiques sur l'environnement (BAPE) report on the sustainable development of the shale gas industry in Quebec, the government has rejected the suggestion that a portion of the royalties raised on shale gas production be transferred to municipalities. Rather, the government has announced that measures will be taken to ensure that municipalities are fully compensated for any special costs borne by municipalities as a result of industry activities. This compensation will be financed by operators in a manner that the government will determine as the industry develops.

In addition, the government has announced that municipalities will receive $100,000 in compensation for each shale gas well operated on its territory to be paid out over a ten year period in the following fashion:

  • $25,000 in the year in which the well begins producing commercially;
  • $15,000 in the second year production;
  • $10,000 in the third year; $8,000 in the fourth year; and
  • $7,000 per year for the following six years.

This compensation will be financed by the gas industry and is yet to be determined by the government.

Surface rights

The government has announced its intention to establish a legal and regulatory framework which will fix standards for agreements negotiated by industry with landowners regarding surface access rights.

The gas development program

The government intends to introduce an optional gas development program which will entail a lower royalty for the initial phases of specific projects authorized by the government but for which the royalty increase will then be more rapid based on the well's profitability.

Authorization of wells for this program will be based on the objective of encouraging geographic concentration of wells in specific zones. The main objective of this program is to reduce initial risks for operators in exchange for a higher share of the revenue for the government over the operational lifespan of the wells covered by the program.

It will be incumbent upon the industry to select the zones to be covered by exploration licenses under the gas development program, subject to government approval. Once the zone is selected and approved, compliance with the gas development program for the whole of the useful life of the wells within the designated zone will be mandatory.

Wells included in the strategic environmental assessment will be eligible for the gas development program and costs incurred by operators to carry out studies for the benefit of the strategic environmental assessment will be considered as eligible expenses for the purposes of the program.

Royalties under the program are calculated as a percentage of either net or gross revenue. For the first period, which runs until an operator has recouped all of its eligible investment and operating costs plus interest, the royalty will be fixed 2% of gross revenue. This period cannot extend beyond ten years.If an operator has not recouped all of its eligible investment and operating costs plus interest within said ten year period, the project is automatically moved up to the second royalty tier.

This second royalty tier, at which royalty is set at the highest between 15% of net revenue or 5% of gross revenue, runs until the operator has achieved a 25% rate of return on its initial investment, plus interest.Once the 25% rate of return is achieved, the project is subjected to the third tier of royalty, which is the highest of 25% of net revenue or 5% of gross revenue. This tier is applicable until the operator achieves a 100% rate of return on its initial investment plus interest rate at which point the fourth tier of royalty applies for the remainder of the project. This fourth tier is the highest of 35% of net revenue or 5% of gross revenue.

The gas development project is scheduled to be introduced in 2012 at which point the government will undertake a call for project proposals from operators. With the adoption of the gas development project, the government is not ruling out the possibility of public equity participation.