The Fallout From Oil Royalties: The Popular, the Principled or the Righteous?

When Ralph Klein took over the helm in Alberta, the province was neck-deep in debt, exhausted by the national energy program, plagued by low energy prices, and in need of some surgical and unpleasant cuts. So, former premier Klein did what he had to do — cut spending to conserve money, cut taxes to stimulate output, and invested every dime left over in setting up the royalty regime that should probably take most of the accolades for recovering the province’s oil patch.

But of course no good deed goes unpunished forever. In a fair society, fair distribution of wealth is key to keeping its basic mandates. So, when one province suddenly develops a case of Midas’ “golden touch,” it comes as no surprise that the Federal government will pay for elaborate studies, polls reports and what- have-you to find answers to a simple question — if one province fares better than the other, isn’t it fair to share the wealth?

And of course the rest of Canada will voice a resounding “yes” to that question. Particularly after alleging that not everyone is benefiting equally from the federation and that the federation is not supposed to create excess wealth on one side and meager incomes on the other.

What usually happens is that populist demands create sufficient pressures on local governments to create new laws, regardless whether such laws are justified or not. Most of the time, it is much easier just to give the people what they want, although, it has to be admitted, the popular choice could be the right one, too. But has the populist choice really been the right one in the case of Alberta’s energy royalties?

You see, when drilling for oil and gas, it is not always and only about the riches below, feasibility studies, or risk-adjusted cost and production forecasts. It is also, and largely, about the royalties that are generally used to determine what will be the producer’s share and how much will go to the government. Why are royalties so important to oil producers? Simply, all other factors of oil and gas production, except for royalties, are difficult to predict, are subject to excess risk, and thus represent inherently volatile variables in any equation.

So, now the rules of the game have changed, even as producers have already made commitments to leases and royalties based on the old rules. To make it worse for most producers, the majority of the commitments were made unilaterally; that is, the government does not have to — nor will it, apparently — honor them.

So, who is the popular, principled or righteous in this story? Well, had the decision to slap new royalties been applied only against new royalty and lease applications, it would have contained all three. But since the new regulations have the ability to “time travel,” I’m afraid Alberta royalties fit only the populist frock, and not the “other” two.

In dollar terms, it means that annual royalty revenues could potentially increase by $1.4 billion within the next three years or less, provided there is no decline in production and applications for new leases and royalty participation rates. The worst case scenario is that the industry simply reduces development and exploration activities, leaving Alberta with no gain at all, and possibly even a net decrease in tax revenues from the oil patch.

Currently, the oil and gas industry in Canada is strangely quiet, perhaps still dealing with the shock. But surely, analysts and number crunchers are burning the midnight oil trying to come up with proper cost estimates and risk-adjustments. It is entirely possible that domestic and foreign producers with stakes in Alberta’s oil patches are going to look at new projects elsewhere. So, regardless of how and if it all works out, unless a populist decision is based on what is principled and what is right, too, the former rarely works in the long run.