Source: Scotiabank – Shut In? Assessing the Merits of Government Supply Intervention in the Alberta Oil Industry

Royalty credit for production curtailment provides middle ground for industry players

To curtail or not to curtail: that is the question Rachel Notley is grappling with right now as Canadian oil prices remained depressed due to a 140,000 b/d mismatch between supply and outtake capacity. The Alberta premier is under intense pressure to act, and industry is divided on the issue. But there may be a middle ground that pleases both sides: a royalty credit for voluntarily shutting in production.

How serious is the problem for industry and the provincial government?

Source: Scotiabank.

Scotiabank estimates that in 2019, Alberta’s upstream industry could lose between CDN$15 billion and CDN$39 billion in royalty-applicable earnings, while the Alberta government could lose between CDN$1.5 billion and CDN$4.1 billion at a time when public coffers are starving for revenue.

In the Alberta government’s last fiscal update, oil-related royalty revenues were forecast to come in around CDN$3.6 billion and make up 7.4% of total government receipts, assuming average West Texas Intermediate prices of US$61/b and a WCS discount of US$24/b, according to Scotiabank.

The excess supply amounts to only three per cent of Western Canadian oil production and some companies, like Canadian Natural Resources, Cenovus, and Athabasca Oil, have already voluntarily limited their supply.

The problem is that there are no easy short-term options.

Enbridge’s 375,000 b/d Line 3 won’t come on-stream for another year. Shipping more crude by rail is difficult because there aren’t enough tanker cars and locomotives. The Trans Mountain Expansion and Keystone XL are bogged down in litigation.

To make matters worse, the big integrated producers (Suncor, Imperial Oil, Husky Energy) that have their own refineries, most of them in the United States, are actually profiting from the differential crisis because their downstream operations are buying feedstock at rock bottom prices. Integrated companies are protecting about 80 per cent of production from the discount, so naturally they argue that markets are working properly and oppose curtailment.

Other large producers (Cenovus, CNRL) are only able to protect 50 to 60 per cent of their production, which means they’re still feeling a fair amount of pain from the differential and support limiting production in order to reduce it.

Hardest hit are the juniors and midcaps, which are forced to sell their production in Alberta and (absent any hedging) suffer the full brunt of discounts that have now spread from heavy grades to lighter crudes. No surprise, they also support curtailment.

Offering a royalty credit for voluntary curtailment might be a strategy that pleases both sides – or at least makes the greatest number of industry players the least unhappy.

The per barrel credit could be set an initial rate the government thinks will be high enough to remove the excess production from the market. The rate can be adjusted over time if new supply comes onstream or the lower rate fails to curtail sufficient production.

Why don’t producers voluntarily cut back production?

The Scotiabank economists provide a tidy explanation: “current curtailment plans are insufficient to completely clear the market and companies that pursue this strategy alone are enduring a first-mover disadvantage as some producers benefit from others’ restraint without enduring any of the pain of cutting. This free-rider dilemma is further complicated by the fact that any efforts to negotiate some kind of regional production alliance or supply restraint pledge would likely run afoul of competition laws…”

Source: Scotiabank.

As an added bonus, Premier Notley can request the Canadian government share the cost of the program. After all, less industry activity affects federal and provincial tax revenue, which averaged $7.3 billion a year from 2012 to 2016, according to Natural Resources Canada.

Prime Minister Justin Trudeau arrived in Calgary last Thursday for a day of speechifying and meeting with energy leaders, and was criticized for not contributing something to the resolution of the oil price crisis beyond a few tax breaks announced in Ottawa’s fall fiscal update.

Notley quite rightly pointed out in her speech to drilling contractors the same day that the market access problem is not of Alberta’s making, that pipeline reviews and approvals are federal jurisdiction, yet the province is being left to struggle alone to find solutions.

While industry debates the merits of curtailing production, economists have weighed in against the idea.

Prof. Kent Fellows is an economist with the School of Public Policy at the University of Calgary. He says that “the first and best place to look for solutions is in find ways to increase export capacity. Literally every additional barrel of export capacity will help as long as the transportation cost is lower than the portion of the differential associated with the transportation constraint.”

The idea of a royalty credit to encourage curtailment doesn’t appeal to him, either.

“While some level of production shut in may be necessary, the market will end up dictating this over time anyway. I don’t see a reason why the province needs to provide an additional incentive here,” he wrote in an email to Energi News.

The answer to Prof. Fellows’ objection may be political.

Unlike economists, politicians must calculate the cost of acting versus not acting when an economic crisis arises. The Premier has already appointed a trio of envoys to meet with industry leaders to suss out potential solutions and she expects a report from them in a few weeks.

With an election only six months away, she can’t afford to wait for market forces to fix the problem. UCP leader Jason Kenney, who is strongly supported by the smaller producers most harmed by the high differentials, has already said Alberta should “leave the door open” to mandated production cuts.

The Premier appears to have little wiggle room and little time to make a decision. If she must order producers to curtail production under the authorities granted by the Alberta Mines and Minerals Act, she should seriously consider making the cuts voluntary using a royalty credit.