“There’s no self-correcting way out of this situation… if [oil] prices don’t rise, there’s no easy way.” – Tombe
The Alberta government is betting on rising oil prices and growing royalties over the next year to pare its budget deficits, but how likely is that scenario? Not very, according to economist Trevor Tombe, as global markets continue to struggle with a crude oil glut and rebalancing forecasts are now pushed into late 2018, or later.
How dependent is Alberta on oil and gas royalties? The 2017/18 budget says that beginning in 2004/05, non-renewable resource revenue – comprised almost entirely of royalties from bitumen, conventional crude oil, and natural gas – represented as much as 55 per cent of provincial revenues.
This fiscal year they will account for just 22 per cent of the $45 billion forecast.
Finance Minister Joe Ceci forecasts bitumen royalties to double this year to $2.5 billion, and then more than double again by 2019/20 – an election year – to $5.3 billion.
“Other” resource revenue is predicted to remain static at $1.2 billion, dropping a bit next year, then rising to $1.35 billion in 2019/20.
In other words, government needs the Alberta oil sands to recover quickly and generate not just more royalties, but also significantly higher corporate and personal income taxes as the provincial economy recovers to almost three percent GDP growth this year.
“Even with low prices royalties should grow but, importantly, not by enough to balance the books without some additional sources of revenue or some real spending restraint,” Tombe said in an interview.
As usual, Alberta is betting on the price of oil.
“Most analysts expect if the OPEC agreement is complied with, and with continued global demand growth, oil supply and demand could be re-balanced by mid-2017,” the government said in its budget report.
Well, we’ve arrived at the middle of the year, with no sign of rebalancing yet, mostly thanks to American shale producers, who responded to rising prices with a drilling boom, especially in the Permian Basin of West Texas.
“The rebalancing of the market is under way, but at a slower pace, given the changes in fundamentals since December, especially the shift in U.S. supply from an expected contraction to positive growth,” says OPEC, which has now pushed market rebalancing forecasts out to March.
As Alberta acknowledges, that sunny outlook depends on OPEC members behaving themselves and adhering to the agreed upon 1.8 million b/d of production cuts, which is by no means certain as smaller players like Nigeria and Libya become restless.
Hanging over the market is the prospect of even higher US shale production, which has proven to be much more responsive than anyone had predicted, partly because of a huge inventory of drilled but uncompleted wells that can be brought on to production much quicker than drilling new wells.
The government generates $315 million for each dollar the price of oil rises. Ceci banked upon an average of $55 for 2017/18. Assuming an average price of $50, then there is a potential shortfall of around $1.5 billion.
If that wasn’t enough bad news, Alberta revenue forecasts may be sideswiped by a rising Canadian dollar, which sat near 80 cents yesterday; government is hoping for $76 cents. “Each cent change in the exchange rate is $215 million, so low prices coupled with a high Canadian dollar are like a double whammy to the Alberta government budget,” says Tombe.
There are two broad categories of bitumen royalties.
The first (called the “gross rate”) is a much lower rate applied to facilities that haven’t paid off their capital costs, which would be the case for new production of the past few years and the next few as well.
The second (called the “net rate”) is a higher rate for facilities that are paid for. That rate is a proportion of profits.
“The rate that’s applied varies depending on the oil price. So when oil prices are low, the royalty rate that’s applied either to the gross or to the net sales is low. And when oil prices are high, the rate that’s applied is high,” said Tombe.
“So, when oil prices are low as they are now, and if they remain low, then this will affect not just firm revenues but also the royalty rate that’s applied to them. And so, low prices do tend to mean far lower royalties than otherwise.”
The upshot for Alberta?
“If the oil price doesn’t rise, then the deficit won’t ever shrink below $10 billion in the foreseeable future,” says Tombe.
Barring a major disruption to the global oil markets like war in the Middle East or the economic collapse of Venezuela, higher prices seem unlikely this year or in 2018.
And that means no good news for the Alberta government – or taxpayers and voters.
“There’s no self-correcting way out of this situation. Certainly, revenues will grow as GDP grows, which is expected this year, and that means that there will be recovering levels of personal and corporate income taxes, but that is entirely insufficient to close the deficit hole we have,” said Tombe.
“So, if oil prices don’t rise, there will be a need to be a policy change either on the spending side or on the revenue side, like new tax measures, or some combination of the two. There’s no easy way out of this. I’m sorry, if prices don’t rise, there’s no easy way.”