Two kinds of oil royalties: lowering one won't necessarily increase the other.
By Erin Weir
StraightGoods
September 14, 2011
Background
The Institute correctly notes that provincial oil and gas revenues comprise both royalties paid on production and bids paid for the right to explore and produce. There is a trade-off because companies will bid more for resource rights in jurisdictions that offer lower royalties and hence higher potential profits.
Proposal
The executive summary states, "We recommend that provinces reduce their reliance on royalties and increase their reliance on bonus bids in the conventional oil and gas industry."
However, the paper is extremely thin on proposals to improve the auction process to ensure that it generates more revenue. One suggestion is to "subsidize explorers to find new — and publicly available — geological information" (page 19).
The CD Howe Institute is advocating a faith-based approach. It wants governments to slash royalty rates, boost exploration subsidies, and hope that these giveaways prompt energy companies to bid more in provincial auctions.
Who Benefits?
These CD Howe Institute directors are involved in extracting Canadian oil and gas:
- Murray Edwards, Canadian Natural Resources
- Al Monaco, Enbridge
- Henry Sykes, MGM Energy Corp.
- Kent Jespersen, La Jolla Resources International (and more)
Others are from related industries such as mining, construction and real estate in Alberta and Saskatchewan.
Auctions
Auctions are an important component of provincial resource revenue. However, there are often too few bidders to make them truly competitive. Start-up companies face liquidity constraints on how much they can bid before getting into production.
Furthermore, bids are severely discounted because the resource's value is unknown prior to exploration and development. Even given perfect information, private companies would apply a higher discount rate than governments to future income.
For these and other reasons, governments have enacted royalties rather than just relying on auctions. A possible improvement would be to have companies bid to pay higher royalty rates (beyond the statutory minimum) instead of up-front cash. However, the CD Howe Institute does not consider such reforms.
Volatility
The CD Howe press release quotes one of the authors as saying, "A shift in emphasis toward auction revenues would have the added benefit of reducing government revenue volatility resulting from short-term energy price shocks."
Anyone who has looked at Alberta or Saskatchewan provincial budgets knows that auction revenue is far more volatile than royalty revenue. After all, bids reflect the incremental exploration and development in a given year, while royalties reflect the ongoing flow of production from established wells.
The Institute's counterintuitive claim is entirely based on one province: "Although Alberta and Saskatchewan count auction results as revenues when the auctions close, British Columbia's bonus and lease auctions revenues are spread out equally over a nine-year time horizon" (page 22).
That is an argument for "modified accounting of resource revenues," but not for more reliance on auctions. Indeed, it would be equally possible and desirable to smooth out royalty revenues over a longer time horizon (e.g. through provincial savings funds).
Unfortunately, the CD Howe Institute's agenda appears to be slashing oil and gas royalties rather than collecting higher and more stable public revenues.
Update (September 19, 2011):
The following letter is in today's Edmonton Journal:
Royalty-rate cut won't help
Re: "Minimizing oil, gas royalties can have positive effect; To improve fiscal outlook, Tory leadership candidates should commit to lower rates," by Colin Busby, Benjamin Dachis and Bev Dahlby, Ideas, September 15.
Colin Busby, Benjamin Dachis and Bev Dahlby argue that cutting oil and gas royalty rates could strengthen provincial revenues by prompting companies to bid more for exploration and drilling rights.
While there is a partial trade-off between royalties and bonus bids, it is a mistake to assume that higher bids would offset lower royalties.
Auctioning exploration and drilling rights are inadequate mechanisms to collect a fair return on Alberta's non-renewable resources. Given the specialized nature of oil and gas extraction, there are often too few bidders to make such auctions competitive. Startup companies are constrained in how much cash they can bid before production is underway.
Businesses bid very cautiously for rights to undeveloped resources of uncertain value. By contrast, royalties reflect the actual value of resources ultimately extracted.
Busby, Dachis and Dahlby also claim, "Increasing reliance on bonus bids could help policy-makers and the public to better see that resource revenues — both royalties and bonus bids — are akin to asset sales."
Alberta's provincial budget currently treats neither royalties nor bonus bids as asset sales, so greater reliance on either one would not change how these revenues are managed. What's needed is a commitment to save more oil and gas revenue in the Heritage Fund. Slashing royalty rates would simply reduce the inflow of provincial revenue available to be saved.
Erin Weir is an economist for the United Steelworkers, Toronto
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