October 2007 Archives

In my prior article, I discussed oil sands royalty regime. In this article, I am going to discuss the taxation regime. Having a solid understanding of both royalty and tax will allow us to better understand Alberta Review Panel Final Report (PDF, 2.25mb).

As before with the royalty discussion, I am going to focus on the high level material only. I am not going to address the minutia.

Once again, I provided a table below with line numbers and item descriptions. Each line will be described in more depth shortly. Please note, the official terminology used by the Alberta and federal governments might differ from my presentation below. I am using the basic terminology that I used when I created the economic models for the NOSTF. If you are unsure of the terms operating costs and capital expenditures, please refer to my earlier article referenced above.

Below I will discuss each line in the above table.

Line 1: Gross Revenue. Gross revenue is the quantity multiplied by price. The quantity is either synthetic crude oil (SCO) or bitumen and the price is the price of the commodity. In the future, I will discuss the SCO versus bitumen. At present, I believe all integrated developers—that is, mining plus upgraders—use SCO pricing and mine developers use bitumen pricing. The mine producers do not produce SCO, so bitumen pricing is obvious. I will comment in the future on bitumen pricing too.

Line 2: Less: Operating Costs. Operating costs are deducted.

Line 3: Equals Preliminary Net Income One. This line simply shows the result of subtracting operating costs from gross revenues.

Line 4: Less. This line sets up the CCA deductions that come next.

Line 5: Capital Cost Allowance (CCA) 41A. Most initial capital expenditures for a mine or an upgrader with an SCO royalty regime are classified as Class 41A. Class 41A, as we will learn in a moment, is a supercharged depreciation class. I am going to cover more about capital cost allowances (CCA) in a future article. For now, CCA is simply the tax deductible expense for capital expenditures. Most new construction capital expenditures fall into this category, capital expenditures associated with expansions of greater than 5%, and capital expenditures in excess of 5% of gross revenue. New capital expenditures by definition represent a new project so those expenditures qualify for a supercharged write-off. Significant plant expansions also qualify for a class 41A treatment. If a developer spends more than 5% of gross revenue, an amount that is typically equal to the maintenance capital, then the regime assumes that the developer is spending capital to reduce the cost structure. Effectively, class 41A is meant to capture significant capital expenditures in the forms of new greenfield projects, major production expansions, and major cost reduction programs. On Line 5, 25% of the class 41A capital expenditure is expensed. That means it is deducted in a similar manner to operating cost.

Line 6: Capital Cost Allowance (CCA) 41B. This is similar to class 41A capital expenditures above, but these capital expenditures are not typically associated with new greenfield projects, major expansions, nor cost reduction programs. Instead, 41B capital expenditures are typical maintenance capital projects. Every year, the plant must replace motors, pipes, and other pieces of equipment. These capital expenditures are typically classified as 41B. On Line 6, 25% of the class 41B capital expenditure is expensed. The difference between CCA 41A and CCA 41B will become apparent in a moment.

Line 7: Equals Resource Profit Before Allowance. This line represents the gross revenue less operating costs, less CCA 41A and 41B deductions.

Line 8: Less. This line sets up additional deductions.

Line 9: Additional Class 41A CCA Deduction If Line 8 is positive and there is additional CCA 41A capital that has not been deducted, then it can be deducted here. In effect, CCA 41A capital qualifies for 100 % deduction. It is as though CCA 41A were an expense and not capital. By taxation standards, this is an extremely rich and aggressive deduction. Please note, recent budgets have changed this provision. This discussion relates back to the NOSTF.

Line 10: Resource Allowance. If, after deducting the Additional Class 41A capital, the sum total is still positive, then a resource allowance deduction of 25% is taken. Resource allowance was a proxy for provincial royalty. Note that regardless of the actual royalty amount, even if only 1% of gross revenue, the resource allowance of 25% still applied. This feature too has changed with recent federal budgets.

Lines 11 and 12: Canadian Development Expense (CDE) and Canadian Exploration Expense (CEE). These are capital expenditures associated with purchasing and quantifying the oil sands reserves. CEE is depreciated at 30%. Compared to 41A and 41B capital, CDE and CEE capital expenditures are small. CCA 41A and CCA41B account for greater than 95% of all capital, so Lines 11 and 12 are not important.

Lines 13: Equals Preliminary Net Income Two. This line is a subtotal.

Lines 14: Less: Loss Carryforwards. If Line 13 is a negative value, it creates a loss carryforward. Loss carryforwards can be applied against future income for up to seven years. Loss can also be applied against prior income for a period of up to three years. For our purpose, we will simply focus on the forward loss carryforwards.

Lines 15: Equals Preliminary Net Income Three. This line is the sum after applying the loss carryforwards. If this sum is positive, then taxes are paid in the next line. If the value is negative, then nothing happens.

Lines 16: Less Taxes Paid. If Line 15 is positive, then the tax rate is applied to the positive value and tax is paid. The federal tax rate, in the mid 1990s, was 29.12%, including large corporation surtax. The tax rate has changed and I will comment in a future article.

Lines 17: Equals Federal Net Income. Gross revenue, less all deductions, less taxes equals Federal Net Income.

The presentation above is for a new company starting a greenfield development. There are flow through intricacies for developers who are expanding or who existing companies entering the oil sands industry. While these rules are very important for developers, they are beyond the reach of this article. The above information provides a solid basis for understanding the federal taxation regime that was present in the late 1990s.

Below I have provided a table for the Alberta taxation. I will not comment on each of the lines because the provincial and federal taxation calculations are very similar.

The operating costs as well as CCA 41A and CCA 41B are the same for the federal taxes. The maximum of royalties paid or resource allowance might allow for some differences. Those differences, if any, affect the remainder of the calculation. The provincial tax rate was 15.5%. That too has changed and will be discussed later in a future article.

The tax calculation is more complex than the royalty calculation. That said, it is neither overly complex nor difficult. One of the superchargers was the 41A immediate write-off of capital expenditures. When economics are tight, that provision is of huge benefit to a developer. I will be addressing the CCA 41A issue soon in a future article.

When working through the federal tax, I mentioned that the resource allowance was a proxy by the federal government for provincial royalty. This is an important point to keep in mind. With the resource allowance, which has been changed, the federal government effectively limited the Alberta's ability to raise its royalty. The federal government only allowed a 25% deduction. If the province raised its royalty beyond 25%, the federal government would not recognize the additional amount above 25% as a federal deduction. Each government wants its piece of the economic pie.

Another set of important points are the historical federal and provincial tax rates. The federal rate, including large corporation tax, was 29.12% and the provincial rate was 15.5%.

With an appreciation of the historical oil sands fiscal regime, we are now better positioned to understand the Alberta Royalty Review and to provide comments. I will provide another article again on Monday, Columbus Day in the U.S. and Thanksgiving Day in Canada. The article will outline my general impressions of the Alberta Royalty Review, and then I write follow-up articles to provide more detail.

If you have questions, feel free to leave a comment or contact me through e-mail.

Calgary model Judith Aldama is featured in the photograph, which is hosted at Flickr. If you click on the picture of Judith, you will be taken to where you can view a larger version and see even more pictures of her.

Before I begin commenting directly on the Alberta Review Panel Final Report (PDF, 2.25mb), I will outline in high level terms the National Oil Sands Task Force (NOSTF) Alberta Oil Sands Royalty. Ultimately, we need to consider how the oil sands royalty and taxation work together. For this article, however, I will focus on the oil sands royalty and in the next article I will focus on the taxation.

I should point out that there have been tweaks made regarding ringfencing and other provisions. I am not going to address the minutia. Rather, I will focus on the higher level topics that allow us to understand the Alberta Royalty Review.

I provided a table below with line numbers and item descriptions. Each line will be described in more depth shortly. Please note, the official terminology used by the Alberta government might differ from my presentation below. I am using the basic terminology that I used when I created the economic models for the NOSTF.

That table does not look too difficult to understand, does it? Let us look at each row and see what we learn.

Line 1: Gross Revenue. Gross revenue is the quantity multiplied by price. The quantity is either synthetic crude oil (SCO) or bitumen and the price is the price of the commodity. In the future, I will discuss the SCO versus bitumen. At present, I believe all integrated developers—that is, mining plus upgraders—use SCO pricing and mine developers use bitumen pricing. The mine producers do not produce SCO, so bitumen pricing is obvious. I will comment in the future on bitumen pricing too.

Line 2: Less. This line simply sets up the deductions.

Line 3: Operating Costs (Opex) Deductions. In a future article coming shortly, I will discuss operating costs and capital expenditures. For those unfamiliar with this terminology, operating costs are those costs for items that are used or consumed in a short period of time. Three large categories of operating costs are labor; energy; and supplies, such as huge tires for trucks, catalyst for the upgraders, and other consumables.

Line 4: Capital Costs (Capex) Deductions. Capital deductions are those expenditures generally associated with infrastructure. The costs of building the mine, extraction, utility, and upgrader facilities are all capital.

Line 5: Net Revenue Before Adjustments. This line is simply gross revenue (money in) less all costs (money out). During the initial construction phase, this number is negative. During subsequent construction phases, this number may or may not be positive, depending on how large the subsequent construction phase is relative to on-going operations and the current price environment. During normal, steady state operations, Line 5 should be positive, unless the pricing environment is extremely adverse.

Line 6: Less: Loss Carryforwards, if any. First we need to understand loss carryforwards. If Line 5 above is negative, it creates or is added to loss carryforwards. The loss carryforwards is carried forward to the following year and increased by the long term bond rate, which is about 6%. In effect, this loss carryforwards represents how much the developer is recently out of pocket. Why is it recently? During the initial construction phase, the developer creates a large loss carryforward as it builds its plants. After several years of normal operation, the loss carryforward is depleted. The developer then might earn several years of good profits. Then, if the pricing environment is extremely adverse for a year, the developer once again creates a loss carryforwards. Or perhaps the developer spends capital to expand its production or reduce its cost structure. Those too will often create a new loss carryforwards. They key point is that loss carry forwards is not a cumulative number for a one time event. Rather, it allows the developer to recuperate losses. When a developer has loss carryforwards, it is said to be in pre-payout mode. When the developer has depleted its loss carryforwards, it is commonly said to be in post-payout. What does the long term bond rate have to do with all this? The long term bond rate is an inflator. It partially compensates companies for their costs, both opex and capex. The long term bond rate is a proxy for debt costs but developers use both equity and debt for the development of their projects, so the long term bond rate is a partial compensation for their costs.

To summarize quickly the preceding paragraph: losses create loss carryforwards. Loss carryforwards can be created multiple times throughout the life of the project. Pre- and post-payout modes refer to whether or not the developer has loss carryforwards. And losses are carried forward at the long term bond rate.

Line 7: Net Revenue Before Royalty. Net revenue before adjustments less carryforwards is the net revenue before royalty. Similar to Line 5, during initial construction this line is negative. During normal, steady state, post-payout operation, this line is positive.

Line 8: Greater of 1% Gross Revenue OR 25% Net Revenue Royalty. This line compares the 1% gross revenue (Line 1) royalty against the 25% net revenue royalty (Line 7) and uses the larger of the two values. In effect, prior to payout, a developer pays 1% gross revenue and post-payout pays 25% net revenue royalty. The minimum value for Line 8 is zero. During the construction phase, gross revenue is zero and net revenue is negative. Thus, the larger of the two values is zero.

Line 9: Equals Net Revenue. This line represents the cash that a developer has after paying royalties.

Some key points to consider:

• 1% gross royalty is a small value; oil prices themselves often fluctuate at or more than 1% within a typical day;
• The developer is allowed to earn the long term bond rate, roughly the cost of long term debt, until paying meaningful 25% net revenue royalty;
  • The ability to earn the long term bond rate before paying substantive royalties greatly reduces a developer's risk;
• If the price environment is poor when the developer begins production, it might remain in pre-payout mode for an extended period of time;
• If the price environment is rich when the developer begins production, it will progress quickly to post-payout mode; and
• Because of the pre- and post-payout modes, a developer has an incentive to spend capital to expand its production or reduce its cost profile.

The oil sands royalty is straightforward. There are just two tiers of royalties, one for pre- and other for post-payout. The intent behind having the two tiers is to allow the developer to earn a return on its investment before paying substantive royalties. Oil sands projects are huge costly undertakings. To reduce a developer's risk, the NOSTF proposed having two tiers.

There are more subtleties that I have shown here. This information, however, serves as a good background for the rest of my commentary and the Alberta Review Panel Final Report. My next article will discuss taxation. The two items need to be considered in conjunction, because together royalty and taxation form the governments' take or their portion of the economic pie. The developer receives the remainder.

Calgary model Judith Aldama is featured in the photograph, which is hosted at Flickr. If you click on the picture of Judith, you will be taken to where you can view a larger version and see even more pictures of her.

I plan to write a few articles reviewing the Alberta Review Panel Final Report (PDF, 2.25mb). Before writing those articles, however, I should provide you with more of my background.

During the 1990s, when the National Oil Sands Task Force (NOSTF) lobbied the provincial and federal government for an oil sands fiscal regime, I worked for Syncrude Canada Ltd. in its business development group. I was the analyst who performed the majority of the numerical analyses for the NOSTF efforts in lobbying the governments. Moreover, I participated in many high level discussions with the industry players as well as the governments. Thus, I am extremely well versed in the fiscal terms and how the fiscal terms were arrived at.

The two dominant oil sands players in the 1990s were Suncor Energy Inc. (SU) and Syncrude Canada Ltd. I believe, though am not positive, that Suncor began its operations sometime in the 1960s, and Syncrude began its operations in 1978. When Syncrude began, it was a joint venture of several companies along with the provincial government. To encourage Syncrude's development, both the provincial and federal governments gave Syncrude a unique set of fiscal terms that were set to expire in 25 years or 2003. Syncrude's initial fiscal terms were generous and not likely to be replicated into the future. Furthermore, all oil sands projects had unique fiscal terms that reflected a company's bargaining strength at the time.

Syncrude knew that it would have to renegotiate its fiscal terms soon. Like most companies, it wanted to expand its operations. And it wanted to create an industry set of fiscal terms so that it would not have to negotiate on a one off basis and so that all companies would be treated equally. If a company negotiated a one off set of fiscal terms, then the government had all the negotiation strength. It could examine the economic strength of the proposed project and set the fiscal terms accordingly. I believe most industry players wanted an industry set of fiscal terms so that individual companies would be compared on an operational basis, not on a fiscal term basis. That is, Company A is doing better than Company B because it is a better operator, not because it negotiated better fiscal terms.

Industry pundits and various futurists were predicting that oil prices would remain in the $20 – $30 real region forever because technology would allow companies to find smaller pools of oil for less cost. Also, there was a fear that another energy source might be developed soon that could displace oil. Thus, the oil sands industry needed a set of fiscal terms that were attractive to encourage development. With oil sands development, the governments could monetize the value of the oil sands while oil sands were still valuable.

I will try to find an online source of the NOSTF report for those who might be interested.

This article summarizes my role with the NOSTF, which created the current fiscal framework. You should know my prior involvement because it will undoubted color my views as I comment on the Alberta Royalty Review.

Edmonton model Nikki G is featured in the photograph, which is hosted at Flickr. If you click on the picture of Nikki, you will be taken to where you can view a larger version and see even more pictures of her.

On Sunday, 30 August 2007, a warm fall day with the temperature at about 15C (60F), Nikki G met at the Alberta Legislature for our initial set of shots. As we were setting up for our shots on the southern steps of the Legislature, a policeman came by and grabbed Nikki for a photo. After the photo, we heard him talking to his friends how having his photo taken with Nikki made his day.

Nikki and I originally planned to begin our photo shoot at Fort Edmonton Park. When I arrived at the park at about 11:45 am, I was directed to park at the very extremities of the parking lot. Within five minutes of my arrival, cars were directed to park on the grass. I asked why Fort Edmonton Park was so busy and learned that it was a free access day to the park. Given that the park would be overflowing with people, I got in touch with Nikki, who was not due to arrive for another 45 minutes. We switched our plans to shoot at the Alberta Legislature instead.

Upon arriving at the Alberta Legislature, we learned that the police were having a Memorial for all the fallen officers in Alberta. So there were plenty of police around the park enjoying their festivities. We saw numerous other photographers, professional and amateurs, taking pictures on a beautiful fall day. Although the weather was forecasted to be cloudy, it was a bright sunny day, which made photography a bit more challenging.

After the Alberta Legislature, Nikki and I moved to the Muttart Conservatory for our last set of pictures. We had seen other fantastic pictures taken from the roof the Muttart Conservatory in Flickr. In those photos, there was water on the roof surrounded by a ridge, creating a terrific scene. When we arrived, the roof was dry and the setting did not appear as beautiful as we had seen earlier. We walked a slight distance to the top of a hill that gave us a tremendous view of Edmonton's downtown skyline. From there, we took our last set of photographs.

I thoroughly enjoyed working with Nikki. She is spirited, fun, enthusiastic, willing to try anything, and just a terrific model. She is extremely beautiful. And, she is a genuinely terrific person. You can read more about her at her Model Mayhem portfolio.

The photograph of Nikki G is hosted at Flickr. If you click on her picture above, you will be taken to where you can view a larger version. I will be adding pictures over the next few weeks.