In the report, the Panel showed various graphs for fiscal regimes around the world. These graphs, however, usually showed undiscounted cash flows. Perhaps that works well when comparing conventional resources, but not oil sands. Conventional production follows and exponential decline, meaning that most of the cash flow comes early in life. Oil Sands have a steady or increasing production with time, meaning that much of its cash flow comes later in life. Thus, undiscounted cash flow charts will overstate the "value" received by oil sands companies.
The Panel in their report Alberta Review Panel Final Report (PDF, 2.25mb) often use undiscounted cash flows to compare government takes in various jurisdictions. As a reminder from prior articles, government take is the proportion that the government charges or takes in the form of royalty and taxes. For example, assume that there is million dollars of cash flow after operating costs and capital expenditures have been paid. If the different levels of governments take seven hundred thousand dollars and leave the developer with three hundred thousand dollars, then the government take is 70% for that year.
The Panel uses the cumulative total cash flows over the life of different projects in various jurisdictions and then ranks them according to governments' takes. For the purposes of government takes, mixing oil sands regimes with conventional oil is wrong.
Before explaining why it is wrong, I need to explain a bit more about conventional oil and why the cumulative cash flow government take methodology is often employed by the conventional oil and gas industry. I am going to discuss decline rates, discount values, and then return to why the methodology is flawed when including oil sands. With that information as a background, I will then discuss marginal tax rates.
Conventional oil and gas production follows a decline curve. That is, after each year, the production flowing from that particular well declines following an exponential decline curve. The decline rates differ depending upon the geology and technology used to recover the oil and gas. In the table below, I have demonstrated the effects of different decline rates for a well with an initial production rate of 1,000 barrels per day.
| Daily Production in Barrels | ||||
|---|---|---|---|---|
| Year | 3% | 5% | 7% | 10% |
| Source: | Kevin H. Stecyk | |||
| 1 | 1000 | 1000 | 1000 | 1000 |
| 2 | 970 | 950 | 900 | 850 |
| 3 | 941 | 903 | 810 | 723 |
| 4 | 913 | 857 | 729 | 614 |
| 5 | 885 | 815 | 656 | 522 |
| 6 | 859 | 774 | 590 | 444 |
| 7 | 833 | 735 | 531 | 377 |
| 8 | 808 | 698 | 478 | 321 |
| 9 | 784 | 663 | 430 | 272 |
| 10 | 760 | 630 | 387 | 232 |
| 11 | 737 | 599 | 349 | 197 |
| 12 | 715 | 569 | 314 | 167 |
| 13 | 694 | 540 | 282 | 142 |
| 14 | 673 | 513 | 254 | 121 |
| 15 | 653 | 488 | 229 | 103 |
| 16 | 633 | 463 | 206 | 87 |
| 17 | 614 | 440 | 185 | 74 |
| 18 | 596 | 418 | 167 | 63 |
| 19 | 578 | 397 | 150 | 54 |
| 20 | 561 | 377 | 135 | 46 |
| 21 | 544 | 358 | 122 | 39 |
| 22 | 527 | 341 | 109 | 33 |
| 23 | 512 | 324 | 98 | 28 |
| 24 | 496 | 307 | 89 | 24 |
| 25 | 481 | 292 | 80 | 20 |
| 26 | 467 | 277 | 72 | 17 |
| 27 | 453 | 264 | 65 | 15 |
| 28 | 439 | 250 | 58 | 12 |
| 29 | 426 | 238 | 52 | 11 |
| 30 | 413 | 226 | 47 | 9 |
In looking at the above table, I want to draw to your attention how fast the production falls off. After ten years, the production has fallen off by roughly one quarter for the 3% decline rate well. For the 15% decline rate well, production has fallen by nearly three quarters. I recall reading that the average international well lasts for between 15 and 20 years. The key learning from this exercise is that the bulk of the cash flows come early.
For an oil sands project, its production profile is very much different. Its production actually tends to increase with time. That is, its production in later years is actually higher than during the initial years. Oil Sands projects are not subject to the same geological natural laws that govern conventional well. Oil sands projects—both mining and in-situ—are completely different from that of conventional. With time, oil sands projects tend to debottleneck and increase efficiency to increase production rates.
So why are the production rates important? Recall that earlier I discussed that for net present value (NPV), early cash flows are much more meaningful than later cash flows. If we value the cash flows, which are highly correlated to production, then conventional production sees relatively little discounting in comparison to oil sands production. Conventional production tends to last for 15 to 20 years with the vast majority of its production in the first ten years. The value of oil sands production is heavily discounted because its production tends to last 40 plus years with the vast majority of its production occurring after 15 years. Thus, from a value perspective, we cannot compare the value of conventional and oil sands production by simply adding up the cash flows. By doing so, we completely neglect the valuation—that is, the net present value—of the cash flows. Thus, undiscounted cash flow graphs give the impression of overstating the value received by oil sands projects.
The Panel's demonstration of government takes showing undiscounted cash flows from conventional and oil sands projects are misleading. While perhaps technically correct from an undiscounted cash flow perspective, from a true value perspective the graphs are meaningless. They present a specious argument. Rather the using undiscounted cash flows, the Panel should have used net present values. The key question is, How much value did the governments and developers receive in different jurisdictions?
If net present value graphs are the proper methodology, then why did the Panel not use them? While I cannot respond for the Panel, I can provide some additional insight that might explain their presentation.
The common practice in the oil and gas consulting game is to show conventional resources around the world using undiscounted cash flows graphs, similar to the graphs presented in the Panel's report. From earlier articles, recall that the discount rate is a proxy for risk. Different countries have different risks associated with them. Angola, Nigeria, Venezuela, Russia, North Sea, Gulf of Mexico and various other oil rich regions all have different risks. The problem is, analysts all view and quantify these risks differently. If a company has been operating in a risky region successfully for many years, it might deem its risks low as it has learned to work cooperatively with the government officials and thus does not perceive much risk. A new entrant might view the risk as substantial. Moreover, different developers will view the geological risks—that is, the prospectivity of the region—differently. To avoid the risk discussion, consultants use undiscounted cash flows. If a well is drilled in the North Sea or off the coast of Angola, its production will still decline with time. Analysts can overlay their own risk profile on the undiscounted cash flows. Setting aside the risk argument for a moment, the analyst can see how different regions of the world stack up with respect to government take.
The problem, again, for including oil sands in the same basket for comparison purposes is that oil sands production does not follow the same decline rate. So drilling off the coast of Angola or the North Sea is not the same as an oil sands project. Again, the vast majority of production from a typical international oil well occurs within the first ten years. For an oil sands project, the vast majority occurs after 15 years.
Another wrinkle is that the discount rate for the governments and the developer are different, even for the same project. One reason is that government still has less risk. For example, if oil price plummets, the oil sands developer is hurt severely. The government is somewhat hedged in that manufacturing, tourism, transportation and other sectors that consume oil will become more profitable. So while the government loses taxes from the oil sands industry, it gains taxes from others. Is the offset one-for-one? I doubt it. A silly example is to imagine the government as a vendor selling suntan lotion and umbrellas on the beach, while the developer as a vendor only selling suntan lotion. Regardless of the weather, the government with its two products will have sales. The developer needs the sun to shine. Another reason is that government can raise capital more cheaply than the developers can. The government long term bond rate has less yield than a similar corporate bond rate. Yet, another reason is that the governments always have the ability to raise taxes to meet shortfalls. Developers are the mercy of oil prices. So for all these reasons, the governments enjoy a lower discount rate than do the developers.
In summary, when comparing government takes, we need to compare the value received by the governments and developers to arrive at a meaningful comparison when mixing conventional and oil sands projects together. When performing an international comparison, this task is almost impossible. And perhaps that is why the Panel took a shortcut and ignored values and simply provided undiscounted cash flows. This methodology presents a visual picture where the developer's take is overstated from a valuation perspective. Thus, for government take comparisons, undiscounted cash flows provide irrelevant information.
Our last topic is marginal effective tax rates. Marginal tax rates are often helpful because we can view how severe or onerous the terms are. Again, we can compare across different fiscal regimes. The challenge, of course, is that fiscal regimes are structured differently and that can make marginal tax rate information less relevant. For Alberta oil sands projects, the developer is allowed to recoup its investment rapidly because the 25% royalty is not imposed until payout. It was even more rapid before when accelerated capital cost allowance was permitted. If we look Panel's set of recommendations, the same general structure is still present. That is, the developer is allowed to reach payout—all its capital investment returned inflated at the long term bond rate—before paying the higher royalty amounts. If a developer were allowed to recoup its investment early, one would expect to see a higher tax and royalty rate at the end. In effect, the developer has reduced its risk by receiving its cash early and now it is payback time. So under this scenario, marginal effective tax rates can be somewhat misleading.
To make the preceding paragraph clearer, imagine the following two scenarios: One, a developer is allowed to pay no taxes and no royalties until it has earned 20% on its investment, which is expected to occur in year 10. Two, a developer pays 30% net profit royalty with no shielding and pays a combined provincial and federal tax of 30% from day one. In year 11, which scenario should have a higher combined royalty and total tax rates? I think most would argue that under Scenario One, the developer has received a great benefit from paying no taxes and royalties and now it is payback time. If you were to look at the marginal effective tax rate in year 11 when the developer in Scenario One is paying high rates for royalty and taxes, you might be tempted to conclude that Scenario One is onerous. In fact, it is likely generous because the developer was allowed to earn a high return before paying anything. Its risk was greatly reduced. The key point from this example is that marginal effective tax rates will, in many cases, fluctuate throughout the life of the project and that looking at any one year can provide a misleading picture. Instead, we need to consider how much value the governments and developers earn over the lives of different projects.
The last statement is really the summary statement for the entire article. That is, when examining the fairness of a fiscal regime, we need to examine the governments' and developers' net present values over the lives of different projects. Then we can judge whether they receive an appropriate share. Using undiscounted cash flow and marginal effective tax rates can and do provide incomplete and misleading conclusions.
Model Linda T is featured in the photograph, which is hosted at Flickr. If you click on the picture of Linda, you will be taken to where you can view a larger version and see even more pictures of her.
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