Canada: Alberta's New Royalty Framework – Same Idea, New Structure?

On January 29, 2016, Alberta Premier Notley announced Alberta's long awaited new royalty framework. The new royalty framework was based on adopting the recommendations from the Royalty Review Advisory Panel Report (the "Panel's Report").

The focus of the Panel's Report was to make recommendations on a modernized royalty framework for crude oil, liquids and natural gas operators to:

  1. Provide optimal returns to Albertans as owners of the resource, 
  2. Continue to encourage industry investment, 
  3. Encourage diversification opportunities such as value-added processing, innovation or other forms of investment in Alberta, and
  4. Support responsible development of resources.

Preserve Existing Royalty Structures for Current Wells and Oil Sands

The Panel's Report concluded that the current royalty rates for oil sands projects are appropriate and will be maintained, with the exception of some changes to allowable costs. A new framework for assessing deductible costs with greater transparency, accountability, and certainty will be implemented. The Government announced that to ensure transparency and understanding of the general public, all costs those oil sands projects are able to deduct when paying their royalties will be publicly disclosed.

Furthermore, all existing oil and gas wells and oil and gas wells drilled in 2016 will pay royalties under the old framework for the next 10 years. It is expected they will be grandfathered in to the new framework thereafter. 

New Royalty Framework for 2017

Due to a change in Alberta's economic market and the reality of the new economy today, Premier Notley overviewed a new royalty framework for oil and gas producers drilling in 2017 and beyond that is notionally intended to provide the same internal rate of return as if the wells had been drilled in 2016, subject to meeting or beating the average industry costs of drilling. Unlike the old structure, this royalty structure will be harmonized across crude oil, liquids and natural gas.

The old royalty structure for crude oil, liquids and natural gas have incorporated elements of a "revenue minus costs" ("RMC") model, however the new framework is meant to permanently adopt a proxy RMC structure. The average drilling cost for any new well will be estimated by proxy using a Drilling and Completion Cost Allowance formula, based on vertical depth and horizontal length ("C*").

Companies planning to drill a well will be provided with a low initial flat royalty rate of 5% for early production revenue until they reach payout for the drilling and completion costs, when cumulative revenue equals C*. Companies will move from the low initial royalties to higher posted royalties which will result in higher returns for Albertans. The elevated post-payout royalty rates will be determined by the commodity prices of the various hydrocarbon streams using a price function formula system. The price function calculated over the remaining life of the well will vary the post-payout royalty rate that companies will pay.

Once hydrocarbon production from the well drops below a certain rate, called the Maturity Threshold, the well will be classified as mature resulting in a downward adjustment to the royalty rates in proportion to declining production rates. This structure recognizes the higher per-unit fixed costs involved with keeping a well running.

Based on the Panel Report the proxy for costs will be calibrated each year to accommodate the realities and changes of the energy business. The Alberta Capital Cost Index will likely be set to 100 in 2017, and allowed to float depending on changes in industry costs. Companies will be required to report their actual capital costs along with other mandatory well information to the Alberta Energy Regulator to serve as statistical inputs to calculate the Capital Cost Index for the subsequent year. 

Increased Transparency and Encouraging Innovation and Opportunities

The Government states that the new drilling cost index will provide information on the average costs of drilling and prices, production volumes, and the allowable costs used to determine royalty payment in the oil sands. This information as well as the Alberta Capital Cost Index will be provided to the public on a continuing basis to provide clear transparency of the expenses and royalty revenues the Alberta public might expect.

The Panel's Report found that the current distortion that discriminates on the basis of hydrocarbon found should be eliminated so that companies will not face the same loss or inefficiency when they are unable to produce the hydrocarbon they were drilling for. Furthermore, the Government has decided to extend current drilling incentives that were scheduled to expire and build them into the new framework to prevent higher prices that may have stifled innovation and opportunities.

The new royalty framework is to be structured with a pricing function formula that encourages innovation by crude oil, liquids, and natural gas explorers and producers. Applying the average industry costs of drilling to the pricing formula will encourage innovation by companies as driving lower costs through innovation results in higher rates of return. This will ensure companies continue to seek innovation and technology advancements to lower costs below the industry average each year increasing their rate of return and the royalty returns to the Alberta public.

The price function formula for the post-payout pricing royalty rate and the Drilling and Completion Cost Allowance (C*) formula are to be finalized with specific formulas and set up procedures to accommodate the modernized royalty framework. These formulas will be established with final parameters during a short calibration period, ending no later than March 31, 2016.

The Government will be creating an internal team of experts that will be monitoring the new royalty framework and the oil and gas industry's costs and prices. This review team will ensure that the royalty rates framework adapts to provide consistency for the industry and public as well as strengthen the Alberta energy sector as we continue to face new realities of the economy.

With the announcement of the new royalty framework and the Panel's Report, Borden Ladner Gervais LLP will continue to report on material developments and the implications to the energy industry. As the Government and the Calibration Team of members of the Natural Gas and Crude Oil and Liquids Expert Groups finalize the Pricing Formula and Drilling and Completion Cost Allowance, the team of experts at Borden Ladner Gervais LLP will provide further insight to the ultimate effects of the new royalty framework coming in 2017. 

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