Alberta Announces Modernized Royalty Framework

Written By Don Greenfield, QC, Duncan McPherson, Jana Prete and Michael Thorne

On January 29, 2016, the Alberta government released the Alberta at a Crossroads - Royalty Review Advisory Panel Report and announced that it will begin drafting a modernized royalty framework (MRF) based on all of the recommendations of the Royalty Review Advisory Panel contained in the report.

Although the report was lengthy, the panel recommended that minimal changes be made to the existing royalty framework (ERF). The report included a significant volume of information and discussion regarding the process taken in developing the report and the factors that need to be considered to create a fair and efficient royalty structure in light of the current challenges facing the industry in Alberta. Set forth below are highlights of the suggested changes to the ERF, the timing of implementation, the next steps to be taken with respect to the MRF, and some comments on practical implications of the implementation of the MRF.

A Single Royalty Structure

Central to the MRF is a single royalty structure for crude oil, liquids and natural gas, involving among other things the same royalty rate. By eliminating the discriminatory treatment of different hydrocarbons, the MRF seeks to reduce exploration risk by allowing producers to assess development opportunities based on market forces instead of how a well might be classified.

The structure will involve a "revenue minus costs" approach where the average drilling cost for any new well would be estimated by using a Drilling and Completion Cost Allowance formula, based on vertical depth and horizontal leg length. The panel recommends that the Drilling and Completion Cost Allowance be determined yearly and that Alberta Energy create and maintain an Alberta Capital Cost Index that will indicate average operating costs for similar-sized wells. They also recommend that derivation and public announcement of the Index occur by March 31 of each year for application on April 1 of the same year. The Index will also apply to oil sands projects.

There will be a flat five percent royalty rate on revenue up to payout. Payout will occur when the total revenues from a well equal the Drilling and Completion Cost Allowance (not the actual costs to drill the well), regardless of the type of hydrocarbon produced. After payout, the royalty rates are to escalate on a price-sensitive scale until such time production drops below a set Maturity Threshold (yet to be determined), after which the royalty rates will be sensitive to declining productivity.

Implementation

The target implementation date for the MRF is January 1, 2017. The MRF will create a distinction between "old wells" and "new wells". Old wells will be wells drilled before the implementation of the MRF and new wells will be wells drilled after the implementation of the MRF. The MRF will apply only to new wells; old wells will continue to be subject to the ERF for 10 years following the implementation of the MRF, at which time they will transition to the MRF.

All wells drilled before 2017 will qualify for and continue to benefit from the Natural Gas Deep Drilling Program and Emerging Research & Technology Initiative, which expire at the end of November 2016 and June 2018, respectively.

Oil Sands

The government will make no changes to oil sands royalty rates under the MRF. The report states that there was little room for an increase given the price levels being projected by both industry and the Alberta government. Instead, the government plans to modernize the process of calculating costs and collecting oil sands royalties and has promised to improve disclosure of cost, revenue and collection information relating to projects and royalties.

Practical Implications

One of the goals driving the standardization of the Allowance is that it will be an incentive for energy companies to innovate, reduce costs and stay competitive, because they will be rewarded if they can bring wells in under the average completed cost thereby remaining at the lower royalty rate even after they have recovered their actual costs. However, it is not clear yet whether this calculation of the Allowance will differentiate sufficiently between highly variable drilling circumstances.

The MRF will allow energy companies to include the capital cost-related portion of the new carbon levy among the costs they deduct before they pay royalties. The new carbon levy was announced in November 2015 when the Alberta government announced its Climate Leadership Plan.

Absent considerably more detail, it is likely not yet possible to model the economies of drilling under the MRF, but the announcement has hopefully brought some certainty to the environment.

Next Steps

The panel recommended that by no later than March 31, 2016 the following be accomplished:

• the creation of a Calibration Team to finalize the Allowance formula and the post-payout royalty rates.
• the development of details of strategic programs for enhanced hydrocarbon recovery and high-risk experimental wells concurrently with the announcement of the details of the MRF.
• the release of complete details of the MRF, including allowances in the MRF to accommodate the sharing of the carbon levy.

The report also asks that Alberta Energy review the Otherwise Flared Solution Gas Royalty Waiver Program before the end of 2016 to ensure that it is adjusted to conform with the Climate Leadership Plan.

The panel also requested that the Alberta government develop a value-added natural gas strategy, starting with the appointment of an expert advisory group. On Monday, February 1, 2016, only three days after releasing the report, the government announced the Petrochemicals Diversification Program, a 10-year royalty credit program that will award up to a total of $500 million of royalty credits to new petrochemical facilities. Petrochemical facilities of course do not pay royalties; earned royalty credits can however be traded to an oil or natural gas producer who can in turn use the credits to reduce their royalty payments.