A mid-September report proposing changes to Alberta's royalty structure, which dates from 1997, has caused a stir in Calgary. Released by a royalty-review panel of the Alberta Department of Energy, the report concludes that Alberta should tax deep gas drilling and the oil sands more heavily to give Albertans their "fair share."

The report is "very disturbing...and used data that was either flawed, inaccurate or dated," Tristone Capital Inc. chairman George Gosbee says. "The conclusions do not reflect the basin economics of western Canada. Capital will flow out of the province [if this proposal is enacted]."

The most punitive aspects of the report are disincentives to drill for deep gas, the very activity thought to hold the most promise to keep the province's gas production adequate, if not growing, the firm reports.

Both EnCana Corp. (Toronto, NYSE: ECA) and Talisman Energy Inc. (NYSE: TLM) have announced drilling cutbacks of up to an aggregate C$2 billion, due to low natural gas prices and in reaction to the royalty report.

"EnCana is the tip of the iceberg," says Tristone E&P analyst Chris Theal. "We're talking about deep gas wells west of the Fifth Meridian that cannot earn an economic return with this new royalty regime as proposed. Those wells won't get drilled and you won't see companies bidding on Crown lands."

Theal says the royalty panel basically assumed flat drilling costs over seven Canadian E&P regions, when in fact costs have soared since 2005, "so you're going to get unrealistic outcomes. We think the panel focused too much on the government take and not enough on the companies' rate of return."

Alberta Premier Ed Stelmach was to issue his formal response to the royalty-review panel's report by the end of October

"This is a very important decision-and my goal is to ensure Alberta's royalty framework strikes the right balance. It must provide Albertans with a fair economic rent on the province's natural resources-while at the same time maintaining an internationally competitive system that allows the Alberta economy to prosper."

Calgary-based energy-research firm Ziff Energy Group reports that economics for new gas activity are at a significant disadvantage compared with most U.S. gas basins. Gas drillers have sharply reduced their once-vigorous activity levels, resulting in thousands of layoffs in the Alberta service industry.

Maintaining existing production levels is unlikely, according to Bill Gwozd, Ziff vice president, gas consulting. If gas prices become relinked to oil prices, there would be an opportunity for increased gas royalties; however, the timing of increased royalties for the gas sector now would have a very unfortunate effect on the industry should the recommendations be accepted and implemented.

The royalty-review panel's 104-page report, "Our Fair Share," recommends the government increase the existing provincial royalty on the oil sands.

"Albertans made it clear that examining the province's royalty regime was a priority to ensure they are receiving their fair share from energy-resource development," Stelmach said.

The panel recommends hiking overall royalties by 20%-nearly C$2 billion annually, primarily on the oil-sands sector in northern Alberta. Along with increasing key rates for oil-sands facilities after they have earned back all construction costs, the report calls for a new severance tax to be levied against the production of all raw oil-sands bitumen. There would be no grandfather clause.

Alberta's Liberals say the government has allowed C$8.6 billion to slip through provincial hands during the past 15 years.

"The industry can hardly believe the extent of the changes," says Greg Stringham, vice president, markets, for the Canadian Association of Petroleum Producers. "It cannot understand how the panel can assume that these recommendations wouldn't affect activity levels, investment and future jobs in making their projections for future revenue increases."

A change in royalties of 1%, up or down, would create a change in drilling activity of roughly 0.7%, according to a recent study by the Alberta Department of Energy. "From current levels of about 20,000 wells per year, a 1% change in royalties would translate to roughly 145 wells...These wells are most likely to be shallow with correspondingly small reserves, thereby having minimal impact on annual production revenues," the Alberta DOE reports.

The panel's gas-well cost data cites an IHS/CERA study on Canadian drilling. IHS and CERA report that six main Alberta areas of drilling showed below-average costs and above-average profitability in North America.

Ziff reports, "The findings published...could direct readers to seriously misleading conclusions, possibly damaging the credibility of the Albert Royalty Review panel." The data from IHS/CERA contradicts well- and field-cost data compiled by Ziff since the mid-1990s that show Alberta to be an increasingly costly place to drill, and less profitable, Ziff reports.

The current drilling-activity slump may bear that out. "The full-cycle cost for gas in Canada has tripled during the last decade, driven by...smaller reserves added, and in the last three years, by rampant service-cost inflation...Canadian gas completions are down 19% this year and gas-rig activity is down 40%...," Ziff reports.

Meanwhile, Canadian royalty trusts continue to try to sort out ramifications of a new federal tax law that will result in the trusts paying taxes as traditional companies do beginning in 2011. Enterra Energy Corp., the administrator of Enterra Energy Trust, Calgary, has suspended its monthly distribution payment to unit-holders for at least six months, beginning in October, to pay debt instead.

The trust is pursuing a number of initiatives to reduce its debt, including the sale of noncore assets announced in September, but believes suspending the distribution at this time will preserve the net asset value of the trust and improve financial flexibility.

Enterra is in compliance with all financial covenants under its credit facilities; however, lenders are reviewing the borrowing base under the senior credit facilities. If the base is lowered, Enterra will have to pay the difference in 60 days. Both management and the board believe conserving cash now, in advance of those requirements, is prudent.

Comments