Wednesday, April 05, 2006

Once in a row: Newfoundland and Labrador’s offshore oil generic royalty regime

Here is the second of the 3 articles recently published in the petroleum supplement in last month's Atlantic Business Magazine.

It's pretty self-explanatory on generic royalty regimes. In the days to follow I'll post the article from an extensive interview with Ed Byrne, provincial minister of Natural Resources.


Fact vs. Fiction
Does Newfoundland and Labrador's generic royalty regime really work?

Once in a row: Newfoundland and Labrador’s generic royalty regime for offshore oil

As negotiations between the government of Newfoundland and Labrador and the Hebron-Ben Nevis project consortium led by Chevron move forward, a major discussion point is the scope of local benefits to the province. That includes the level of resource rent the province will receive in the form of direct oil royalties.

But doesn’t the province already have in place a generic royalty regime that is supposed to apply to all offshore projects developed since Terra Nova? The answer to that question is yes and no.

When the first projects were developed (Hibernia and Terra Nova), the issues of local benefits and provincial share of revenues were the subject of long and protracted negotiations. In the end, each project was developed under different a royalty regime and different industrial benefit model. In the case of Hibernia, the province opted for more jobs up front, combined with infrastructure development (specifically, the Bull Arm construction site) and a lower total royalty income over the life of the project. For Terra Nova the province chose faster access to royalties, placing less emphasis on local industrial benefits.

But in 1996 Newfoundland and Labrador’s Energy Minister of the day, Dr. Rex Gibbons, introduced a generic royalty regime to bring clarity to the process. The generic regime was intended to ensure a fair return for the province, and at the same time to provide the fiscal and regulatory predictability that would reduce investment risk and promote exploration and development of even the smaller, more marginal fields. With a generic royalty regime, future projects could be developed with a clear understanding of the provincial claim on revenues, leaving only the local benefits package open for negotiation.

But this regime covers oil projects only. The government of Newfoundland and Labrador has repeatedly promised to develop a royalty regime for natural gas - most recently, as part of the current process to develop a provincial energy plan. Industry has cited the lack of a regime as an impediment to gas development. The issue has now come to a head with Polaris Resources Ltd. and Paramount Resources Ltd. launching legal action to prevent CNLOPB from stripping them of their offshore licences for failing to fulfill exploration commitments: Polaris and Paramount argue that without the long-promised gas regime, it has been impossible to determine project economics and raise exploration funds. This matter will be heard in the Supreme Court of Newfoundland and Labrador on March 2, 2006; it is the first time in the history of Newfoundland's offshore industry that any company has mounted such a legal challenge.

Dr. Gibbons says today that the intent was that "the generic system would apply to all future oil and gas development, notwithstanding any oil quality. At the time we evaluated every royalty system in the world, I think. We had a consulting group go out and look at the various royalty systems all around the globe, and then we eventually came up with what we considered to be an appropriate system for this province.

"It gave certainty to the industry and certainty to government, that this is the system under which we are going to look at all developments in the future."

Indications of success came quickly, as Husky Energy made specific reference in its 2001 Development Plan Application for White Rose to the calculation of royalties to be paid under the new generic regime.

That might have been the end of the issue - but then came along Hebron Ben-Nevis. Unlike the other fields developed offshore Newfoundland so far, Hebron oil is mostly heavy crude (18-21̊, compared to Hibernia’s 29̊). Heavy oil is more costly to extract and, compared to the light, sweet crude typically found in Grand Banks reserves and sells at a 15-20 per cent discount in the international market. Compounding the issue is Hebron’s problematic reservoir structure, where the lower-quality oil is easiest to extract while the better oil is located in more fractured formations.

All this makes Hebron Ben-Nevis a higher-risk, more marginal field than the others, and so the pressure is on from the developers - and the local supply and service industry who depend on new developments for ongoing business opportunity - to exempt it from the generic royalty regime.

In June 2003 then-Premier Roger Grimes first floated the idea of modifying the regime for Hebron, with the province taking less money either at the beginning or overall, in order to help get the project moving along. He stated at the time, "If part of finding a way to make that happen is a change or alteration of the regime to make it attractive enough to do without giving up the interest of the province, then you can rest assured that we will enter into those discussions."

The Progressive Conservative opposition, now government, has been consistent in refusing that option. Since taking office, their language has hardened further. If there was to be any change to the regime, Premier Williams made it abundantly clear last April, he wanted to increase, not decrease, the provincial share of benefit. Since then, he has continued to demand richer royalties, in addition to demanding an equity stake for the province.

What is the point of a generic royalty regime, if successive governments want to change the royalty share and royalties become a negotiating point for every new development under consideration?

Dr. Gibbons notes that the current generic royalty regime should not be considered writ in stone, "Would there ever be some tinkering with the systems over time? Absolutely. Any system that’s put in place, you might make minor adjustments over time to make sure you consider things that might have been overlooked or circumstances that might not have existed over time. So a generic royalty system can be modified.

"There might be circumstances come up relative to a particular field, where we say that it [the generic royalty regime] doesn’t quite fit with this one. Maybe we really need to give some thought to whether or not there should be some modification. But I’m still inclined towards keeping, where you can, a generic system and a system that applies to everything."

Certainly, other jurisdictions have established royalty systems - but they tend to distinguish between different levels of risk, oil qualities and project types rather than be generic. In the world of oil, one size rarely fits all. Alberta, for example, in 1996 instituted a royalty regime specifically designed for oil sands production.

As for the application of the generic royalty regime to Hebron Ben-Nevis, the government of Newfoundland and Labrador and the Chevron-led consortium are deep in talks, with both sides inclined, at this point, to say as little as possible. As Chevron point man Mark MacLeod says, "It would be inappropriate for me to discuss this issue while we are in negotiations on fiscal arrangements."

With only White Rose producing under Newfoundland and Labrador’s generic royalty regime, and serious consideration being given to changing it (in some way) for Hebron-Ben Nevis, it seems that the province’s firm and stable royalty environment is more elastic than it originally appeared. This is not necessarily a bad thing. Perhaps introducing a little flexibility is just what the region requires to stimulate upstream activity. One thing is certain: the generic royalty regime for offshore oil is serving as a benchmark in negotiations between the government of Newfoundland and Labrador and project proponents, rather than the last word. The last word for Hebron appears to be coming in April 2006.

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