Oil sands, OSR 97, and
Overruns
Something is fishy in Murray Smith’s Department of Energy and it’s costing Albertans billions.
There is an interesting article called Money Pit in the July 2004 issue of the National Post Business magazine. It discussed the massive overruns that have occurred in oil sands projects since the implementation of Oil Sands Royalty Regime by the Klein government in 1997. The size of the overruns on three major projects totaled $7.3B. Projects that were initially estimated at $9.6B were now going to cost $16.9B.
Here’s a breakdown of the three projects.
Something very strange has happened since 1997 when the Klein government introduced the Oil Sands Royalty Regime Act (known as OSR97). Oil sands companies have completely lost their ability to estimate a project’s cost. Cost overruns like this would bankrupt most companies yet shares in companies with oil sands interests just kept going up. Why is this?
Digging into the OSR97 Act itself sheds some light.
OSR97 was put in place to provide unique financial incentives to companies that would construct oil sands facilities. Here’s the way OSR97 works, taken verbatim from the Department of Energy website at
http://www.energy.gov.ab.ca/osd/docs/guides/osr_guide_chp1.pdf
Key Features of the
Oil Sands Royalty Regulation, 1997
So the Alberta Government charges only 1% of the selling price of oil as a royalty to these companies until the project costs have been covered by the company profits from the project. After this, the government collects 25% of the company profits which is the net revenue; (selling price less production cost). In essence, we the taxpayers pay for 99% of the capital cost of these plants with royalties that we don’t collect. After that, when the plant is paid for, we start collecting our pound of flesh as Premier Klein is fond of saying. We start to collect 25% of net. The companies pocket the other 75% of the profits.
In order to participate in OSR97 projects have to be submitted to the Department of Energy with cost estimates. It is the responsibility of the Minister of Energy Murray Smith and his department staff to validate these estimates. If estimates are too high and the government figures they won’t get enough in royalty payments, the project is denied.
Let’s go back to our three projects. All three of these projects were approved by Alberta Energy at their original estimates. What was $9.6B in estimated project costs ballooned to $16.9B – an overrun of $7.3B. This is $7.3B of additional capital cost that must be recovered before the companies starting paying royalties at the 25% rate and this has cost the Alberta tax payer big money. Here’s how much. All prices are in Canadian dollars using a conversion factor of .8. A selling price of $40 US a barrel was used to approximate an average price. If current prices of $50US a barrel were used, the royalty losses to Albertans would be substantially higher.
|
Assume
Selling Price/barrel at: |
$ 50 ($40
US) |
|
Assume
production cost/barrel at: |
$ 15 ($12
US) |
|
Net
profit/barrel |
$35 |
|
Overruns |
$7.3 B |
|
Extra
barrels to make up for overrun |
208.5
million |
|
Royalty
at 1% of gross |
$104.3M |
|
Those
royalties at 25% of net |
$1825.0M |
|
Lost
royalties due to overruns |
$1720.7M |
|
Number of
Albertans |
3 million |
|
Cost to
each Albertan |
$573.57 |
Let’s say it in words. These projects avoid paying royalties
of 25% of net until they sell enough additional oil to make up for their cost
overruns of $7.3B. Based on a net profit
of $35/barrel this
works out to 208.5 million extra barrels. The government does collect $104.3M in
royalties on this but they would have collected $1825.0M on this oil if the
projects had come in on budget. It costs the taxpayer the difference which is
$1720.7M or $573.57 for every man woman and child in the province. It seems to
me that in most free enterprise jurisdictions the companies themselves pay for
their planning mistakes, not the taxpayer. Not so apparently in
But here is the really disturbing part.
In his 2004 Annual Report, Auditor General Frank Dunn found that the Department of Energy had some shortfalls. Mr. Dunn, unlike Shelia Fraser the Federal Auditor General, makes his reports quietly and uses sophisticated accounting and business terms that many of us have trouble understanding. Here is the key recommendation he made for the Department. The italics are direct quotes from the 2004 Report.
Recommendation No. 10
We recommend that the
Department of Energy:
·
Set
expected ranges for analyzing the costs and forecasted resource prices
submitted on oil sands project applications.
·
Incorporate
risk into its present value test used to assess project applications.
Translation: They should do their job which is to determine if project applications are reasonable and will benefit Albertans. Here’s some of what the Auditor General found that led him to make Recommendation #10. Emphasis is mine.
The Department used actual and projected costs submitted by project
operators to determine if the projects were economically justified without
always
assessing the validity of the costs.
We found that for only 2 out of
10 projects, the Department
benchmarked costs against industry
benchmarks. The Department did not have expected ranges (targets) for
the
costs and forecasted resource prices
which were submitted on oil sands
project applications and used to analyze economic justification of projects.
The Department did not retain
key support for its assessment of the economic justification for three
projects. This support included the
Department’s computer spreadsheets and documentation of its calculations
and the
results.
Translation: The auditor general looked at a sample of 10 of the 48 projects submitted for approval. Of the 10 he looked at only 2 were checked by the Department of Energy to see if the estimated costs were valid. When asked to show how they arrived at their conclusions, the Department could not produce the spreadsheets and justifying documentation.
You have to ask yourself, given the massive financial incentives to keep project cost estimates low at the approval stage; coupled with the knowledge that the employees of the Department of Energy didn’t check things too closely and had a tendency not to keep things like spreadsheets and justifying documentation, if submitting lowball estimates wasn’t too attractive for some of our oil sands companies to pass up.
Here’s some more from the Auditor General. Emphasis is mine.
We reviewed 5 of the Department’s audit files from 48 active projects
and
found the following:
• The documentation of risk assessment in five files was deficient
because it did not deal with certain common risks to the Department.
For example, the risk that a project
operator may have a history of
making
aggressive deductions, the risk
of royalties being reduced by
non-arm’s
length sales or costs, the risk of duplicate costs being
claimed in
the project or in two projects owned by the same
organization, or the risk that recovered costs are not being reported in
full to
the Department.
• For all five files, there was no indication of the nature of the work
performed to ensure costs were eligible under the OSR97. The OSR97
requires that costs be directly attributable to the project, reasonable in
the circumstances, incurred by or on behalf of the project owners,
incurred on or after the effective date of the project, and incurred for
one of ten purposes outlined in the OSR97.
•Also, all five files did not
document that the costs were paid in the
time
period required by the OSR97.
Translation: There are common ways that companies can fiddle with their reporting to reduce their royalty payments. Employees at the Department of Energy it would appear did not see the need to guard against this. The Auditor General only checked 5 of 48 projects and all 5 had these problem. There is a good likelihood that many more, if not all, would have the same problems had they been checked. Was this simply incompetence on the part of Department employees or was there direction from their political masters to go easy on the oil sands companies?
There’s more but you get the idea.
If you want to read more you can call up the Auditor General’s Department and
they will send you a free copy of the 2004 Annual Report. In
My concern is not particularly
with the oil sands companies. They are in business to make money for their
owners and one has to expect them to take advantage of a Department of Energy
that is either incompetent or not inclined to enforce the rules. However, Minister
Murray Smith and his Department of Energy have some answering to do to the
Auditor General and more importantly to the citizens of
Here are some questions for Premier Klein and Energy Minister Murray Smith.
John Mathewson -