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Who wins and who loses from rising production costs in the oil sands

There are more losers than you think, says Andrew Leach


 

Jeff McIntosh/AP Photo

I am sure most Canadians (and even many Albertans) don’t think too much about the impact of rising production costs in the oil sands. The most obvious consequences of oil sands cost inflation are things like wages, which, we’ve been trained to think, can stimulate demand for goods and services and consequently GDP growth. Some, then, might even argue that high and climbing costs are a good thing — more dollars in the hands of the workers, right? Sure, if you’re an oil sands worker or in the business of supplying the oil sands. Beyond that, you likely don’t think much about it — and you really should.

Both oil sands royalties and corporate income taxes are paid on a net revenue basis (yes, oil sands royalties are initially paid on gross revenue, but at a lower rate which applies until cumulative net revenue has provided a small return on initial capital, so it’s basically the same thing). This means that cost inflation shrinks the tax and royalty base, lowering the value that resource owners (Albertans) receive via royalties as well as the payments made to Alberta and Canadian government treasuries via taxes. The expectation of future inflation will also reduce the value paid for oil sands leases, although lease sales are not as frequent as they once were. Inflation also erodes after tax profits, which affects shareholders, including, likely, your pension funds.

Of course, some of those additional expenditures will form taxable income for individuals or corporations, so the tax side of the ledger is more complicated than the royalty side. Still, it’s worth thinking about the impact of inflated costs on the base. Cost inflation, all else equal, is not free money to workers — it’s a transfer from profits, royalties, and taxes to payments for labour and capital.

How much does it matter? Potentially, a lot. Consider that, in 2004, a bitumen mine was expected to cost less than $20,000 per barrel per day of capacity in today’s dollars, according to the Canadian Energy Research Institute (CERI). Today, we’ve just seen the first phase of Imperial Oil’s Kearl mine go online with costs of more than $100,000 per barrel per day (per flowing barrel) of capacity (albeit with some expenditures related to future phases built-in to that figure). CERI’s latest study projects capital costs for a bitumen mine to be over $75,000 per flowing barrel. Operating costs for non-integrated mines like Kearl, estimated at less than $7.50/bbl in today’s dollars in 2004 are now projected to be about $18.50/bbl.  Over the life of a project, these cost increases can make a huge difference to the project owners. And to you.

For a 110,000 barrel per day mine, each additional billion spent on start-up capital translates to about $525-$560 billion million fewer taxes and royalties (in today’s dollars) over the 40 year life of the project.* Depending on the other project parameters and oil prices (I’ve used the U.S. Energy Information Administration 2013 reference case as well as a $15.00 differential between WTI and diluted bitumen), the foregone royalties and taxes can even be slightly larger than the foregone profits to the operator. The same story exists for operating costs. Each additional $5 per barrel in operating costs reduces average royalties and taxes by $2.60-2.70 per barrel.

If you put those two story-lines together, a mine which costs $20,000 per barrel per day to build and $10 per barrel to operate would pay an average of $42.50 per barrel in royalties and taxes (again, today’s dollars) over the life of the project if the U.S. Energy Information Administration price forecast proves accurate. That same project with a build cost of $75,000 per flowing barrel and $20 per barrel operating costs would pay over $10 per barrel less in taxes and royalties. Increase the costs to $100,000 per flowing barrel in capital costs and $30/bbl average operating costs, and you’re down over $15 per barrel in taxes and royalties. When a project of that size can be expected to produce 1.5 billion barrels of bitumen over its lifetime, $10-$15/bbl can really add up.

It’s easy to think of cost inflation as the oil companies’ problem and the workers’ benefit, but in reality there are about 35 million more stakeholders to consider.

* These figures are calculated using a discounted cash flow model of an oil sands mine. Cash flows are only discounted at the rate of inflation as they are reported above in constant 2013 dollars. Other important assumptions not specified above are a $0.99 US/Cdn FX rate, a $4/bbl diluent premium over light oil and a $CDN 15 difference between the $CDN-equivalent WTI price and WCS prices at Hardisty, both increasing with inflation, and transportation charges of $1/bbl for diluent and $1.50/bbl for dilbit to/from Hardisty. Royalty and tax codes are assumed constant over time, and all costs inflate at 2 per cent.


 

Who wins and who loses from rising production costs in the oil sands

  1. There’s no future in dirty energy in this century. The whole country can’t live off of Alberta’s resource welfare checks. Alberta isn’t even making it.

    Neo-con ignoramuses want to turn Canada into Russia: a “resource super-power.” But how many Canadians want to get shipped off to Siberia to work in an open pit mine?

    Canadians want good job and business opportunities close to home. That requires a productive value-added economy. Digging holes in the ground isn’t going to cut it.

    We need real vision and sound economics to keep up with the rest of the developed world. Neo-cons caused the 2008 global economic meltdown. They will make a similar mess of our economy if we are fool enough to let them.

    • Yeah, thats what amazes me. Alberta itself, almost solely oil, can’t make it and yet they want the rest of us to join them in the soup!

  2. Good post. I hope you continue on with this theme on inflation specifically related to the oil sands activities – and carry it on further to root causes and possible policy responses.

  3. So let me get this straight: lower margins mean less royalties. But as was briefly mentioned but not fleshed out, capital costs and labour costs transfer revenue to labour (and capital but I think much of this is Canadian sourced). Perhaps the author should remind readers about the total share of labour income that is absorbed by the tax base.

    Higher labour costs seem rather consistent with supply and demand. When economic growth is juiced by approving massive capital projects it shouldn’t be a surprise when labour mobility lags, and labour costs go through the roof.

    • Your second paragraph is exactly correct. Can’t cover everything in a short post, but I wrote about those dynamics here (http://www2.macleans.ca/2013/08/26/cheap-oil-sands-crude-production/) last week. As to your first paragraph, see the sentence which reads, “some of those additional expenditures will form taxable income for individuals or corporations.”

  4. It’s easy to see then why picking up the true cost of environmental degradation (and risk) caused by the oil/ tar sands amounts to a moral hazard.

  5. Indeed because oil price inflation will always mean high costs of living since prices in the market also rise. It will only spell trouble for the people who are not working in the oil industry. – http://legacyroyalties.com/

  6. Was not the agreement signed by Ralph Klein for 1% royalty to the Alberta Government until the project was paid for. I do not understand all the discussion of costs but I am wondering if Alberta is still giving away tar sands production at 1% and if not, how many companies have completed their project and are now paying Albertan’s what price.

  7. it also impacts investments flows to the oil sands. I don’t see the demand side of the equation falling, due the industrial way we extract the bitumen. We can’t say lower wages or taxes because that wont happen. If an alternative existed such and equity position for workers building the facilities. Not in a company but lets say you remit a portion to an association because the agreements are province wide. Long term it could keep wages lower to keep it competive

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