Alberta’s taxpayer-financed refinery: value-added job creator or boondoggle?

5 questions for Alberta’s new energy minister

by Andrew Leach

Chris Schwarz/Government of Alberta

Alberta’s bid to add value to its bitumen took a big hit last week when the operator of a new refinery reported a 50% increase in capital costs.  At the same time, it was quietly announced that the province has put almost $2 billion more in financial commitments behind the project. Alberta’s new Energy Minster, Diana McQueen, will have more than a few difficult files on her desk but the Sturgeon Refinery (previously known as the North West Upgrader) may be one of the toughest.  Will the government’s value added strategy pay off, or are we on the road to another government-backed upgrader boondoggle?

The Sturgeon Refinery, the first refinery to be built in decades in North America, is expected to take bitumen supplied by the Government of Alberta as well as from oil sands heavyweight Canadian Natural, and process it to produce diesel fuel, naptha diluent for use in transporting oil sands bitumen and other refined products.

Sounds simple, right? The province collects bitumen in lieu of cash for royalties and, in turn, guarantees a stable supply of bitumen to a new refinery in Alberta. The refinery’s similar deal with Canadian Natural, a major player in the industry, shows the venture makes business sense. And the Alberta government benefits from increased demand for bitumen, a more stable supply of diesel fuel, and from value-added jobs. 

Not so fast.  The province is likely taking far more risk than you think—risk that will likely only pay off only if the bitumen bubble lasts for decades.

This is not a simple, staple supply relationship. The Sturgeon Refinery will operate under an agreement (PDF) which includes commitments from the province and Canadian Natural to pay the refinery through a toll for bitumen processing. The toll would adjust to allow the operator of the refinery to recover its initial capital costs, to repay debt, and to earn a rate of return on equity. It would also see the Province and Canadian Natural pay for the refinery’s operating costs, as long as those operating costs don’t fall out of step with other refineries in Alberta.  The contract provided a 10% return on the equity share of the first $5 billion spent, and then a pro-rated return on additional spending up to $6.5 billion in total project costs.  In other words, as long as the project was built on-time, close to on-budget, and operated well, the owners would make money regardless of whether the price difference between bitumen and diesel made the investment profitable—the province, as well as Canadian Natural, were taking the risk on the commodity prices, not the operator. To make matters still more complex, Canadian Natural is also a 50% owner of the refinery itself, through the North West Redwater Partnership.

On September 20th, 2013 (yes, all of 11 weeks ago), Premier Redford attended a sod turning for the then-estimated-to-be $6 billion dollar refinery. On Thursday of last week, it was revealed that costs had jumped to $8.5 billion for the 50,000 barrel per day plant. On Thursday, North West Redwater Partnership, the parent company of the Sturgeon Refinery also announced it had re-negotiated the terms of its agreement with the toll-payers, the Alberta government and Canadian Natural, to cover these new costs.  The text of the renegotiated contract is not yet public, but here’s what we know:

  • The contract now includes a lower rate of return on equity of 5%, and the equity share of the project remains at 20%, with the remainder financed through debt. Over 30 years, the 5% rate of return on the $2 billion equity share will amount to toll payments of about $3.9 billion;
  • The Alberta Government and Canadian Natural each agreed to loan $300 million (in subordinated debt) to the North West Redwater Partnership, to be repaid through the toll. Basically, if you can follow this, the Alberta government and Canadian Natural are loaning part of the capital for the project to its owners, and then allowing the owners to pay them back through the tolls paid by the Alberta government.  Think of this like someone loaning you money to make the down-payment on a building which they’ve also agreed to rent from you under the condition that you pay them back over 10 years using some of the money they pay you in rent.  The rate of return on this debt will be prime plus 6%, according to releases;
  • According to North West, “if additional financing is required, the toll payers (again, the Alberta-government and Canadian Natural) have agreed to advance the additional funds as required to complete the project.” So, the Alberta government has committed to this refinery being built, no matter how much it costs, at least according to the project proponent.

In an emailed statement, the Minister of Energy stated that, “The strategic reasons that led us into this partnership are as valid today as they were when the Government of Alberta committed to it three years ago,” and that, “the project remains a good deal for taxpayers.”

The Government of Alberta agreed to cover the costs of servicing an additional $1.5 billion in debt (the Alberta government’s share of the new debt costs) which will be covered by the toll, and to loan the project proponent an additional $300 million which the proponent will use to finance their own investment in their own project. Further, they’ve agreed to do this all again if the refinery gets even more expensive.

Given what the Government agreed to, the explanation offered by Ken Hughes, the previous energy minister, for both the circumstances surrounding these changes and the impact this will have on the Government is lacking. With this in mind, I have 5 questions which I believe the new Minister of Energy needs to answer in her first week on the job:

1. What is the Alberta Government’s estimate, given these new costs, of the tolls to be paid per barrel of bitumen processed, and thus the necessary price differential between bitumen and the products produced in order for the province to come out ahead?

2. Was the Premier aware that costs were likely to increase significantly when she participated in the ground-breaking on September 20th, 2013? And if not, why not? Certainly, the potential for significant cost over-runs must have been known 12 weeks ago.  Who knew what and when?

3. Why did the government choose to loan money to the North West Redwater Partnership—a loan which will be used to invest in the project? What were the advantages to the people of Alberta in structuring the transaction in this way?

4. The previous Minister of Energy stated that this remains a good investment for Alberta, in part, because it would, “create thousands of jobs.” At the same time, we hear daily about a labour shortage in the oil sands sector. Has the Alberta Government estimated the degree to which financing this project will exacerbate the labour shortage, drive cost inflation, and further erode oil sands royalties?

5. Did the Alberta government consider purchasing the refinery from North West as part of these negotiations? To use the analogy from above, rather than loaning North West the money to buy the building which it would then rent to you, why not buy the building yourself?

Over to you, Minister.




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Alberta’s taxpayer-financed refinery: value-added job creator or boondoggle?

  1. The contract now includes a lower rate of return on equity of 5%, and the equity share of the project remains at 20%, with the remainder financed through debt. Over 30 years, the 5% rate of return on the $2 billion equity share will amount to toll payments of about $3.9 billion.

    I don’t quite follow this. Initially $6.5 billion, 20% equity, 10% ROE (for some reason I thought it was 7%)

    Now, $8.5 billion, 20% equity, 5% ROE.

    This your understanding as well? If not, can you elaborate?

    • Check the contract. You’ll find that a more reliable source than your thoughts as to the mandated ROE. It’s 8.5 billion with 5% ROE, but the question of what’s equity and what’s debt is not clear, since part of the equity is now also debt, via the $600m loan. So, it’s more properly closer to a 90-10 debt-equity split.

      • So, bottom line, what’s the difference in ROE payments between then, and now? Give a range if there in uncertainty.

        So, you’re suggesting, of the $8.5 billion, equity is now either $1.7 billion (20%) or $850 million (10%) at 5% ROE

        Previously it was $1.3 billion (20% of $6.5 billion) at 10% ROE.

        Have I got it now?

        • Not quite. Read the contract, or the post. The 10% only applied in the first case to equity up to $5 billion. The return on equity between 5 and 6.5 billion was straight-lined to zero at 6.5b.

          • When I worked in a utility, the financial incentive was to spend as much as possible so that the company could goose it’s equity position (in other words, there was an incentive to be inefficient). But, keep ROE same. This does not appear to be the case here.

            It seems NWU is worse off here financially

            1. Say $1.7 B @5% = $85 million
            2. Say $1.3 B @10% = $130 million (your fine tuning noted, but ignored at this level)

            You agree?

          • Details matter. As you’d know had you worked for a utility, what matters is deemed costs and deemed equity and the returns/flow-through conditions on each.

          • Yeah, but in regulatory hearings, where those details are determined, and tested, the regulator is required to have such info before passing judgment. CPCN etc.

          • Gee, someone really should write a post calling on the government to clarify those details!

    • You can get Northwest’s view of the implications in their disclosure to shareholders, but I’ll wait until gov’t has published amended contract before being convinced. Basically, the new deal leverages the 5% ROE terms for Northwest with 50% debt in the equity share, so the toll ROE and the realized ROE from the toll will be different. How different depends on interest on the sub debt.

  2. Re: AB gov’t financing incremental debt, and repaying through tolls.

    The cheapest debt is usually gov’t. So, under a utility type arrangement (costs are flow throughs), wouldn’t this be the cheapest option for gov’t? Alternatively, NWU could obtain commercial debt at some premium and pass it on to toll payers (gov’t).

    • Yes, that’s the logic.

      • So, can we remove question #3?

        • No. Put your public service to good work. Count the number of instances where it’s been stated that there’s no government debt in this project, and that the government is not guaranteeing the debt

          • That’s politics. I was looking at finance which should be apolitical (notwithstanding price forecasts which can be) .

          • It’s finance, not politics – it’s not government debt which is backing the debt share of the project, or even fully gov’t secured debt. I’m sure you can work out the difference. That’s why Q#3 is there.

  3. The AB gov’t has committed to I think 75% of the 50,000 barrel/d capacity. Got an idea as to what pct of total AB bitumen royalty forecast this would amount to over the life of the project?

    • There’s a report on the BRIK website from 2009 http://www.energy.alberta.ca/BRIK.asp. It obviously depends on your views of production, costs, and prices in the long term as well as the share taken in kind vs in cash.

      • So, by 2030, figure 2, BRIK forecast of ~ 500,000 Bbl/d. Or about 7.5% of AB’s royalty @37,500.

        • Well done with the reading and the division. See comments above about sensitivities.

          • It was a simple test to see if AB was putting all its eggs in one basket. Some risk management theory suggests diversity is an important strategy, within reason. Notwithstanding sensitivities.

          • You get what you give – you pick at every detail in every calculation.

          • It’s an important point. Worth picking at.

  4. Of course it’ll end up being a boondoggle. There’s a reason why nobody in the private sector is building new refineries. It’s because they’re not economically viable projects. I can’t really see any reason why the Government of Alberta can suddenly make it economically viable.

    • Rick, you missed marking my first comment down. Check with your programmer. There appears to be a software bug.

        • Atta boy. You went back and got it.

          • Atta troll.

  5. Local upgrading and refining and provincial financial backing is a hedge.

    If the bitumen bubble disappears, it will not be a profitable venture, but the government will be making so much money from bitumen royalties, and any losses will be small relative to bitumen royalties.

    If the bitumen bubble doesn’t disappear, then it will be a big financial winner, adding Alberta value added, and tax revenues to compensate for reduced bitumen royalties.

    The ability to take bitumen royalties in kind, and upgrade locally also enables the government to prevent oil multinationals from playing transfer pricing games.

    Hedging, like any insurance, comes with a cost. But it helps in the worst case scenario (a persistent bitumen bubble). It helps prevent oil multinational transfer pricing monkey business. And if the bitumen bubble disappears, the public financing of the upgrader will have been the cost of the hedge/insurance.

    The public financing of the upgrader should be viewed as a hedging/insurance endeaver, not as a money-making venture. In the best case, the venture will not make any money (but the province will be rolling in bitumen royalties). in the worst case, it will be wildly profitable (but the province will be receiving depressed bitumen royalties). One hopes one never has to collect on the insurance or the hedge.

    • Alberta’s Energy Minister: “we continue to expect a better return for Albertans’ barrels of
      bitumen through this enterprise than if we simply took the royalties in cash.” Sure sounds like he’s hoping to collect on the hedge.

      • What do you expect him to say?

        Do you thing most ordinary people would understand the hedge/insurance/preventing-multinational-financial-trickery reason for the project?

        It the best case scenario for Alberta, Alberta is rolling in massive bitumen royalties, and the upgrader is a boondoggle.

        It is being built in case the worst case scenario happens, the bitumen bubble persists, and to insure a transparent bitumen pricing market.

        in a world of Enron, and in a world of LIBOR price-fixing by banks, Alberta has to have some ability to insure no bitumen pricing games by the multinationals.

        And shouldn’t it be partly your job to actually explain the hedging strategy rather than the poltical slant of your article, and that why even though the upgrader will likely be a boondoggle, the people of Alberta should really be hoping it is a boondoggle, because that will mean the provinces is rolling in bitumen royalties.

        • I would expect him (now her) to say something like what you said above.

        • If you happened to hear my radio interview with Rob Breakenridge tonight, I referenced this comment. Unfortunately, I couldn’t credit you.

  6. 1. What is the Alberta Government’s estimate, given these new costs, of the tolls to be paid per barrel of bitumen processed, and thus the necessary price differential between bitumen and the products produced in order for the province to come out ahead?

    Let’s see if we can tease out a back of the envelope calculation while we wait for the new minister to get up to speed and reply.

    In the NWU presentation of Nov 2012.
    http://www.northwestupgrading.com/images/pdf/presentations/nwu%20investor%20pres%20nov%202012.pdf

    Specifically page 12 showing product fundamentals (keeping in mind it covers 2012 period only) , and page 18 – future cash flows.

    Assuming WTI price of $90, 22% Heavy differential (~$20), 10% diesel premium, it suggests $7.82 profit per barrel for AB gov’t feedstock provider.

    …..
    Now, assuming all other costs the same, add in the $2 billion inflated cost, and apply it against total throughput.

    @ 20% equity, debt = $1.6 billion. @6% interest = $96 million.
    Now, take off reduced equity payment $85 million – $130 million = – $45 million
    So, additional costs = $96 million – $45 million = $51 million

    Throughput = 50,000 barrels/d x 365 = 18.25 million barrels/yr.
    So, additional toll = $51 million/18.25 million barrels = $2.79 / barrel

    New profit = $7.82 – $2.79 = $5 /barrel

    Old break even was $20 spread – $7.82 = $12.18 / barrel
    New break even = $20 spread – $5 = $15 /barrel

    So, back of the envelope, quick and dirty – if you predict spread between bitumen and refined products will be greater than $15/barrel, project is a go. Less than $15/barrel, you (AB gov’t) lose money.

    • You understand that NWU is not the Alberta government, right? *update* but thanks for taking the time to hash out the numbers. I’ll post mine from a complete model at some point later.

      • Huh? You suggesting they have different books?

        Ballparkish in any event.

        • Would love to see the AB gov’t's version of your calculations.

          • There’s always the Freedom of Information and Protection of Privacy Act.

            Don’t think it would be protected as a commercial secret. Maybe the media can follow-up.

  7. thanks for taking the time to hash out the numbers. I’ll post mine from a complete model at some point later

    OK. But serious q from an economics perspective.

    Suppose, hypothetically it was completely revenue neutral – and you knew for certain the costs and revenues – ie no risk whatsoever.

    Which way would you vote as an economist, and why?

    • Not sure I follow – i.e. in expectation you’re going to end up even money, but you give up some of the bitumen upside and hedge some of the bitumen downside? I don’t think there’s an economists’ answer to that – it’s a matter of risk preferences, so to me the answer to the question would come down to how Albertans feel about the trade. Generally speaking, if you’re lowering risk without impacting expected returns, that would be a positive thing, but there are other factors at play here as well.

      • Ok, rephrase.

        Status quo – you accept a payment for bitumen from the producer in cash.

        Revenue neutral option. You get a refinery built in AB, have the associated local investment, jobs, taxes. And it costs you nothing. You still get bitumen price from status quo. You remove some of the bitumen volume (so good), but you may add to local inflation.

        Is it black and white, or still grey from economics perspective – ie up to Albertans (political decision).

        • Grey. That’s why economists have two hands.

          • OK, I missed that reply. That’s a good one. Thx

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