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.

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