Should we trust the Alberta PCs on energy policy?

In the leadup to Alberta’s election, I’ve been compiling pieces on the parties’ energy platforms, beginning with the NDP and the Wildrose.  In the last of this series, I set my sights on the platform of the Progressive Conservatives — the so-called Prentice plan (PDF) — and what it would mean for Alberta’s energy resources, for refining in Alberta, for greenhouse gas policy, and for savings.

First, on oil sands resource management, the most recent budget shows that oil sands royalties are expected to decrease to only $1.50 per barrel — the royalty regime captures a share of profits, and that share decreases at lower prices, so for a given percentage drop in prices, profits drop as does the royalty rate, and so royalties drop by a much larger percentage than prices — and we’ve seen cost-inflation erode what would otherwise be a much more robust royalty take. At the same time, Premier Prentice has been emphatic that now is not the time to review the royalty regime, as doing so would create uncertainty at a time when investments are already being reconsidered.  Is it possible to both agree and disagree with Prentice? I’m an economist, so I’ll try to do one with each hand.

He’s right that any uncertainty with respect to potential future royalty increases could lead to otherwise viable investments being reconsidered, and with oil sands projects challenged by low prices, that’s a legitimate concern. That concern, however, is trumped by the primary responsibility of the government of Alberta in this area—the government acts as the agent of the people who own the resource.  As a result, the government must be able to convince Albertans that the system we have in place creates the sharing of risks and returns that Albertans expect. That’s very clearly not the case today, at least for anyone without a stake in the industry. This should come naturally to Premier Prentice—as a banker, he would have seen deals evaluated in exactly this way. Further, with his prior experience in law and in government, he should be able to position himself as the person Albertans want at the table, the person who can drive a suitably hard bargain with industry, and the person who will direct the government to deliver the most value from the resource base to Albertans. Instead, we’ve mostly seen a Premier who looks uncomfortable even discussing the issue, and assures Albertans that any attempt to evaluate whether our interests are being served will be harmful to our interests. I definitely see Jim Prentice as having the right background to steward Alberta’s resources for Albertans, but I haven’t seen enough of that Jim Prentice during this campaign.

Second, when it comes to resource processing, or the so-called value-added debate, the Progressive Conservatives have brought us a potential boondoggle in the Northwest Upgrader—something even Premier Prentice has acknowledged was a bad deal. As the Premier has said, the project might yet prove beneficial to the province, but that’s only in a world we really don’t want to see. Let me explain.

The Northwest Refinery is not a typical refinery investment. For those of you not familiar with the project, the Northwest Upgrader is being built under a public-private partnership in Redwater, outside of Edmonton.  The refinery will be paid a toll to produce diesel fuel, naphtha, and other products from 37,500 barrels per day of bitumen collected by the province in royalties and has a similar contract for processing 12,500 barrels for Canadian Natural Resources Limited (CNRL). To make matters more confusing, CNRL is also an owner of 50 per cent of the partnership that owns the refinery and a provider of subordinated debt to the project. A recent column in the Edmonton Sun sums up what the contractual tolling arrangement means for the project: “No matter the North American price for bitumen, or the local price for oil and gasoline, the upgrader/refinery will make enough on the cost-plus ‘toll’ formula to cover its capital and operating costs, and give its owners a return on their investment.” A report last year from Moody’s explained that, “This is a highly unusual upgrader/refinery project in the sense that many of the risks normally encountered by a refinery are not present for [the Northwest refinery].” Those usual risks—costs of operations and the margin between crude and refined products—are largely borne by the government.

The toll, in the most recent estimate available, averages to a cash cost of $63 per barrel of bitumen processed, or $26 billion over a 30 year contract—about $47 per barrel of bitumen (or $35 per barrel of diluted bitumen) processed plus inflation if you prefer to think in those terms. As project proponent Ian MacGregor stated in an interview with the Edmonton Journal, that’s effectively the average margin that refining would have earned over the past year if you assume that you would not have caused diesel and products prices in the market to drop or bitumen prices to rise by operating the refinery. So, in order to believe that this refinery will be beneficial to the province, you have to believe that we’ll continue to be in a situation in which, in the words of Jim Prentice, we’re losing billions of dollars per year in profits, taxes and royalties because our bitumen is selling at well below market values. The same margin, calculated assuming we were getting tidewater prices (net of tolls) for our bitumen and assuming our refined product prices return to closer to continental averages, would have been about $30 per barrel of bitumen. This isn’t just my opinion—the same basic findings were validated by Moody’s Investments in a May 2014 report assessing the debt risk of the partnership. Moody’s states (emphasis mine) that:

When the tolls are taken into account, given the risks retained by the (Government of Alberta and CNRL who is a partner in the project), such as increased construction costs, flow through costs, interest rate and foreign exchange, depending on market conditions, the (Government of Alberta and CNRL) may generate very little net profit if not incur a net loss in some years, especially in the early years, by committing to process the diluted bitumen through NWR versus a straight sale of the untreated feedstock in the markets. The (Government of Alberta, CNRL and the Northwest Redwater Partnership) expect though that, over the 30-year term of the processing agreement, the NWR upgrading/refining route will be profitable from their point of view and will continue to have value after the initial term of the processing agreements, once all the debt is repaid. We note that that analysis is based on relatively conservative assumptions and does not rely on any real increase in oil prices. However (the analysis) does assume nominally growing net margins over time that will be realized only if the various discount/premium to WTI assumptions for various products hold, if operating costs are well controlled and if operating performance is maintained at high levels. The analysis excludes any “externalities” such as, for Alberta, additional tax paying jobs, and for both feedstock providers, a potential impact of better pricing on the remaining diluted bitumen production, which is sold in the markets.

Again, this is an area where the banker in Jim Prentice needed to come out more forcefully: the PC campaign clarified for me that he’s indicated that the province signed a bad deal and, after the province doubled down when the deal started to go south, maybe he’s right that we’re now in too deep, and we’re better off with the refinery than without. Perhaps, while pushing for pipelines, the premier feels we should have a hedge in case they don’t get built, in which case the refinery will likely be more profitable. Again, a fair position, but I’d have preferred to see him have to spell it out more clearly. I’d also have preferred to see more details on what exactly a PC government would do to enable further refining and upgrading.  Prentice said that, “We have to do more upgrading, we have to expand our petrochemical footprint in this province, we have to diversify our economy.” The open question is how. One hopes that it won’t be through another deal like that which we’ve signed with Northwest.

Third, on GHG policy, we’ve heard for a long time that a new policy is coming, but no details are part of the Prentice plan. (Disclosure: I’ve provided opinion and analysis to both the provincial (2014-15) and federal (2012-13) governments on development of new greenhouse gas policies for Alberta’s oil sands.) We’ve heard recently that the federal government has sent letters to the provinces requesting details on provincial positions and targets in advance of setting a target for the climate change talks in Paris in December. Given his time as federal environment minister, as well as his previous work in the energy sector, Premier Prentice is a natural candidate to lead on this file—he knows the details as well as any of his provincial colleagues, and he also knows the federal cabinet well.  Perhaps this has all been put to good use, but publicly that’s not clear. We should know before we cast our ballots on Tuesday what a PC government’s key message will be to Ottawa on this file. Previous PC governments committed to a target that would have required very stringent policies to meet, and yet imposed a relatively weak policy with little chance of meeting our long-term target. Of note, the province is likely going to meet, or at least come close to its 2020 targets, partly because oil sands and coal-fired power have not grown as was forecast. The Prentice plan states that the PCs will “commit to achieving ambitious greenhouse gas emissions reductions through a comprehensive climate change strategy.” I wish we had more details.

On climate change policy, a natural area for Alberta to look more deeply is coal-fired power, an area familiar to Premier Prentice from his previous role as federal environment minister. Ironically, one of his fiercest opponents in that role, as the federal government was pushing for more stringent coal-fired power regulation, was the Government of Alberta. While Premier Prentice has opened the door to more stringent regulation of coal-fired power here in Alberta, in particular when running for the leadership of the PCs, he also opened his campaign with a speech at a coal mine and the only mention of coal in the Prentice plan is with respect to the premier’s own background working in the mines  Coal is already forecast to be an increasingly less important part of Alberta’s electricity-generating mix (the Alberta Electricity System Operator forecasts only 10 per cent of Alberta electricity to be supplied from coal by 2035), and so an even harder push in this area would have been welcome.

Nationally, our oil sands have become symbolic of Canada’s lack of effort on the climate change file. Premier Prentice lists one of his platform’s key priorities as market access for our resources, but it seems clear that one of the reasons we don’t have that access is because we haven’t been able to implement credible GHG policy, or environmental policy more broadly. Again, this is an area where I feel that Jim Prentice could be the right person to represent Alberta’s interests, but he hasn’t shown us that yet. He’s perhaps unwilling to ruffle feathers in Calgary, where the industry has yet to come to terms with the fact that we’re far better off with an industry advocating for effective policy applied to all industries in Canada than with an industry trying to exempt itself from it.

Finally, the PC plan envisions investing budget surpluses in the Heritage Savings and Trust Fund, and they have pledged to double the Heritage Savings and Trust Fund by 2025. I’m curious, as I have been with the other parties, as to whether the mandate of this fund would remain the same or whether the PCs would be amenable to a policy to see it invested solely outside of Alberta. There are a couple of planks in the Prentice plan that drew my attention in this regard: plans to expand tourism and agricultural industries under the guise of economic diversification, as well as a push to expand the petrochemical sector. I had the pleasure of attending the last economic summit hosted by Jim Prentice’s predecessor, Alison Redford, and at that event there were no shortage of suggestions as to how Alberta’s savings could be invested to promote industries other than oil and gas. I would love to know that Jim Prentice, should he remain premier after May 5, will again put on his banker hat for decisions such as these: let’s make the mandate of the Heritage Fund clear, and let’s make sure it doesn’t become a flow-through for spending on pet projects in the province.

I hope this, along with my other two policy write-ups, gives you some further information and food for thought before you cast your ballot on Tuesday if you haven’t done so already.