How we calculate royalties

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Previously, we’ve talked about the purpose of royalties — that is, to collect the value of the oil, natural gas and oil sands resources owned by Albertans. (Albertans own them, so we should collect the value of them when they are produced and sold.)

We’ve also talked about the structure Alberta uses to collect that value . (Made up of two mechanisms: land sales; and monthly royalty payments over the operational life of the well or project.)

Many people wonder how, within that structure, Alberta currently calculates the actual payments that are made by energy companies. We’ll look at each of the two mechanisms in the structure: land sales and royalties.

Land Sales

Land sales are essentially sealed-bid auctions done online. When energy companies find areas of the province they think are promising, they formally express interest in these areas to the government. The government holds a competitive bidding process for the mineral rights to these areas. Anyone can submit a bid. All bids need to be equal to or greater than minimum amounts set by the province, but interested companies can bid as high as they wish.

At the close of the bid process, the government looks at all the bids, and the company that submitted the highest bid wins . The company submits its payment (called a “bonus bid”) and, in return, acquires the right to produce and sell the applicable resources. The term “bonus bid” is similar to a contract “signing bonus” – for example in sports.

So the amounts that Alberta collects from land sales aren’t determined by the government, but based on how valuable the highest bidder thinks the mineral rights are. This means land sales amounts are affected by the underlying geology and geography, and their effects on the exploration, development and production lifecycle, given changes in technology. Land sales are also very influenced by what a bidder expects for future resource prices (and future royalty rates, which are price sensitive).

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Royalties

Monthly royalty payments, on the other hand, are calculated by the government. Different calculations are used for different types of resources.

For conventional crude oil and natural gas , a sliding-scale formula is used to calculate the monthly royalty payment for each well. This formula depends primarily on two elements: how much of the resource was produced by the well, and the price received for that resource. Separate formulas are used for oil and natural gas, but they all are based on the same two key elements (production and price). Other factors can include well depth, and the makeup of the oil and gas produced. Details on the formulas can be found on Alberta Energy’s website .

In these formulas, the production calculated for each oil and gas well is used in the calculations. These production amounts are registered with the government. For the price components, reference “par prices” are used by Alberta Energy in the calculations. These change monthly, and are based on the actual prices traded on the open market.

Using the formulas, the calculated royalty rates payable on conventional oil wells can range from 0% to 40%. The calculated royalty rates that are payable on the “gas” portion of natural gas (i.e., methane and ethane) can range from 5% to 36%. (Different rates apply to denser liquids like propane and butane that can be part of a natural gas stream.)

A well can pay a different rate each month, depending on how the formula shakes out. No two wells are alike. Each well pays different rates over its entire life.

Oil sands projects are generally much larger investments than crude oil and gas wells, and they are far fewer in number (about 120 projects, compared to about 150,000 oil and gas wells). So Alberta uses a more detailed royalty structure for them. All costs and all revenues for each oil sands facility are reported. These are used to calculate a “payout” point — the time at which it has recovered its major operating and capital costs and an allowable return on its investment — and to calculate annual net revenues after that point.

There are separate royalty rates for an oil sands project before and after its payout point.

In the pre-payout period, the project pays a royalty based on a percentage of its gross revenues. (This ranges from 1% to 9%, depending on the price of oil.)

In the post-payout period, the project pays a royalty based on whichever is higher:

Why The Complicated Formulas?

To help understand the reasoning behind these calculations, let’s go back to our pasta-making scenario. Recall that you’re the proud owner of a very special pasta-making machine, and your plan is to produce and sell homemade pasta at the local market for the next 10 years.

Instead of doing it all yourself, you’re going to lease rights to a pasta company which will produce and sell homemade pasta on your behalf. The pasta company will raise the necessary capital, assume all the risks, incur the day-to-day costs of producing and selling the pasta, and receive the price for homemade pasta that is sold. You already held an auction to pick the pasta company, and it paid you a signing bonus for the rights to produce and sell homemade pasta on your behalf for the next 10 years. (That was your pasta “land sale”.)

Now you’ll want to collect the rest of the value of the homemade pasta that is produced and sold using your pasta-making machine. So you tell the company it needs to send you monthly payments over the 10 years it operates. At a minimum, these payments might be based on how much pasta the company sells. After all, if they produce and sell lots of homemade pasta, that’s potentially lots of value.

But you and the pasta company both know that the going price of pasta will change over 10 years, depending on how many other people are selling pasta at various times.

This presents risks to both you and the pasta company. You want to take advantage of those times when pasta prices are high. If you don’t structure the payments carefully, there’s a risk you might not get the best value you could have.

At the same time, the pasta company is nervous about times when pasta prices are low, because at those times it might not raise enough revenue to cover its day-to-day expenses. In fact, it’s hoping that times of peak pasta prices will help off-set the losses it incurs during times of low prices.

As the owner, you want to balance both of these concerns. So you decide that the payments should be based on how much homemade pasta is produced and sold each month AND the price received for the pasta during the month.

Source: Alberta Energy

All Facts