Andy Nelson on Saudi Kremlinology

My friend Andy Nelson has a good comment here on Saudi oil production that I’d like to elevate to the level of a post:

I think the Saudis could still swing if they wanted to. Their
downstream investments in Jubail and elsewhere could be leading to
nationalistic decisions to shut in production for future domestic
processing. Figuring out Saudi strategy seems to be the new
kremlinology.

I believe that centrally planned oil industries like
Saudi Arabia’s will peak and crash. Areas that are open to foreign
investment and free trade, have multiple competing players, and
transferable leases will plateau or expand.

As a case study you can
look at Canada. When we had an industry based on natural drive,
pinnacle reef reservoirs we were net importers and self sufficiency was
just a dream. Now the cheap easy oil is all gone, but by reducing
barriers to foreign investment, allowing oil to be exported rather than
kept in the country at subsidized prices, and allowing assets to be
bought and sold easily, Canada is now a net exporter, even while
domestic consumption has increased.

Related posts:

  1. Petrodollars and Saudi Prince Alwaleed
  2. Digging Deep into Demographics
  3. Andy Kessler on Media 2.Uh-Oh
  4. Revisiting Peak Oil, and the Undulating Plateau
  5. Alan Greenspan: How I Spent My Bubble Bursting Days, Part II

Comments

  1. As a case study you can look at Canada. When we had an industry based on natural drive, pinnacle reef reservoirs we were net importers and self sufficiency was just a dream. Now the cheap easy oil is all gone, but by reducing barriers to foreign investment, allowing oil to be exported rather than kept in the country at subsidized prices, and allowing assets to be bought and sold easily, Canada is now a net exporter, even while domestic consumption has increased.

    That sounds really good, maybe even cool. Unfortunately, I believe it’s wrong.

    Quoting from Alberta Gov’t Website: http://www.energy.gov.ab.ca/736.asp

    In 2005, conventional crude oil production made about 34 per cent of Alberta’s total crude oil and equivalent production, which is about 23 per cent of Canada’s total crude oil and equivalent production. This amounts to about 5 per cent of total North American crude oil and equivalent production.

    The conventional oil sector has been a perennial driver of the Alberta economy for more than 50 years, and the Oil Development Business Unit has its sights set on ensuring that this valuable resource sees another 50 years of contribution to our province. The Conventional Oil Business Unit promotes and encourages exploration and development of reserves, calculates and collects royalties from producers and markets Crown’s share of crude oil production through private sector marketing agents.

    Development of Alberta’s conventional oil industry has created an extensive infrastructure that facilitates the continued drive to locate, drill for and transport the oil to market. This infrastructure continues to grow: from 2000 to 2005, industry invested almost $100 billion in the province’s conventional oil and gas industry.

    If Alberta didn’t have the oil sands, Canada would be a net importer. So the next question is what drove the oil sands industry to spend $100 billion? The answer is revised fiscal terms by the created National Oil Sands Task Force (NOSTF) in the mid 90s and higher oil prices.

    What was so special about the fiscal terms? On the taxation side, immediate capital write-off for new mines, existing mines increasing production by more than 25%, and those mines that spent capital in excess of 5% of gross revenue. 5% of gross revenue is an arbitrary deemed value roughly equivalent to maintenance capital–capital just to keep the plants well maintained. So in other words, if a mine is spending more than maintenance capital, that additional capital gets immediate capital write-off. That certainly juices returns. On the royalty side, developers are allowed to earn the long term bond rate before paying meaningful royalties. Prior to “payout”, royalty is set at 1%. Post payout (and companies can go and out of payout situations depending on their capital profiles), the royalty is set at 25% of royalty net income (revenue less opex less capex). Also, prior to the NOSTF, every project negotiated its own fiscal terms. Now, there’s more or less a level playing field. Without going into all the details of the fiscal terms, incumbents do have an advantage and it relates to ringfencing and 41A CCA immediate capital write-off and royalty deductions for expansions.

    Why did the provincial and federal governments provide such rich incentives? Well, there are at least two reasons. One, the industry and governments wanted to create a level playing field and wanted to get away from one-off negotiations. And two, the prevailing thought in the mid 90s when oil was in the $20s was that if industry and governments didn’t monetize oil soon, a new technology might displace oil and it would be worthless. So to encourage industry players to step up and spend billions to develop oil sands, a new fiscal regime was put in place to recognize that oil sands projects require a long time to develop and are risky. A lot of engineering and construction time as well as buckets of capital are required before the developer sees its first drop of oil.

    For those that are interest on general fiscal stuff, you might wish to investigate Garnaut and Clunies Ross, “Uncertainty, Risk Aversion and the Taxing of Natural Resource Projects”.

    Anyway, to cut to the chase, fiscal terms and high prices are what enabled the oil sands to proceed at a breakneck pace, not a reduction in foreign barriers. That said, free trade is a good thing. But it should not be credited with things it did not do.

  2. Andy Nelson says:

    Around 1980 the Exxon board approved about $14B to be spent at Cold Lake, Alberta. That was back when $14B was serious money. Then government policy changed, foreign financed projects were going to be taxed at a higher rate, and part of the production would have to be sold domestically at the made in Canada oil price. The project was cancelled. Peter Foster gives names, places, dates and times regarding the negotiation in his book “The Sorcerer’s Apprentices”.
    So I agree with Kevin that “fiscal terms and high prices are what enabled the oil sands to proceed at a breakneck pace”, but it wasn’t that long ago that fiscal terms were horrible and Canadian producers could not realize the high international price of oil.
    My larger point is that most producing areas in the world are more similar to Canada in 1980 than Canada in 2007, and if Saudi Arabia were to open it’s market, a lot of the billions forecast to be spent in the oil sands would flow to exploration, exploitation and enhanced recovery in Saudi Arabia. The Saudis could pocket all of the money they’ve made to date, auction rights to the highest bidders, charge lavish royalties on production, and all of the future capital investment would come from the US, Europe and China at no risk to the Saudis.
    You can look at the oil sands and the recent growth of the Irish economy as incubators in the study of what happens to foreign investment and domestic prosperity when taxes are lowered. Unfortunately our federal government is signaling that some of the oil sands tax breaks will end later this month, rather than extending the tax breaks to other industries.
    If it made sense to monetize oil at $20, doesn’t it make more sense to monetize oil at $60?
    Hey Paul, thanks for the elevation!

  3. Around 1980 the Exxon board approved about $14B to be spent at Cold Lake, Alberta. That was back when $14B was serious money. Then government policy changed, foreign financed projects were going to be taxed at a higher rate, and part of the production would have to be sold domestically at the made in Canada oil price. The project was cancelled. Peter Foster gives names, places, dates and times regarding the negotiation in his book “The Sorcerer’s Apprentices”.

    Yes, that might well have been the case. It predates the work of the NOSTF referenced above. Then Alberta premier Lougheed had negotiated a special tax provision for Syncrude in the 70s. Effectively, it allowed Syncrude to deduct royalties for tax payments twice. But it only had a lifespan of 25 years, until 2003. Thus, in the mid 90s, Syncrude had a strong incentive to create a harmonious new fiscal regime that would apply to everyone. If Syncrude didn’t help create a new fiscal regime, it would have had to negotiate its own on a one-off basis. Given that it was and is very profitable, it would have been a difficult negotiation.

    So there were definitely some wonky things that took place in the 70s and 80s.

    So I agree with Kevin that “fiscal terms and high prices are what enabled the oil sands to proceed at a breakneck pace”, but it wasn’t that long ago that fiscal terms were horrible and Canadian producers could not realize the high international price of oil.

    The period of the 80s, to which you refer, is in and about the time of National Energy Program and when Petro-Canada was formed by nationalizing companies. But that period is long since over, fortunately.

    My larger point is that most producing areas in the world are more similar to Canada in 1980 than Canada in 2007, and if Saudi Arabia were to open it’s market, a lot of the billions forecast to be spent in the oil sands would flow to exploration, exploitation and enhanced recovery in Saudi Arabia. The Saudis could pocket all of the money they’ve made to date, auction rights to the highest bidders, charge lavish royalties on production, and all of the future capital investment would come from the US, Europe and China at no risk to the Saudis.

    But if you were the Saudi’s, would you follow that path? I wouldn’t and here’s why.

    If the Saudi’s were suddenly to hold giant auctions for all their lands and reserves with an appropriate royalty, it would create a bonanza of untold proportions. Foreign companies would come in, buy the rights, and produce as much as possible as quickly as possible while maximizing the NPV of the reserves. If the Saudi oil were flood the market and stop production in other parts of the world because of Saudi’s inherent economic advantage, the Saudis would quickly drain their reserves while becoming very wealthy, even wealthier than they are today. Sounds good, right? But challenge for the Saudis is that they would be awash in cash.

    How can being awash in cash be a problem? One major problem is that it does not allow the society to acclimatize itself to its newfound wealth. The society is not given the opportunity to develop its people and create lasting sustainable opportunities for them. Instead, people look at the pot of gold (or oil) and want their fair share.

    If you look at the Hobbema reserve in Alberta, it serves as a good, perhaps extreme, example of what happens when too much money is injected too quickly.

    CBC: The Current http://www.cbc.ca/thecurrent/2006/200601/20060109.html

    Hobbema is a community at the junction of four Indian Reserves, with a combined population of roughly 12-thousand people. It may be the size of a typical prairie town, but it’s riddled with big city problems: guns, gangs, and crack cocaine. It wasn’t always this way in Hobbema. The community used to have low unemployment, and much less violence. It also used to have a lot of oil money.

    In our last half hour, we heard about the gang problems on the Hobbema Reserve near Edmonton. Hobbema and Siksika share a few unfortunate statistics. The unemployment rate on the Siksika reserve is really no better — it hovers at between 70 and 80-percent.

    But unlike Hobbema, Siksika’s royalty distribution is far more modest. When someone turns 18, the cheque is in the 5 to 10-thousand dollar range, not 200-thousand. That alone might make kids at Siksika less vulnerable to the gangs now in Hobbema, gangs with names like Redd Alert and the Alberta Warriors. But they are hanging around Siksika, trying to recruit.

    So if you were running Saudi Arabia, would you want flood the economy with untold wealth? Or would you want to maintain a large but fair market share of the oil market, develop your people and your infrastructure, provide opportunities for your people over several generations, and be able to influence price and ensure that Saudi Arabia receives a healthy share of the economic rent?

    I know what I would do–I would do as Saudi Arabia is doing. I would keep the oil flowing for a long time while transitioning the people, economy, and society.

    You can look at the oil sands and the recent growth of the Irish economy as incubators in the study of what happens to foreign investment and domestic prosperity when taxes are lowered.

    Yes, the Irish example is often held out as a great example of what happens when you lower taxes. But I will see your Irish example and raise you the Venezuelan example. For years and years, Venezuela allowed foreign companies to develop its oil reserves with low tax and royalty schemes. The rich in Venezuela often paid no taxes. During this time, about 80% of Venezuelans lived in poverty while oil companies made billions and the rich lived very good lifestyles. We all know what happened next: a mad man took over and is now a democratically elected dictator.

    Another good example is Russia. Should it allow foreign companies to come in and gobble up the reserves like or should it develop its reserves on its own? It’s a tough question, for which there is no right or wrong answer. On one hand, the economic and technological boost would be good for the country in the short term. You have to remember that the reserves only have so much value. If foreigners come and develop the reserves, they want their cut of the action. How much is left over? Where will Russia be in 30-40 years time when the aggressive oil development program is over? Have a look at various internet sites and study Russia’s problems with regard to the health of its citizens and so on.

    Or does Russia take a more moderate development approach? It knows that if it floods the market with its oil, the international oil price will plunge and its oil will be gone in a short time. So then what? With its current moderate approach, it has already repaid its debts and built a strong war chest of foreign reserves. Now it can and does dictate to Europe, China, and Asia how much those countries will pay for natural gas. Oil, because it is fungible, is sold for the prevailing world oil price. And it is keeping most of the spoils for itself.

    An excellent contrasting example is Mexico with its nationalized Pemex. Rather than comment on it, I will refer you to an excellent article published yesterday in The New York Times titled Output Falling in Oil-Rich Mexico, and Politics Gets the Blame (free registration is required). Mexico is likely going to require foreign investment, whether it wants it or not.

    Given what I have written, do I think Alberta should nationalize its oil sands industry and turn the clock back to the 80s? No, most definitely not. Alberta has benefited greatly from foreign investment. But one should not take our success and think it can and should be applied everywhere else. Other countries and regions will choose different courses of actions for very good reasons. And some will do dumb things.

    To summarize to this point, in the 70s and 80s, Canada had some wonky political policies. For example, remember the foreign investment review agency (FIRA)? After when much loved Mulroney came to power, Canada was open for business. But that alone didn’t kick start the oil sands development. If that were all that had happened, Canada would be a net importer of oil today. It was a Liberal government that cooperated with the NOSTF and Alberta to granting the new fiscal regime. Alberta had granted a generous royalty scheme. [For those interested, I elaborated a bit more in a blog article.] And then that got the ball rolling with Syncrude and Suncor planning expansions. Along came higher oil prices and now Alberta is experiencing a boom.

    Unfortunately our federal government is signaling that some of the oil sands tax breaks will end later this month, rather than extending the tax breaks to other industries.

    The real questions are: 1) Do oil sands companies require the generous fiscal regime to develop the resources? and 2) What is the economic share that the oil sands companies are receiving–in other words, how much of the value pie are they taking? and 3) Is that share of the pie appropriate? When the NOSTF did its work back in the mid 90s, the sharing of the pie was roughly one-third to the Feds, one-third to the province, and one-third to the developer. The ratios held firm for a wide range of prices. Since then, federal corporate taxes have come down from roughly 30% to 20% (supporting your point of low taxes equals development) and provincial taxes have come down from roughly 15% to 10%. So at this point, the one-third, one-third, one-third rule generalization no longer applies. It is much more skewed toward the developer.

    What if similar generous tax provisions were extended to all businesses? The Canadian economy would be en fuego with all the activity. All profitable businesses could expand or modernize at the complete expense of the taxpayer. Immediate capital write-off is a license to spend. If a business has a $100 in profit, it either could pay taxes on it, or reinvest it in the business and have its tax paid go down by $100. You would see a lot of brand new shiny factories and equipment.

    If it made sense to monetize oil at $20, doesn’t it make more sense to monetize oil at $60?

    Part of the reason for wanting to monetize at $20 was the fear that technology would permanently keep prices low. Yes, reserves were depleting, but companies used technology more effectively to access smaller and smaller pools of oil and were able to use more advanced recovery techniques from existing pools. If you believed that prices were going to be permanently low and that oil sands could be an attractive business, but not an over-the-top-home-run business, then incentives and monetizing made sense. Moroever, if a developer happened to get bad luck and come on stream when prices were in a slump–say, $15/barrel for a five year period–the developer might never have received its cost of capital back. So those were some of the reasons why the Alberta and Federal governments were generous back in the 90s.

  4. Earlier I wrote the following:

    Immediate capital write-off is a license to spend. If a business has a $100 in profit, it either could pay taxes on it, or reinvest it in the business and have its tax paid go down by $100.

    That’s incorrect. Taxes go down by taxe rate times capital expenditure. So if the combined tax rate is 30%, then for a $100 expenditure the tax savings is $30.

    Let’s look at a few different examples.

    Example 1: If a new oil sands company spends $10 billion over a five year period to develop a greenfield operation, then it is allowed to earn (revenue less opex less capex less royalty, which is very low at 1% gross revenue) $10 billion before paying taxes. The initial $10 billion of capital expenditures is pooled as losses. As soon as the cash starts rolling in, the losses are applied against the prior losses. This is a huge, huge advantage for oil sand companies being able to recoup the capital quickly.

    Example 2: An existing operation currently earns (revenue less opex less capex less royalty, which is very low at 1% gross revenue) $1 billion decides to improve its facilities by lowerings its costs. This $1 billion is in excess of its maintenance capital, which has been arbitrarily set at 5% of gross revenue. Thus, the $1 billion of capital expenditures are eligible for immediate tax write-off. The oil sands company pays no taxes that year.

    Example 3: A family bakery earns (revenue less opex less capex) $200K. It decides to modernize its bakery and spends $200K on capital expenditures. The $200K probably goes into a regular CCA tax pool that qualifies for a 25% double declining balance deduction with the half year rule applied in the first year. So in year 1, it is allowed to deduct 50% times 25% times $200K, or $25K. It must still pay tax on the remaining $175K in earnings. Assume a combined tax rate of 30%, and the bakery pays $52.5K in taxes.

    Contrast Examples 2 and 3. In Example 2, no taxes paid. In Example 3, substantial taxes are paid. That difference exemplifies the oil sands companies’ economic advantage.