Thursday, 11 October 2007

Royalty Review Update #2: Political Risk

For the better part of 7 years, while Crestar was working Latin American oil & gas opportunities, I evaluated economics and risks of projects in comparison to projects in Canada. Make no mistake, our projects were competing for investment in Canada. Companies invest to get a return, and why go somewhere else when you can make money at home. Now, that doesn’t discount the potential value in risk diversification, and I assessed that, too. But contrary to the belief of some, we don’t invest in one project over another because it makes more oil and gas, we invest because it makes more money.

Investing away from your back yard adds risk, simply because you know more about your back yard than somewhere else. In the oil business, there are several kinds of risk. There’s technical risk – are the hydrocarbons there? Will they come out of the ground? How much will come out of the ground? There’s capital risk – what will it cost? There’s competitive risk – will somebody else get it after I found it?

And there’s political risk. Throughout this process, one of the fundamental tenants of the Royalty Review panel is that people will still invest in Alberta because of the stable political climate, and that has intrinsic value.


As one who measured and estimated political risk, the way you assess it is the risk that a government will change the fiscal regime mid-stream without compensation or protection. The risk that they’ll, say, change the royalties without grandfathering – which is exactly what the Panel has proposed.

Companies don’t care if it’s right wing, left wing, centrist governments, or that elections happen and governments change (because they do). Companies care that the basis upon which they made their investment decisions change. That changes the reasons for investing in the first place.

When I worked Venezuela from 1997-2003, the risk we assessed was whether a change in government would result in creeping or overt nationalization of the industry. They had done it before, in the 1970’s when Exxon, Shell, Chevron and Texaco were nationalized out of the country and the assets formed PDVSA, the known national oil company. In 1998, Sr. Chavez was looking like he was coming to power, and he very clearly wished to regain control of the energy sector. And in 2006, he announced that PDVSA’s share of all production sharing contracts would increase from an average of 25% (there were about 50 contracts ranging from 5% to 60%) to a minimum of 51% in each contract. If the companies didn’t like it, they could leave and PDVSA would get 100%.

So changing the terms happens, and in that case we correctly predicted it would. But here’s the info no one seems to mention: for all their bluster, Venezuela has never done those moves without compensation. In the 1970’s, multiple billions were paid by PDVSA to the exiting companies –PDVSA “bought them out”. Now, one could argue whether or not the price was fair, but the Venezuelans paid a lot. In the 2006 stepchange, Chevron, BP and Total have agreed with the compensation offered in their projects, but Exxon and ConocoPhillips didn’t want PDVSA having 51% in their contracts, and chose to leave. Compensation negotiations have been ongoing. Exxon is going to arbitration because they don’t like the amount. But every company is going to get something.

Not in Alberta. Fiscal terms for Exxon’s Kearl Lake project in the oil sands would be changed without compensation in mid-construction. Fiscal terms for my oil and gas projects will arbitrarily get worse, and things we --and everyone else in the industry -- chose to do last year will now become retroactivly uneconomic.

Two weeks ago, Ecuador, where I operated the project my company owned for 4 years, decided to arbitrarily increase royalties, such that the government would get 99% of incremental revenues above a certain price. Alberta is better; it’s only 80% in the Panel’s proposal.

Alberta is acting like a third world country, and not a good one at that. By the measures I used to assess projects for Exxon, Crestar, Gulf and ConocoPhillips, Alberta just became one of the highest risk jurisdictions in the world from a political risk perspective. Even if the Alberta government only decides to implement some of the proposals, unless it grandfathers all existing schemes, it will stay right up there in political risk. And there is more oil and gas in Nigeria than here, which now has less political risk. I know where investment will go, and Talisman, Nexen, ExxonMobil, ConocoPhillips, PetroCan, and everyone else who can shift dollars overseas will indeed shift some -- and the companies have mentioned that, though it's being perceived as a "threat". Trust me, it's not.

Political risk = lower investment = lower spending = slowing economy = lower government revenues.

Next post: More on the two billion dollar myth.

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