Can Bonus Bids Capture Economic Rent? Should Governments Opt for Increased Reliance on Bonus Bids Over Royalties?

Transcription

1 Can Bonus Bids Capture Economic Rent? Should Governments Opt for Increased Reliance on Bonus Bids Over Royalties?

2 The Toronto based C.D. Howe Institute (Institute) has recommended that governments should reduce their reliance on royalties and increase their reliance on bonus bids as a way to better capture the economic rent associated with oil and gas production. The institute s study observes that because government revenues from resource extraction rely on both up-front auctions [bonus bids] and royalties upon production, any increase in the latter should naturally reduce government revenues from the former. Theoretically, a bonus bid with no royalties or taxes would be the ultimate example of a fiscal system that captures the economic rent with the least administrative cost and with no risk to government. Why is it then that no government, indeed no resource owner, follows this model? To shed light on the answer to this question it is useful to recognize that there are a number of issues that need to be understood before the question can be answered in any practical sense. First, the pure bonus bid model requires an efficient market with perfect information and sufficient competition. Apart from the fact that perfect information is a theoretical concept that does not exist in reality, perhaps the closest situation is that between two oil and gas companies of comparable size and experience. Here the process can be assumed to be fully understood by both parties and that both parties possess the same degree of market power and resource understanding. Governments however typically do not have the same level of specific understanding. This should not matter if there is an open and competitive bidding process with the selection based on the highest bid and the bidder being a rational agent. For governments, the issue is one of risk sharing where does government want to be along the fiscal continuum from pure risk aversion (bonus bids) to minimal risk sharing (ad valorem royalties, to risk sharing through a share of profits, and finally to full risk sharing as is the case equity participation? Page 1

3 It is interesting to note that a survey of over 500 fiscal systems around the world representing 250 jurisdictions and 156 countries, shows that those jurisdictions with the highest government shares are those that rely on some combination of profit sharing; e.g., Norway. Other jurisdictions also include equity participation. The study shows that no resource owner relies either solely or mostly on bonus bids. For simplicity in this discussion, we ignore profit sharing and equity participation and concentrate on bonuses and royalties. The essential question becomes: if bonus bids increase, will royalties fall by the same amount, by less, or by more? The Institute observes that a $1 increase in royalties will result in more than a $1 decrease in bonus bids. This is because the effect of an ad valorem royalty is to cause production to be cut off before it would otherwise. In the theoretical model this makes perfect sense. Indeed, the practical application of expected monetary value analysis to economic decision-making (the procedure that investors use to determine how much they are willing to bid) also yields this result ad valorem royalties lower production and thereby lower the overall project value. Since the value bid for a project is based on its expected value, the bonus bid would also be lower. It is noted that many jurisdictions attempt to correct for the premature cut-off effects of pure ad valorem royalties with sliding scales based on price and production rate. Without recognizing the sliding scale royalty option, such as that applied in Alberta, the institute attempts to quantify the royalty impact. It states that: Simple models indicate that the overcompensation effect [that the decrease in bid is greater than the increase in royalty] could be quite significant. For example, if the royalty rate is 20 percent and abnormal profit represent 40 percent of the value of output, then the bonus bid is predicted to decline by $1.60 for a $1.00 increase in royalty revenue (in present value terms). If abnormal profit is 30 percent of the value of output, the bonus bid is predicted to decline by $2.40 for every $1.00 dollar increase in royalty revenue. These calculations indicate that a royalty rate increase might reduce bonus bids by a larger amount for marginal resource properties that yield little net present value, over and above profits at a minimum rate of return and royalties paid. Page 2

4 The institute s explanation so far assumes that investors are indifferent with respect to risk! We know, of course, that this is certainly not a reasonable real-world assumption, particularly for the oil and gas industry. The institute recognizes this assumption in footnote 13, stating that: Several caveats concerning the overcompensation effect should be noted. First, the effect applies only to new resource properties, as higher revenues from existing wells will compensate for this revenue loss. Second, to the extent that firms are risk averse, their bids will be less than the expected abnormal profit. In other words, with bidding by risk-averse firms, a royalty increase may be undercompensated, meaning that a $1.00 increase in royalty revenues might reduce the bonus bid by less than a $1.00. Third, the burden of the royalty rate increase might be shifted to workers and to other inputs used by the resources sector, not just to bid values. Fourth, as discussed in more detail in a later section, the degree of capitalization is also reduced because, under the corporate income tax, bonus bids are treated as Equivalent to a capital expenditure and depreciated over time, while royalty payments are fully deductible when they are incurred. Now the situation seems to be reversed! When real-world risk is considered, the institute sees that an increase in bonus bids in fact leads to the need for an even greater royalty decrease. Stated differently by relying on bonus bids, the resource owner actually receives less. So why then does the institute call for greater reliance on bonuses as a policy to increase benefits for governments? So far it seems that the institute does not accept that oil and gas investors are risk averse or prefer money earlier rather than later. Before we explore this matter further it is interesting to consider the U.S. experience. The U.S. and the Western provinces of Canada are unique in the extent to which they rely on bonus bids. To be sure, many jurisdictions around the World require bonus bids as a method of allocating petroleum extraction rights or initiating a petroleum contract. The practice is followed most in jurisdictions such as the newly independent states (NIS) of the former Soviet Union (FSU), the Middle East, Africa, and many Asian countries. In jurisdictions that are considered to have fully stable and transparent legal systems; e.g., United Kingdom, Australia, Denmark, Norway, bonus Page 3

5 bids tend not to be applied, or if they are, it is as a means of allocating rights not as the primary means of capturing economic rent. Part of the explanation for the U.S.- Canada experience no doubt relates to historical practice in the development of the petroleum industry in the U.S. specifically and, by influence, more generally in North America. The bonus bid model is followed by private land owners in the United States. Texas, for example, has some 800,000 private royalty owners and their, virtually universal, fiscal system of choice is high royalties with bonus bids. Since we would expect the Texas situation to represent a competitive environment and that theory should at least approximate the real world, the U.S. example suggests that the institute s model may be missing some important component. In this context, it is interesting to observe that U.S. jurisdictions tend to apply both higher bonus bids and higher ad valorem royalties than those seen in Western Canadian jurisdictions. One might argue that Texas is simply too far away and that the only relevant comparator is neighboring provinces; i.e., in this case, British Columbia, Alberta, Saskatchewan, and Manitoba. The institute looks at bonus bid data for British Columbia, Alberta, and Saskatchewan, for two years before Alberta s 2007 royalty review and for two years after. The following table is drawn from the institute s report. Western Canada Bonus Bids $ hectare $ Amounts (Millions) BC AB SK BC AB SK Pre Oct Post Oct , The results seem to indicate that indeed something happened in Alberta, relative to BC and SK. The obvious distinguishing event was royalty change in AB, but not in BC or SK. Following Alberta s Page 4

6 proposed royalty changes the bonus bids amount decreased by 40% in AB and increased by 300% in SK and by 360% in BC. While it might be tempting to relate the 2007 bonus decrease in Alberta to the introduction of new royalties, this can be a very dangerous assumption. Consider the chart below showing bonus revenue by select North American jurisdiction, including BC and AB. Perhaps one could argue that the post 2007 increase in AB is due to the subsequent decrease in royalties from those initially proposed. On this logic however there is no explanation for the 440% increase in Louisiana from 2007 to 2008 or the 48% decrease in the following year Louisiana royalty rates were not changed over this period. The royalty rates in Texas were similarly unchanged yet from 2009 to 2010 bonus bids per acre increased by more than 300%. Similarly, royalty rates in Wyoming did not change yet bonus bids in that state increased by 640% from 2009 to As with the BC-AB-SK comparison, bonus bids seem to be significantly influenced by more than royalty rates. Another recent U.S. example is Colorado. In May 2011, Colorado increased the royalty rate on state lands from 12.50% to 16.67% - officials for Colorado report that there was no measurable impact on bonuses that could be related to the royalty change. Colorado also posted two special land offerings with royalty rates increased even further to 20%. For these offerings, the state received record bonus bids. While the Alberta royalty changes are no doubt an obvious event that could contribute to reduced bonuses, it is important to recognize that not-so-obvious events were the discovery at the same time of one of North America s most attractive shale gas plays, in British Columbia and the emergence of North America s most lucrative tight oil play the North Dakota Bakken, which extends into Saskatchewan. While the decline in Alberta is coincident with the introduction of higher, at least different, royalties, most evidence for the change in Alberta s relative position at that time points more to an increase in BC and SK. Page 5

7 Many and varied factors could contribute to the Alberta decline; for example, industry negotiation and positioning to maximize the likelihood of removing or softening the perceived royalty increases. Focused policy initiatives to attract interest in BC and SK in response to emerging U.S. experience could be another factor. The extreme high activity levels in Alberta may have contributed to Alberta not recognizing earlier the impacts of the U.S. shale gas revolution. In addition, if the change in bonuses was related to reduced project values caused by increased royalties one would expect the $ per hectare values to decrease. This however did not happen. In fact these values actually increased. One thing for sure is clear the number of land sales and the total hectares sold did decrease in Alberta while they increased in BC and SK. Industry uncertainty with respect to Alberta royalties could be part of the explanation. Uniquely attractive and emerging projects in BC and SK, as already mentioned, could also be part of the explanation. Page 6

8 These types of qualitative arguments, however logical, do little to shed light on the interaction between bonuses and royalties and, more importantly, on whether resource owners would be better off with a greater reliance on bonuses as the institute recommends. A more constructive approach is to: first, accept that risk is important any other assumption in this regard is simply not consistent with industry practice; and second, produce a quantitative demonstration of the impacts, on the basis of the same approach and methodology that is followed by investors when determining the amount to be bid. This approach is the expected monetary value (EMV) analysis already identified. This is the same as conventional cash flow analysis with appropriate adjustments for non-time related risk and for the time-value of money. To help move the illustration along, let s assume that risk is unchanged between the two cases so it can be ignored and that the time value of money for the investor is represented by a real discount rate of 10% - a common industry bench mark. For a given royalty rate, what bonus bid would be required to keep the investor NPV unchanged? Stated differently, how much would bonus bids have to decrease for a given increase in royalties? The results are presented in the table below. The table first reports (Case 1) for a representative project before fiscal terms are applied, showing a 55% ROR and a NPV10 of $7,633 K. Case 2a next shows the results with normal corporate income tax and a royalty rate is 12%. The royalty amount for this case would be $2,880 K. Case 2b shows the bonus required to keep the investor NPV10 at the same level as it would be with the 12% royalty. This bid would be $1,400 K, implying that royalty revenue is worth 2.06 times more than revenue from bonuses. When the full tax impacts are considered, the royalty preference decreases to 1.20 times before discounting for the government s time-preference for money and to 1.16 times after discounting. Page 7

9 The before-tax royalty preference value increases to 2.57 when we apply a risk premium of 20% to the bonus. The after tax discounted value is 1.22, showing that for every dollar that bonuses are reduced, royalties could be increases by 1.22 dollars. Experience shows that a 20% risk premium is likely conservative. Increased risk and longer lead time projects would show even greater resource undervaluation from bonuses. When we look at a marginal (ROR approx. 10%) investment prospect the after tax preference for royalty over bonuses increases to This is based on the bid assumption of $1,400 K before the volume of recoverable reserves is known. If, after the bid, the reserves turn out to be sufficiently low so as to cause the project to be marginal, the investor would have been better off offering to increase its royalty rate from 12% to 33%, and pay only a nominal bonus bid. Page 8

10 Summary: The quantitative evidence supports the view of industry experts, that: (a) the more upfront the fiscal levy is the more onerous it is on investment decisions and (b) rather than being a sign of a good fiscal system, consistently high bonuses might indeed be a sign of insufficient royalties. Quantitative analysis based on industry practice and established investment criteria shows that governments would in all likelihood be better off realize higher revenues with a greater reliance on royalties than on bonus bids. Even if we were to assume that bonus bids can capture the economic rent it has to be recognized that up front levies add risk cost and costs, by definition, reduce economic rent. So even if bids could capture the economic rent, they contribute to ensuring that there is less rent to capture. Greater reliance therefore on bonus bids reduce both the size of the pie available for sharing and the share that governments can expect to capture. Page 9