In this densely worded 4-page memorandum and Appendix from Deputy Provincial Treasurer A.F. “Chip” Collins to Treasurer Lou Hyndman, a financial analysis is undertaken by the staff within Fiscal Policy & Economic Analysis. The initials at the end of the memorandum indicate G. Lynn Duncan an Assistant Deputy Provincial Treasurer and A.G . (Arnie) Heisler, the Comptroller were its principal authors.
This memorandum responds to a number of questions posed to the department in early March. The central question to be answered was “what is the value of the foregone production and is there a financial reward from shutting in production?” This would have been also been a central question for the Notley government back in 2017-18 when the differential was so low certain segments of the oil industry lobbied the government to curtail production in a low price environment. In the 1981 situation, it was the National Energy Program stymying Alberta producers (and the Alberta government) from fully realizing significant “windfall” gains from the then extraordinary rise in world oil prices.
The first paragraph begins: “We have no information that would suggest a drop in the price of oil over the next 5-10 years.” Of course history told a different story. Part of the rationale for this call:- “other sources indicate a high probability that this decline would be more than offset by increasing demand in the rest of the world, notably among the less-developed countries.” This turned out to be the case 20 years later with the emergence of China and other parts of Asia, such as South Korea, increasing global demand.
Every financial model requires assumptions and the assumptions used for arriving at foregone revenue from production cuts seems wildly optimistic in hindsight. The department suggested world prices in 1982 of about $48/barrel and $56/barrel in 1983. The financial analysis also assumed that world oil prices would grow by 10 per cent per year after 1990.
It is important to recall that during this period, inflation rates were in the double digits and the brutal recession orchestrated by the U.S. Federal Reserve under Paul Volker was beginning to wear down global inflation with spillover effects on both inflation and reduced energy demand.
The model was used to examine the future value of foregone revenue after a certain number of years invested at 10 per cent which would have been less than the current yield on the Government of Canada bonds (“risk free rate”) in March 1982 of around 14 per cent.
The memorandum then goes on to discuss the uncertainties underlying the analysis: how long is the production reduction? when can the foregone production be eventually produced and the biggest uncertainty of all-at what oil price would be volumes be produced?
Another issue examined was whether and how to disclose the amount of revenue deferred as a result of of a reduction in oil production. The memorandum goes into the niceties of “deferred revenue or credits” For a variety of reasons the Department rejects the use of creating such an account, concluding “we do not think that there is any way in which the Auditor-General could agree to a separate “suspense” account representing value of oil not raised by reason of production cutbacks.”
Deputy Provincial Treasurer FE-4752-7
Hon. Lou Hyndman 27-Mar-81
Provincial Treasurer 7-4106
Oil Production Reduction- Possible Questions
Your Memorandum of 3-Mar-81
The following points correspond to the questions posed in your 3-Mar-81 memorandum.
- We have no information that would suggest a drop in the price of oil over the next 5-10 years. A recent Wall Street Journal article discussed the possibility of declining North American demand by the end of the century due to conversion to alternative energy sources. However, other sources indicate a high probability that this decline would be more than offset by increasing demand in the rest of the world, notably among the less-developed countries.
- In Mar-82 under NEP pricing, the domestic price for conventional oil will be $19.75/barrel. On the world market we expect oil to be selling for about $48/barrel.
- Mar-83 Under NEP pricing, the domestic price for conventional oil will be$21.75/barrel. on the World Market we expect loyalty to be selling for about $56/barrel.
- The following table shows the value of the revenue foregone in 1981 and 1982 as a result of the cutback if it had instead been realized and invested at 10%:
@10%, Value in….. 83-84 84-85 87-88 92-93
($millions) 1,372 1,509 2,009 3,236
2,3,4 Questions 2, 3, and 4 appear to be aimed at answering the questions: what is the value of the foregone production and is there a financial reward from shutting in production? These questions cannot be fully answered by developing a series of cash value numbers as shown above. The answer depends on
- the duration of the production reduction
- the length of time before which the foregone production can be produced, and
- the price at which it is produced.
The second unknown is a factor which may have received little attention to date for mainly technical reasons, one cannot assume that all of the withheld volumes will be produced in 1982, 1983, or any particular year for that matter. We have contacted the ERCB Oil Department. Based on their knowledge of typical pool production profiles, they estimate it could take as long as 20 or 30 years before all of the oil production foregone during the reduction programme is recaptured, if ever. Because of the uncertainty surrounding this variable, we have also examined the case under which all of the foregone production could be recaptured within 10 years.
The above variables or unknowns and the need to give the numbers some perspective require that the financial merits of the production reduction be considered in terms of rates of return rather than by examining a series of cash values. As shown on the attached table, the Province is only financially better off on the cutback volumes if the province can win significant price concessions as a result of the cut back. If no price concessions are won, the rate of return on the cutback volumes under the NEP prices less than the 10% which we could reasonably expect to earn on investing the royalty revenue if there was no cutback in production.
But, the more comprehensive comparison is the rate of return on the incremental revenue generated on all production (not just the cutback volumes) as a result of all of the possible price concessions. If the revenue effect on all production is measured, then the financial return to the cutback is enormous given any significant concessions in terms of moving the conventional price toward the international price. In fact the NEP prices after 1981 would only need to be improved by about 5-6 percent in order for the rate of return from the reduction programme from all Alberta oil production to be 20% (assuming a one-year cutback and a recapture period of 20 years). This implies that the reduction programme is a justifiable investment if price concessions of more than about 5% higher than the NEP are perceived as attainable.
5. Lost Oil Company Revenue. Although the oil companies will lose a large amount of gross revenue, they would have received only a small portion of that revenue and net terms had no Reduction Program been in effect. With lower production, their taxes, royalties and operating cost will all be lower. Boss they’re real loss equals their net back per barrel times the number of barrels of foregone production, not price times foregone production. The current netback is about $3-3.50/ barrel while the price is about $17.75/barrel. On this basis we would estimate the net revenue loss to the oil companies to be about a hundred and seventy million if the cutback lasta for one year. However, as with the government’s foregone royalty revenue, the oil companies “lost” revenue is actually just deferred, and, in this case as well, the return from selling at future, higher prices would have to be estimated prior to determining the real loss.
6. Lost Jobs. The employment impact of the National Energy Programme is difficult to estimate with any precision, and to focus on the number of jobs lost due to the cutback is even more difficult. However some lost jobs should be expected, initially in the oilfield services industry. Preliminary estimates show the employment impact to result in much less than 1000 jobs lost due to the reduction programme compared with some 5,000-6,000 jobs lost due to the impact of the NEP. However, as these estimates are very preliminary, we would caution against referencing them specifically in public. Instead one may wish to refer to the relative insignificance of the cutback impact on jobs as compared with the impact of NEP on employment.
7. We assume that the purpose of the “suspense” account would be to disclose the amount of revenue deferred as a result of a reduction in oil production. The suspense amount could only be shown as deferred revenue. Deferred credits or revenue arise on the receipt of an asset, usually cash, where the associated revenue is to be taken into income over a determined future, e.g., premium or exchange gains on the sale of debt to be amortized over the life of the liability. In this case no asset is realized. The only conceivable one is accounts receivable at sometime in the future which is not determinable and it is not receivable because it is not based on any transaction that has taken place. The amount is not measurable because of price uncertainties and we understand the recovery is also uncertain because, as mentioned above, there is no technical way of determining when or even if the oil will be raised. This would present accounting difficulties in the future as there is no basis for removal of the deferred credit and related assets from the accounts.
The only other accounting practice that could remotely relate to the above is the case of a production situation where all the work has been completed, disposition of the product is assured at a definite price. In this case, amounts are taken into income by way of valuing the inventory at the disposition or sale price. In our situation, We do not have a measurable inventory, we do not know the price, and further we do not think that the intention is to increase income but to, in some manner, disclose deferred or foregone revenue.
In view of the above, we do not think that there is any way in which the Auditor-General could agree to a separate “suspense” account representing value of oil not raised by reason of production cutbacks.
For internal evaluation purposes we will, nonetheless, be able to show the impact on future revenue should the production reduction be terminated.
Conclusion
Looking at the production cutback as an investment in an acceptable energy agreement, the above shows that anything above a 5% increase in prices, above NEP prices, yields a substantial rate of return. It is questionable, however, whether the production reduction should be considered as an investment in this way and, perhaps more importantly, whether all revenue gains from a revised pricing- sharing arrangement can be attributed to the cutback. At the other extreme, one could look at the production reduction strictly in terms of the financial gains that might be made on that production alone from higher future prices. From this perspective the cutback will be a financial success if substantial price concessions are won and not otherwise (i.e., considering risks, it likely would be unwise to buy production at current Canadian prices to be held for resale at future, higher prices).
A.F. Collins
ajs/PS/LL/A GH/GLD
Att.
cc. G.B. Mellon
| RATE OF RETURN ON PRODUCTION REDUCTION a) | ||||
| (PERCENT) | ||||
| Duration of Cutback | Period of Recapture b) | NEP Prices | 75% of World Price by 1986 c) | 100% of World Price by 1986 c) |
| 1 year | 10 Years | 8.7 | 13.4 | 17.7 |
| 1 Year | 20 Years | 7.9 | 11.4 | 14.3 |
| 1 Year | 30 Years | 6.5 | 10 | 12.2 |
| 2 Years | 10 Years | 9.4 | 14.4 | 18.9 |
| 2 Years | 20 Years | 7.9 | 11.6 | 14.6 |
| 2 Years | 30 Years | 6.4 | 10.1 | 12.3 |
| Note: | ||||
| a) | rate of return is estimated for cutback volumes only | |||
| b) | period over which production deferred during reduction programme is eventually recovered | |||
| c) | the forecast of world price used is that to which tentative agreement was reached during ENR/EMR discussions. Those discussions only dealt with a forecast to 1990; we hav3e assumed world prices will grow at 10%/year after 1990. | |||
ALBERTA TREASURY
Fiscal Policy &
Economic Analysis
20-Mar-81
Source: Provincial Archives of Alberta, PR1986.0245 (Hyndman Papers), Box #415, File #642.
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