Lack of diversification is an invitation to risk and disaster that nearly all investors are aware of. Very few of them, whether institutional, corporate, or individual, would put their total net worth into one sector. Yet, that is just what Alberta, Newfoundland and Labrador, and Saskatchewan have done.
The economies of those provinces are already heavily dependent on the fortunes of the petroleum industry. The corporate and personal income taxes that the industry generates are key to all three provinces. These revenues decline when the oil price declines and industry activity subsides.
On top of that, these provinces’ ownership of the underlying subsurface mineral rights, and the rights to lease sales for drilling on the properties, means that they are further committed and lashed to the notoriously volatile and erratically performing industry—an industry that may not have a future beyond a few more decades, if that.
In contrast, the industry in the United States has very little drilling on state or federal lands, other than offshore or in the state of Alaska. While state governments certainly suffer when the industry experiences a downturn, as in the 2014-2020 period, they are not in dire financial straits, as the provinces of Alberta and Newfoundland and Labrador are, and, to a lesser extent, Saskatchewan is.
American states have little land or subsurface rights of their own. The vast majority of oil and gas drilling and production occurs on privately owned land. The landowners derive royalties from the production and the disturbance on their property. State and federal governments glean income tax from the corporations and their employees, but do not receive royalties, except in the rare circumstances where they hold the subsurface rights.
Many other industries and companies are usually active in the oilpatch states (agriculture, finance, manufacturing, construction, services), so if oil prices and profits slide, it is not necessarily a source of heavy damage to state treasuries. If those states also had royalty income and land-lease sale income, their fiscal situations could be as dire as those in Canada. Their non-ownership of these assets and rights has largely been a blessing.
This may seem counterintuitive to Alberta residents. The oil and gas industry has long been a source of the province’s legendary prosperity, which has given Albertans the highest per capita incomes in the nation, even in periods of depressed oil and gas prices. Yet, the era of more than 70 years of prosperity could be in jeopardy, and the continued fixation and dependence on fossil fuel fortunes could bring disaster to the province.
Not all the industries and ways of life of today are guaranteed to persist into the far future, or even the nearer future. There are also determined anti-petroleum forces that seek to make the industry extinct even sooner than might naturally occur. These include the green or climate change lobby and sympathetic politicians. Carbon pricing is escalating and the continued pressure on institutional investors and financial institutions to no longer fund fossil fuel projects or operations connected to them are increasing.
It is unclear whether oil and gas will still be a viable industry by the end of the century. Some other energy technologies will more than likely supplant it, if not entirely then substantially, well before then, particularly if advances in the efficiency of solar panels, batteries, and other energy storage, fuel cells, and small modular nuclear reactors continue at their current pace. The anti-carbon lobby is also relentless and seems unstoppable. Therefore, a solution that would have been regarded as heresy in Alberta and elsewhere in Canada should be seriously considered.
The oil and gas subsurface rights in Alberta and the rest of the Canadian oilpatch should be sold off to private investors, to eliminate the dependence on a volatile and risky industry with a finite life. This would also increase the industry’s flexibility as it could adjust its royalty and other terms with the rights-holders without distortions to the provincial treasury. Excessive reliance on one industry is a recipe for fiscal and economic disaster, as Alberta’s consequent wild swings in revenues and cuts to service and benefits to its citizens demonstrate decade after decade.
While it is unclear what the sale of these rights could net Alberta, Saskatchewan, or Newfoundland and Labrador financially, clues can be found in companies which are publicly traded in Canada and own nearly all the royalties to their production. This is the legacy of the early land grants to the Canadian Pacific Railroad, the Hudson’s Bay Company, and some other lucky, early landowners.
One company, Freehold Royalties (trading under the symbol FRU on the TSX), had total revenue of $140.837 million in calendar year 2019. Of that, royalty revenue was approximately 96.25 percent, or $135.55 million. FRU’s enterprise value (EV), which is the market value of shareholders’ equity plus total debt minus cash and cash equivalents, is $726.34 million as of year-end 2020. Its EV to revenue ratio therefore is 5.36.
As 2020 was an even more depressed year for the industry than 2019, this valuation could be conservative. FRU has about 6.6 million acres of royalty lands. Royalty production volumes were 10,229 barrels of oil equivalent (BOE) per day. The ratio of EV to daily production is about $71,000 per barrel per day.
Here are the same calculations for a similar company, Prairie Sky Royalties (PSK on the TSX). Prairie Sky has about 7.8 million acres of fee or royalty lands. Royalty production volumes were 21,757 BOE equivalent per day. Total revenue, which appears to be almost entirely from royalties, was $268.4 million in calendar year 2019.
PSK’s EV is $2.35 billion as of year-end 2020, giving an EV to revenue ratio of 8.76. A weighted average by EV of the two firms would give an average ratio of 7.96. EV/daily production is $108,000.
Again, as 2020 was an even more depressed year for the industry than 2019, these valuations could be conservative. Alberta’s total oil production for the nine months ending September 30, 2020 was 157.8882 million cubic metres, or 993.12 million barrels, or 3.62 million barrels per day, of which 15 percent, or 543,000 barrels per day, was conventional oil, which FRU and PSK largely produce. The weighted average (by production) of the EV to daily production ratio of the two firms is $96,000.
Applying this average EV to daily production ratio to the portion of Alberta oil production that is conventional, i.e., the 15 percent that is not derived from the oilsands, gives an EV for Alberta’s non-oilsands properties of $96,000 times 520,000 barrels per day (eliminating FRU’s and PSK’s production, less an estimate for production in Saskatchewan and North Dakota), equalling $49.9 billion.
That is, Alberta’s taxpayers and citizens could yield something in the neighbourhood of nearly $50 billion for the sale of the conventional oil and gas properties the province holds, even at today’s depressed oil and gas prices and depressed oil and gas industry valuations. That is just the 15 percent of production that is conventional oil, and actually does not include natural gas production, which is of similar magnitude. Natural gas production could have greater potential, given that shale gas (and liquids) production in the province, in the far northwest, and in the Duvernay formation in the central and southeastern parts of the province, is at an early exploitation stage that is not yet fully valued.
This also does not include the value of the royalties on oilsands production. This was about 3.1 million barrels of oil per day for the first nine months of 2020. Making a crude (please excuse the pun) assumption that the EV per barrel is 70 percent that of the lighter conventional oil assets, this gives a total EV for the oilsands properties of 3.1 million barrels per day, times $96,000 per barrel per day, times 70 percent, equalling $208.3 billion.
So, thus far, an estimate of the value of just the known liquids-producing properties is a total approaching $260 billion. The gas production value is a little more complicated to estimate. Alberta produced 83.5467 billion cubic metres in the first 274 days of 2020, or 308.29 million cubic metres per day, or 11.5 million Giga Joules, ‘GJ’, per day. Prices are roughly in the $2.25/GJ range, or $25.87 million per day. Natural gas has a lower price per unit of energy than oil does. There are 38.51 GJ per cubic metre of light oil, or 6.55 GJ per barrel. It was trading at about USD$30/barrel (Western Canada Select) in late 2020, or ~CAD$40/barrel, equaling $6.11 per GJ. So, natural gas is 37% as valuable per GJ as oil is.
Alberta’s natural gas production of 308.29 million cubic metres per day, times a conversion rate of .005883 barrels of oil equivalent to each cubic metre of natural gas, is 1.814 million boe, ‘barrels of oil equivalent’, per day. Applying the Enterprise Value of $96,000 per day earlier estimated for oil production, times the 37% value of natural gas vis-à-vis oil, the Enterprise Value of gas royalties in Alberta would be about $64 billion. The total Enterprise Value of royalties for conventional oil, oil sands production and natural gas production is thus $324 billion. That could certainly put a major dent in Alberta’s current fiscal debt pile.
The value of the shale formations has not been estimated at all, and could be very large.
Yet, the risk of developing these assets and realizing their commercial potential is not something that Alberta residents should depend on. Having something as important as government revenues pay for law enforcement, health care, roads and other infrastructure, and construction and maintenance, subject to wild swings in oil and gas prices was never a great idea. However, greed, complacency, and backward-looking bias all lulled Albertans, people across this nation, and other petroleum-reliant nations and regions, into inaction.
Courageous and rational leaders should start the process of rigorous valuation of all oil and gas assets in Alberta, Saskatchewan, Newfoundland and Labrador, and other places in Canada, to set in motion a later, careful, gradual divestment of these valuable but risky assets. These assets may have a sunset that is sooner than they want to believe, and could even be worthless by the end of the century.
The proceeds should be put in a true sovereign wealth fund (unlike the oft-plundered Heritage Savings Trust Fund) similar to Norway’s, and then invested in diversified non-petroleum assets world-wide, with the investment income used to pay government expenses. It could make some sense also to put corporate income tax from energy sources into the fund.
Never again should Albertans and other Canadians be subject to the erratic whims of energy markets without protection.
Note: Data from company annual reports, Alberta government statistics, and Capital IQ via Yahoo! Finance.
Ian Madsen is a senior policy analyst with the Frontier Centre for Public Policy.
Photo by Tiago Nakamura on Unsplash.