Canada: Alberta, Alberta

Summary:

On May 26, for the first time in 44 years, the Canadian Province of Alberta will be governed by the left-leaning New Democratic Party (NDP). After a 28-day election, the right-leaning Progressive Conservatives (PCs) were trounced at the polls, putting the fate of tax rates, environmental policy, and royalty rates for oil and gas production in a vastly different setting than Alberta has seen in this century.

Alberta’s democratic process makes it highly likely that the governing party’s priorities will be enacted into law; however, we believe the impact to the energy sector is not nearly as negative as investors and observers seem to believe currently.

Discussions with various Alberta Legislative Assembly staff indicate that major policy concerns are unlikely to be presented until 4Q15 and crude oil prices, the province’s climbing unemployment rate, $5 billion deficit, and significantly reduced real GDP will hang heavily on the decisions of the new majority party. Furthermore, some of the most troubling components of the NDP agenda for the energy sector are contingent upon what we expect to be a time-consuming study and may be coupled by faster-than-expected approval of certain oil pipelines.


  • Incoming Premier Rachel Notley laid out an aggressive agenda for the 2015-2017 time period designed to diversify the energy-dependent province of Alberta. The left-leaning New Democratic Party (NDP) will control 53 seats in the 87-member Legislative Assembly, a significant increase from the four it held prior to the election and the first time it has held sizeable representation in the Assembly since the 1930s.
  • A two percent increase in the corporate tax rate, a commission to study higher royalty fees on oil and gas production, a minimum wage increase, and an $89 million Job Creation Tax Credit are the party’s highest priorities at this time. While a corporate tax increase could be implemented as early as 4Q15, we believe an increase in royalty fees is unlikely to be implemented prior to 2Q16.
  • Investors and the energy sector reacted negatively in the immediate aftermath of the NDP’s victory, but upon closer inspection it appears that the most aggressive of the party’s priorities impacting the energy sector may be at least six months away, if not much further, and could be offset by the approval of certain pipelines earlier than expected.

This month’s election in Alberta, Canada produced a stunning upset that Rafi Tahmazian of Canoe Financial LP in Calgary declared “completely devastating” in a widely publicized comment to Bloomberg News. The senior portfolio manager specializing in energy investments went further to explain that “[t]he perception from the market based on their comments is they’re extremely dangerous.” While the stated agenda of the NDP is certainly more hostile to the energy sector than the Progressive Conservative party, which controlled Alberta for the last 44 years, we believe that the agenda of the left-of-center New Democratic Party is contingent on a number of components that may delay the implementation of increased royalty fees on energy companies and may actually speed up the approval of two pipelines in the country in the meantime.

In this report we will delve into the specifics of Alberta’s political structure and decision-making process and provide a detailed breakdown of current royalty fees. Most importantly, based off of numerous conversations with staff in the Legislative Assembly and the Office of the Minister of Finance, we believe meaningfully negative legislative policy is unlikely to be enacted until 4Q15 at the earliest. Furthermore, there may be some energy sector beneficiaries with the new more environmentally-friendly face of the NDP at the helm of Alberta’s government.

Timing Expectations

Alberta is currently in the midst of an election appeals period which lasts through May 25. Between now and then, anyone who wishes to appeal the election outcome may do so, but come May 26 members-elect will be sworn as members of the Third Session of the 28th Legislature. Discussions with the Alberta Legislature staff indicate that the calendar is still very much in flux for the remainder of 2015. There is typically a spring and fall “Sitting of the Assembly” but the specific dates are determined annually by the premier. At this time there has been no official determination made as to the exact legislative schedule of the Assembly. However, recent discussions with Assembly staff indicate that the new members will likely not convene until June.  In general, the Assembly meets for the Spring Sitting beginning on the second Tuesday in February and concluding no later than the first Thursday in June. The Fall Sitting begins on the last Monday of October and ends no later than the first Thursday in December.

 

Prior to the ouster of the Progressive Conservatives, the Assembly was scheduled to be in session each Monday through Thursday from May 19 to June 4. A recess was then expected to last from June 5 through October 26. As we will discuss in further detail below, the opening days of a new session are generally critical for a new government as they outline their plans for legislative activity for the upcoming session. However, in this case we understand that the majority of new legislative planning will be unlikely to occur until this fall, much later than it appears investors currently expect.

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Waiting for a Budget

On the opening day of a new legislative session, the Lieutenant Governor reads the “Speech from the Throne,” which outlines the majority party’s plans for the session. Over the following days the 87-member body hosts an inclusive debate outlining the merits and drawbacks of the proposed agenda. Within two weeks of a new session the majority party typically will release its “Budget Address” describing the majority party’s tax and spending plans. It is our understanding based on discussions with the Alberta Minister of Finance Office that the budget address for the incoming Premier will not be released until the fall session, meaning we will likely not see any specific legislative agenda items discussed until 4Q15. The fall session of the Legislative Assembly usually lasts about a month and a half from mid/late October through the first week of December; the following session of the legislature historically does not convene until the second Tuesday in February but most of the legislative activity does not begin until the first or second week of March. As a result, any work not completed by late November/early December often will not be picked up again for several months.

Alberta boasts a highly regimented and organized daily order of business with major proceedings generally occurring between 3:00pm and 6:00pm Monday through Wednesday and from 3:00pm to 4:30pm on Thursday. Evening sessions are possible but are called for specifically by the majority government. This structured scheduling should provide investors with a clear(er) sense of timing and action on legislative matters than they are perhaps used to with the legislative branch in the United States.

Study First + Keep an Eye on Crude Prices

“When the governing party has a majority of seats in the Assembly, the passage of government Bills is virtually assured.”

-Alberta Citizens Guide

The quote above highlights a key difference between the US and Canadian legislative process: because Alberta has a unicameral legislature (additional details on the Legislative Assembly’s structure begin on page 8) and party unity is so strong, effectively any legislation the New Democrats may want to propose is highly likely to become a law. This is likely a source of concern among investors following this issue from afar, Because the ruling political party generally comes into office with a mandate, commentary made during an election cycle can be disconcerting. The specifics of the NDP’s platform, however, seem to be much more tempered than they appear at first glance.

When the NDP releases its agenda (in 4Q15 in our view), we expect that it will include a 2% increase in the corporate tax rate. Inarguably, this is a negative for all Alberta corporations but more attention and concern has arisen around the idea of increasing royalty fees for oil and gas production. It is our understanding of the incoming Premier’s position that she will simply be supporting the study of increased royalty fees and that any fee increase would likely not come until crude oil prices have rebounded.

We will not hazard a guess as to when crude oil prices will increase but, based on a close analysis of the Legislative Assembly and its historical activity, we believe that even if crude oil prices rebounded tomorrow, at the earliest an increase in royalty fees would not be agreed to until March 2016. As mentioned above, the Legislative Assembly of Alberta historically only meets twice per year; last year they were in session for 42 days. Should the legislature propose a study in 4Q15, and a council convenes to complete that study – barring a meaningful break from past precedent – the legislative assembly would not be back in session to review and debate its findings until March 2016 at the earliest.  In sum, the agenda of the NDP is not to immediately increase royalty fees but rather to study the current fee structure; additionally, because of the expected delay in the release of a budget to 4Q15 and the legislative calendar, a shift in royalty rates in Alberta is not likely any sooner than 2Q 2016 at the earliest, in our view.

Alberta Oil Sands Production and Royalties

Over the last ten years, Alberta conventional oil production flattened out while oil sands production has grown, on average, 8% each year. Total crude oil production has grown 6% a year since 2005, as production of synthetic crude (a derivative of bitumen, the oil sands product) and crude bitumen are up 10% and 7% per year respectively since 2005. The share of production from the oil sands region has risen from 63% of total Alberta production in 2005 to 80% of crude production last year. The figures 2 and 3 below shows the growth in Alberta oil sands production and production revenues over this time period and the commensurate growth in royalty revenues for the Alberta government since 1997.

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As production from the oil sands drove crude production growth in Alberta, royalties from oil sands producers have surged from $42.9 million CAD in 2005 to $951 million CAD in 2013 (the last year for which data is available). The base oil sands royalty rates that are the most likely target for the NDP are assessed for a certain portion of total production, including synthetic crude. Under the Oil Sands Royalty Regulations, projects in the pre-payout phase are assessed a royalty of 1-9% of revenues, the monthly average price of WTI in Canadian dollars being used to determine that percentage. When the project moves into the post-payout phase, it begins paying royalties on net revenues of 25-40% of the yearly average of WTI in Canadian dollars. The figures 4 below shows the royalty schedule for post payout projects at different prices for WTI in Canadian dollars while figure 5 reflects how the exchange rate between U.S. and Canadian dollars can influence the royalty rate, even as the WTI price remains constant. The relatively low royalty rate at low WTI and the strength of the U.S. dollar combine to somewhat insulate Albertan producers from the full impact of the low oil price. A higher royalty would have the impact of exacerbating the low oil price impact on producers.

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Breakeven Analysis for Alberta Oil Sands Producers

Though the exchange rate and lower royalty may soften the blow of a sub-$80 WTI, new oil sands projects have a very high marginal cost. A January 2015 analysis of key Alberta Oil Sands projects estimated the following WTI breakeven prices for new oil sands developments. In figure 6 overlaid the current WTI ($62 USD) and a “high” WTI ($80 USD), as well as the current royalty structure and a “high” royalty (40%) to illustrate project economics in these cases. We used the current exchange rate to calculate royalties.

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The breakeven prices for most mining projects well exceeds the current WTI price, often requiring prices at or above $85/bbl, while lower cost in-situ projects like Christina Lake, Foster Creek and Nabiye have breakeven prices around $70/bbl WTI. Raising the royalty would worsen the current impact of low-priced oil, and it would incrementally challenge the higher-cost projects should oil prices recover. Under the existing royalty schedule five projects are economic at $80 USD WTI. If the royalty were assessed at a flat rate of 40% of net revenues (currently the highest rate), the number of projects that would be economic falls to three. Nonetheless, the vast majority of the projects have breakeven prices that require even higher oil prices, which are not economic under even the current structure of the royalty rate. We note that the decision to pursue new project development is more complex than this analysis indicates, and many of even the higher cost projects may have good reason to continue. However we also note that, based on the current economics, a higher royalty rate does not appear to “make or break” these new projects. Rather, low oil prices are a stronger disincentive than the royalty would likely be. Finally, it is worth noting that the top-level royalty is already high – 40% of net revenues or 9% of gross revenues. Though we do not know what the royalty increase might be, it is possible that a higher royalty would have a more meaningful negative impact at lower WTI prices (where the royalty is as low as 25% of net revenues or 1% of gross revenues) than at high WTI prices.

Environmentally Friendly = More Pipelines?

“No one will accuse Alberta of having a tight partnership between government and industry with the new government, and I think that will help speed regulatory approvals for projects like the Energy East pipeline.”

-Bob Page Former Vice President of Sustainability with TransAlta

An underappreciated component of the ascent of the NDP, in our view, is the perception of Alberta as environmentally friendly as a result of the ouster of the Progressive Conservative party. Simply by ushering in a new government, Alberta has illustrated (to itself and outsiders) that the environment is a higher priority and we believe  there is a possibility that in the longer run, the election of the NDP may actually speed up the approval of two pipelines.

Rachel Notley campaigned to stop spending taxpayer dollars on the Keystone XL pipeline and stated repeatedly that the Northern Gateway crude oil pipeline that would connect Alberta’s oil sands with a Pacific coast terminal in British Columbia was a threat to British Columbia’s environment. These projects may still go through; the Northern Gateway specifically has the support of the federal government. for example. Notley’s comments have positioned her well to the left of the Progressive Conservative party and her election this month sent a strong message that the Alberta constituency wants to be less aligned with the energy industry and be more observant of environmental needs going forward. In our view, this much-desired separation (at least optically) from Calgary oil interests may actually make it easier to get approval for two other pipeline projects: TransCanada Corporation’s Energy East pipeline and the Kinder Morgan’s TransMountain pipeline that runs from Alberta to Burnaby, British Colombia.

By selectively deciding which pipelines to approve and not giving carte blanche to the energy industry, Notley may well streamline the approval process for these two pipelines while effectively shelving, but not outright rejecting, the Keystone and Northern Gateway pipelines. The party’s views on these pipelines are likely to develop further in the coming months and we expect significant lobbying by the companies as well as discussions with the federal government of Canada will play an increasingly larger role in the decision making process of the NDP. We will be more closely monitoring the pipeline debate in Alberta in the coming months as debate in the United States over Keystone XL and other approval components reemerge.

How a Bill Becomes a Law: Alberta Edition

The first step towards introducing a bill in the Alberta Legislative Assembly mirrors to an extent the US federal government: the majority party presents a fiscal year budget detailing its agenda and what follows is a debate and the introduction of bills reflecting the priorities of that original budget. The Alberta fiscal year begins on April 1. After assessing the state of the provinces’ fiscal health, and ideally within two weeks of taking power in Alberta, the government (majority party) delivers a Budget Address, historically through the Minister responsible for finance, laying out the agenda of the government. Over the following days, the Legislative Assembly debates the budget put forth by the government and various committees consider the key components of the budget including the majority party’s economic forecasts. The flow chart below lays out the specifics of this process in the full Legislative Assembly.

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We will follow this process closely in Alberta in 4Q15 but, for the time being, the most important component for investors to watch is public sentiment and debate around the NDP’s platform. Alberta places a heavy emphasis on public opinion and approval. With roughly half a year to go before the Assembly considers any bills and a formal budget is even presented, a lot can change. We do not mean to say that the NDP will suddenly become supportive of reducing royalty fees, but the party may decide that anti-terrorism legislation (for example) is a higher priority or reforming healthcare or education programs is more important, which could further delay action on energy issues.

Alberta’s Government

The provincial Canadian legislatures differ from the United States Congress in one key important way: they are unicameral, meaning that there is only one chamber of legislative members (the Legislative Assembly) that votes on a bill before it becomes the law of the province, as opposed to the U.S. bicameral system comprising the House of Representatives and Senate. Provinces are effectively autonomous; once their Legislative Assembly passes a law the monarch’s representative (known as the Lieutenant Governor) signs off on it. While the Lieutenant Governor has the authority to strike down a law, the tactic has not been deployed in approximately fifty years and would be a major departure from current practice.

When Canadians refer to “government,” they’re speaking primarily of the leadership of the majority party, known more formally as the Premier and Cabinet. These are roughly comparable to the Speaker of the House or the Majority Leader in the Senate – they represent the majority leadership and are commonly referred to simply as “government”. When a proposed bill is introduced by “government” Canadians mean it to have been introduced by the majority party. Should a major agenda item of the majority party (Premier/cabinet/government) be defeated, it is considered a “vote of nonconfidence” and the tenure of the majority party (Premier/cabinet/government) is effectively terminated. If a major agenda item of the governing party fails, that party is effectively ousted and a new election is held to replace it at that time. This is what took place with the Progressive Conservative Party in the last election.

What that means in practice is that when a majority party takes over the Legislative Assembly its proposals may be tweaked through the amendment and debate process but generally they are enacted into law unless a vote of “nonconfidence” emerges in which case the proposal is rejected and the majority party is ousted. There is no minimum term of service for the Legislative Assembly members and so they can be ousted at any time. Shortly after a vote of nonconfidence on a major policy agenda an election is held and the entire Legislative Assembly and Premier/Cabinet positions are re-determined. It is for this reason that the majority party often stays tightly unified, unlike in the United States where members from one state or another will vote for their local interests over party ideology. There are currently 87 members of the Legislative Assembly (MLAs) hailing from four major political parties: 1) the Progressive Conservatives, who held control of Alberta for the last 44 years; 2) Alberta liberals; 3) New Democrats, who won the most recent election by a landslide; and 4) the Wildrose Alliance, a far-right leaning party.

Canadian Government Structure

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RISKS

The legislative and regulatory agendas are subject to change at the discretion of leadership. Unprecedented economic conditions could instigate unanticipated and/or sweeping shifts in policy. Predicting the future is a hazardous endeavor and economic / market forecasting is an imprecise science. Actual outcomes may differ substantially from our forecasts. The predictions and opinions expressed herein are subject to change at any time.

ANALYST CERTIFICATION

I, Henrietta Treyz, certify that (i) the recommendations and opinions expressed in this commentary accurately reflect the analyst’s personal views about any and all of the subject securities or issuers discussed herein and (ii) no part of the analyst’s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the analyst in the commentary.

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