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Modelling the economic implications of offshore oil : the case of Hibernia Plourde, André 1985

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MODELLING THE ECONOMIC IMPLICATIONS OF OFFSHORE OIL: THE CASE OF HIBERNIA by ANDRE ROGER PLOURDE B.A., University of New Brunswick, 1978 M.A., University of New Brunswick, 1979 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY in THE FACULTY OF GRADUATE STUDIES Department of Economics We accept this thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA A p r i l 1985 (S) Andre Plourde, 1985 In presenting t h i s thesis i n p a r t i a l f u l f i l m e n t of the requirements for an advanced degree at the University of B r i t i s h Columbia, I agree that the Library s h a l l make i t f r e e l y available for reference and study. I further agree that permission for extensive copying of t h i s thesis for scholarly purposes may be granted by the head of my department or by h i s or her representatives. I t i s understood that copying or publication of t h i s thesis for f i n a n c i a l gain s h a l l not be allowed without my written permission. Department O f Economics  The University of B r i t i s h Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3 Date May 3, 1985 DE-6 (3/81) ABSTRACT The development and production of Canadian offshore petroleum deposits raises three key sets of issues of interest to economists. F i r s t are questions r e l a t i n g to the impact of r o y a l t i e s and taxes on producer decisions, and hence on the l e v e l and e f f i c i e n c y of resource taxation. Other issues concern the impacts on the o v e r a l l economy during both the construction and production phases. A t h i r d set of issues relates to the d i s t r i b u t i o n of powers and resource revenues between federal and p r o v i n c i a l governments, including the links between p r o v i n c i a l resource revenues and equalization payments. This thesis develops a numerically tractable economic model designed to examine these issues. At the model's core i s a one-to-one r e l a t i o n s h i p between development plans and production p r o f i l e s . This property i s exploited i n simulating the behaviour of a price-taking, net-present-value-maximizing producer under conditions of c e r t a i n t y . The model i s linked with a macroeconometric model of the Canadian economy to study the p o t e n t i a l consequences of Hibernia, a petroleum deposit located in the Eastern Canadian offshore region. This deposit was chosen for analysis because i t s s i z e , l o c a t i o n and low costs ( r e l a t i v e to current world o i l prices) combine to raise a l l of the issues l i s t e d above. In most cases studied, producer responses to government p o l i c i e s r e s u l t i n the d i s s i p a t i o n of less than five percent of the deposit's net present value to society. Although cases are i d e n t i f i e d where these responses have more serious consequences, the r e s u l t i n g d i s s i p a t i o n of p o t e n t i a l net benefits never exceeds 15 percent. The extension of s p e c i f i c forms of royalty and tax r e l i e f to the producer generally reduces the d i s t o r t i o n a r y e f f e c t s of government p o l i c i e s . The simulated e x p l o i t a t i o n of Hibernia induces small but sympathetic changes in most macroeconomic v a r i a b l e s . The net crowding-out e f f e c t s on other industries are shown to be r e l a t i v e l y small, and to be more prevalent during the construction period. The r e s u l t s suggest that the larger share of the net benefits accruing to governments flows to the p r o v i n c i a l treasury under three of the revenue-sharing systems modelled. However, Newfoundland and Labrador would lose a substantial portion of i t s Hibernia revenues under a l l of the equalization systems modelled. iv TABLE OF CONTENTS ABSTRACT i i TABLE OF CONTENTS iv LIST OF TABLES v i i LIST OF FIGURES ix ACKNOWLEDGEMENT x CHAPTER 1 INTRODUCTION 1 CHAPTER 2 THE PRODUCTION AND TAXATION OF OFFSHORE PETROLEUM RESOURCES 5 2.1 Introduction 5 2.2 The Taxation of Extractive Resources 6 2.3 Applied Reservoir Economics: A Partial Review 11 2.3.1 Petroleum as an Exhaustible Resource 11 2.3.2 The Basic Static Model 14 2.3.3 The MIT Model 17 2.3.4 The Platform Location Model 19 2.3.5 The Odell-Rosing Model . 23 2.3.6 The Lowenstein Model 27 2.4 Concluding Remarks 30 CHAPTER 3 THE OFFSHORE DEVEL0PEMENT MODEL: OUTLINE AND APPLICATION.. 36 3.1 Introduction 36 3.2 A Model of the Development and Production of Offshore Oil Deposits 37 3.2.1 Overview of the Model 37 3.2.2 Model Description 39 3.2.3 On Some Properties of the Model 59 V CHAPTER 3 (continued) 3.3 Applying the Model to the Case of Hibernia 64 3.3.1 The Hibernia Discovery 64 3.3.2 A Discussion of the P r i n c i p a l Estimates and Assumptions. 67 3.3.4 Regulation and Taxation P o l i c i e s 73 3.3.4 Studies of the Economics of Hibernia 76 3.4 Incorporating an Energy-Producing Project into MACE 79 CHAPTER 4 GOVERNMENT POLICIES AND THE DECISION TO DEVELOP 88 4.1 Introduction 88 4.2 The Framework of Analysis 89 4.2.1 Assumptions Relating to MACE 89 4.2.2 Assumptions Relating to the Offshore Development Model.. 92 4.3 Development i n the Absence of Government P o l i c i e s 95 4.4 Development under Alt e r n a t i v e P o l i c y Regimes 98 4.4.1 Introduction 98 4.4.2 Optimal Development Plans 99 4.5 Summary 105 CHAPTER 5 SENSITIVITY ANALYSIS 119 5.1 Introduction 119 5.2 Changes i n the Base Case Assumption 120 5.3 Adverse Shocks ...126 5.4 Conclusion 130 CHAPTER 6 THE INCIDENCE AND DISTRIBUTION OF ECONOMIC RENTS FROM HIBERNIA 140 6.1 Introduction 140 6.2 Base Case Assumptions and Adverse Changes 141 6.3 Conclusion 151 CHAPTER 7 MACROECONOMIC CONSEQUENCES 162 7.1 Introduct ion 162 7.2 Hibernia and the Nat ional Economy 163 7.3 Resource Discover ies and the 'Dutch Disease' 173 7.4 Conclus ion 178 CHAPTER 8 HIBERNIA, FISCAL EQUALIZATION AND ENERGY RENTS IN CANADA..186 8.1 Introduct ion 186 8.2 A l t e r n a t i v e Approaches to F i s c a l E q u a l i z a t i o n 187 8.3 E q u a l i z a t i o n and the Revenues from Hibern ia 192 8.4 Hibern ia and the D i s t r i b u t i o n of O i l and Gas Rents i n Canada 198 8.5 Conclusion 203 CHAPTER 9 CONCLUSIONS AND DIRECTIONS FOR FUTURE RESEARCH 214 BIBLIOGRAPHY 224 APPENDIX 1 ALGEBRAIC REPRESENTATION OF CERTAIN DETERMINISTIC MODELS..233 APPENDIX 2 A STUDY OF THE RESERVOIR PRODUCTION SIMULATION PROCESS 241 APPENDIX 3 GOVERNMENT POLICIES, PRODUCTION RIGHTS AND REVENUE SHARING 249 A3.1 Introduct ion 249 A3.2 J u r i s d i c t i o n a l Rights in Offshore Areas 250 A3.3 Taxat ion and P a r t i c i p a t i o n 253 A3. 3.1 The Federal L e g i s l a t i o n 253 A3.3 .2 The Newfoundland and Labrador L e g i s l a t i o n 258 A3.4 J u r i s d i c t i o n and Production Rights 260 A3.5 J u r i s d i c t i o n and Revenue Sharing 263 A3.6 Concluding Remarks 265 APPENDIX 4 VARIABLE AND COEFFICIENT LISTS AND MODEL TRANSLATION 269 v i i LIST OF TABLES Table 3.1 Estimates of Platform Costs and Operating Expenditures 87 Table 4.1 Some of the Assumptions Underlying Cases 1, 2 and 3 109 Table 4.2 Net Present Value of Alte r n a t i v e Hibernia Development 114 Plans in Absence of Government P o l i c i e s , b i l l i o n s end-1984 d o l l a r s Case 3. Fixed and Floating Platforms Table 4.3 Net Present Value of Alt e r n a t i v e Hibernia Development 115 Plans, b i l l i o n s end-1984 d o l l a r s Federal Regulations Case 2. Fixed and Floating Platforms Table 4.4 Net Present Value of Alte r n a t i v e Hibernia Development 116 Plans, b i l l i o n s end-1984 d o l l a r s Newfoundland and Labrador Regulations - "c a r r i e d i n t e r e s t " option Case 2. Fixed and Floating Platforms Table 4.5 Net Present Value of Alt e r n a t i v e Development Plans, 117 b i l l i o n s end-1984 d o l l a r s Newfoundland and Labrador - "working i n t e r e s t " option Case 2. Fixed and Floating Platforms Table 4.6 Optimal Producer Choices Under Various P o l i c y 118 Alternatives Table 5.1 Changes to Base Case Assumptions 135 Table 5.2 Optimal Producer Choices for Hibernia Development 136 Consequences of Favourable Changes i n Assumptions Table 5.3 Optimal Producer Choices for Hibernia Development 137 CASE 2 and DELAY Table 5.4 Optimal Producer Choices for Hibernia Development 138 Consequences of 02, K2 and LOWER P Table 5.5 Net Present Value of Alte r n a t i v e Hibernia Development 139 Plans Consequences of Adverse Shocks Fixed Platforms Table 6.1 Economic Rents from Hibernia Development 160 Optimal Producer Choices Consequences of 02 and K2 Table 6.2 Economic Rents from Hibernia Development 161 Optimal Producer Choices Consequences of LOWER P and DELAY v i i i ix LIST OF FIGURES Figure 4.1 Net Present Value of Alternative Hibernia Development 110 Plans i n Absence of Government P o l i c i e s , b i l l i o n s end-84 $ Case 1. Fixed Platforms Figure 4.2 Net Present Value of Alt e r n a t i v e Hibernia Development 111 Plans in Absence of Government P o l i c i e s , b i l l i o n s end-84 $ Case 1. Floating Platforms Figure 4.3 Net Present Value of Alt e r n a t i v e Hibernia Development 112 Plans i n Absence of Government P o l i c i e s , b i l l i o n s end-84 $ Case 2. Fixed Platforms Figure 4.4 Net Present Value of Alt e r n a t i v e Hibernia Development 113 Plans in Absence of Government P o l i c i e s , b i l l i o n s end-84 $ Case 2. Floating Platforms Figure 6.1 D i s t r i b u t i o n of Economic Rents from Hibernia under 158 Alte r n a t i v e Regulation and Revenue-Sharing Systems Base Case with R e l i e f . Optimal Producer Choices Figure 6.2 D i s t r i b u t i o n of Economic Rents from Hibernia under 159 Alte r n a t i v e Regulation and Revenue-Sharing Systems Base Case. Optimal Producer Choices Figure 7.1 The Impact of Hibernia on Energy Development, m i l l i o n s 182 1971 d o l l a r s Figure 7.2 Changes in Real GNP under Alternative Project 183 S p e c i f i c a t i o n s , b i l l i o n s 1971 d o l l a r s Figure 7.3 Per Cent Changes in Certain Key Variables Induced by 184 the Development of Hibernia Figure 7.4 Per Cent changes in Real 1971 and Nominal Non-Energy 185 Exports Induced by the Development of Hibernia X ACKNOWLEDGEMENT John H e l l i w e l l p a t i e n t l y guided me through the process of writing t h i s t h e s i s . I fee l p r i v i l e g e d to have been able to benefit from his advice and suggestions, and to have been nurtured by his support and encouragement. I have learned a lot from him and I owe him much. Thank you, John. Paul Bradley was very h e l p f u l i n the days when this thesis was taking shape. In addition to him, I would l i k e to thank Tracy Lewis, P h i l Neher, Don Paterson, Brian Scarfe, Tony Scott and Margaret Slade for h e l p f u l comments. My colleagues at the I n s t i t u t e for Pol i c y Analysis i n the Unive r s i t y of Toronto were also very supportive. I also wish to express my gratitude to Energy, Mines and Resources Canada for funding this work. I want to thank Alan Chung who was extremely h e l p f u l with the construction of figures and tables as well as in showing that the postal service between Vancouver and Toronto indeed works. For the i r support and encouragement, I also wish to thank my parents, Diane Dupont, E r i c and Syl v i a H e i k k i l a , and David Ryan. F i n a l l y , I want to express my gratitude to my wife and colleague, Mary MacGregor. Her love, support and unflinching f a i t h kept me going i n the days when the l i g h t at the end of the tunnel seemed p a r t i c u l a r l y dim. 1 CHAPTER 1 INTRODUCTION After years of disappointment and hundreds of mill i o n s of dollars i n exploration expenditures, Canada's offshore regions have yielded a number of important o i l discoveries. The most notable among these are located under the Beaufort Sea and on the Grand Banks of Newfoundland. To date, none of these deposits has been developed and few studies have examined the economic implications of such projects in Canada. Studies of similar developments in areas l i k e the North Sea have shown that the development and production of major offshore petroleum deposits raises three key sets of issues of interest to economists. The f i r s t concerns the links between the motives of producers, government pol i c i e s and the realized value of the f i e l d . Do government regulation and taxation p o l i c i e s affect producer behaviour and i f so, how important i s the induced dissipation of potential net benefits l i k e l y to be? How responsive are these p o l i c i e s to economic conditions and to the physical characteristics of individual deposits? A different set of questions surrounds the macroeconomic consequences of development and production. How do such large capital-intensive projects affect the national economy? Are the effects of construction a c t i v i t i e s l i k e l y to d i f f e r from those of the production period? How si g n i f i c a n t are the crowding-out effects on other industries l i k e l y to be? Another set of issues i s peculiar to federations, l i k e Canada, with important economic powers divided among or shared by more than one j u r i s d i c t i o n . How i s the government share of revenues to be divided between the federal government and that of the j u r i s d i c t i o n nearest to the 2 f i e l d ? Furthermore, since o i l and gas revenues accruing to p r o v i n c i a l governments are subject to f i s c a l equalization in Canada, what are the consequences of development and production on the equalization system as a whole, and on the p o s i t i o n of the province most affected? This thesis develops a consistent a n a l y t i c a l fromework to examine these issues and applies i t to the case of Hibernia, a large petroleum deposit located in the Eastern Canadian offshore region. Hibernia was chosen for analysis for three main reasons. Its s i z e , currently estimated to exceed 1 b i l l i o n barrels of recoverable reserves, makes i t a giant by industry standards. In addition, Hibernia is l i k e l y to be the f i r s t Canadian offshore o i l f i e l d to be developed since the available estimates suggest that i t s development, production and transportation costs are l i k e l y to be low in comparison to both current world o i l prices and other offshore deposits recently discovered in Canada. F i n a l l y , i t s l o c a t i o n , less than 300 kilometres o f f the coast of Newfoundland, gives r i s e to i n t e r e s t i n g d i s t r i b u t i o n a l issues since the two l e v e l s of government involved intend to share some of the revenues from Hibernia and since Newfoundland and Labrador has t r a d i t i o n a l l y been a 'have not' province. The numerically tractable economic model of the development and production of offshore petroleum deposits developed and used in t h i s thesis can be characterized as follows. Development and production a c t i v i t i e s are treated as discounted streams of costs and revenues since the long productive l i v e s of offshore o i l f i e l d s are preceded by periods of substantial investment in the construction and i n s t a l l a t i o n of the productive c a p i t a l . To provide a more accurate depiction of r e a l i t y , the model also allows the productive c a p a b i l i t i e s of the f i e l d to be b u i l t up over time as platforms are i n s t a l l e d and as wells are d r i l l e d and made 3 a v a i l a b l e for production. A s l i g h t l y modified exponential decline process i s used to charac-t e r i z e the time path of the productive c a p a b i l i t i e s of the f i e l d . Given assumptions about a few att r i b u t e s of the deposit, this allows the model to derive estimates of the production p r o f i l e which are consistent with these a t t r i b u t e s but are responsive to changes in the development plan. This one-to-one r e l a t i o n s h i p between development plans and production p r o f i l e s is exploited to construct a model of optimal producer choice of development plans. The optimization process assumes'price-taking, net-present-value-maximizing behaviour based on expected values of future costs, prices and tax parameters. In the absence of government p o l i c i e s , the producer i s modelled to manipulate as many as six decision variables to i d e n t i f y the development plan and the length of the productive l i f e which maximize the net present value of the f i e l d . - The introduction of government p o l i c i e s changes the nature of the producer's optimization problem. The taxes and r o y a l t i e s imposed by government p o l i c i e s are perceived as p o t e n t i a l l y avoidable costs of production by the producer, who seeks to maximize the net present value of his after-tax returns from the project. This means that the model allows government p o l i c i e s to influence producer decisions, which may r e s u l t i n the d i s s i p a t i o n of a portion of the deposit's potential net benefits to society. F i n a l l y , to overcome some of the l i m i t a t i o n s imposed by the fact that the analysis deals with conditions of ce r t a i n t y , the model i s designed to be e a s i l y subjected to s e n s i t i v i t y a n a l y s i s . This model i s linked with MACE, a two-sector model of the Canadian economy to study the po t e n t i a l consequences of Hibernia. This procedure 4 was adopted to avoid some of the problems associated with p a r t i a l equilibrium analysis, to f a c i l i t a t e the examination of macroeconomic issues and to provide a more accurate ch a r a c t e r i z a t i o n of the implications of Hibernia on f i s c a l equalization i n Canada. The analysis proceeds as follows. After a short review of the relevant l i t e r a t u r e i n chapter 2, chapter 3 outlines the model of the development and production of offshore petroleum deposits used i n this th e s i s . Details r e l a t i n g to the a p p l i c a t i o n of the model to the case of Hibernia can also be found i n t h i s chapter. Chapters 4 and 5 are concerned with microeconomic issues. In p a r t i c u l a r , the optimization properties of the model are used to examine the p o t e n t i a l for d i s t o r t i o n a r y e f f e c t s of government p o l i c i e s i n a number of d i f f e r e n t economic environments. Chapters 6 and 8 deal with d i s t r i b u t i o n a l questions. The implications of several revenue-sharing proposals for the d i s t r i b u t i o n of the govern-ment share of pot e n t i a l net benefits between Ottawa and the government of Newfoundland and Labrador are charted. The e f f e c t s of offshore o i l revenues on a l t e r n a t i v e f i s c a l equalization systems are also examined. Macroeconomic issues are examined in chapter 7. By simulating the development and production of Hibernia i n conjunction with MACE, i t i s possible to derive a consistent representation of the consequences of the project for the national economy. Issues related to the crowding-out e f f e c t s on other industries are also examined. Conclusions and di r e c t i o n s for future research can be found i n chapter 9. The thesis concludes with a series of appendices which discuss c e r t a i n s p e c i f i c issues i n greater d e t a i l than i s fea s i b l e i n the body of the text. 5 CHAPTER 2 THE PRODUCTION AND TAXATION OF OFFSHORE PETROLEUM RESOURCES 2.1 Introduction One of the main objectives of this thesis is to explore issues related to the level and efficiency of resource taxation in the context of the development and production of petroleum deposits located in the Eastern Canadian offshore region. To do so requires a detailed account of the relevant royalties and taxes as well as information about the costs and attributes of specific reservoirs or f ields. A l l this information must then be brought together in an economic model of the development decision which offers a number of channels through which government policies can affect the simulated behaviour of the producer. This chapter outlines some of the principal directions which the l i terature on petroleum economics has explored during the last two decades. Section 2.2 examines some of the key theoretical developments concerning the role of taxation in exhaustible resource models. Some implications for applied models of resource extraction are also noted. After setting petroleum within the context of the economic theory of exhaustible resources, section 2.3 provides a review of a number of applied studies of reservoir economics. Special attention is paid to the way in which the key theoretical concerns are reflected in models of the behaviour of profit-maximizing producers operating in the context of a market economy. This includes an examination of the scope for producer responses to royalties and taxes which is offered by these models. Methods chosen to reflect the special aspects of the development and production of offshore reservoirs are also discussed in this section. 6 From a l l this information, section 2.4 d i s t i l l s a number of desirable properties of models of the development and production of offshore petroleum deposits in a market economy. These properties w i l l provide guidelines used in chapter 3 for the construction of the offshore development model used in this t h e s i s . 2.2 The Taxation of Extractive Resources The pioneering e f f o r t s of Gray [1914] and H o t e l l i n g [1931] contain some references to the e f f e c t s of taxation on the pattern of e x p l o i t a t i o n of exhaustible resources. However, i t was not u n t i l the p u b l i c a t i o n of the volume edited by Gaffney [1967] that the economic l i t e r a t u r e on the taxation of extractive resources started to develop in earnest. 1 Even then, Burness [1976] seems to have been the f i r s t to set the problem within the context of a formal optimization framework. Sweeney [1977] independently derived a market imperfection function which characterizes the intertemporal d i s t o r t i o n s caused by various market forces, including a few forms of taxation. Both v e r i f i e d the conclusion that had been reached by others before them: under conditions of perfect competition, a p r o f i t -maximizing producer may or may not change his choice of extraction p r o f i l e for a known stock of resources in the face of taxation, depending on the nature of the instrument used. Dasgupta and Heal [1979, chapters 6 and 12] show that, under appropriate conditions, the competitive intertemporal a l l o c a t i o n of a known stock of an extractive resource i s s o c i a l l y optimal. Hence, changes in producer behaviour induced by resource taxation w i l l d i s t o r t this intertemporal a l l o c a t i o n and r e s u l t in the d i s s i p a t i o n of a portion of the economic rents that could otherwise be generated by this given resource 7 stock. This gives r i s e to a number of issues related to the e f f i c i e n c y consequences of s p e c i f i c resource taxation measures. The key to deriving a formal representation of the e f f e c t s of d i f f e r e n t tax instruments l i e s with the recognition that, from the competitive producer's point of view, the chosen intertemporal a l l o c a t i o n of a given stock of an extractive resource must s a t i s f y two conditions. As argued by Dasgupta, Heal and S t i g l i t z [1980], i t must result i n an equilibrium in the market for flows. That i s , the p r o f i t a b i l i t y of extracting the marginal unit must be the same in a l l time periods. The chosen intertemporal a l l o c a t i o n must also bring about equilibrium in the market for stocks. It must recognize that the resource i s an asset which yi e l d s a return to i t s producer through price appreciation and, as such, requires a rate of return equal to that on any other asset. If the introduction of taxation disturbs the pre-tax equilibrium, the producer w i l l seek to re-arrange the intertemporal a l l o c a t i o n of the resource so that the two equilibrium conditions are met. It is possible to consolidate the r e s u l t s that emerge from this l i t e r a t u r e as follows. In simple models of the competitive firm where, notably, the cost of extraction does not depend on cumulative extraction, 2 commonly used tax instruments have the following dynamic e f f e c t s . An invariant tax assessed on each unit extracted increases per-unit extraction costs. Its introduction thus creates an incentive to defer production from a given deposit and may even render e x p l o i t a t i o n p r i v a t e l y unprofitable. If there are several deposits with d i f f e r e n t costs, cumulative t o t a l extraction may be reduced by a per-unit tax. A per-unit subsidy reduces extraction costs and thus creates an incentive to accelerate production. Furthermore, i f costs vary across deposits, i t s 8 introduction may increase cumulative extraction since i t lowers the cut-off grade. The introduction of an ad valorem tax (often c a l l e d a royalty) decreases the unit price received by the producer. It w i l l r e s u l t i n production being accelerated (delayed or unaffected) depending on whether the market price is growing at a rate greater than (less than or equal to) the rate of i n t e r e s t . Again, i f costs vary across deposits, cumulative extraction may be reduced since the cut-off grade has been increased. A proportional subsidy on each unit extracted, on the other hand, creates an incentive to accelerate (to delay or not to change) production i f the unit price is growing faster than (slower than or at a rate equal to) the rate of i n t e r e s t . Obviously, cumulative extraction may increase since the subsidy e f f e c t i v e l y lowers the cut-off grade. A pure p r o f i t s tax is a tax on economic rents and as such does not a f f e c t production decisions. However, the introduction of depletion allowances which are e s s e n t i a l l y subsidies to extraction a l t e r s this r e s u l t . If cost depletion i s defined as a fixed nominal amount per unit extracted then i t s e f f e c t s are the same as a per-unit subsidy. On the other hand, the introduction of a percentage depletion allowance, defined as a fixed proportion of current revenue, has the same e f f e c t s as a 3 proportional subsidy. It should be noted that income taxes are commonly modelled as p r o f i t s taxes in s t y l i z e d models of resource extraction. However, in most j u r i s d i c t i o n s , income taxes and taxes on returns to equity in general are p o t e n t i a l l y d i s t o r t i o n a r y since they are assessed against the income of factors of production and as such d i f f e r from pure p r o f i t s taxes. For a discussion of these and related issues, see Church [1981, pp.80-85] and 9 Gaudet and Lasserre [1984]. Using these s t y l i z e d models, q u a l i t a t i v e (but not quantitative) characterizations of the d i s t o r t i o n s induced by a number of means of taxation have been derived. Unfortunately, as the structure of these t h e o r e t i c a l models becomes r i c h e r , i t becomes impossible to derive even q u a l i t a t i v e predictions of the e f f e c t s of many of these tax instruments. The main reason for t h i s r e s u l t i s that the introduction of any kind of depletion e f f e c t or multi-input r e f i n i n g process s i g n i f i c a n t l y complicates the intertemporal r e l a t i o n s h i p between extraction and costs. This, in turn, means that the r e l a t i o n s h i p between the market price and the net price of the resource as well as among net prices over time i s more d i f f i c u l t to represent. The c h a r a c t e r i z a t i o n of any intertemporal equilibrium a l l o c a t i o n of a known stock of an exhaustible resource i s thus more complex and less l i k e l y to y i e l d unambiguous q u a l i t a t i v e r e s u l t s when 5 subjected to comparative dynamic analysis. Therefore, although we know that the introduction of taxation w i l l induce a profit-maximizing producer to choose the extraction p r o f i l e for a given deposit which maximizes his after-tax return, numerical methods may o f f e r the only means through which the induced d i s t o r t i o n s from the competitive a l l o c a t i o n can be measured. In addition to enabling one to derive estimates of both the magnitude and d i r e c t i o n of the d i s t o r t i o n s induced by s p e c i f i c forms of taxation, the a p p l i c a t i o n of numerical methods to the analysis of the e f f e c t s of taxation on the e x p l o i t a t i o n of given resource deposits o f f e r s another advantage. It allows c e r t a i n r e s t r i c t i v e assumptions, e s p e c i a l l y about the nature of the extraction technology, to be relaxed thus making possible the construction of a model which depicts r e a l i t y more c l o s e l y . 10 An important question, however, has yet to be addressed: why do we observe that extractive industries are generally subject to substantial regulation and taxation? Three reasons are usually put forth to explain the existence of government intervention i n markets for extractive resources. F i r s t , i t i s argued that there could be d i s t o r t i o n s from competitive equilibrium associated with the e x p l o i t a t i o n of these resources. Three common examples are the public-good nature of exploration, the "rule of capture' problems mostly associated with the e x p l o i t a t i o n of petroleum resources and the existence of non-competitive market structures. Second, governments may choose to intervene in markets for extractive resources to correct d i s t o r t i o n s that occur elsewhere in the economy. Studies in this area t y p i c a l l y s t a r t from the premise that the attainment of a f i r s t - b e s t solution is impossible. Given that, one of the tasks facing a government is to devise an optimal structure of d i s t o r t i o n a r y taxes which may include the taxation of extractive i n d u s t r i e s . The economic l i t e r a t u r e on optimal taxation and the problem of the second best explores this area in d e t a i l . F i n a l l y , there i s the b e l i e f that economic rents belong in the public domain. In Canada, this b e l i e f i s reinforced by the fact that rights to most o i l and gas deposits have not been alienated. In general, therefore, the Crown also acts as landlord. In addition, the e x p l o i t a t i o n of extractive resources usually generates economic rents. The suggestion that such rents might exist i s of i t s e l f s u f f i c i e n t to create a gleam in every tax c o l l e c t o r ' s eye since i t usually s i g n i f i e s the p o s s i b i l i t y of getting something for nothing: a tax on economic rents is non-distortionary, at 7 least in the short run and in a p a r t i a l equilibrium framework. However, 11 the instruments of taxation r e l i e d upon by governments usually do not e x c l u s i v e l y tax economic rents. The analysis of the d i r e c t i o n and magnitude of the r e s u l t i n g departures from the competitive equilibrium a l l o c a t i o n has been an important concern of the economic l i t e r a t u r e on the taxation of extractive resources. This observation suggests a fourth reason. Taxes levied against the revenues of non-renewable industries may belong in the f i s c a l package of a government because they are perceived to be less d i s t o r t i o n a r y than the next best a l t e r n a t i v e . This broader aspect of the p o t e n t i a l comparative advantage of such taxes w i l l not be pursued further in this t h e s i s . However, i t should be kept i n mind when probing the e f f e c t s of the various instruments designed to tax the revenues generated by ventures such as the development and production of Hibernia. In t h i s t h e s i s , resource taxation w i l l be thought of as a series of measures through which governments r a i s e revenues and exercise t h e i r r i g h t s as landlords. The next section provides a review of numerically tractable economic models which have been used to examine the consequences of resource taxation on the development and production of offshore petroleum r e s e r v o i r s . 2.3 Applied Reservoir Economics: A P a r t i a l Review 2.3.1 Petroleum as an Exhaustible Resource From an economic perspective, crude o i l is an extractive resource l i k e any other. It i s exhaustible in the conventional sense and i t s e x p l o i t a t i o n gives r i s e to problems of intertemporal a l l o c a t i o n . To study these intertemporal a l l o c a t i o n problems, the economic l i t e r a t u r e 12 represents the supply of crude o i l as an integrated process which consists of three stages: exploration, development and extraction. Exploration must f i r s t y i e l d the discovery of o i l - i n - p l a c e in pools c a l l e d r e s e r v o i r s . Development of s p e c i f i c reservoirs transforms the o i l - i n - p l a c e into reserves which can then be extracted. It i s useful to think of this process as being the r e s u l t of two decisions taken by firms at d i f f e r e n t points in time. Based on i t s expectations about future benefits, a firm f i r s t decides on the l o c a t i o n , timing and l e v e l of i n t e n s i t y of i t s exploration e f f o r t . Upon the discovery of a r e s e r v o i r , the firm must decide whether to proceed with development and, i f so, choose a development plan and i t s associated production p r o f i l e . In doing so, the firm uses the information obtained through exploration but treats expenditures on exploration as sunk costs and examines the economics of development in l i g h t of the expected costs and benefits of d i f f e r e n t development plans. Under s p e c i f i c behavioural assumptions, the most desirable development plan from the firm's point of view can be i d e n t i f i e d . Development and production can be expected to ensue only i f the anticipated net benefits accruing to the firm under the p r i v a t e l y optimal plan are p o s i t i v e . To a reservoir engineer, offshore and onshore reservoirs are both sets of geological conditions which bear petroleum. There are no convenient ways of d i s t i n g u i s h i n g between the two types since the physical conditions which govern production are the same whether a reservoir i s located under the Canadian p r a i r i e s or in the continental s h e l f . The production economics, however, d i f f e r s u b s t a n t i a l l y . To extract the riches of an offshore r e s e r v o i r , a d i f f e r e n t technology must be used and i t s investment requirements dwarf those necessary to develop and 13 produce a comparable onshore r e s e r v o i r . For example, production platforms must be b u i l t and i n s t a l l e d which w i l l a f f e c t the number, timing and l o c a t i o n of wells. This implies that the decision to develop an offshore reservoir i s c r u c i a l l y affected by the investment requirements. In addition, the lumpiness of the investment program suggests that i t would be inappropriate to represent development costs with a continuously d i f f e r e n t i a b l e function. Therefore, the attainable portion of the production surface i s l i k e l y to be a f i n i t e set of points since many of the intermediate points w i l l simply not be f e a s i b l e . As was suggested in the previous section, the introduction of r o y a l t i e s and taxes changes the nature of the producer's optimization problem. For example, a net-present-value- maximizing producer w i l l perceive r o y a l t i e s and taxes as p o t e n t i a l l y avoidable costs of production and w i l l seek to maximize the net present value of his after-tax return. In such circumstances, i t i s possible for the p r i v a t e l y optimal development plan to d i f f e r from that which maximizes the net present value of the f i e l d to society. If t h i s i s the case, a portion of the potential net present value of the deposit to society w i l l have been dissipated because of the e f f e c t s of government p o l i c i e s on producer behaviour. Empirical studies of offshore reservoir economics have generally concentrated on the development and production stages, and thus assumed that exploration had previously occurred and yielded the discovery of a given r e s e r v o i r . In this t r a d i t i o n , several numerically tractable models of the development and production of offshore petroleum reservoirs have been proposed i n the economic l i t e r a t u r e . In these models, o i l production a c t i v i t i e s are characterized by i n i t i a l c a p i t a l expenditures followed by long periods of extraction and are thus analysed as discounted streams of 14 revenues and expenditures. A p a r t i a l equilibrium framework i s generally used and exogenous factors are assumed to be completely described by a set of tax parameters, a number of other parameters including the discount rate, and the time p r o f i l e s of two variables (wellhead price of crude o i l and general rate of price i n f l a t i o n ) . Within this framework, the behaviour of a price-taking, net-present-value-maximizing producer can be simulated, as can the consequences of the introduction of (or changes in) government taxation p o l i c y and of changes in the general economic environment. q The fiv e models reviewed in the next subsection a l l use the expected values of costs, p r i c e s , tax parameters and c h a r a c t e r i s t i c s of given reservoirs to derive point estimates of t h e i r net present values and of the e f f e c t s of resource taxation. After Van Meurs [1971, chapter 4 ] , these models w i l l be referred to as 'deterministic'. Reasons for l i m i t i n g the scope of this l i t e r a t u r e review to include only deterministic models w i l l become apparent in the next chapter. 2.3.2 The Basic S t a t i c Model The discovery and subsequent e x p l o i t a t i o n of petroleum resources under the North Sea has given r i s e to a number of studies into the economics of such ventures. 1*^ Representative of a class of these studies is the work of Robinson and Morgan [1976;1977;1978]. 1 1 In t h e i r analysis of the development of o i l f i e l d s i n the UK and Norwegian sectors, these authors employ an approach which w i l l be c a l l e d the basic s t a t i c model. This model simulates the behaviour of a net-present-value-maximizing producer under the assumption that his choice of development plans and production p r o f i l e s for s p e c i f i c reservoirs i s la r g e l y unaffected by 15 r o y a l t i e s and taxes. Hence, a development plan and a production p r o f i l e are exogenously s p e c i f i e d for each reservoir under study. i • • 12 The model s unit of analysis i s the r e s e r v o i r . Considerations such as the number, loc a t i o n and timing of wells and platforms are thus only important so far as their implied l e v e l and d i s t r i b u t i o n of investment requirements are known. The approach also treats the l e v e l of recoverable reserves as a known c h a r a c t e r i s t i c of the r e s e r v o i r . Even though four of the f i v e models reviewed in this section approach the determination of the l e v e l of recoverable reserves in t h i s manner, the process by which the measure i s derived remains lar g e l y undefined. The following paragraph outlines an attempt at r a t i o n a l i z i n g the choice of such a measure of resource stock. The geological conditions which characterize a given res e r v o i r are assumed known. One of the elements of the set of fe a s i b l e extraction technologies (usually fixed production platforms with the p o t e n t i a l for secondary recovery) i s assumed to be used to produce the r e s e r v o i r . The a p p l i c a t i o n of this technology i s then assumed to define a maximum quantity of crude o i l which, given enough time, can be recovered from the r e s e r v o i r under study. That quantity i s then c a l l e d the l e v e l of recoverable reserves and i s assigned as a c h a r a c t e r i s t i c of the r e s e r v o i r . As a r e s u l t , recoverable reserves defined i n this manner can be considered a physical measure of resource stock since they are not influenced by changes in prices or costs. A set of exogenous weights defines each year's production as a fixed proportion of recoverable reserves. The assumed time p r o f i l e of weights determines both the f i r s t - and l a s t - p o s s i b l e extraction periods. As with a l l other models reviewed in this section, the stream of annual production 16 revenues i s obtained by imposing an exogenous price path for crude o i l on the production p r o f i l e . Total c a p i t a l expenditures, assumed to be e n t i r e l y equity-financed, are aggregated from a series of a c t i v i t y categories whose expenditure requirements are s p e c i f i e d both i n t h e i r l e v e l and timing. Annual operating expenditures are s p e c i f i e d and assumed to stay constant, in r e a l terms, over the l i f e of the r e s e r v o i r . Government taxation p o l i c i e s are e x p l i c i t l y modelled. Development and production are then simulated, the l a t t e r continuing as long as the revenues accruing to the producer are at least as large as the associated avoidable costs. This implies that although recoverable reserves are defined as a c h a r a c t e r i s t i c of the r e s e r v o i r , actual recovery is both p r i c e - and c o s t - s e n s i t i v e . As should have been gathered from these few paragraphs and the algebraic representation of appendix I, the structure of this approach i s very r i g i d ; the only two parameters over which the model can search are 1 3 the f i r s t and l a s t periods of production. Kemp [1975] and Morgan and Robinson [1976a] are examples of studies which have used the basic s t a t i c model to examine the e f f e c t s of r o y a l t i e s and taxes on the (private) p r o f i t a b i l i t y of developing petroleum deposits located in the B r i t i s h and Norwegian sectors of the North Sea. The main conclusions which emerge from these studies are that the introduction of or changes in resource taxation p o l i c i e s t y p i c a l l y a f f e c t the d i s t r i b u t i o n of net revenues much more than th e i r l e v e l and that the producer's decision to develop a given deposit i s r e l a t i v e l y robust to the introduction of various types of r o y a l t i e s and taxes. 17 The structure of the model at least i n part explains this dominance of d i s t r i b u t i o n a l issues. In this framework, government p o l i c i e s can a f f e c t the simulated behaviour of the producer in only two ways. F i r s t , r o y a l t i e s and taxes can reverse the producer's decision to develop by making an otherwise p r o f i t a b l e venture p r i v a t e l y unprofitable. Second, under suitable assumptions about future o i l prices and given a f i r s t period of production, resource taxation p o l i c i e s may r a i s e the cut-off grade by moving the l a s t period of production closer to the present than would have been the case i n an unregulated environment. However, this model of f e r s no way of capturing the dynamic e f f e c t s of r o y a l t i e s and taxes on the producer's choice of a development plan and hence, of a production p r o f i l e . Since the v a r i a b l e costs of production of offshore o i l tend to be much smaller than the fixed c a p i t a l costs, any analysis of the e f f e c t s of r o y a l t i e s and taxes on producer behaviour that does not emphasize their impact on the investment decision w i l l tend to underestimate the magnitude of the induced d i s s i p a t i o n of net b e n e f i t s . 2.3.3 The MIT Model A series of papers f i r s t present, then r e f i n e an integrated process model of the three stages of the supply of crude o i l from offshore basins 1 h l i k e the North Sea. The model includes a res e r v o i r development submodel which can be thought of as an extension of the basic s t a t i c model. Since the submodel i s part of an integrated process approach, development and production are e x p l i c i t l y conditional on exploration and the subsequent discovery of a reservoir which, i n each case, i s characterized by a given l e v e l of recoverable reserves. As with the basic s t a t i c model, the unit of analysis i s the reservoir and the production 18 p r o f i l e i s defined by a series of exogenous weights which i m p l i c i t l y determine the f i r s t - and l a s t - p o s s i b l e production periods. Using data from producing North Sea f i e l d s , the authors estimate r e a l c a p i t a l expenditure equations for a series of a c t i v i t y categories. These are then used to forecast r e a l c a p i t a l expenditures for each a c t i v i t y as a function of the l e v e l of recoverable reserves characterizing the re s e r v o i r under s t u d y . 1 5 These expenditures, assumed to be e n t i r e l y equity-financed, are aggregated across categories and d i s t r i b u t e d over time according to an 16 exogenous set of weights. The treatment of operating expenditures is simi l a r to that of c a p i t a l expenditures; the only important difference being that r e a l annual operating expenditures, assumed to remain constant over time, are forecast with an equation estimated as a function of recoverable reserves. The submodel also incorporates a detai l e d d e s c r i p t i o n of the relevant taxation and regulation p o l i c i e s . A cash flow approach i s then used to calculate the net present value of each reservoir discovered as well as i t s d i s t r i b u t i o n between producer and government. The development and production of a given reservoir are assumed to ensue only i f the net present value to i t s producer i s p o s i t i v e . If i t i s n ' t , the reservoir joins the queue of discoveries whose development and production await a more favourable economic climate. As with the basic s t a t i c model, the only two parameters over which the model searches are the f i r s t and la s t periods of p r o d u c t i o n . 1 7 Even i f c a p i t a l and operating expenditures depend only on the l e v e l of recoverable reserves, i t can be argued that the r e s u l t i n g endogenous determination of the development plan imbues this model with a greater degree of f l e x i b i l i t y than that of the basic s t a t i c model. An int e r e s t i n g 19 feature of the model i s a t t r i b u t a b l e to th is increased f l e x i b i l i t y : d i f f e r e n t r e s e r v o i r s izes can now be c o n s i s t e n t l y handled endogenously. By extension, i t is now poss ib le to define the minimum economic r e s e r v o i r s ize in a l t e r n a t i v e states of the world. Otherwise, the p o t e n t i a l e f f ec t s of taxat ion and regu la t ion and of changes i n the economic environment are i d e n t i c a l to those of the basic s t a t i c model. This explains the s i m i l a r i t y of the r e s u l t s concerning the consequences of resource taxat ion obtained in Adelman et a l . [1976] and Eckbo [1979b] which use the MIT model with those to be found i n studies such as Morgan and Robinson [1976a] which r e l y on the basic s t a t i c model. 2.3.4 The Platform Locat ion Model Drawing from the operations research l i t e r a t u r e , Devine and Lesso [1969;1972] have proposed a cost -minimiz ing model of the development of offshore o i l f i e l d s that excludes f i e l d - t o - s h o r e t ranspor ta t ion . F r a i r and Devine [1975] l a t e r cast the problem as a maximization of a f t e r - t a x p r o f i t s over a p r e - s p e c i f i e d planning h o r i z o n . Dogru, Lesso and Brons [1977] suggested a net-present-value-maximizat ion model which, while excluding taxat ion p o l i c y , assigned a key ro le to the s e l e c t i o n of a f i e l d - t o - s h o r e p i p e l i n e t ransporta t ion system. Given the phys i ca l c h a r a c t e r i s t i c s of the r e s e r v o i r and the number and l o c a t i o n of targets to be reached by production we l l s , the fo l lowing 18 problem i s solved by Devine and Lesso [1969;1972]. A wel l d r i l l i n g cost funct ion which depends on the h o r i z o n t a l and v e r t i c a l distances separating platforms and targets i s s p e c i f i e d , as i s a platform cost funct ion which depends on the number of targets produced from each p lat form. Since the t o t a l cost of an i n d i v i d u a l p la t form, inc lud ing d r i l l i n g cos t s , r i s e s 20 proportionately more slowly than the number of wells contained in i t , there exists a tradeoff between the size of platforms and the proximity of targets to platforms. Given a number of platforms, the problem is then to choose t h e i r size and l o c a t i o n as well as the a l l o c a t i o n of wells to platforms 19 which minimizes the cost of development. To obtain a solu t i o n , the authors r e l y on the a l l o c a t i o n - l o c a t i o n algorithm which proceeds i n the following manner. Given an a r b i t r a r y assignment of targets to platforms, the algorithm finds the platform locations which minimize d r i l l i n g costs. Then, the targets are reallocated among the platforms to minimize d r i l l i n g and platform costs given the loca t i o n s . This yields yet another l o c a t i o n subproblem since, i n general, the cost-minimizing platform locations w i l l have changed in l i g h t of the new target a l l o c a t i o n s . Convergence occurs when the solution of the lo c a t i o n subproblem i s compatible with that of the a l l o c a t i o n subproblem. As i s common with such numerical optimization techniques, the 'optimal' solution i s dependent on the i n i t i a l values of the parameters over which the algorithm searches. In l i g h t of this shortcoming, the authors recommend that the problem be solved for a number of d i f f e r e n t i n i t i a l platform l o c a t i o n s . The modifications to the basic approach suggested by F r a i r and Devine [1975] and Dogru, Lesso and Brons [1977] transform the platform location model into something much more akin to a model of the development and production of offshore o i l r e s e r v o i r s . While retain i n g the assumptions of exogenously given number and l o c a t i o n of targets, both papers approach the problem as a maximization of the present value of a net revenue stream over a given period of time. 21 As with the basic s t a t i c model and the MIT model, annual revenues are obtained by imposing an exogenous price path for crude o i l on the rese r v o i r production p r o f i l e . D r i l l i n g and platform costs are determined with the use of equations similar to those devised by Devine and Lesso [1972]. Operating expenditures, on the other hand, are specifed by platform and for each year. Both approaches treat recoverable reserves as a known c h a r a c t e r i s t i c of the r e s e r v o i r . It i s also assumed that a l l wells in a reservoir have the same properties i n terms of th e i r productive c a p a b i l i t i e s . Given an assumed i n i t i a l well production rate, an exponential decline process which relates current reservoir output to cumulative production is then 20 s p e c i f i e d to simulate production. Since the l e v e l of recoverable reserves, the number of wells and the i n i t i a l well production rate uniquely determine the reservoir decline rate, once the value of these parameters i s s p e c i f i e d , the production p r o f i l e i s f u l l y characterized. Dogru, Lesso and Brons [1977, pp.5-6] use a number of numerical optimization techniques to find the highest pre-tax net present value of the development which now includes a field-to-shore transportation system. Given the number of platforms, the model exploits the tradeoffs inherent in the well d r i l l i n g and platform cost functions and introduces a p i p e l i n e cost function which depends on length and diameter. Again, the 'optimal' so l u t i o n depends on the i n i t i a l platform lo c a t i o n s . F r a i r and Devine [1975], on the other hand, ignore the question of field-to-shore transportation but introduce an e f f e c t i v e tax rate on net income which i s assumed to capture a l l the e f f e c t s of taxation p o l i c y . They also modify s l i g h t l y the production process by assuming that for a s p e c i f i e d number of years at the beginning of i t s productive l i f e , 22 r e s e r v o i r production w i l l be constant at a rate less than i t s productive c a p a b i l i t y . After that time, an exponential decline process i s assumed to govern reservoir production. Since a l l platforms need not be i n s t a l l e d nor a l l wells d r i l l e d before production s t a r t s , the problem can be broken down into two parts: an a l l o c a t i o n - l o c a t i o n problem which i s solved as in Devine and Lesso [1972] and a p l a t f o r m - i n s t a l l a t i o n / w e l l - d r i l l i n g problem. After making a few s i m p l i f y i n g assumptions, the authors use a l i n e a r mixed-integer programming algorithm to obtain 'good' solutions to the second part of the problem. Unfortunately, this solution s t i l l depends on the i n i t i a l platform l o c a t i o n s . Although neither model i s ever subjected to s e n s i t i v i t y analysis, a few r e s u l t s seem obvious. For example, an increase (decrease) in the cost of d r i l l i n g a well, c e t e r i s paribus, w i l l create an incentive to use more (fewer) production platforms and vice versa. However, the fact that these models are defined over a s p e c i f i c planning horizon, i n conjunction with hhe absence of a shut-down rule ensuring that production i s stopped when avoidable costs exceed expected revenues, c u r t a i l s the p o t e n t i a l e f f e c t s of changes in the economic environment, including taxation p o l i c y . Even i f i t were possible to change the structure of the model to eliminate these two properties and to incorporate a more detai l e d d e s c r i p t i o n of the relevant taxation p o l i c i e s , the fact that the number of targets i s pre-s p e c i f i e d implies that the production p r o f i l e i s e f f e c t i v e l y exogenous. This, in turn, suggests that the scope offered by such a model for endogenous producer responses to the introduction of r o y a l t i e s and taxes, and to changes in the economic environment would be no wider than that offered by the basic s t a t i c model. 23 2.3.5 The Odell-Rosing Model Odell and Rosing [1977a] have examined the economics of three f i e l d s situated in the B r i t i s h sector of the North Sea that were either producing 21 or scheduled for development in 1976. The authors hypothesize that producers l e f t to their own devices w i l l choose a development strategy d i f f e r e n t from that which would maximize government revenues from any given f i e l d . Their model is thus designed to evaluate the e f f e c t s of the number and locations of production platforms on the net present value of each f i e l d and i t s d i s t r i b u t i o n between producer and government over an 22 economically relevant time period. The basic unit of analysis for both development and production i s thus the platform. A two-dimensional representation of each f i e l d is s p e c i f i e d and divided into a number of equal-sized hexagons, the center of each hexagon being a possible platform l o c a t i o n . This representation is then used in conjunction with contour information to give a measure of the o i l - i n - p l a c e under each hexagon. Under s p e c i f i c assumptions about the nature of the extraction technology, the model derives a measure of the volume of producible reserves in each hexagonal column. It is then assumed that each fixed platform equipped for production and i n j e c t i o n has a limited areal sweep and can drain a given maximum number of columns in accordance with 23 • an exogenous production schedule. This creates a r e l a t i o n s h i p between the f i e l d ' s productive c a p a b i l i t i e s and i t s production p r o f i l e , on the one hand, and the i n t e n s i t y of development, on the other. As the number of platforms increases, so do the l e v e l of recoverable reserves and the f i e l d ' s output at each point in time. However, i f platforms are located too close to one another, t h e i r drainage areas overlap thus causing a reduction in t h e i r t o t a l recovery p o t e n t i a l . 24 The l e v e l and d i s t r i b u t i o n of c a p i t a l expenditures associated with the construction and i n s t a l l a t i o n of a platform of known size are determined exogenously. S i m i l a r l y , operating expenditures are s p e c i f i e d over platform units. This implies that each f i e l d ' s production p r o f i l e i s supported by a unique development plan and introduces some scope for 2 4-optimization over the number and location of production platforms. When compared with the three approaches previously reviewed, i t becomes evident that the Odell-Rosing model provides a broader scope for taxation p o l i c i e s to a f f e c t the simulated behaviour of the producer. Since the authors are interested in the divergence between producer choices and government i n t e r e s t s , the model includes a detailed d e s c r i p t i o n of the relevant B r i t i s h p o l i c i e s i n e f f e c t at the time the study was undertaken. Odell and Rosing then assume that the opportunity cost of money i s lower for the government than for private producers and that a l l investment i s debt-financed. Given a number of platforms and th e i r l o c a t i o n , a cash flow approach i s used to measure the net present value of any given f i e l d as well as i t s d i s t r i b u t i o n between producer and government. The exercise is repeated using d i f f e r e n t numbers and locations of platforms. The authors show that, given government p o l i c i e s , a private producer w i l l choose a development strategy that i s less intensive than that which maximizes government revenues for each of the three f i e l d s studied. They then v e r i f y the robustness of their r e s u l t s by reaching the same conclusion with d i f f e r e n t assumptions about a number of key parameters. In l i g h t of the assumed d i f f e r e n t i a l between private and public opportunity costs of money, a means of r e c o n c i l i n g the in t e r e s t s of the two parties i s suggested. It consists of the government undertaking to 25 finance the c a p i t a l expenditures required to b u i l d and i n s t a l l the additi o n a l production platforms while not acquiring an equity share in the project. The pot e n t i a l gains i n tax revenues due to the more intensive development are shown to be great enough to warrant this kind of p o l i c y . The authors do not discuss the l i k e l y behavioural responses of private firms to such an incentive system. A rather scathing c r i t i q u e of the approach [Wall, Wilson and Jones 1977] along with a response from the authors [Odell and Rosing 1977b] appeared less than a year after the p u b l i c a t i o n of the i r study. Once the dust had s e t t l e d , the r e l a t i o n s h i p between s p a t i a l coverage and the productive c a p a b i l i t i e s of a reservoir surfaced as the most contentious issue. Wall et a l . claimed that the assumption of the existence of such a r e l a t i o n s h i p i s unwarranted. Odell and Rosing countered that the assumption i s indeed warranted for an analysis of the problem in an "economically relevant time period" [1977b, p.301]. Although Wall et a l . chose not to dwell on this point, the assumption of a pre-specified planning horizon i s c r u c i a l to the analysis and central to their disagreement with Odell and Rosing. The problem rests with the possible confusion of cumulative extraction and ultimate recovery. By r e l y i n g on an exogenously s p e c i f i e d length of the production period, Odell and Rosing's analysis concerns i t s e l f with cumulative extraction during that period. For short enough time periods, one should indeed expect cumulative extraction to increase with the number of wells used to produce a given f i e l d . However, within c e r t a i n l i m i t s , the quantity of crude o i l that can ultimately be recovered from a given f i e l d w i l l generally tend to be r e l a t i v e l y unaffected by the 25 number of wells used to produce i t . 26 This i s not to deny that, in some cases, the geological properties of a f i e l d may be such that some reserves might never be produced i f a more 26 intensive pattern of development were not adopted. Rather, i t i s meant to suggest that the exogenous s p e c i f i c a t i o n of the length of the production period may drive a wedge between cumulative extraction at the end of the period and ultimate recovery which w i l l tend to favour more intensive development patterns. Another point, completely ignored by the c r i t i c s , also seems to be important. Since the model uses the maximization of government revenues as an objective, the conclusion that r e s e r v o i r development i s not intensive enough could e a s i l y be reversed i f d i f f e r e n t taxation p o l i c i e s had been modelled. One i s reminded of a r e s u l t obtained by Dasgupta, Heal and S t i g l i t z [1980, pp.170-171] showing that, under c e r t a i n conditions, the government can manipulate as few as two p o l i c y instruments to make any pattern of intertemporal resource a l l o c a t i o n p r i v a t e l y optimal. It would also be i n t e r e s t i n g to find out whether Odell and Rosing's r e s u l t s would change i f a more conventional objective were adopted. The Odell-Rosing model shares with the platform location model the problems caused by an exogenous planning horizon. Even i f i t were possible to relax this constraint and change the optimization c r i t e r i o n , the geological information required to construct a three-dimensional representation of the f i e l d under study removes any comparative advantage that this approach might have except in cases where these data are r e a d i l y a v a i l a b l e . 27 2.3.6 The Lowenstein Model The thrust of Lowenstein 1s paper i s c l e a r l y stated: "[t]he model's basic intent i s to add f l e x i b i l i t y to the choice of the production process" [Lowenstein 1977, p.10]. By allowing the model to simulate the choice of a production p r o f i l e , Lowenstein hopes to create a ri c h e r framework of analysis which would provide a more complete representation of the options available to a net-present-value-maximizing producer. Of p a r t i c u l a r interest to the author are the ef f e c t s of government p o l i c i e s on producer decisions. In this model, the well emerges as the basic unit of production. In conjunction with treating the l e v e l of recoverable reserves as a known c h a r a c t e r i s t i c of the re s e r v o i r , Lowenstein makes two assumptions that enable him to describe the productive c a p a b i l i t i e s of a given r e s e r v o i r . F i r s t , as was the case with the platform location model, a l l wells in a reserv o i r are assumed to have the same properties i n terms of the i r productive c a p a b i l i t i e s . Second, the l e v e l of recoverable reserves i s 27 assumed not to be affected by the speed of recovery. Given an assumed i n i t i a l well production rate, an exponential decline process which r e l a t e s current to cumulative extraction i s sp e c i f i e d and assumed to characterize reservoir production. The c a p i t a l expenditures undertaken i n any given year are defined across a number of categories and depend on the le v e l of a c t i v i t y . Operating expenditures are s p e c i f i e d by platform and for each year of operation. Each possible production p r o f i l e is therefore associated with a unique development strategy which c a r r i e s implied streams of c a p i t a l expenditures, operating expenditures and revenues. 28 This degree of f l e x i b i l i t y i n the model's representation of the choice of a production p r o f i l e and the linkages between development and production are exploited i n the following manner. Given a s t a r t i n g time for production, i t i s possible for the model to choose a reservoir decline rate and the associated development plan which support the implied production p r o f i l e that maximizes the net present value of the 28 r e s e r v o i r . However, the r e s u l t i n g s t e a d i l y d e c l i n i n g production p r o f i l e may require the i n s t a l l a t i o n of large quantities of productive c a p i t a l , more and more of which w i l l be l y i n g i d l e as reservoir production f a l l s . Such circumstances would create incentives to reduce extraction in the early years i f the present value of the cost savings exceeds the present value of the foregone revenues. The model deals with these issues in the following way. The current output-cumulative production r e l a t i o n s h i p of the exponential decline process i s used to i d e n t i f y a depletion p r o f i l e with a l e v e l of annual production that could be maintained for some years which, with i t s associated development plan, r e s u l t s in a higher net present value of the rese r v o i r than the peaked p r o f i l e and associated development plan compatible with the same reservoir decline rate. The r e s u l t i n g depletion p r o f i l e s t i l l embodies the u n r e a l i s t i c assumption that the flow of production i s at i t s highest point in the f i r s t year of the productive l i f e of the r e s e r v o i r . A more r e a l i s t i c treatment would be to allow for a gradual build-up of the reservoir's productive c a p a b i l i t i e s as more wells are assumed to be d r i l l e d into the structure. Unfortunately, the approach adopted by Lowenstein can not r e a d i l y be modified to incorporate such a feature. 29 The model has fiv e choice v a r i a b l e s : the f i r s t period of development, the r e s e r v o i r decline rate, the i n i t i a l l e v e l of production, the l a s t period of production, and, since a l l wells implied by the reservoir decline rate need not be d r i l l e d before production can begin, the timing of wells d r i l l e d after production has started. The author reports that once decisions are made about the reservoir decline rate and the i n i t i a l l e v e l of production, the choice of an optimal d r i l l i n g schedule i s of secondary importance. No r e s u l t s are reported for the other two decision v a r i a b l e s . The p o t e n t i a l e f f e c t s of government p o l i c i e s in such an approach should now be c l e a r . A net-present-value-maximizing producer may be influenced by the e f f e c t s of taxation and regulation in his choice of development plan and, hence, production p r o f i l e . Furthermore, under the assumption that the solution to the optimization problem unconstrained by government p o l i c i e s i s s o c i a l l y optimal, i t i s possible to measure the economic losses associated with government intervention. Lowenstein addresses t h i s problem for three North Sea reservoirs and finds that substantial economic losses can be attributed to the tax p o l i c i e s of the . . 2 9 B r i t i s h government. The author mentions that this suggests the p o s s i b i l i t y of developing p o l i c i e s which would leave both private producers and society in better p o s i t i o n s . However, this r e s u l t i s not further exploited. It should also be mentioned that the paper does not attempt to simulate the e f f e c t s of d i f f e r e n t assumptions about the economic environment on the s o c i a l l y and p r i v a t e l y optimal development plans and, by extension, on the magnitude of the economic losses induced by government p o l i c i e s . 30 2.4 Concluding Remarks This review of fiv e deterministic models of the development and production of offshore reservoirs has served to highlight an equal number of desirable properties of such models. F i r s t , the lumpiness of the investment plan, the time lag between between development and production and the time-consuming nature of the process imply that a net-present-value approach which discounts streams of revenues and expenditures at an appropriate rate should be used to study the economics of offshore r e s e r v o i r s . Furthermore, i f the model i s to have anything to say about the impact of r o y a l t i e s and taxes on producer behaviour, i t should include a det a i l e d d e s c r i p t i o n of the relevant taxation systems. Second, since the model seeks to simulate the behaviour of r a t i o n a l economic agents in a l t e r n a t i v e states of the world, i t should be cast in an optimization framework. For example, the model should allow for the endogenous determination of the productive l i f e of each r e s e r v o i r . Third, at the core of the model should be a systematic r e l a t i o n s h i p through which each exogenously s p e c i f i e d development plan could be associated with a unique extraction p r o f i l e which would be consistent with the underlying c h a r a c t e r i s t i c s or attr i b u t e s of each r e s e r v o i r . This would widen the scope for optimization offered by the model and, more s p e c i f i c a l l y , would allow i t to r e f l e c t the dynamic e f f e c t s of r o y a l t i e s , taxes and the economic environment in general on the producer's choice of a development plan. However, since the physical properties of i n d i v i d u a l reservoirs generally influence t h e i r p r o d u c i b i l i t y , the degree of f l e x i b i l i t y which the model makes available to the producer should not be overstated. 31 Fourth , in appl ied economic studies of th i s k i n d , one should seek to b u i l d models which incorporate the key features of the processes through which r e s e r v o i r s are developed and produced. For example, the model should allow for a gradual bu i ld -up of the productive c a p a b i l i t i e s of i n d i v i d u a l r e s e r v o i r s as platforms are i n s t a l l e d , wel ls d r i l l e d and made a v a i l a b l e for product ion . In the same v e i n , the model should d i f f e r e n t i a t e between r e s e r v o i r s and f i e l d s thus f a c i l i t a t i n g the study of the economics of f i e l d s which consis t of more than one r e s e r v o i r . F i n a l l y , i t should be poss ib le to submit the model to an analys i s of i t s s e n s i t i v i t y to changes in c e r t a i n key parameters. Within the context of a de termin i s t i c model, th i s would allow for a l imi ted study of the e f fects of uncerta inty and t h e i r d i s t r i b u t i o n between government and producer. Another aspect of the d e t e r m i n i s t i c models reviewed above is worthy of a t t e n t i o n : a l l of them cast the development and production of offshore r e s e r v o i r s in a p a r t i a l e q u i l i b r i u m framework. Two reasons suggest that using th i s type of approach to analyse the impl ica t ions of a ' l a r g e ' project such as the development of a giant offshore o i l f i e l d w i l l produce an incomplete p i c t u r e . F i r s t , the project may have repercussions that cannot be captured or adequately measured by a c e t e r i s paribus approach. Second, a p a r t i a l e q u i l i b r i u m approach does not allow changes in the economic environment induced by the project to f i l t e r through and af fect the economics of the project i t s e l f . Robinson and Morgan [1977;1978, chapter 8] o f fer a l imi ted assessment 30 of the macroeconomic impl ica t ions of the North Sea developments. They use the basic s t a t i c model in conjunct ion with assumptions about the l i k e l y scale of future developments and forecasts of a few key 32 macroeconomic variables to estimate the e f f e c t s of North Sea o i l on the UK economy. Although this approach provides a limited means of capturing the e f f e c t s of offshore development on an open economy, i t does not allow project-induced changes in the economic environment to be brought to bear on the analysis. A more consistent method of approaching this problem would be to incorporate the project into a macroeconomic model of a national economy. This would provide both a method of capturing the macroeconomic e f f e c t s and a feedback mechanism. The next chapter outlines an approach that t r i e s to incorporate a l l these elements into a simulation model of the development and production of offshore petroleum r e s e r v o i r s . 33 FOOTNOTES This is not to say that the intervening period witnessed no contributions to this l i t e r a t u r e (see, for example, McDonald [1961]) but rather that the papers in Gaffney [1967] consolidated the work done in this f i e l d and opened new avenues of research. For example, Dasgupta and Heal [1979, chapter 12] assume that the marginal cost of extraction i s constant. Conrad and Hool [1980;1981] assume that the marginal cost of extraction i s either constant or growing with the l e v e l of extraction i n each period. The above discussion was la r g e l y based on r e s u l t s presented in Conrad and Hool [1980, chapter 3] and Lewis and Slade [1983]. See, for example, Sweeney [1977, p.129] and Conrad and Hool [1981, p.30] . For example, see Lewis and Slade [1983, pp.25-34]. See, for example, Dasgupta and Heal [1979, pp.361-363], Lewis and Slade [1983, p.l] and Slade [1983, pp.1-2]. See Dasgupta and Heal [1979, chapter 12] and Church [1981, chapter 3]. Although s i m i l a r studies have been done for a number of extractive i n d u s t r i e s , I have chosen to review only those contributions which examine the e f f e c t s of taxation on offshore o i l e x p l o i t a t i o n . Bradley, H e l l i w e l l and Livernois [1981], Foley and Clark [1982], H e l l i w e l l [1978] and Slade [1983] are examples of studies examining the e f f e c t s of resource taxation in other extractive i n d u s t r i e s . Appendix 1 contains algebraic representations of most of these models. See, for example, Davis [1981], Kemp [1975] and MacKay and Mackay [1975] . See also Morgan and Robinson [1976a;1976b] . This approach of f e r s no convenient way of d i f f e r e n t i a t i n g between reservoirs and f i e l d s . Therefore, to simplify the exposition, i t w i l l be assumed that each f i e l d consists of a single r e s e r v o i r . As with a l l the models reviewed i n this chapter, the potential for choosing the f i r s t period of production remains la r g e l y unexplored. With the exception of the MIT model (to be reviewed next), i t is s p e c i f i e d exogenously. 1 4 See Adelman et a l . [1976], Adelman and Jacoby [1977], B e a l l [1976], Eckbo [1977;1979a;1979b] and Eckbo, Jacoby and Smith [1978]. 9 10 11 12 1 3 \ 34 15 16 17 18 19 20 21 22 23 2h 25 26 The po t e n t i a l for expanding the set of independent variables was recognized early on (see Adelman et a l . [1976, pp.15-19]) but never acted upon (see Eckbo, Jacoby and Smith [1978, pp.222- 223] and Eckbo [1979a, p.41]). Suffice i t so say that the extension required to consider a d i f f e r e n t debt-equity financing r a t i o is straightforward and can e a s i l y be incorporated into the analysis as shown in Eckbo, Jacoby and Smith [1978, pp.222-224]. A given res e r v o i r sees i t s development and production simulated as soon as the net present value to i t s producer i s p o s i t i v e . Other than that, no e f f o r t i s made to examine the economics of postponement. Since i t i s assumed that each well reaches only one target, the number of wells must equal the number of targets. Therefore, assuming that the number and loc a t i o n of targets are exogenously determined implies that the number and location of wells are also exogenous. It i s , of course, possible to repeat the exercise using a d i f f e r e n t number of platforms and thus obtain a solu t i o n which i s 'optimal' along yet another dimension. This method i s used extensively throughout the petroleum industry (see, for example, Campbell [1959, chapter 9] and Nind [1981, chapter 2]). The f i e l d s in question are F o r t i e s , Montrose and Piper. Although nothing i n the log i c of the approach requires this assumption, the f i r s t period of production i s not treated as a choice v a r i a b l e . Instead, the authors use either the actual production start-up date (as in the case of Forties) or that implied by the actual development plans. It should be noted that a l l three f i e l d s were under production by the time the study was completed. This makes any d i s t i n c t i o n between ' f i e l d ' and 'reservoir' l a r g e l y i r r e l e v a n t for the purposes of simulating development and production using this model. Although this d e s c r i p t i o n conveys the essence of the approach used by Odell and Rosing, the solu t i o n procedure is in fact s l i g h t l y more complex than suggested. The authors assume that a hexagonal column can only be produced i f i t i s reached by a well. Given the number and size of platforms, the a l l o c a t i o n - l o c a t i o n algorithm (discussed i n subsection 2.3.4 above) i s used to determine the maximum quantity of o i l that can be recovered from a given r e s e r v o i r . This optimization procedure i s then repeated for a d i f f e r e n t number (and, by extension, d i f f e r e n t locations) of platforms. See Bradley [1967, chapter 4 and e s p e c i a l l y pp.43-48] and the references given therein. Montrose, for example, appears to be such a case. See Odell and Rosing [1977a, pp.107-114]. 35 These assumptions are frequently encountered i n discussions of simple techniques designed to represent reservoir production processes. For example, see Nind [1981, pp.361 and 377]. Bradley [1967, chapter 4] also dwells on this topic. In the context of this model, choosing a reservoir decline rate amounts to choosing the number of production wells. The reservoirs studied are Cormorant (which i n a l l l i k e l i h o o d refers only to South Cormorant), Forties and Ekofisk. The author assumed that a l l three were s i n g l e - r e s e r v o i r f i e l d s . It should also be noted that Ekofisk, although situated under Norwegian waters, saw i t s development and production simulated as i f i t were subject to B r i t i s h p o l i c i e s . Other studies of the macroeconomic implications of North Sea o i l and natural gas include MacKay and Mackay [1975], Gaskin and Chipman [1978] and Lewis and McNicoll [1978]. 36 CHAPTER 3 THE OFFSHORE DEVELOPMENT MODEL: OUTLINE AND APPLICATION 3.1 Introduction As i t s t i t l e i n d icates, this chapter performs two main functions. It outlines the offshore development model developed and used in this t h e s i s , and describes i t s a p p l i c a t i o n to the case of Hibernia. Thus, section 3.2 develops an economic model of the development and production of offshore o i l deposits that i s based on the features suggested in the l a s t section of chapter 2 above. Emphasis i s placed on developing a numerically tractable model which o f f e r s a number of channels through which government p o l i c i e s and the general economic environment can a f f e c t the simulated behaviour of a net-present-value-maximizing producer. Some of the properties and shortcomings of the model are also discussed in t h i s section. Section 3.3 describes how this model i s applied to the case of Hibernia. A b r i e f d e s c r i p t i o n of the f i e l d ' s c h a r a c t e r i s t i c s prefaces a discussion of the problems l i k e l y to be associated with petroleum development and production in this area of the North A t l a n t i c , and of the i r implications of consequence to this study. The offshore development model i s then t a i l o r e d to r e f l e c t the s p e c i f i c case of Hibernia. In addition, an outline of the relevant regulation and taxation systems i s provided. Studies of the economic v i a b i l i t y of Hibernia are also discussed in this section. An examination of the scope of these studies and of the methods on which they were based w i l l point the way to possible improvements and extensions. In c e r t a i n cases, the conclusions reached by these studies w i l l also provide a set of benchmarks against which to 37 compare the r e s u l t s obtained i n this t h e s i s . F i n a l l y , section 3.4 outlines the extensions to the approach necessary to set the development and production of Hibernia in the context of the national economy. Linkages between the macroeconometric model of the Canadian economy used in the analysis and the offshore development model, as i t applies to Hibernia, are also discussed i n d e t a i l . 3.2 A Model of the Development and Production of Offshore O i l Deposits 3.2.1 Overview of the Model The model developed and used i n th i s thesis treats an offshore petroleum deposit (or f i e l d ) as a set of non-communicating reservoirs which contain crude o i l of a known and uniform q u a l i t y . Each rese r v o i r i s assumed to be homogeneous and to be described by two a t t r i b u t e s : i n i t i a l p r o d u c t i v i t y of a well and i n i t i a l stock of recoverable reserves. The model accepts exogenously determined values for these attr i b u t e s and assumes that the stock of recoverable reserves i n each reservoir i s a physical measure of resource a v a i l a b i l i t y whose magnitude is conditional on the use of secondary recovery techniques. A modified exponential decline process i s used to characterize the decline behaviour of the productive c a p a b i l i t i e s of i n d i v i d u a l wells and hence, the production p r o f i l e for each reservoir and thus for the f i e l d as a whole. Each production platform must be constructed and i n s t a l l e d before i t s wells can be d r i l l e d and made available for production. By r e l y i n g on an exogenous s p e c i f i c a t i o n of the number of production wells contained i n a platform and by keeping track of the d i s t r i b u t i o n of platforms across reservoirs and over time, the model can derive endogenous responses of the production p r o f i l e to changes in the number of the d i s t r i b u t i o n of 38 platforms (and hence wells) used to produce the f i e l d . This reveals a key property of the model: i t establishes a one-to-one r e l a t i o n s h i p between development plans and production p r o f i l e s . This property is exploited to simulate the behaviour of a price-taking, net-present-value-maximizing producer under conditions of c e r t a i n t y . The structure of the model i s such that optimal producer choices are simulated for fiv e aspects of development and production. The producer i s allowed to choose the f i r s t period of development for the f i e l d as a whole, the number of platforms ultimately used to drain the f i e l d , the d i s t r i b u t i o n of platforms among re s e r v o i r s , the dates of f i r s t a c t i v i t y on each platform and the length of the productive l i f e of each r e s e r v o i r . A simple extension w i l l permit a sixth dimension to the optimization process: the model can also be used to simulate the choice of the type of production system. However, the attr i b u t e s of each reservoir and the assumed exponential decline process combine to c u r t a i l the degree of f l e x i b i l i t y offered by the model when simulating the behaviour of a r a t i o n a l producer. Through t h i s , the model attempts to r e f l e c t the consequences of the geological and geophysical constraints that producers of offshore petroleum deposits are l i k e l y to face. One of the uses which can be made of this model, and one which w i l l be emphasized i n subsequent chapters, i s to study the consequences of government p o l i c i e s on the behaviour of a r a t i o n a l producer. By incorporating d e t a i l e d descriptions of some regulation and taxation systems and allowing the producer to optimize the net present value of h i s after-tax returns, the model w i l l allow us to estimate the magnitude of the p o t e n t i a l d i s s i p a t i o n of net benefits induced by the a p p l i c a t i o n of r o y a l t i e s and taxes. A s i m i l a r procedure can also be used to test the 39 model's s e n s i t i v i t y to changes i n other key variables and parameters. 3.2.2 Model Description The following d e s c r i p t i o n of the offshore development model i s more det a i l e d than that of the fiv e types of deterministic models to be found in chapter 2 and appendix 1. This i s in part due to the structure of the model used in this thesis and i t s emphasis on simulating the development and production of i n d i v i d u a l r e s e r v o i r s . A large portion of the extra d e t a i l , however, can be traced back to an attempt to provide a better c h a r a c t e r i z a t i o n of the time-consuming nature of the a c t i v i t i e s related to the development and production of offshore petroleum r e s e r v o i r s . Therefore, a number of the equations that follow simply define pointers which indicate when development expenditures are f i r s t undertaken, when reservoirs are f i r s t produced as well as when other s i g n i f i c a n t aspects of the relevant offshore a c t i v i t i e s are simulated to occur. It i s hoped that through t h i s d e s c r i p t i o n , the reader w i l l get a better f e e l for which margins are emphasized by the model and for which aspects of the modelling e f f o r t are more r i g i d . It i s assumed throughout that the model i s defined i n annual terms and that a l l expenditure requirements and production revenues are expressed i n r e a l terms. A time period — t Q — i s exogenously s p e c i f i e d as the base year used in a l l c a l c u l a t i o n s . This assumption greatly s i m p l i f i e s the task of model d e s c r i p t i o n . However, the s h i f t to a c u r r e n t - d o l l a r basis does not a f f e c t the model's underlying properties and i t i s this c u rrent-dollar version which i s in fact used in the subsequent chapters of t h i s t h e s i s . Nonetheless, i t should be emphasized that in the d e s c r i p t i o n that follows, a l l relevant magnitudes are expressed in units 40 of t Q d o l l a r s . In a manner s i m i l a r to that adopted i n the Odell-Rosing model, the offshore development model used i n this thesis assumes that each production well d r i l l e d from a given platform can reach only one res e r v o i r . However, not a l l the wells whose production i s gathered by a given platform need tap the same r e s e r v o i r . In i t s present form, the model assumes that each platform can gather the crude o i l extracted from a maximum of two re s e r v o i r s . Although t h i s assumption i s not required to close the model, i t i s made because i t f a c i l i t a t e s the task of describing the model. F i n a l l y , as was mentioned e a r l i e r , the model accepts values for three a t t r i b u t e s of the deposit (or f i e l d ) . F i r s t i s the number of reservoirs i n the f i e l d . A second a t t r i b u t e i s the i n i t i a l productive c a p a b i l i t i e s of a well i n each r e s e r v o i r . Third i s the l e v e l of recoverable reserves (here, as with four of the models reviewed i n chapter 2 above, a physical measure of resource stock) i n each r e s e r v o i r . Now that the preliminaries have been dispensed with, the obvious place to begin the task of describing the model i s with development a c t i v i t i e s . Equation (3.1) shows the r e l a t i o n s h i p between the vector of f i r s t years of development — t l " ' — for platforms with wells independent-ly reaching reservoirs i and j , and the f i r s t period of development for the f i e l d as a whole — t\: t . h(«) :> 0 t 1 J = t + h(np..) .. .. (3.1) 1 1 l J t 1 J = t J 1 for i , j = l , . . . , s . 1 1 J In this equation, n P i j represents the number of platforms with wells independently reaching reservoirs i and j which i s ultimately used during the production period. 41 The ro l e of the funct ion h(• ) i n the above equation i s to ass ign a number to each re levant platform which determines how many years separate i t s f i r s t period of constuct ion a c t i v i t y from t^. The value of h ( » ) i s bounded below by zero since the f i r s t period of cons truct ion a c t i v i t i e s on the f i r s t platform to be i n s t a l l e d on the f i e l d must be the same as t^. i • Since i t w i l l be required l a t e r , l e t us now define t^ as the f i r s t period of development for r e s e r v o i r i . This i s , of course, equal to the -t. smallest element in the vector t ^ . •f. To ensure consistency with the notat ion used i n appendix 1, l e t t ^ represent the vector of l a s t periods of development for platforms with wells independently reaching r e s e r v o i r s i and j : t . -t. t 1 J = t 1 J + m m g iven . (3.2) h i Equation (3.2) simply s t i p u l a t e s that the l a s t period of development for any given platform is modelled to occur a p r e - s p e c i f i e d number of years — m — af ter the beginning of cons truc t ion a c t i v i t i e s on that p lat form. Now, *. i • • i i l e t t^ be the larges t element i n the vector t^ and thus represent the l a s t period of development a c t i v i t i e s re la ted to r e s e r v o i r i . Annual c a p i t a l expenditures ( i n t Q d o l l a r s ) on production platforms with wells independently reaching r e s e r v o i r s i and j — C E £ j t — a r e obtained as fo l lows: 0 i f tj*> t > t** ? p i i (3.3) ) Y • CEP £ kt i j otherwise; C E P . , g iven . CE. . = Therefore , the l e v e l of c a p i t a l expenditures undertaken at time t and re la ted to r e s e r v o i r s i and j i s equal to a weighted sum of platform costs 42 across a l l relevant platforms. In the above equation, CEPij represents the cost of b u i l d i n g and i n s t a l l i n g a production platform equipped for secondary recovery, and of d r i l l i n g a l l i t s wells into reservoirs i and j . Platform costs are allowed to vary across reservoir configurations to r e f l e c t the fact that the depth of reservoirs and other physical c h a r a c t e r i s t i c s may influence costs. However, the model f a l l s short of s p e c i f y i n g an expression to obtain the various C E P i j 1 s but instead r e l i e s on exogenous estimates. This approach to the determination of annual c a p i t a l expenditures i s formally i d e n t i c a l to that used in the platform l o c a t i o n , the Odell-Rosing and the Lowenstein models. Here, however, more emphasis i s placed on d i s t i n g u i s h i n g between platforms destined to produce d i f f e r e n t r e s e r v o i r s . The reason for emphasizing this d i s t i n c t i o n r e l a t e s to the design of shut-down rules which w i l l independently determine the optimal productive l i f e of each r e s e r v o i r . Another common element with some of the models discussed i n chapter 2 above i s the use of an exogenous weights to define the proportion of t o t a l expenditure requirements for each platform which i s undertaken i n any given year: t j j . . . . \ ~ ^ i i \ t = 1 ; i f fciJ> z > t t J t h e n \ t = °- ( 3 > 4 )  t = t i Equation (3.4) ensures that the p r o f i l e of weights for each platform k i s well defined over the relevant time period and that the sum of the weights for the construction period of each platform exactly exhausts the exogenously given platform c a p i t a l cost — CEPj_j . Equation (3.5) shows that the number of platforms producing r e s e r v o i r s i and j during year t — n P i i t — depends on c a p i t a l 43 expenditures undertaken p r i o r to that year: ( t - 1 ) n p i i t = Z( I i - C E i i r ^ 4 ( 0 g i v e n * ( 3 > 5 ) r=tj^ J The idea here i s to re l a t e cumulated c a p i t a l expenditures on i n d i v i d u a l platforms to whether or not these platforms have been b u i l t and i n s t a l l e d , and t h e i r wells d r i l l e d and made available for production. The method used i n the basic s t a t i c , Odell-Rosing and Lowenstein models r e l i e s on the expenditure and production estimates for the deposits under study to provide information as to when platforms are simulated to begin production. The same approach has been adopted i n this t h e s i s . In order to determine the optimal length of the productive l i f e of in d i v i d u a l r e s e r v o i r s , i t i s necessary to d i s t r i b u t e the c a p i t a l expenditures on platforms across a l l the reservoirs which form a given f i e l d . Equation ( 3 . 6 ) thus represents c a p i t a l expenditures undertaken during year t and a t t r i b u t a b l e to reser v o i r i : ).. = e.. = 1 n J J CE.^ = I CE..^ • 9.. 6.. = 1 - 6.. ( 3 . 6 ) , J l 9. . given, i j S J- J. i .   E . . e e.i t , = 1 i j t i j i j J 1 A Equation ( 3 . 6 ) s t i p u l a t e s that a given share — — of the c a p i t a l expenditures on platforms designed to produce reservoirs i and j — C E - L J J - — i s attributed to reser v o i r i . Summing across a l l pairs of res e r v o i r s w i l l then y i e l d the c a p i t a l expenditures undertaken i n time period t and a t t r i b u t a b l e to reservoir i . As we w i l l see l a t e r , the 0^j's are exogenously given and represent the proportion of wells from a platform straddling reservoirs i and j which i s used to produce reservoir 44 F i n a l l y , as equation (3.7) shows, c a p i t a l expenditures on the en t i re f i e l d during year t cons is t of the summation of the CE-j_ t's across a l l r e s e r v o i r s in the f i e l d : s CE = I CE (3.7) i - l As the l a s t f ive equations have demonstrated, the model assumes that the unit cost of platforms i s not affected by the number of equal - s ized platforms used to produce a given r e s e r v o i r or f i e l d . Odel l and Rosing [1977a, p.41] make the same assumption and argue that: "[t]here are . . . few, or even no, economies of scale in the costs of moving from a one to a two to a three to an n-plat form f i e l d . " Lowenstein [1977] and the developers of the platform l o c a t i o n model, in p a r t i c u l a r F r a i r and Devine [1975], i m p l i c i t l y make the same assumption. Since the basic s t a t i c and MIT models do not e x p l i c i t l y model the cons truct ion and i n s t a l l a t i o n of s p e c i f i c p lat forms, i t i s impossible to judge whether these two models are based on s i m i l a r assumptions about the shape of the cost curve for product ion plat forms. For the purposes of c a l c u l a t i n g the opportunity cost of the c a p i t a l assumed employed in developing and producing any given f i e l d , the offshore development model cumulates r e a l c a p i t a l expenditures into a stock of c a p i t a l whose service flows are valued at the i r s o c i a l opportunity cos t . Since the model assumes that pr ices of c a p i t a l goods are determined in competit ive markets, the two approaches are formally i d e n t i c a l and the seven equations out l ined above can be said to provide an accurate representat ion of the essence of the approach used in th i s t h e s i s . Now that the model i s equipped to simulate the cons truct ion and i n s t a l l a t i o n of p la t forms , the d r i l l i n g of wells and the br ing ing on 45 stream of individual platforms, i t seems appropriate to turn to a description of its reservoir production simulation process. Let t^ represent the f i r s t year of production from reservoir i . The model posits that the following equation holds: t^ = + c c given . (3.8) Equation (3.8) t e l l s us that t^ is reached only after a period of a given length of time — c — has passed after the year which marked the f i r s t period of development of reservoir i — t^ . As was noted in chapter 2 above, this approach was used by a l l five models reviewed. An exponential decline process, in its purest form, is the f i r s t block upon which the production simulation process used in this thesis is erected. It posits a linear relationship between the instantaneous rate of production of a well in reservoir i and cumulative production from the same reservoir: q!fc = q7 - o>i • Q i t ^7 given (3.9) where q! is the instantaneous production rate of a well in reservoir i at i t time t, q^ is the i n i t i a l instantaneous production rate of the same well, c j £ is the rate of decline of the well's productivity and, assuming for the time being that only one well taps the reservoir, Q t^ is the cumulative production from the reservoir at time t. Under the assumption that each reservoir is homogenous and that a l l wells in a given reservoir have the same decline behaviour, i t is possible to aggregate, across wells in a consistent manner and to represent the instantaneous rate of production of reservoir i at time t — q-j^ — as follows: 1 46 N • q' = q. = N • q. - N. • u. • Q. . (3.10) i t i t i l l i t In this equation, Nj_ represents the number of wells used to produce re s e r v o i r i , which, for the time being, i s assumed to remain constant over the entire productive l i f e of the r e s e r v o i r . As with the Lowenstein model and a version of the platform l o c a t i o n model [F r a i r and Devine, 1975], this equation i s at the heart of the process used in this thesis to simulate res e r v o i r production. As Nind [1981, chapter 2 and e s p e c i a l l y pp.31 and 43-44] reminds us, an exponential decline process as characterized by equation (3.10) does not provide a complete representation of the i n t r i c a t e pressure dynamics which govern rese r v o i r production. However, as Nind also points out, decline curves are widely used in the petroleum industry because they are simple and convenient tools that can be used to provide estimates of the productive c a p a b i l i t i e s of given reservoirs over time. It i s thus on the basis of i t s s i m p l i c i t y , i t s i n t e r e s t i n g properties and i t s usage both in the petroleum industry and in economic studies of offshore reservoir production that the exponential decline process was chosen for use in this t h e s i s . Let us now explore some other properties of the basic exponential decline process. Under the assumption that a l l reserves i n i t a l l y contained i n a given reservoir can p o t e n t i a l l y be extracted, the following w i l l hold i f the stock of recoverable reserves — RR^ — i s unaffected by the speed of recovery: 2 l i m Q. = RR. RR. given., (3.11) Based on equation (3.10), this implies that the following also holds: 47 I™ N. • q. - N. • a). • Q = 0. (3.12) t * 0 0 l M i l l x i t That i s , the instantaneous reservoir production rate equals zero in the l i m i t . By substituting equation (3.11) into equation (3.12) and solving for w^ , one obtains the following expression: t — u i - qi/RRi- (3.13) As this equation shows, C J ^ , which w i l l be c a l l e d the t h e o r e t i c a l decline rate of the pr o d u c t i v i t y of a well i n reservoir i , depends only on q^ and RR^. Notably, i t i s independent of the number of wells used to produce the r e s e r v o i r . This property of the exponential decline process permits us to vary the number of production wells over time, while s t i l l allowing the consistent aggregation of the productive c a p a b i l i t i e s of wells i n a given r e s e r v o i r . This allows us to derive representations of the r e s e r v o i r production p r o f i l e which w i l l show the ef f e c t s of varying the number of wells, but s t i l l be consistent with the chosen representa-t i o n of the rese r v o i r production process and the underlying attr i b u t e s of the r e s e r v o i r . Therefore, l e t equation (3.14) represent the number of wells used to produce r e s e r v o i r i at time t — ^ i t ' s N. = T 6.. • N • np.. N given. (3.14) i t . , i i l i t Here, N i s the exogenously given number of wells i n a platform and, as we have seen e a r l i e r i n this subsection, i s the f r a c t i o n of the number of wells i n a platform straddling reservoirs i and j which produces reservoir i . The number of platforms producing reservoirs i and j at time t i s denoted by n p ^ j t . 48 The f i r s t of four modi f icat ions to the bas ic exponential dec l ine process introduced i n th i s thes is may now be o u t l i n e d . If the number of wells used to produce r e s e r v o i r i i s allowed to vary across but not wi th in time periods (years , since the model i s annual) , the r e s e r v o i r ' s instantaneous rate of product ion at time t becomes, as in Lowenstein [1977]: q. = N. ' qT - N. • co. • Q . (3.15) i t i t l i t l i t Through th i s equation, the offshore development model brings on stream the product ion of i n d i v i d u a l platforms as soon as a given platform i s b u i l t and i n s t a l l e d , and i t s wel ls have been d r i l l e d and made a v a i l a b l e for product ion . The s tructure of Lowenstein 1 s approach is such that h i s ver s ion of equation (3.5) can not r e a d i l y be used to simulate the gradual bu i ld -up of the r e s e r v o i r ' s productive c a p a b i l i t i e s . Although using a d i f f e r e n t c h a r a c t e r i z a t i o n of the product ion process for a r e s e r v o i r or f i e l d , Ode l l and Rosing [1977a] s p e c i f i c a l l y allow the production of each platform to come on stream as the cons truct ion and re la ted a c t i v i t i e s edge towards complet ion. The approach used in th i s thes is r e l i e s on techniques s i m i l a r to those found in Lowenstein [1977] and F r a i r and Devine [1975] but uses them in a manner more c l o s e l y akin to the procedures followed i n Odel l and Rosing [1977a]: i t r e l i e s on an exponential dec l ine process but allows the productive c a p a b i l i t i e s of i n d i v i d u a l platforms to come on stream as soon as the re levant c o n s t r u c t i o n , i n s t a l l a t i o n and d r i l l i n g a c t i v i t i e s are assumed to have been completed. The second modi f i ca t ion cons is t s of p o s i t i n g the existence of annual r e s e r v o i r productive e f f i c i e n c i e s — — of less than 100 per cent: 49 q i t = e i ' ^ N i t * q i " N i t * " i * Q i J B i S i v e n - (3.16) This simple twist of the basic exponential decline process was not introduced i n any of the models reviewed i n chapter 2 above. It i s used here to r e f l e c t the fact that maintenance requirements t y p i c a l l y imply that the down time for offshore production platforms is s i g n i f i c a n t . The model accepts values for f?£ which are exogenously determined and r e f l e c t conditions peculiar to the reser v o i r or f i e l d under study. It i s easy to show that none of the key properties of the exponential decline process are affected by the introduction of th i s modification. A t h i r d modification to the basic exponential decline process posits the existence of a time period at the beginning of a reservoir's productive l i f e when i t s decline rate (and hence the decline rate of the wells which produce i t ) i s less than i t s t h e o r e t i c a l value. This can be interpreted as a simple method of capturing the consequences of the app l i c a t i o n of secondary recovery techniques on the reservoir's productive c a p a b i l i t i e s . As was argued i n chapter 2 above, most of the five models reviewed try to incorporate the e f f e c t s of secondary techniques on reserv o i r production but do not r e l y on an e x p l i c i t formulation to do so. Although four of these models e x p l i c i t l y include the concept of a reservoir or f i e l d peak production rate which is maintained for a period of time, i t i s not primarily designed to capture the e f f e c t s of secondary recovery on p r o d u c i b i l i t y . The f i f t h model, that developed by Odell and Rosing, incorporates a s i m i l a r element but applies to the productive c a p a b i l i t i e s of i n d i v i d u a l platforms as opposed to that of reservoirs of f i e l d s . By introducing an e x p l i c i t formulation to account for the consequen-ces of secondary recovery on reservoir production, the model used i n this 50 thesis o f f e r s a simple extension of the treatment afforded to secondary recovery techniques i n the models of chapter 2. However, the offshore development model f a l l s short of providing a decision rule to determine the extent to which i t i s economically feasible to apply secondary recovery techniques to i n d i v i d u a l r e s e r v o i r s . i f tg .> t >_ t ^ ; tg given; T i — 1 ; Y i 8 i v e n (3.17) •Q.t] i f t j > t > t\. Equation (3.17) distinguishes two periods in the productive l i f e of a re s e r v o i r . The f i r s t period extends from t ^ , when production gets under way, to tg. During this time, the well decline rate i s assumed to be an exogenously given f r a c t i o n — Y i — of i t s t h e o r e t i c a l rate. A second period extends from tg to tg, when the reserves contained i n the reserv o i r are to be f u l l y exhausted. During this second period, the f u l l force of decline i s assumed to be f e l t . It can be shown that the value of Y^ — the m u l t i p l i c a t i v e factor which corrects the value of the decline rate to account for the fact that the decline process was modelled to be slowed down during the f i r s t period — w i l l exceed unity and w i l l be conditional on the assumed value of Y i . The idea here i s to derive and expression for Y| which ensures that the production simulation process i s s t i l l consistent with the underlying attr i b u t e s of the reservoir and that the r e s u l t i n g extraction p r o f i l e , i n the l i m i t , exhausts the stock of recoverable reserves assumed to be i n i t i a l l y contained i n the r e s e r v o i r . * i t 3.*[N. «q. - N. *Y-*w.»Q. ] l 1 i t ^ i i t l l ^ l t J B.'JN. «q. - N. 'Y!( I L i t I i t l Y J - U K 51 The approach adopted i n this thesis i s the following. If the instantaneous rate of production of a well at the end of the f i r s t period i s treated as the i n i t i a l productive c a p a b i l i t y of a well at the beginning of the second period and i f the remaining stock of reserves at the beginning of the second period i s defined as the difference between the stock of reserves i n i t i a l l y contained i n the reservoir — RR{ — and cumulative extraction at the end of the f i r s t period — Q. i — then, the following w i l l hold:"* As argued i n the der i v a t i o n of equation (3.10) above, i t i s possible to represent the productive c a p a b i l i t i e s of a well i n a given reservoir as the flow of production from the reser v o i r — here, q ^ i — divided by the number of wells used i n production — here, N. i . Although this method i t 3 creates a d i s c o n t i n u i t y at time t ^ , the sum of the stocks of production during the two.periods w i l l nonetheless equal the stock of recoverable reserves i n i t i a l l y contained in the re s e r v o i r . In addition, i t should be clear that the key properties of the exponential decline process w i l l s t i l l hold within each of the two periods. The fourth modification to the basic exponential decline process introduced i n this thesis i s to allow the length of the time period during which the decline rate i s constrained to be less than i t s t h e o r e t i c a l value to be se n s i t i v e to the i n t e n s i t y of development. As the number of wells (and hence the number of platforms) used to produce a given reservoir increases, the model should r e f l e c t the fact that pressure maintenance i s made more d i f f i c u l t and hence that production rates are Y !( Y.)«w. = i i i /[RR - Q i ] . 1 i t 3 (3.18) 52 l i k e l y to f a l l more r a p i d l y . Although not e x p l i c i t l y addressing issues related to the e f f e c t s of secondary recovery techniques, the approaches adopted in Lowenstein [1977] and F r a i r and Devine [1975] incorporate an inverse r e l a t i o n s h i p between the peak production rate and the length of the time period for which this peak rate i s maintained. The approach used by Odell and Rosing [1977a] includes a s i m i l a r inverse r e l a t i o n s h i p . This time, however, i t i s not as well defined (nor i s i t as strong) and operates through the assumed r i s i n g interference among the areal sweeps of platforms which accompanies increases in the of platforms used to produce a reservoir or f i e l d . Equation (3.19) provides an algebraic representation of the reservoir production simulation process used in t h i s t h e s i s . At i t s core i s a basic exponential decline process which, as we have seen, has been modified in four ways. F i r s t , the number of wells used to produce a given res e r v o i r i s allowed to vary over time. Second, annual productive e f f i c i e n c i e s , though exogenous., need not equal 100 per cent. Third, the productive l i f e of the r e s e r v o i r i s divided into two periods the f i r s t of which i s marked by a decline rate constrained to be less than i t s t h e o r e t i c a l value. F i n a l l y , the length of t h i s f i r s t period i s inversely related to the number of wells used to produce the r e s e r v o i r . Thus, 0 i f t\ > t > tg B.#[N. »q. - N. *Y. *w. *Q.  ] i f t ^ N . J > t > t\ l L i t l i t l l i t J ° i t — — * (3.19) i t h.'fN. »q. - N. *Y!( Y.)* l L i t l i t l l i. *Q. I otherwise. I x i t J Equation (3.20) d e t a i l s the posited r e l a t i o n s h i p between t ^ and N^t: 53 t 3 ( N i t ) = m a X ^ [ t 2 + d l " f ' N i t ] * r ^ d l given f given (3.20) where r is the current year, d l i s the exogenously s p e c i f i e d maximum number of years for which the f i r s t period of production can extend and f is an exogenous constant which retrenches a given number of years from the length of the f i r s t period of production for each well used to produce a given r e s e r v o i r . Since the offshore development model i s designed to be solved year by year, the test i m p l i c i t i n equation (3.20) i s performed every year u n t i l the constraint i s found to be binding. After that, any a d d i t i o n a l production wells d r i l l e d into a reservoir i are assumed to decline at a rate equal to Y ' . ' O ) . . F i n a l l y , i f a l l reservoirs in a f i e l d are assumed to be non-communi-cating then t h e i r productive c a p a b i l i t i e s are independent of one another. This implies, as suggested in equation (3.21), that the instantaneous rate of production from the f i e l d simply equals the sum of the instantaneous reservoir production rates across a l l reservoirs in the f i e l d : It should be noted that equations (3.9) to (3.21) r e l a t e to instantaneous production rates, whether for i n d i v i d u a l wells, reservoirs or f i e l d s . Based on these, appendix 2 derives a number of expressions which can be used to calculate t o t a l production during time periods of given length (here, years, since the offshore development model i s annual) and which are consistent with the underlying instantaneous rates of production as represented by equations (3.9) to (3.21). As noted in appendix 2, these exact (to a constant of integration) d i s c r e t e representations of the exponential decline process are also used by the offshore development model. s q t = . \ q i t . 1=1 (3.21) 54 The model defines r e a l annual operating expenditures a t t r i b u t a b l e to res e r v o i r i at time t — 0E^ t — as a weighted sum of the relevant expenditures associated with a l l production platforms whose wells reach the reservoir i n question. The weights are again the proportion of each platform's wells which reach reservoir i : 0 i f t\ > t > t\ 0E. t s (3.22) £ 6.. • np.. • OEP otherwise, OEP given. i=l J J Equation (3.22) assumes that the r e a l annual cost ( i n t Q d o l l a r s ) of operating one production platform — OEP — does not vary across reservoirs and i s given exogenously. As was suggested in the discussion of equation (3.6) above, the determination of the optimal length of the productive l i f e of i n d i v i d u a l reservoirs requires that a l l the relevant expenditures be d i s t r i b u t e d among a l l producing reservoirs i n the f i e l d under study. Equation (3.22) embodies this p r i n c i p l e i n the determination of the l e v e l of operating expenditures a t t r i b u t a b l e to s p e c i f i c r e s e r v o i r s . Based on equation (3.5) above, i t i s possible to define the number of platforms used to produce the f i e l d at time t as follows: s s np t - [ I I .nP i U l/2 (3.23) i=l j=l since n p ^ j t represents the number of platforms with wells independently producing reservoirs i and j at time t. The d i v i s i o n by two simply ensures that no double-counting occurs when the model is used to simulate the development and production of a mult i - r e s e r v o i r f i e l d which c a l l s for a number of platforms whose wells independently produce two r e s e r v o i r s . 55 Following the lead of Odell and Rosing [1977a, e s p e c i a l l y pp.91 and 95], the offshore development model allows for the existence of economies of scale at the operating stage. Provisions have thus been made to permit the model's representation of r e a l annual operating expenditures for a f i e l d as a whole to r i s e proportionately more slowly than the number of platforms used i n production: s 0Efc = FE(np ) + I 0 E i t FE(') given. (3.24) i=l The model i s thus designed to accept the value of an exogenously defined expression — FE(np t) — which i s either zero or a decreasing function of np t and represents the extent of economies of scale at the operating stage. A value of zero for FE(np t) s i g n i f i e s that there are no economies of scale to be exploited by a multi-platform production system for a given f i e l d . Lowenstein [1977] and F r a i r and Devine [1975] impose t h i s a d d i t i o n a l r e s t r i c t i o n on the i r a n a l y sis. The fact that FE(np t) i s not rese r v o i r s p e c i f i c creates some problems when tr y i n g to determine the optimal length of the productive l i f e of i n d i v i d u a l r e s e r v o i r s . As i t was used in this thesis, the offshore development model contains a number of rules and tests which ensure that the measure of operating expenditures for a given reservoir r e f l e c t s the p o t e n t i a l l y avoidable operating expenditures undertaken by the producer at any point in time. The reader i s referred to appendix 4 for a more det a i l e d o u t l i n e of this procedure. The p a r t i c i p a t i o n of government in the revenues from offshore o i l production a c t i v i t i e s i s usually ensured by r o y a l t i e s on gross production revenues as well as through other taxes and levies which take into consideration the expenditure requirements and the revenues generated by 56 such projects. Equation (3.25) provides a general representation of net government revenues from r o y a l t i e s and taxes — G^: G t = G ( p t - t c t , q t ; CEfc , C E ^ ,. . .; 0E f c, OE^,...) (3.25) where p t i s the r e a l crude o i l price and t c t represents field-to-shore transport costs, both expressed i n t Q d o l l a r s per b a r r e l and determined exogenously. 6 Naturally, when the model is used to study the economics of developing and producing a given reservoir or f i e l d , a detai l e d descrip-t i o n of the relevant government p o l i c i e s i s substituted for th i s general expression. The task of apportioning government revenues among the reservoirs of a given f i e l d i s complicated by two c h a r a c t e r i s t i c s shared by the roya l t y and tax systems prevalent i n most j u r i s d i c t i o n s . F i r s t , a large f r a c t i o n of government revenue-raising instruments is designed to be applied against the production from i n d i v i d u a l f i e l d s (the so-called 'ring fence' approach to taxation). Second, some of the taxes apply against a measure of t o t a l revenues accruing to an economic agent i n a given j u r i s d i c t i o n . In Canada, as i n many other countries, an example of such an instrument i s the corporation income tax. For the purposes of this t h e s i s , the offshore development model includes a number of rules and tests which seek to ensure that the share of the producer's f i s c a l costs that are attributed to a given reservoir corresponds c l o s e l y to a measure of the p o t e n t i a l l y avoidable f i s c a l costs facing the producer of th i s r e s e r v o i r . As was the case with operating expenditures, the reader is referred to appendix 4 for a more detai l e d outline of these procedures. Equations (3.1) to (3.25) describe the offshore development model's representation of the development and production of a given offshore o i l f i e l d . Equation (3.26) sets out the problem which i s assumed to be solved 57 by a price-taking, net-present-value-maximizing producer: •*. max * t\ [(p -tc ).q -(CE +0E +G )] {t np,NP,h(np ),tj} NPV = I - - _ z . (3.26) 1 1 J 5 t - t i (1 + d ) t _ t ° Here, NPV represents the net present value of the f i e l d to i t s producer and d stands for the r e a l rate of time preference. Equation (3.26) i d e n t i f i e s f i v e aspects of the model's representation of development and production over which the optimization behaviour of the producer i s simulated. The f i r s t choice v a r i a b l e is t ^ , the i n i t i a l year of development for the f i e l d as a whole. The model also simulates the producer's choice of t$ , the vector of l a s t periods of production from each reservoir in the f i e l d . The remaining three aspects of development and production over which the model simulates the optimization behaviour of the producer r e l a t e to the number of platforms ultimately used to produce the f i e l d and i t s d i s t r i b u t i o n both across reservoirs and over time. Hence, NP refers to the number of platforms used to produce the f i e l d . The s by s symmetric matrix whose ( i , j ) t h element — n P i j — represents the ultimate number of platforms with wells producing reservoirs i and j i s denoted by np. F i n a l l y , the function h ( • ) , f i r s t encountered in equation (3.1), y i e l d s a schedule representing the number of years separating the f i r s t period of construction for each platform from t ^ . The following optimization procedure i s applied when the model i s used to simulate the development and production of a given f i e l d . The f i r s t step consists of assigning values to a l l variables and parameters which equations (3.1) to (3.26) i d e n t i f y as being exogenous. The second step i s then to generate an exogenous s p e c i f i c a t i o n of a development plan. This consists of a f i r s t period of development for the f i e l d as a 58 whole — t^ , a number of platforms — NP — and i t s d i s t r i b u t i o n across re s e r v o i r s — n P i j — a s well as over time — h(np^j). The model i s then solved to determine values for each element of the vector of last i 7 periods of development — t s . This procedure is repeated for d i f f e r e n t exogenous s p e c i f i c a t i o n s of the development plan. Although cumbersome, this procedure w i l l reveal the c h a r a c t e r i s t i c s of the global maximum over the fe a s i b l e set of development plans even though i t might be impossible to construct a rigorous proof of i t s existence. It w i l l also y i e l d information on the steepness of the net present value surface in i t s various dimensions. Although not emphasized in the above discussion, the model can also be used to simulate development and production using d i f f e r e n t types of production systems. This implies that the model can simulate the producer's choice over a sixth aspect of development and production; namely, the decision to use a s p e c i f i c type of production system. In the absence of r o y a l t i e s , taxes and other relevant government p o l i c i e s , equation (3.26) i s used to determine the development plan and the productive l i v e s of reservoirs which y i e l d the highest net present value of the f i e l d . Under the assumption that private and s o c i a l rates of time preference are equal, this provides a measure of the p o t e n t i a l net present value of the f i e l d to society. Given a development plan, the introduction of r o y a l t i e s and taxes creates a wedge between the net present value of the f i e l d and the net benefits of development and production which accrue to the producer. That wedge represents the share of the net present value of the f i e l d which is captured by the government. As was argued in chapter 2 above, the introduction of r o y a l t i e s and taxes implies that the p r i v a t e l y optimal 59 development plan and productive l i v e s of reservoirs may d i f f e r from those which y i e l d the pot e n t i a l net present value of the f i e l d to society. In subsequent chapters, the sum of net benefits accruing to the government and to the producer using the p r i v a t e l y optimal development plan w i l l be c a l l e d the r e a l i z e d net present value of the f i e l d . The difference between the pot e n t i a l net present value of the f i e l d to society (calculated under the assumption that G t equals zero) and i t s r e a l i z e d value w i l l provide us with a measure of the d i s s i p a t i o n of net benefits induced by government p o l i c i e s . The optimization procedure w i l l thus y i e l d q u a l i t a t i v e and quantitative information about the pot e n t i a l consequences of policy-induced d i s t o r t i o n s in the behaviour of a r a t i o n a l producer. 3.2.3 On Some Properties of the Model One of the key properties of the model derives from i t s combined use of the platform as the marginal unit of development and of a production simulation process which allows the extraction p r o f i l e to respond systematically to changes i n the number of wells (and hence the number of platforms) used to produce the reservoir or f i e l d . The end r e s u l t of such an approach, as was argued i n Lowenstein [1977] and Odell and Rosing [1977a], i s the creation of a one-to-one r e l a t i o n s h i p between development plans and production p r o f i l e s . Each exogenously s p e c i f i e d development plan i s thus associated with a unique endogenously determined production p r o f i l e . As was suggested e a r l i e r , this widens the scope offered by the model to simulate the r a t i o n a l economic behaviour of producers of offshore o i l deposits. The assumptions r e l a t i n g to the form of the decline process and the determination of c a p i t a l and operating expenditures have serious 60 implications for the properties of the offshore development model. In p a r t i c u l a r , marginal and average (per-barrel) extraction costs r i s e r a p i d l y as the number of platforms used to drain the f i e l d i s allowed to 8 increase. In addition to the assumed constant unit cost of platforms, two factors play an important role i n bringing about this r e s u l t . Since the i n s t a l l a t i o n of subsequent platforms is constrained to occur l a t e r i n the productive l i f e of the f i e l d , per-well p r o d u c t i v i t i e s are lower because of the implications of past production on the assumed exponential decline process. Given this decline process, the use of additi o n a l platforms (and thus of addit i o n a l wells) to produce the f i e l d ' s reserves also implies increases i n the decline rate of some and possibly a l l reservoirs i n the f i e l d under study. Of the five types of model reviewed i n chapter 2 above, the model used i n this thesis i s most c l o s e l y related to the Lowenstein and Odell-Rosing models. It shares with the former i t s reliance on an exponential decline process to simulate reservoir production. With the l a t t e r i t shares a gradual build-up of the productive c a p a b i l i t i e s of the f i e l d as platforms are b u i l t and i n s t a l l e d , t h e i r wells d r i l l e d and made avai l a b l e for production. In addition, i t shares with both of these models an approach which seeks to associate s p e c i f i c development plans with unique production p r o f i l e s . In a l l three models, the attrib u t e s of the deposit act as constraints on the degree of f l e x i b i l i t y available to the producer i n his choice of optimal development plans. What the present e f f o r t o f f e r s that neither the Lowenstein nor the Odell-Rosing model allows i s a clear d i s t i n c t i o n between reservoirs and f i e l d s . From an economic standpoint, this permits the d i f f e r e n t i a t i o n of the extensive (how many platforms are used for the f i e l d ) and the 61 intensive (how many platforms are used for each reservoir) margins of development. In turn, the optimization procedure can then simulate the behaviour of a r a t i o n a l producer along these two dimensions. As was suggested e a r l i e r , the offshore development model's treatment of the consequences of secondary recovery techniques also marks a simple extension of the approaches adopted by Lowenstein [1977] and Odell and Rosing [1977a]. Since the model used in this thesis requires exogenous estimates of the attr i b u t e s of each reservoir in a given f i e l d , i t s informational requirements are s l i g h t l y higher than those of the Lowenstein model. However, because of i t s r e l i a n c e on an exponential decline process and on exogenous estimates of the stock of recoverable reserves, the model used i n this thesis requires s u b s t a n t i a l l y less information about the a t t r i b u t e s of the deposit under study than does the Odell-Rosing model. There is no doubt that this comes at the cost of less g e o l o g i c a l l y precise representations of deposits and t h e i r productive c a p a b i l i t i e s but i t also allows the offshore development model to be used to study the economics of reservoirs and f i e l d s for which this type of information i s not r e a d i l y a v a i l a b l e . Given the above discussion, which margins does the approach used i n t h i s thesis tend to neglect? Two that come to mind are both related to the model's d e f i n i t i o n of a production platform. F i r s t , i t i s assumed that a l l platforms are of the same s i z e , where size is defined as the number of production wells in a platform. Second, the model treats platforms as the marginal unit of development whereas this role might be more appropriately attributed to a well. Of the fiv e models reviewed in chapter 2 above, only the platform l o c a t i o n model has been used to examine these types of issues 62 and even then, the analysis was quite limited i n scope. Two related factors argued against the development of a model which would allow the number of production wells to be determined independently of the number of platforms and which would allow d i f f e r e n t - s i z e d platforms to be used in simulating production. F i r s t , as noted in Devine and Lesso [1972, pp.B-386 and B-387], the t o t a l cost of an offshore development platform t y p i c a l l y r i s e s more slowly than does the number of wells which i t contains. Not only would this complicate the model's representation of c a p i t a l expenditure requirements for platforms, but i t would also r a i s e the informational requirements associated with modelling the development and production of s p e c i f i c f i e l d s . Second, although general in approach, the model used in this thesis was developed primarily to study a s p e c i f i c f i e l d — Hibernia. As w i l l become evident in the next two subsections, the kinds of data needed to meet these add i t i o n a l information requirements i s simply not available for Hibernia. It i s for these reasons that I have opted to assume that a l l platforms are of the same size and that the marginal unit of development is the platform. Given a l l the other constraints on the approach, proceeding in this fashion w i l l provide lower-bound estimates of the p o t e n t i a l net present value of any f i e l d to society. However, the same can not be said about the measure of d i s s i p a t i o n of net benefits used i n this t h e s i s . This r e s u l t i s due to the fact that the two magnitudes from which this measure i s derived (the p o t e n t i a l and the r e a l i z e d net present values) are both subject to the error discussed above but not n e c e s s a r i l y to the same extent. Therefore, the d i r e c t i o n of the bias i n the measure i t s e l f cannot be unambiguously determined. 63 The model can also be used in a simple examination of the v u l n e r a b i l i t y of the project to changes i n the economic environment. By undertaking a study of the s e n s i t i v i t y of the model's r e s u l t s to changes in the values taken by c e r t a i n key parameters and var i a b l e s , i t i s possible to paint a picture of the f i n a n c i a l r i s k associated with the project as well as i t s d i s t r i b u t i o n among the parties involved. Seen i n thi s l i g h t , systems of regulation and taxation acquire a new function: they are means through which government (as landlord) and industry share the f i n a n c i a l r i s k associated with given projects. It should be noted that, although i n t e r e s t i n g , such an analysis of the e f f e c t s of uncertainty i s rather l i m i t e d . The key problem is that expenditure and revenue streams and the i r d i s t r i b u t i o n associated with any p a r t i c u l a r state of the world are perceived by the model as being given. In f a c t , however, when a producer contemplates whether or not to develop a s p e c i f i c f i e l d , his decision w i l l be based on uncertain expectations about the future time p r o f i l e s of many va r i a b l e s . It would thus appear desirable to model e x p l i c i t l y the processes by which producers form expectations about many economic and geologic v a r i a b l e s . The informational requirements associated with proceeding i n this fashion are p r o h i b i t i v e . However, i t would be possible to treat only a subset of these variables as being determined by stochastic processes. Even then, a number of d i f f i c u l t issues a r i s e : which variables to choose, which p r o b a b i l i t y d i s t r i b u t i o n s to use, what form should the stochastic processes take and over which variables should they be defined. There e x i s t s , i n the petroleum industry, a 'conventional wisdom' about which variables to emphasize and which d i s t r i b u t i o n s are l i k e l y to be appropriate when modelling development and production decisions based 64 on stochastic processes. However, even though offshore petroleum development and production i s now quite common in areas l i k e the Gulf of Mexico and the North Sea, the l i k e l y scale of the Hibernia development widely exceeds anything seen i n the Gulf of Mexico and the environmental conditions on the Grand Banks of Newfoundland are even tougher than those encountered i n the North Sea. Therefore, the lack of an adequate analogue to Hibernia among producing f i e l d s severely c u r t a i l s the value of any information based on this conventional wisdom. For these reasons, I have adopted a deterministic approach to modelling the development and production of Hibernia and opted for a less ambitious analysis of the ef f e c t s of uncertainty. 3.3 Applying the Model to the Case of Hibernia 3.3.1 The Hibernia Discovery In May of 1979, under a farm-in arrangement with Mobil O i l Canada Ltd., Chevron Standard Ltd. spudded a wildcat well, Chevron et a l . Hibernia 0-15, on the Grand Banks of Newfoundland. 1 1 By the end of the year, the Canadian petroleum industry was convinced that after years of unsuccessful exploration, an important o i l f i e l d had f i n a l l y been discovered i n the Eastern Canadian offshore area. The completion of nine appraisal wells in the area held by Mobil O i l Canada Ltd. under p r o v i n c i a l and federal exploration permits has helped to delineate and assess the 12 g e o l o g i c a l l y complex Hibernia f i e l d . Situated under r e l a t i v e l y shallow waters (between 75 and 85 metres) some 310 kilometres o f f the southeastern shore of the island of Newfoundland, the structure i s believed to contain two important 1 3 multi-layered and non-communicating zones of o i l - b e a r m g sands which 65 have been lab e l l e d the Avalon and Hibernia r e s e r v o i r s . Reports also indicate that the two r e s e r v o i r s , though p a r t l y overlapping, have d i f f e r e n t reference depths with Hibernia being located deeper under the ocean floo r than is A v a l o n . 1 5 It has also been suggested that the r e l a t i v e locations of the reservoirs are l i k e l y to be such as to preclude the • 16 i n c l u s i o n of dual completion wells in any development plan. A recent paper [Handyside and Chipman 1982] studies the productive c a p a b i l i t i e s of the Hibernia f i e l d using an i n t r i c a t e r e s e r v o i r simulation model. Based on their review of the geological and petrophysical properties of the f i e l d , the authors suggest that the i n i t i a l p r o d u c t i v i t y of a well in the Avalon res e r v o i r i s l i k e l y to exceed that of a well reaching Hibernia. The paper also estimates the quantities of in-place resources to approach 4.6 b i l l i o n barrels of crude o i l ( d i s t r i b u t e d roughly one quarter-three quarters in favour of Avalon) and 6.1 t r i l l i o n 17 . . . cubic feet of natural gas. Under the assumption that the o i l i s extracted using a gas-water i n j e c t i o n scheme, Handyside and Chipman [1982, Figures 3 and 12] estimate recovery rates approaching 30 per cent for Avalon and 50 per cent for Hibernia over a thirty-year productive l i f e . Based on these estimates, the paper concludes that the stock of recoverable reserves contained in the two reservoirs would stand at approximately 1.6 b i l l i o n b a r r e l s . Hibernia i s thus well on i t s way to becoming the largest o i l f i e l d ever discovered in Canada. Its development would mark the f i r s t attempt in this country to extract crude o i l from an offshore deposit. In addition, indications are that the expected development and production costs for Hibernia are less than current world o i l prices and at least as low as those of a l l other offshore petroleum deposits so far discovered in 66 Canada. The lack of an adequate analogue to Hibernia among producing offshore f i e l d s has led to much speculation about the choice of a production system. O r i g i n a l l y , members of the operating consortium favoured a f l o a t i n g production system centered on two or three large semi-submer-s i b l e s . In the aftermath of the Ocean Ranger tragedy, however, the interested companies have been forced to give a second look to a fixed 19 • production system based on concrete gravity platforms. At the time of wr i t i n g , a clear favourite between fixed and f l o a t i n g systems had yet to emerge. In terms of field-to-shore transportation, however, a favoured mode has emerged: tankers are seen to have a d i s t i n c t advantage over pipelines for two main reasons. F i r s t , the presence of icebergs makes the b u r i a l of pipelines desirable. However, for close to two thirds of the distance separating Hibernia from Newfoundland, the ocean floor i s bedrock which there i s reportedly no known way of trenching. Furthermore, the pour point for Hibernia crude has been estimated at about 10 degrees Celsius while the average water temperature i n this area of the North A t l a n t i c hovers around zero. Under such conditions, an interrupted flow i n the pipeline - 20 could see the crude turn to gel or s o l i d within eight hours. Therefore, i n the analysis that follows i t is assumed that tankers assure the transportation of Hibernia crude from the production f a c i l i t i e s to shore. The f i e l d ' s l o cation also gives r i s e to a number of i n t e r e s t i n g issues. In Canada, some important economic powers are divided among federal and p r o v i n c i a l governments while others are shared by these two j u r i s d i c t i o n s . The d i s t r i b u t i o n of ownership and taxation r i g h t s to petroleum deposits f a l l s within these categories. This raises questions 67 concerning the source of j u r i s d i c t i o n and the d i s t r i b u t i o n of the govern-ment share of the net benefits from Hibernia. In addition, o i l revenues accruing to p r o v i n c i a l governments are subject to f i s c a l equalization i n Canada. Since Newfoundland and Labrador i s presently a net r e c i p i e n t of equalization payments, any increase in o i l revenues flowing to i t s government w i l l have repercussions on i t s r e l a t i v e p o s i t i o n within the equali z a t i o n system. Therefore, not only can government p o l i c i e s p o t e n t i a l l y a f f e c t producer behaviour but they w i l l c e r t a i n l y a f f e c t the d i s t r i b u t i o n of the government share of net benefits between Ottawa and St. John's. 21 3.3.2 A Discussion of the P r i n c i p a l Estimates and Assumptions This subsection i s concerned with the d e t a i l s necessary to t a i l o r the offshore development model to the case of Hibernia. In doing so, i t brings together estimates and assumptions concerning various aspects of the f i e l d and of i t s intended development and production which were drawn from a number of d i f f e r e n t sources. A number of estimates and assumptions have been taken from Handyside and Chipman [1982]. F i r s t , Hibernia i s assumed to consist of two non-communicating r e s e r v o i r s . Second, the larger r e s e r v o i r , designed to correspond to Avalon, i s assumed to contain two-thirds of the f i e l d ' s recoverable reserves. The remaining portion of the f i e l d ' s estimated stock of recoverable reserves i s thus assumed to be contained in the Hibernia r e s e r v o i r . Although Handyside and Chipman put the stock of reserves in the f i e l d at 1.6 b i l l i o n b a r r e l s , the analysis in this thesis w i l l sometimes be based on an assumed stock which d i f f e r s from this estimate. However, the r e l a t i v e sizes of the two reservoirs w i l l always be the same as that 68 suggested by Handyside and Chipman. Third, these authors assume that the i n i t i a l p roductivity of a well d r i l l e d i n Avalon is equal to 15 thousand barrels per day while the comparable figure for the Hibernia reservoir is assumed to be 10 22 thousand. Again, while d i f f e r e n t assumptions about the absolute magnitude of these res e r v o i r a t t r i b u t e s w i l l sometimes be made, the same r e l a t i v e p r o d u c t i v i t i e s of wells i n the two reservoirs w i l l be maintained throughout. Estimates of platform costs and operating expenditures for both fixed (concrete gravity) and f l o a t i n g (purpose-built semi-submersible) platforms were drawn from three sources: Newfoundland and Labrador Petroleum Directorate (NLPD) [1980], Wilby [1981] and NLPD [1982]. Table 3.1 presents the p r i n c i p a l cost estimates used i n this thesis as well as their d i s t r i b u t i o n over time. The investment requirements as well as the timing of c a p i t a l expenditures associated with the construction and i n s t a l l a t i o n of a two-platform fixed system were made available to me by the NLPD [1982]. Similar information for a three-platform f l o a t i n g system can be found i n NLPD [1980, p . l 4 ] . 2 1 + In both cases, to transform the expenditure estimates so that information on i n d i v i d u a l platforms was made av a i l a b l e , I have r e l i e d on the proposition, advanced in Odell and Rosing [1977a], that the unit cost of platforms i s not affected by the number of equal-sized platforms used to produce a given reservoir or f i e l d . A d r i l l i n g program i s associated with the i n s t a l l a t i o n of each production platform. A fixed platform i s assumed to have 21 s l o t s reserved for production wells. Each f l o a t i n g platform, on the other hand, i s assumed to gather the production from two clusters of wells each 69 containing seven production wells. The d r i l l i n g program for each platform i s also assumed to include provisions for a few spare wells and a number of gas r e - i n j e c t i o n and water i n j e c t i o n wells. An estimate of the l e v e l and d i s t r i b u t i o n of the c a p i t a l expenditures associated with the d r i l l i n g program of a two-platform fixed system can be found i n NLPD [1982]. Since development plans based on two fixed and three f l o a t i n g platforms are here posited to require the same number of production wells, i t has been assumed that these estimates can also be applied to a three-platform f l o a t i n g system. Again, in the s p i r i t of Odell and Rosing [1977a], I have assumed that there are no economies of scale associated with the d r i l l i n g a c t i v i t i e s for in d i v i d u a l platforms. However, proceeding i n this fashion has required a few modifications to the expenditure estimates, p a r t i c u l a r l y with reference to the timing of d r i l l i n g a c t i v i t i e s and to the fact that Avalon i s the shallower of the two r e s e r v o i r s . Consistent with the information contained in NLPD [1982], the model assumes that a five-year lag separates the f i r s t year of construction and the beginning of production from a given fixed platform. In that year, only eleven of the production wells are assumed to be in operation. The other ten wells are brought on stream the next year. To conform with the apparent conventions of the data source, i t i s assumed that productive c a p a b i l i t i e s equivalent to those of one platform can be added in any year after the f i r s t year of production from the f i e l d . As with the NLPD studies, the delay between beginning of construction and f i r s t year of production i s assumed to be four years for a f l o a t i n g platform. Again, to conform with the conventions of the data source, the model assumes that, once i n s t a l l e d , i t i s possible to bring the production 70 of an ent i re platform on stream in one year. The model o f fers three choices for the l o c a t i o n of each p lat form. It can see a l l i t s wells being used to d r a i n e i ther of the two r e s e r v o i r s or i t can s traddle both. In th is case, one h a l f of i t s wells produce each 27 . . . r e s e r v o i r . In a n t i c i p a t i o n of the existence of geographical constra ints on the pattern of development, i t i s assumed that a maximum of one s t r a d d l i n g fixed platform can be used to produce the f i e l d while two such f l o a t i n g platforms are al lowed. In i t s present form, the model does not al low for a combination of f ixed and f l o a t i n g platforms to be used to deplete the f i e l d . F i n a l l y , as suggested i n the previous subsect ion, i t has been assumed that tankers w i l l be used to transport the Hibern ia crude to shore. Therefore , i t has also been assumed that t ranspor ta t ion costs can be adequately captured by a f ixed levy on each b a r r e l of crude o i l ex trac ted . This approach was adopted in NLPD [1982] from which the estimates of transport costs have been taken. Estimates of annual operating expenditures for f ixed platforms were obtained from NLPD [1982]. Those for f l o a t i n g systems are from NLPD [1980, K l 28 p.15] . The model respects the s l i g h t degree of economies of scale associated with a two-platform fixed system that was evident in the expenditure est imates . The estimates for a f l o a t i n g system d i s p l a y a s i m i l a r feature which can be seen to be p r i m a r i l y the r e s u l t of scale economies i n ice 29 management, upkeep and the operat ion of the d i v i n g support v e s s e l . To s i m p l i f y the a n a l y s i s , i t has been assumed that the operat ion of a f l o a t i n g system gives r i s e to the same degree of economies of scale as does that of a f ixed system. It i s assumed, however, that these are 71 exhausted as soon as two fixed or three f l o a t i n g platforms are used to produce the f i e l d . In most cases, I have assumed, as do the data sources, that annual per-platform operating expenditures remain constant i n re a l terms over the entir e productive l i f e of the platform. The only exception to this occurs when production from a straddling platform continues after one of the reser v o i r s i s shut down. In such cases, the same degree of economies of scale as that described in the preceding paragraph is assumed to p r e v a i l for a l l such platforms. As was suggested i n subsection 3.3.2 above, the model assumes that the p r o d u c t i v i t y decline process i s slowed for a number of years at the beginning of the productive l i f e of each reservoir as a res u l t of gas . . . . . . 30 r e - i n j e c t i o n and water i n j e c t i o n . This concept i s made operational by assuming that the decline behaviour proceeds at a f r a c t i o n of i t s t h e o r e t i c a l value. For the purposes of this t h e s i s , i t has been assumed that this f r a c t i o n i s equal to 0.5. It i s also assumed that the use of secondary recovery techniques can slow down the decline process for a maximum of eight years for each r e s e r v o i r . The model then shaves one year from this period for each fourteen wells used to drain a given r e s e r v o i r . For example, a development plan which e n t a i l s the use of one fixed platform to produce each reservoir is assumed to have an eight-year period during which secondary recovery i s assumed to slow down the process of depletion for the f i e l d . This corresponds to the build-up and constant production periods of the 31 exogenous extraction p r o f i l e suggested i n NLPD [1982]. Once the f u l l force of decline i s assumed to govern^reservoir production, a d d i t i o n a l wells d r i l l e d into a structure are assumed not to aff e c t the form of the 72 process. F i n a l l y , i t has been argued that the presence of icebergs and pack ice in the v i c i n i t y of the production area w i l l sometime require that f l o a t i n g platforms stop production, disconnect and move to safer waters u n t i l the threat of c o l l i s i o n has subsided. This, i n conjunction with normal maintenance requirements and the rough seas of the Grand Banks area, has led some members of the operating consortium to suggest that average annual productive e f f i c i e n c i e s of some 75 per cent should be expected for a f l o a t i n g system. The same source argues that a fixed system would have better productive e f f i c i e n c i e s but f a l l s short of suggesting an 32 order of magnitude. However, concrete gravity platforms must also be maintained and the d i f f i c u l t environmental conditions are l i k e l y to a f f e c t tanker operations under either type of production system. I have therefore chosen to assume that the average annual productive e f f i c i e n c y of a fixed system i s 80 per cent. To incorporate this consideration into the analysis, one may simply assume that a given production year i s 75 or 80 per cent of a calendar year, as the case may be. During this period, each well i n a given reservoir i s treated as i f i t were producing at i t s f u l l p o t e n t i a l . For the rest of the calendar year, i t i s assumed that no production takes place. The most glaring omission i n this discussion of p r i n c i p a l estimates and assumptions has been the lack of references to the regulation and taxation p o l i c i e s assumed to p r e v a i l . The next subsection examines these and related issues. 73 3.3.3 Regulation and Taxation P o l i c i e s U n t i l recently, questions related to the exercise of rights to the Hibernia resources were the cause of a dispute between the federal government and that of Newfoundland and Labrador. Acting on the b e l i e f that i t was vested with j u r i s d i c t i o n a l r i g h t s , each l e v e l of government issued comprehensive sets of regulations purporting to control the exploration, development and production of petroleum resources on the Grand Banks. The j u r i s d i c t i o n a l dispute and the actions of the two governments provide an ideal backdrop for a comparative study of the e f f e c t s of government p o l i c i e s . By modelling the proposed sets of p o l i c i e s , the offshore development model w i l l allow us not only to compare the e f f e c t s of each royalty and taxation system on the investment de c i s i o n of the producer but also to examine each system's implications on the d i s t r i b u t i o n of Hibernia revenues between the two levels of government. The p o l i c y mix proposed by the federal government is described in the National Energy Program [Canada. Energy, Mines and Resources 1980] and i t s subsequent update [Canada. Energy, Mines and Resources 1982b], various federal budget documents [Canada. Finance 1980; 1981], the Canada O i l and Gas Act [Canada 1982] and the l e g i s l a t i o n r e l a t i n g to the taxation of corporate income. B r i e f l y , the p o l i c i e s assure Petro-Canada (or another federal Crown corporation) a substantial share of the offshore production r i g h t s and set a minimum l e v e l of Canadian ownership of these rights before the development of any given f i e l d i s allowed to proceed. On the revenue side, the government imposes the federal corporation income tax (FCIT), a basic royalty (FBR) against a l l production and a progressive incremental ro y a l t y (PIR) designed to be responsive to the cost conditions 74 f i e l d . F i n a l l y , the provisions of the petroleum and gas revenue tax (PGRT) also apply. The federal government encourages offshore a c t i v i t i e s through exploration and development incentive grants, the rates of which are affected by project locations and the degree of Canadian ownership of the players. Even i f these federal p o l i c y proposals were to p r e v a i l , the d i s t r i b u t i o n of government revenues from offshore a c t i v i t i e s between Ottawa and the producing provinces would s t i l l be undecided. Over the years, revenue-sharing systems have been agreed upon by the federal government and a number of provinces. Although Newfoundland and Labrador has never been a party to any such agreement, chapter 6 examines the p o s i t i o n that both Canada and the province would find themselves in i f the terms of the Maritime Agreement [Canada. Energy, Mines and Resources 1977] or the Nova Scotia Agreement [Canada. Energy, Mines and Resources 1982a] were applied to the d i s t r i b u t i o n of the relevant Hibernia revenues. The regulation and taxation system proposed by the government of Newfoundland and Labrador i s described in the province's Petroleum and Natural Gas Act and the associated petroleum regulations [Newfoundland and Labrador 1978]. Under the l e g i s l a t i o n approved by the House of Assembly, the province reserves a substantial share of the rights from a l l offshore production permits in favour of a Crown corporation of i t s own, the Newfoundland and Labrador Petroleum Corporation (NLPC). The p r o v i n c i a l regulations s t i p u l a t e that the NLPC may elect to exercise i t s option in the form of either a 'working' or a 'carried' i n t e r e s t . Under the provisions of the working i n t e r e s t , the NLPC e s s e n t i a l l y becomes a f u l l - f l e d g e d member of the operating consortium and as such shares proportionately i n a l l development expenditures and 75 production revenues. The NLPC opting for a carried interest would imply that i t i s not responsible for any share of the i n i t i a l c a p i t a l expenditures and must allow private p a r t i c i p a n t s to recoup th e i r investment three times before government p a r t i c i p a t i o n in net operating revenues can begin. Since their implications are l i k e l y to be d i f f e r e n t , the provisions of both options have been modelled. P r o v i n c i a l government revenues also accrue from two types of royalty: a basic royalty (NLBR) applicable at a constant rate against a l l production and a s l i d i n g scale royalty (SSR) the rate of which increases with the annual production from each f i e l d . The p r o v i n c i a l treasury would also be e l i g i b l e to receive i t s share of CIT revenues. Under the terms of the p r o v i n c i a l l e g i s l a t i o n outlined above, revenues to the federal treasury are r e s t r i c t e d to i t s share of the CIT and the provisions of the PGRT. With the exception of the CIT, a l l of these provisions impose a 'ring fence' around the a c t i v i t i e s of a given f i e l d . This simply means that expenditures incurred and income earned cannot be transferred across f i e l d s for purposes of taxation. In the case of the CIT, which i s levied on a company-by-company basis, i t i s assumed that the provisions of the l e g i s l a t i o n can always be f u l l y exploited. Therefore, in the early years of development, i t is assumed that the companies forming the operating consortium have onshore income against which they can claim a l l of t h e i r allowable offshore expenditures. A review of the regulation systems reveals a number of s i m i l a r i t i e s . For instance, a l l systems reserve the r i g h t to the l e v e l of government which enacted them to request payment of the government share of offshore revenues i n kind instead of cash and, i f the need i s demonstrated, to 76 reduce royalty payments. Furthermore, none of the systems seem to impose r e s t r i c t i o n s on the allowable production per well, reservoir or f i e l d . 3 5 However, in an e f f o r t to eliminate the problems associated with 'rule of capture' production, both sets of regulations require that every f i e l d be 36 developed and produced as a uni t . 3.3.4 Studies of the Economics of Hibernia The NLPD has undertaken a series of studies designed to evaluate the economics of the Hibernia discovery and the ef f e c t s of offshore development on the province. Two of these studies [NLPD 1980;1981] are of p a r t i c u l a r i n t e r e s t to us. The f i r s t provides an analysis of the economic v i a b i l i t y of the Hibernia f i e l d . The subsequent e f f o r t updates the f i r s t study to account for po l i c y changes by the federal government. Meanwhile, the Economic Council of Canada was busy completing a study on the economic s i t u a t i o n of Newfoundland which i t had undertaken to in 1978. When the f i n a l report was released, i t contained a chapter dealing with the e f f e c t s of offshore o i l and gas on the p r o v i n c i a l economy [Economic Council of Canada 1980, chapter 8]. Although the scope of this chapter was s u b s t a n t i a l l y broader than a study of the economic v i a b i l i t y of any p a r t i c u l a r f i e l d , the Council also published a background document which dealt s p e c i f i c a l l y with the development of Hibernia [Wilby 1981]. Based on expenditure estimates obtained from a consultant's report, the NLPD proposed a cash flow model of the development and production of Hibernia which ignored a l l considerations r e l a t i n g to field-to-shore transportation. Although concentrating on the case where the l e v e l of recoverable reserves was assumed to equal one b i l l i o n b a r r e l s , the study also examined the economic v i a b i l i t y of s i n g l e - r e s e r v o i r f i e l d s containing 77 0.5 and 1.5 b i l l i o n b a r r e l s of recoverable o i l . The p r i n c i p a l conclusions of the study are that under a l l the proposed regu la t ion and taxat ion schemes, the development of Hibern ia with a fixed production system is not p r i v a t e l y p r o f i t a b l e even i f i t i s assumed that world o i l pr ices p r e v a i l . However, when the f i e l d is assumed to be produced with a f l o a t i n g system, the project i s a marginal p r o p o s i t i o n only when the r e s u l t i n g product ion is assumed to be pr iced below world l e v e l s . Since the NLPD is p a r t i c u l a r l y interes ted in the s ize and d i s t r i b u t i o n of net revenues between the federal and p r o v i n c i a l governments, some e f f o r t was expended on examining the revenue-sharing impl i ca t ions of the proposed p o l i c i e s . The province of Newfoundland and Labrador was shown to capture a larger share of the p o t e n t i a l resource revenues under the regulat ions i t has proposed than under any of the systems advanced by the federal government, even after the e f fec t s on i t s e q u a l i z a t i o n entit lements have been taken into account. The study also concludes that the producer share of net revenues i s s i m i l a r under a l l of 37 the proposed tax regimes. The paper by Wilby [1981] is e s s e n t i a l l y a refinement and extension of the ideas advanced in the NLPD s tudies . The approach he chooses to fol low is the same as that used in these studies and the expenditure estimates are taken from the same source. Not s u r p r i s i n g l y , h i s conclusions are s i m i l a r to those reached by the NLPD. However, he finds Hibern ia to be a s l i g h t l y more a t t r a c t i v e propos i t ion from the pr ivate sec tor ' s point of view than do the e a r l i e r s tudies . Furthermore, contrary to the re su l t s of the f i r s t NLPD study, he concludes that the pr ivate p r o f i t a b i l i t y of the project i s not i n s e n s i t i v e to the system of 78 regulation and taxation assumed to be in e f f e c t . Wilby argues that these discrepancies can be explained by the fact that his work includes a more 39 accurate depiction of the various proposed tax provisions. Wilby's extension of the NLPD studies takes two p r i n c i p a l forms. F i r s t , the paper provides a short but i n s i g h t f u l discussion of the way in which the development of Hibernia w i l l a f f e c t the system of f i s c a l e q u a l i z a t i o n . Under the terms of the 1977 f e d e r a l - p r o v i n c i a l f i s c a l arrangements (which are assumed to apply for the entire length of the development and production periods), a change in the f i s c a l capacity of any one province a f f e c t s the r e l a t i v e status of the other provinces as well as that of the federal government through i t s impact on the 'national average* . However, both the discussion and the quantitative estimates presented by Wilby are limited to an analysis of the e f f e c t s on Newfoundland and Labrador's p o s i t i o n . Second, Wilby subjects his model to an analysis of the s e n s i t i v i t y of i t s r e s u l t s to changes in a number of parameters and v a r i a b l e s . Although i n t e r e s t i n g , the analysis i s constrained by the fact that the approach o f f e r s l i t t l e scope for the producer to a l t e r his development plan in the face of changes in the economic environment. There i s a simple reason for t h i s : the approach adopted by both the NLPD and Wilby i s e s s e n t i a l l y that used by Robinson and Morgan in th e i r analysis of the economics of North Sea o i l production. Subsection 2.3.2 above suggested that the r i g i d i t y of th i s approach was due in large part to i t s reliance on exogenous development plans and production p r o f i l e s . The remaining chapters of this thesis w i l l extend these economic analyses of Hibernia in three p r i n c i p a l d i r e c t i o n s . F i r s t , the approach w i l l focus more sharply on the p o t e n t i a l e f f e c t s of government p o l i c i e s on 79 producer behaviour as well as on the consequences for the d i s s i p a t i o n of net benefits from development and production. As suggested e a r l i e r , the offshore development model i s well suited to examine these types of issues since i t o f f e r s a number of channels through which government p o l i c i e s as well as the economic environment i n general can af f e c t the simulated behaviour of a r a t i o n a l producer. The analysis of chapters 4 to 6 seeks to exp l o i t these properties of the model. Second, the repercussions of the development and production of Hibernia on the national economy w i l l be examined. Chapter 7 attempts to do this by simulating the development and production of Hibernia i n conjunction with a macroeconometric model of the Canadian economy. F i n a l l y , a study of the po t e n t i a l impact of Hibernia on Newfoundland and Labrador's entitlements and on the system of f i s c a l e qualization in general should be undertaken. For instance, since the rules of the game were changed in 1982, an i n t e r e s t i n g exercise would be to compare the implications of the f i e l d ' s development and production under the assumption that the terms of the 1977 system had been extended i n d e f i n i t e l y with that r e s u l t i n g from the assumption that the provisions of the most recent system apply for the entire simulation period. Chapter 8 takes a few steps i n that d i r e c t i o n . 3.4 Incorporating an Energy-Producing Project into MACE So f a r , the discussion has shied away from an important consideration: modelling the integration of Hibernia into the national economy. Setting the development and production of an offshore o i l f i e l d in the national context requires a view of the role of energy in the Canadian economy. The MACE (for MACro and Energy) model embodies such a 80 view. Although the interested reader i s referred to H e l l i w e l l , McRae et a l . [1983] for a detailed d e s c r i p t i o n of MACE, an outline can e a s i l y be sketched. The model divides the Canadian economy into two sectors: one uses c a p i t a l and natural resources to produce energy and the other uses c a p i t a l , energy and labour to produce everything els e . The output of the energy-using sector i s thus equal to the gross domestic product at factor cost plus net energy imports. At the core of MACE i s a two-level production function, for the energy-using sector, that f i r s t sees c a p i t a l and energy bundled together in a c o n s t a n t - e l a s t i c i t y - o f - s u b s t i t u t i o n inner function which r e l i e s on a vintage approach. 4 0 'Energized c a p i t a l ' is then combined with e f f i c i e n c y units of labour i n a Cobb-Douglas outer function to produce output. A l l factor demands can then be derived c o n s i s t e n t l y and in such a way as to minimize the t o t a l costs of production. Since the rate of u t i l i z a t i o n of factors i s free to vary over the cyc l e , the parameters of the production function are either estimated through the factor demand equations or are determined by sample averages. In the l a t t e r case, the constraint that actual factor-use r a t i o s be equal, on average, to their desired values and exhibit the same trend over the 1952-1980 period of estimation i s respected. A dynamic approach to the integration of the development and production of Hibernia into the national economy suggests i t s e l f . If both models could be run simultaneously and their r e s u l t s made to be mutually consistent then, the economic environment simulated by MACE would be free to influence the r e s u l t s of the offshore reservoir development model and vic e versa. To allow for this kind of i n t e r a c t i o n , linkages must be b u i l t 81 between the two models. The required links from the offshore development model to MACE are fo u r f o l d . F i r s t , the f i e l d ' s production must be modelled to enter the Canadian energy supply picture. Due to the location of Hibernia, i t i s assumed that the extracted crude o i l w i l l be consumed east of the Ottawa Valley l i n e . Since this region presently r e l i e s on foreign sources to s a t i s f y i t s marginal demand for o i l products, bringing Hibernia on l i n e w i l l r e s u l t i n reduced Canadian imports of energy. From MACE's perspective, Hibernia production simply displaces an equivalent flow of crude o i l imports. 1* 1 Second, the productive c a p i t a l used to develop any petroleum deposit is the re s u l t of investment i n energy production. MACE w i l l thus treat the c a p i t a l expenditures associated with any Hibernia development plan as energy investment that would not otherwise have been undertaken. The simulated changes i n the f i s c a l p o s i t i o n of governments r e s u l t i n g from the development and production of Hibernia are captured by MACE at 42 . . . either of two places. The provisions of the corporation income tax are treated as giving r i s e to d i r e c t taxes on an energy-producing venture. A l l other relevant sources of government revenues and expenditures enter d i r e c t l y the equation representing the public sector balance. F i n a l l y , MACE includes a separate treatment of the o i l and gas section of the Canadian f i s c a l e qualization system. Its provisions w i l l be modified to capture the e f f e c t s of changes i n Newfoundland and Labrador's f i s c a l p o s i t i o n that would re s u l t from the development and production of Hibernia. This information on the implications of Hibernia on the equalization system can then be used i n an analysis of the d i s t r i b u t i o n of 1+3 economic rents from o i l and gas production among the d i f f e r e n t regions. 82 The required linkages from MACE to the offshore development model can e a s i l y be described. F i r s t , the Hibernia model draws the values of a number of parameters (such as the rate of economic depreciation, the after-tax opportunity cost of c a p i t a l , the rate of discount and the tax opportunity cost of c a p i t a l ) and of a number of variables from MACE. In p a r t i c u l a r , the offshore development model accepts three variables endogenous to MACE: the domestic rate of i n f l a t i o n , the price of foreign exchange and the relevant Canadian crude o i l pr i c e . This implies that a feedback mechanism has been i n s t i t u t e d : the project can aff e c t the economic environment which, i n turn, influences the economics of the project. 83 FOOTNOTES 1 This is shown in Nind [1981, chapter 2]. 2 This amounts to assuming that the rate of recovery is always below the maximum e f f i c i e n t rate (MER). For non-technical d iscuss ions of MER, see Davidson [1963, pp.92-94] and Dasgupta and Heal [1979, pp. 440-441]. However, i t i s not equivalent to assuming, as Uhler [1979, p.109] does, that pressure dynamics are such that there ex is t s a given maximum production rate associated with each r e s e r v o i r . 3 4 5 6 7 8 9 10 This issue i s further explored in appendix 2. The propert ies of the exponential dec l ine process are such that the stock of reserves i n i t i a l l y contained in a given r e s e r v o i r would, i n theory, be f u l l y exhausted only in the l i m i t , as t •*• 0 0 . Expressions represent ing cumulative product ion as well as beginning- and end-of -per iod instantaneous production rates for time periods of given lengths are derived in appendix 2. Although not apparent from equation (3 .25) , the government i s assumed to bear a tax opportunity cost on invested c a p i t a l . Once the flow of production from a given r e s e r v o i r i s stopped, the model does not al low i t to become p o s i t i v e at a l a t e r date. This property is common among models which allow for an endogenous determination of the simulated product ion p r o f i l e . See, for example, Ode l l and Rosing [1977a, e s p e c i a l l y chapter 4 ] . See, in p a r t i c u l a r , Devine and Lesso [1972] as well as F r a i r and Devine [1975]. See, for example, S u l l i v a n [1982]. 1 1 The wel l has s ince been redesignated Chevron et a l . Hibern ia P-15. In order of spudding date , the nine completed appra i sa l wel ls are: Mobil et a l . Hibernia 0-35, B-08, G-55 and G-55A, K-18, the i l l - f a t e d J -34 , 1-46, K-14 and B-27. At the time of w r i t i n g , d r i l l i n g was proceeding on another Hibern ia w e l l , C-96. Since G-55 was abandoned af ter reaching a depth of only 212 metres, i t i s usua l ly ignored i n d i scuss ions of d r i l l i n g a c t i v i t y (see Eastern Offshore News [3(1), p.3]) . 1 3 Some wells have also encountered a t h i r d zone of o i l - b e a r i n g sands which has been l a b e l l e d Jeanne d ' A r c . At the time of w r i t i n g , however, l i t t l e was known about i t s geo log ica l propert ies (see, for example, Oilweek [33(36), p .37] ) . As a r e s u l t , the analys i s ignores i t s ex is tence . 84 1 k I t should be noted that the o f f s h o r e development model i s designed to accomodate any number of r e s e r v o i r s . The f a c t that the H i b e r n i a f i e l d c o n s i s t s of on l y two r e s e r v o i r s reduces the d i m e n s i o n a l i t y of the problem but does not otherwise a f f e c t the p r o p e r t i e s of the model. 1 5 See Oilweek [32(28), pp.13-28]. 1 6 See E a s t e r n O f f s h o r e News [ 6 ( 2 ) , pp.2-3]. 17 Although Handyside and Chipman [1982, pp.5-6] a l s o document the presence of small q u a n t i t i e s of condensates, the a n a l y s i s w i l l ignore the p o s s i b i l i t y of e x t r a c t i n g these r e s o u r c e s . 18 See E a s t e r n O f f s h o r e News [ 6 ( 2 ) , pp.2-3] and Oilweek [33(14), pp.12-13]. 19 Compare, f o r example, Oilweek [31(23), pp.12-20] and LeBlanc [1980] with Oilweek [33(21), p.10]. See Oilweek [32(4), p . 4 ] . 21 Appendix 4 c o n t a i n s a t r a n s l a t i o n from machine-readable language of the o f f s h o r e development model as i t was a p p l i e d to the case of H i b e r n i a . 22 See Handyside; and Chipman [1982, Table s 3 and 5 ] . 23 . With the e x c e p t i o n of the p r o v i s i o n s f o r berms designed to p r o t e c t f i x e d p l a t f o r m s from i c e b e r g s , these e s t i m a t e s are s i m i l a r to those presented i n Wilby [1981, p.12].. 24 . . . The e s t i m a t e s used i n t h i s t h e s i s do not i n c l u d e the 30 per cent c o n t i n g e n c y allowance assumed by the NLPD (see NLPD [1980, p . 1 0 ] ) . Wilby [1981] a l s o used these e s t i m a t e s and ignored the cont i n g e n c y allowance. 25 T h i s assumption does not seem to v i o l a t e common North Sea p r a c t i c e s w i t h r e s p e c t to the use of c o n c r e t e g r a v i t y p l a t f o r m s . See K l i t z [1980, chapter 7 ], O f f s h o r e Engineer [ A p r i l 1982, pp.55-63] and World  O i l [195(3), pp.159-166]. 26 T h i s i s a common-assumption i n d i s c u s s i o n s of the p r o d u c t i o n of the H i b e r n i a f i e l d u s i n g semi-submersibles. See, f o r example, Oilweek [31(33), pp.64-66]. 27 '• • The t w e n t y - f i r s t w e l l of each f i x e d p l a t f o r m i s assumed to reach A v a l o n . 28 P l e a s e r e f e r to t a b l e 3.1. 29 Refer to NLPD [1980, p.15] and compare the l a s t two columns. It should be remembered- that the model's assumptions about the l e v e l o f r e c o v e r a b l e r e s e r v e s c o n t a i n e d i n each r e s e r v o i r .are c o n d i t i o n a l on the use of secondary r e c o v e r y t e c h n i q u e s . T h e r e f o r e , any a d d i t i o n a l r e s e r v e s that are p r o d u c i b l e only as a r e s u l t of i n j e c t i o n are a l r e a d y 85 31 32 33 34 35 36 37 38 39 40 i n c l u d e d i n the model's e s t i m a t e s . The purpose of t h i s m o d i f i c a t i o n i s s i m p l y to r e f l e c t the f a c t t h a t p r e s s u r e maintenance u s u a l l y slows the d e c l i n e p r o c e s s i n a d d i t i o n to c r e a t i n g more r e s e r v e s . I t i s , however, l o n g e r by two years than the c o r r e s p o n d i n g p e r i o d s suggested i n the NLPD s t u d i e s . T h i s r e l a t i o n s h i p a l s o h o l d s f o r a t w o - p l a t f o r m f l o a t i n g system. See W i l b y [1981, pp.8-9]. See Oilweek [31(33), pp.64-65]. Appendix 3 p r o v i d e s a more d e t a i l e d d i s c u s s i o n o f the i s s u e s s u r r o u n d i n g j u r i s d i c t i o n and the proposed government p o l i c i e s . U n f o r t u n a t e l y , some degree o f o v e r l a p between t h i s s u b s e c t i o n and the appendix i s u n a v o i d a b l e . A l l of them a l s o i n c l u d e some k i n d o f 'me f i r s t ' p r o v i s i o n s under which the producer i s e x p e c t e d , whenever p o s s i b l e , to g i v e p r e f e r e n c e to l o c a l l a b o u r and sources of s u p p l i e s . The model assumes t h a t such p r o v i s i o n s a f f e c t n e i t h e r the investment r e q u i r e m e n t s a s s o c i a t e d w i t h any development p l a n nor producer d e c i s i o n s . However, under the terms o f the r e g u l a t i o n s adopted by Newfoundland and La b r a d o r , the p r o v i n c i a l government r e s e r v e s the r i g h t to d e l a y the development and p r o d u c t i o n o f c e r t a i n f i e l d s o t h e r than H i b e r n i a . See Newfoundland and L a b r a d o r , Mines and Energy [1977, pp.35-45] and Newfoundland and Labrador [1978, pp.1007-1008]. The o f f s h o r e development model e x p l o i t s t h i s p r o v i s i o n i n the f o l l o w i n g manner. A l t h o u g h the p r o d u c t i o n r i g h t s to H i b e r n i a w i l l most l i k e l y be d i s t r i b u t e d among f i v e or s i x f i r m s , most of the a n a l y s i s assumes t h a t the o p e r a t i n g c o n s o r t i u m a c t s as a s i n g l e f i r m , r e f e r r e d to as 'the pr o d u c e r ' . However, the second study c o n c l u d e s t h a t the p r o v i s i o n s c o n t a i n e d i n the f e d e r a l government's N a t i o n a l Energy Program [Canada. Energy, Mines and Resources 1980] r e s u l t i n a g r e a t e r share of net revenues f l o w i n g to the f e d e r a l t r e a s u r y at the d e t r i m e n t o f both producer and p r o v i n c i a l c o f f e r s . The author suggests t h a t the producer share o f net revenues i s lower under the r e g u l a t i o n s proposed by the government o f Newfoundland and La b r a d o r than under any of the f e d e r a l p r o p o s a l s , i n c l u d i n g the p r o v i s i o n s c o n t a i n e d i n the N a t i o n a l Energy Program. See W i l b y [1981, pp.43-44]. See W i l b y [1981, pp.83-84]. Through i t s use of a v i n t a g e approach, MACE r e c o g n i z e s t h a t the age s t r u c t u r e of the c a p i t a l s t o c k a f f e c t s i t s energy e f f i c i e n c y . 1 + 1 I f , at any t i m e , the s i m u l a t e d l e v e l o f output from H i b e r n i a exceeds Canadian crude o i l import r e q u i r e m e n t s , MACE w i l l assume t h a t the s u r p l u s p r o d u c t i o n i s e x p o r t e d to the U n i t e d S t a t e s and p r i c e d at p r e v a i l i n g w o r l d l e v e l s . 86 In MACE, 'the government' refe r s to a l l three l e v e l s : f e d e r a l , p r o v i n c i a l and municipal. The treatment offered by MACE of the d i s t r i b u t i o n of economic rents among the regions i s based on the provisions of the equalization system, consumption for consumer rents, production for rents accruing to the p r o v i n c i a l governments and population for the Canadian share of producer rents and that accruing to the federal government. Table 3.1 Estimates of Platform Costs and Operating Expenditures PLATFORM COSTS Cost : Di s t r i b u t i o n by Year Type Location Cost 1 2 3 4 5 6 7 8 9 FIXED Avalon 3 2210 0.065 0.093 0.164 0.281 0.282 0.109 0.002 0.002 0.002 Hibernia 2430 0.059 0.085 0.149 0.268 0.295 0.138 0.002 0.002 0.002 Both 2320 0.062 0.089 0.156 0.274 0.268 0.145 0.002 0.002 0.002 FLOATING Avalon 1385 0.029 0.335 0.469 0.148 0.017 0.002 Hibernia 1475 0.026 0.316 0.465 0.176 0.015 0.002 Both 1400 0.028 0.325 0.444 0.185 0.016 0.002 OPERATING EXPENDITURES — each fixed platform: 67 m i l l i o n 1983 d o l l a r s — additional fixed charge for f i r s t platform used: 15 m i l l i o n 1983 d o l l a r s — each fl o a t i n g platform: 106 m i l l i o n 1983 do l l a r s — additional fixed charge for f i r s t platform used: 29 m i l l i o n 1983 d o l l a r s — additional fixed charge for second platform used: 23 m i l l i o n 1983 d o l l a r s These estimates have been adapted from NLPD [1980, pp.14-15;1982]. See also Wilby [1981, pp.11-12]. The t o t a l cost of one platform i s expressed i n m i l l i o n s of 1983 d o l l a r s and includes a l l expenditure requirements related to construction, i n s t a l l a t i o n and d r i l l i n g . Differences i n costs and d i s t r i b u t i o n s across locations are due to estimated differences in d r i l l i n g costs which are related to the depths of the two re s e r v o i r s . In subsequent figures and tables, any platform producing only the Avalon rese r v o i r w i l l be denoted by A. S i m i l a r l y , any platform producing only the Hibernia reservoir w i l l be denoted by H while any platform with wells reaching both reservoirs w i l l be denoted by B. Thus, for example, AB w i l l r e fer to a two-platform production system where the f i r s t platform i n s t a l l e d produces only Avalon while the second platform w i l l have wells reaching both reservoirs. Operating expenditures are expressed in annual terms. 88 CHAPTER 4 GOVERNMENT POLICIES AND THE DECISION TO DEVELOP 4.1 Introduction The key concern of this chapter i s to examine the pote n t i a l for and the consequences of d i s t o r t i o n s i n producer behaviour induced by government p o l i c i e s . After o u t l i n i n g , in section 4.2, the key assumptions upon which the analysis i s based, the remaining sections of the chapter describe and apply a two-step approach to studying the impacts of r o y a l t i e s and taxes on the development and production of Hibernia. Since one of the objectives of this thesis i s to derive quantitative estimates of the ef f e c t s of government p o l i c i e s , i t i s necessary to derive yardstick measures of the pote n t i a l net present value of Hibernia in alt e r n a t i v e states of the world. This i s the task undertaken in section 4.3 where MACE and the offshore development model outlined in chapter 3 above are used to assess the economics of the development and production of Hibernia. At this juncture, the project i s assumed to be outside the reach of government p o l i c i e s directed at developments of this kind. The models are used to i d e n t i f y , for d i f f e r e n t cases, the development plans which maximize the po t e n t i a l net present value of the f i e l d . The behaviour of a price-taking, net-present-value-maximizing producer i s probed i n section 4.4. By incorporating into the offshore development model the provisions of a number of al t e r n a t i v e p o l i c y regimes and repeating the exercise performed i n section 4.3, i t i s possible to simulate the ef f e c t s of these p o l i c i e s on producer behaviour and thus, to use the terminology introduced in the previous chapter, obtain estimates of the r e a l i z e d net present value of the f i e l d . The r e s u l t i n g d i s t r i b u t i o n 89 of net benefits between government and producer is an additional product of this experiment. F i n a l l y , section 4.5 compares the r e s u l t s of the previous two sections and measures the d i s s i p a t i o n of pote n t i a l net benefits r e s u l t i n g from the d i s t o r t i o n a r y e f f e c t s of government p o l i c i e s on producer decisions. However, save for a few exceptions, s e n s i t i v i t y analysis i s relegated to chapter 5. 4.2 The Framework of Analysis 4.2.1 Assumptions Relating to MACE For the purposes of this t h e s i s , the equations of MACE's energy-using sector are solved endogenously u n t i l 1996. 1 After that time, values for the relevant MACE variables required by the offshore development model are determined exogenously. The version of MACE used has been tuned to r e p l i c a t e h i s t o r y i n the 1974-1982 i n t e r v a l . For MACE to derive a picture of the Canadian economy over the 1983-1996 period, a few targets and rules have to be spe c i f i e d and assumptions must be made about the values of ce r t a i n Canadian, US and OECD v a r i a b l e s . Of primary importance are f i s c a l and monetary p o l i c y i n Canada, the in t e r n a t i o n a l trade and foreign exchange markets and foreign i n f l a t i o n rates, r e a l income growth and inte r e s t rates. Over the 1983-1986 period, r e a l expenditures by a l l three l e v e l s of government in Canada follow the projections of the A p r i l 1983 federal budget. In l a t e r years they are assumed to r i s e 2 per cent annually i n re a l terms. Taxation rates continue at 1982 levels modified by the provisions introduced in the A p r i l 1983 federal budget. 90 Canadian monetary p o l i c y i s assumed to be a tradeoff between interest rate and monetary growth targets. The monetary authority i s given a target growth rate of the stock of high-powered money of 8 per cent and a target (nominal) short-term interest rate derived from an estimated p o l i c y reaction function. The l a t t e r depends primarily on the l e v e l of foreign exchange reserves and the US bond rate (for which a Bank of Canada forecast of 8.4 per cent is used over the entire 1983-1996 period). Actual growth of the stock of high-powered money i s then set equal to the geometric mean of these two targets. Some of the r e s u l t i n g pressure is shifted to the foreign exchange market where a 'leaning against the wind' exchange rate determination mechanism ensures that movements in the price of foreign exhange (US currency) are cushioned by Bank of Canada intervention but always occur i n the d i r e c t i o n indicated by the balance of payments. After 1996, the price of foreign exchange is assumed to equal $Cdn 1.30 in a l l cases. Forecasts for most US and OECD variables were obtained as a re s u l t of 2 MACE's p a r t i c i p a t i o n i n a recent Energy Modeling Forum study. Between 1983 and 1986, r e a l US GNP i s thus set to grow at annual rates varying between 1 and 4 per cent. After 1986, th i s rate is assumed to equal 3 per cent. Real output i n major OECD countries (excluding Canada and the United States) is set to grow at rates which vary between 1 and 3.5 per cent in the 1983 to 1986 period. Starting in 1987, this annual rate of growth i s set at 3 per cent. The rate of increase i n the i m p l i c i t price index of US absorption varies between 3 and 6 per cent in the years up to and including 1986 and is equal to 6 per cent thereafter. A version of purchasing power pa r i t y i s assumed to be maintained i n the post-1996 period. The general rate of 91 price i n f l a t i o n i n Canada i s thus set to grow at an annual rate of 6 per cent a f t e r 1996. Although projected early on in the forecast period to vary between 7 and 9 per cent, the OECD GDP de f l a t o r is assumed to grow at the same rate as the i m p l i c i t US absorption price index i n the post-1986 period. S i m i l a r l y , the growth rate of the price of world export goods and non-energy exports s t e a d i l y declines from 9 per cent u n t i l i t reaches 6 per cent in 1987 and maintains this value u n t i l 1996. Based on exogenous forecasts of c e r t a i n world variables including the world crude o i l p r i c e , MACE endogenously derives projections of domestic energy demand as well as i t s breakdown among o i l products, natural gas and e l e c t r i c i t y . The processes of discovery and e x p l o i t a t i o n of the Western provinces' reserves of conventional o i l and gas have also been modelled. The output of the Great Canadian O i l Sands (now Suncor) and Syncrude plants completes MACE's representation of Canadian o i l and gas production. To concentrate on the role of Hibernia, i t has been assumed that neither additional o i l sands plants nor any other f r o n t i e r developments come on stream during the forecast period. Imports from OPEC are thus assumed to make up any remaining s h o r t f a l l of domestic production over demand. Canadian exports of crude petroleum to the United States are exogenous to MACE. The levels used i n the forecast period are based on past experience and are limited to heavy o i l . The drop i n world o i l prices between 1981 and 1983 combined with the continuing deregulation of natural gas prices have created what has been c a l l e d a gas 'bubble' in the United States. As a r e s u l t , Canadian exports of natural gas are currently proceeding at less than h a l f the volumes 92 approved by the National Energy Board (NEB). Furthermore, to maintain that l e v e l of sales, Canadian natural gas export prices were s u b s t a n t i a l l y reduced. The version of MACE used in this thesis has been modified to r e f l e c t these developments. In January 1983, the NEB approved addi t i o n a l exports of natural gas to the United States for the 1983 to 2000 p e r i o d . 3 It has been assumed that these entire a d d i t i o n a l volumes w i l l be exported without any change in the current p r i c i n g structure. 4.2.2 Assumptions Relating to the Offshore Development Model Since the objective of this chapter i s to look at the economics of the development decision, exploration and a l l other pre-development expenditures on Hibernia are treated as sunk costs and thus ignored in the net-present-value c a l c u l a t i o n s . However, when these expenditures represent roy a l t y and tax deductions that would only be available to the producer i f development takes place, they are linked to revenues from the project. Government grants received by the producer are treated s i m i l a r l y . Capital expenditures incurred as a r e s u l t of the simulated development of Hibernia are cumulated into a r e a l stock of c a p i t a l which is assumed to depreciate at an annual rate of 5 per cent. Within one year of the l a s t period of production from the f i e l d , any remaining portion of the c a p i t a l stock i s f u l l y depreciated. Other parameters used in the net-present-value c a l c u l a t i o n s are taken from MACE. Thus, the average r e a l ( a f t e r tax) supply price of c a p i t a l to business and the r e a l discount rate are assumed to be equal to 7 per c e n t . 4 The average r e a l annual tax return on i n d u s t r i a l c a p i t a l (the tax opportunity cost) i s assumed to equal 3 per cent. It has also been assumed that one t h i r d of the private (and Petro-93 Canada) investment i s debt-financed. Bonds are subsequently r e t i r e d over a ten-year period following the beginning of production. The economics of the development decision have been examined for three cases. Table 4.1 summarizes the i r geologic (and physical) and economic assumptions. Case 1 represents a consolidation of the currently available information on Hibernia upon which i s imposed, after 1983, a f a l l i n g r e a l world o i l p r i c e . The geologic and physical assumptions are taken from Handyside and Chipman [1982] and the expenditure levels from NLPD [1980;1982], as summarized i n table 3.1. For the purposes of this t h e s i s , case 2 i s considered the base case. It treats the reservoir size and the p r o d u c i b i l i t y assumptions made in Handyside and Chipman [1982] as overly o p t i m i s t i c and reduces them accordingly. O v e r a l l , the f i e l d i s here assumed to contain 1.2 b i l l i o n b a r r e l s of recoverable crude o i l , 25 per cent less than suggested by Handyside and Chipman. S i m i l a r l y , the i n i t i a l productive c a p a b i l i t i e s of wells reaching the two reservoirs have been reduced by 40 per cent, to 9 and 6 thousand barrels per day for Avalon and Hibernia, respectively. The warning issued i n a report on North Sea o i l production [United Kingdom. Department of Energy 1976] i s also heeded: projects with a large development content can be expected to run over budget. This problem i s exacerbated by the absence of an adequate production analogue to Hibernia among producing f i e l d s . In response, projected investment requirements are increased by 50 per cent over those of case 1. However, world o i l prices follow the same path as that assumed in case 1. Case 3 assumes that the c h a r a c t e r i s t i c s of the f i e l d are the same as in case 2, but sets i t s development and production i n an economic environment characterized by lower world o i l prices and even higher 94 c a p i t a l and operating costs. As the above descriptions reveal, case 1 embodies the most o p t i m i s t i c view of Hibernia, case 3 the most pe s s i m i s t i c , with case 2 f a l l i n g i n between. Cases 1 and 3 are designed to provide upper and lower bounds of the economic v i a b i l i t y of the f i e l d . It i s f e l t that the actual outcome of the development and production of Hibernia w i l l l i k e l y f a l l within these bounds which i n part explains the s e l e c t i o n of case 2 as the base case. As far as such comparisons are possible and f a i r , given the differences in the approaches adopted, the assumptions made in Wilby [1981] seem most sim i l a r to those of case 1. The same can be said about the assumptions made i n NLPD [1980;1981] with the exception of t h e i r provision of a 30 per cent contingency allowance on c a p i t a l expenditures, thus moving a few steps in the d i r e c t i o n of case 2. However, the world o i l price forecasts used by both Wilby and the NLPD are more favourable to the project than those of cases 1 and 2. The 1983 amendments to the 1981 Ottawa-Alberta energy agreement [Canada. Energy, Mines and Resources 1983] extended the new o i l reference price (NORP) coverage to include a l l o i l in pools discovered between 1974 and 1981. It i s thus assumed that the production from Hibernia i s e l i g i b l e to receive the NORP.5 F i n a l l y , i t should be noted that throughout the remaining sections and chapters of this t h e s i s , per-barrel revenues w i l l be measured at the wellhead and w i l l thus be net of the cost of field-to-shore transporta-t i o n . Why use such a cumbersome d e f i n i t i o n of r e a l revenues? Two reasons suggest themselves: in the relevant government documents, NORP i s defined as the price of a b a r r e l of o i l delivered at Montreal. 6 Therefore, the 95 p r i c e received by the producer at the production f a c i l i t i e s i s NORP appropriately adjusted for transport costs. Second, in the case of crude o i l , r o y a l t i e s and taxes are usually assessed against wellhead revenues with due allowance made for transport costs. For the purposes of t h i s t h e s i s , i t thus seemed more appropriate to use a measure of wellhead revenues that was adjusted for transport costs. 4.3 Development i n the Absence of Government P o l i c i e s The r e s u l t s from the optimization runs of the offshore development model in the absence of government p o l i c i e s are summarized in figures 4.1 through 4.4 and table 4.2. These r e s u l t s reveal that, in a l l three cases, i t i s possible to i d e n t i f y at least one development plan which yi e l d s a non-negative net present value for the f i e l d . However, under the assumptions of case 3, the p o t e n t i a l net present value of the f i e l d i s maximized when only the reserves contained in the Avalon reservoir are extracted. Under these conditions, the Hibernia reservoir is shown to be too c o s t l y to warrant development and production. Although differences between the two types of production systems decrease as the i n t e n s i t y of development r i s e s , the r e s u l t s also suggest that the net-present-value-maximizing development plan always involves the choice of fixed platforms. E a r l i e r studies (NLPD [1980] and Wilby [1981]) had reached the opposite conclusion. How can this difference be explained? By assuming that the f i e l d can be produced as a single r e s e r v o i r , the NLPD and Wilby reduce the importance of the constraint that avoidable costs of production at least equal expected revenues. This in e f f e c t creates a bias in favour of f l o a t i n g systems since t h e i r operating costs are larger than those of fixed systems. The model used in this 96 thesis provides a better cha r a c t e r i z a t i o n of this constraint on production since the margin of development can be i d e n t i f i e d independently for the 10 two r e s e r v o i r s . More important, however, are differences in the expenditure estimates used in the e a r l i e r studies and this one. The estimates used by both the NLPD and Wilby were based on the assumption that the i n s t a l l a t i o n of a fixed production system would require the construction of protective berms on the ocean f l o o r . Since f l o a t i n g platforms can be moved to avert the threat of a c o l l i s i o n with an iceberg, protective berms were believed unnecessary. The expenditure estimates for fixed platforms used in this thesis were taken from NLPD [1982] where no allowance i s made for the construction of protective berms. Rather, i t is believed that the kind of platforms considered for Hibernia would be s o l i d enough to withstand c o l l i s i o n s with icebergs small enough to penetrate the r e l a t i v e l y shallow waters of the northeastern Grand Banks. Under the assumptions of case 1, t h i s r e s u l t s i n a decrease of 1.5 b i l l i o n 1980 d o l l a r s i n the c a p i t a l expenditure requirements of a two-platform fixed system, and of correspondingly more i n cases 2 and 3. However, by changing conditions at the margin, the introduction of government p o l i c i e s could by i t s e l f reverse the f i x e d / f l o a t i n g ranking suggested by this model. The analysis of subsection 4.4.3 w i l l allow us to determine whether or not this i s the case. By r e f e r r i n g to the table 4.2 and figures 4.1 .to 4.4, i t i s possible to i d e n t i f y development plans which are optimal along four dimensions: fixed or f l o a t i n g system, number of platforms, their d i s t r i b u t i o n between the two re s e r v o i r s and the l a s t period of production for Avalon and 97 Hibernia. But what about the f i r s t period of a c t i v i t y for the f i e l d as a whole and for each i n d i v i d u a l platform? The model suggests that any delay i n the beginning of a c t i v i t i e s past 1985 res u l t s in a reduction of net ben e f i t s . For example, a one-year delay i n the development of the f i e l d reduces the net present value of the optimal plan for case 1 by about 1.4 b i l l i o n end-1984 d o l l a r s (9 per cent). This i s due to the fact that under the assumptions of case 1, the (real) net price of an extracted unit of the resource grows more slowly than the rate of i n t e r e s t . Optimal management of the resource would thus suggest that extraction i n the present i s more p r o f i t a b l e than i n the future, c e t e r i s paribus. As one moves from case 1 to case 3, the net e f f e c t of the changes in assumptions i s to make the (real) net price of the resource grow even more slowly over time. Any delay w i l l thus reduce present values by more in the higher-cost cases 2 and 3." The r e s u l t s for delays, longer than the minimum assumed by the model, between the i n s t a l l a t i o n of i n d i v i d u a l platforms are, when applicable, s i m i l a r i n character but smaller i n magnitude. The optimal development plans associated with cases 1 and 2 involve the i n s t a l l a t i o n of three and two fixed platforms re s p e c t i v e l y instead of the single platform of case 3. As noted e a r l i e r , p o t e n t i a l net benefits are maximized under the assumptions of case 3 when only the Avalon rese r v o i r is developed and produced. O v e r a l l , the optimal development pattern always involves more wells d r i l l e d into Avalon than into Hibernia. The assumptions r e l a t i v e to i n i t i a l productive c a p a b i l i t i e s and reserv o i r size are lar g e l y responsible for this r e s u l t . The development plans which y i e l d the highest net benefits for f l o a t i n g systems never once involved the maximum number of straddling platforms allowed by the model. Any advantage that might have been derived 98 from the i n s t a l l a t i o n of a second straddling platform were thus too small to be exploited. 4.4 Development under A l t e r n a t i v e P o l i c y Regimes 4.4.1 Introduction The objectives of this section are twofold. F i r s t , the e f f e c t s on producer behaviour of the relevant federal l e g i s l a t i o n , the Newfoundland and Labrador l e g i s l a t i o n with both 'carried' and 'working' int e r e s t s (Federal or Fed., N&L c and N&L w, r e s p e c t i v e l y , in the text and the relevant tables) are to be estimated and compared. Second, the d i s t r i b u t i o n s of net benefits between producer and government implied by the provisions of the three royalty and taxation systems w i l l be derived and contrasted. Since the focus of this chapter i s not on the d i s t r i b u t i o n of the relevant share of net benefits between federal and p r o v i n c i a l governments, I have chosen to report r e s u l t s only on the all-government share. The r e s u l t s reported in tables 4.3 to 4.5 were selected as follows. Included are the development patterns for both fixed and f l o a t i n g systems which y i e l d the highest net benefits to the producer under the provisions of the three p o l i c y regimes and the base case assumptions. The remaining entries are those in which the net present value to the producer reaches i t s highest point given a type of production system and a number of platforms. Similar tables can be constructed with the r e s u l t s for cases 1 and 3. However, these would y i e l d few additional insights and I have chosen not to include them in the text but opted instead to summarize thei r key implications i n table 4.6. The references to ' r e l i e f i n table 4.6 w i l l be explained l a t e r and, for the time being, the discussion w i l l 99 be r e s t r i c t e d to the cases prefixed by 'w/o r e l i e f , meaning 'without any form of royalty and tax r e l i e f for the producer' . Net benefits accruing to Petro-Canada are here subsumed in the producer share. Reasons for proceeding in this manner are outlined i n appendix 3. This presupposes that Petro-Canada shares in the private p a r t i c i p a n t s ' assumed objective of maximizing the present value of the net returns accruing to them. 4.4.2 Optimal Development Plans Tables 4.3 to 4.6 contain selected r e s u l t s from the optimization runs i n the presence of s p e c i f i c royalty and taxation systems. These r e s u l t s suggest that, on average, the share of net benefits which accrues to the government exceeds 70 per cent. In general, the size of this share varies within a r e l a t i v e l y narrow band although i t co n s i s t e n t l y reaches i t s 12 lowest point under the terms of the federal l e g i s l a t i o n . In a l l cases reported, however, development remains p r i v a t e l y p r o f i t a b l e i n the presence of r o y a l t i e s and taxes. The set of circumstances which comes closest to having government p o l i c i e s reverse the producer's decision to develop occurs when the provisions of the N&L c are joined to the assumptions of case 3. In this case, a small change in assumptions (e.g., a 5 per cent reduction in the size of Avalon) is s u f f i c i e n t to render development p r i v a t e l y unprofitable. So f a r , I have only discussed the p o t e n t i a l for government p o l i c i e s to reverse the producer's decision to develop. What other forms of d i s t o r t i o n can be captured by the model and how important are they? The offshore development model allows the d i s t o r t i o n a r y e f f e c t s of government p o l i c i e s to be f e l t along six dimensions. 100 F i r s t , r o y a l t i e s and taxes applied against the returns to factors of production are perceived as p o t e n t i a l l y avoidable costs of production by net-present-value-maximizing producers. Given the assumptions l i s t e d i n table 4.1, their introduction i s l i k e l y to make the e a r l i e r shutdown of a given res e r v o i r p r i v a t e l y p r o f i t a b l e , c e t e r i s paribus. This i s the most common form of d i s t o r t i o n and can be observed i n every case: the productive l i f e of Avalon and, when applicable, Hibernia i s always shortened by the introduction of the p o l i c y regimes. In general, these e f f e c t s are quite small and never exceed 2 per cent of the r e a l i z e d net present value of the f i e l d . However, the additional proportion of reserves l e f t i n the ground i s generally twice as large as that of net benefits d i s s i p a t e d . The high-grading e f f e c t s of government p o l i c i e s are thus moderated by the fact that the crude o i l l e f t in the ground would have been r e l a t i v e l y c o s t l y to extract. In the l i m i t , the above implies that government p o l i c i e s may reverse the development decision as perceived by the producer. As was suggested e a r l i e r , although tables 4.3 to 4.6 show no such occurrences, r e l a t i v e l y small changes in assumptions would be s u f f i c i e n t to reverse this r e s u l t . Second, i t i s also possible for government p o l i c i e s to reverse the producer's rankings of the two types of production systems. Although the three systems of r o y a l t i e s and taxes modelled respond non-linearly to changes in assumptions, the economics of fixed systems s t i l l dominate those of t h e i r f l o a t i n g counterparts from the perspective of both producer and society. Therefore, the introduction of government p o l i c i e s does not reverse the f i x e d / f l o a t i n g ranking derived in section 4.3 above. Third, given a type of production system, r o y a l t i e s and taxes may induce the producer to choose a number of platforms d i f f e r e n t from that 101 which maximizes the net present value of the f i e l d to society. As the res u l t s of tables 4.3 to 4.6 show, four such cases emerge. The model suggests that under the assumptions of case 1 and the terms of both versions of the Newfoundland and Labrador l e g i s l a t i o n , the producer chooses a two-fixed-platform development plan with the r e s u l t that about 5 per cent of po t e n t i a l net benefits are di s s i p a t e d . For reasons discussed i n subsection 3.2.3 above, the properties of this model are such that the simulated i n s t a l l a t i o n of a th i r d fixed platform i s accompanied by large increases i n marginal and average (per-barrel) extraction costs. Under the assumptions of case 1, these increases in costs are large enough to make the magnitude of the addit i o n a l net benefits generated by the i n s t a l l a t i o n of a t h i r d fixed platform r e l a t i v e l y small. Therefore, the consequences of government p o l i c i e s which reverse the producer's decision to i n s t a l l t his a d d i t i o n a l platform w i l l also be r e l a t i v e l y small. Under the assumptions of case 2, the incentive systems i m p l i c i t i n the N&L c and N&L w are again such that the producer chooses to i n s t a l l one fewer platform than the number which would maximize the net present value of the f i e l d to society. In these cases, however, the decision to r e l y on an A-fixed production system implies that more than 13 per cent of the p o t e n t i a l net present value of the f i e l d could be diss i p a t e d . A comparison of these two sets of government p o l i c i e s with the terms of the federal l e g i s l a t i o n reveals that the l a t t e r ' s exclusion of a s l i d i n g scale r o y a l t y and i t s lower e f f e c t i v e CIT rate (including the existence of development incentive grants) are mainly responsible for the simulated differences i n producer behaviour. Fourth, given a type of system and a number of platforms, i t i s possible to make the producer choose a d i f f e r e n t d i s t r i b u t i o n of platforms 102 than that which y i e l d s the highest net present value for the f i e l d . The r e s u l t s reported in tables 4.3 to 4.6 ind icate that the incent ive systems i m p l i c i t in the three p o l i c y regimes modelled are such that at the p r i v a t e l y optimal development p lan , the producer always chooses the d i s t r i b u t i o n of platforms which y i e l d s the highest net present value of the f i e l d to soc i e ty . F i f t h , i t may be in the producer's best in teres t s to delay development and production when faced with s p e c i f i c forms of regu la t ion and taxat ion . Results not presented in the tables showed that the in troduc t ion of the p o l i c y regimes modelled never changed the producer's choice of the year which marks the beginning of a c t i v i t i e s on the f i e l d . F i n a l l y , the producer may respond to the in t roduc t ion of government p o l i c i e s by choosing lags between the i n s t a l l a t i o n of i n d i v i d u a l platforms which are longer than the minimum lengths imposed by the model. Again , r e s u l t s not reported in the tables showed that none of the r o y a l t y and taxat ion systems modelled were such as to induce the producer to do so. A few d i f ferences in the dynamic propert ies of the three p o l i c y regimes modelled have already been noted. Are there any other d i f ferences and what are t h e i r causes? The re su l t s reported in tables 4.3 to 4.6 reveal that under the terms of the federal l e g i s l a t i o n and the N&L c, the share of net benef i t s accruing to the government tends to r i s e as the p o t e n t i a l net present value of the f i e l d f a l l s . As was suggested e a r l i e r , the consequences of th is i m p l i c i t r e l i a n c e on instruments of taxat ion which do not f u l l y respond to changes in cost and revenue condit ions could eventual ly be strong enough to render p r i v a t e l y unprof i tab le projects with p o s i t i v e net present values to soc i e ty . 103 Under the terms of the N&L w, however, the producer share of the r e a l i z e d net benefits e s s e n t i a l l y remains constant across a l l three cases. What accounts for this difference between the N&L w and the other two p o l i c y regimes modelled? As reported in appendix 3, the terms of the N&L w provide for a payment by the NLPC to private producers for i t s a c q u i s i t i o n of a 40 per cent share of the production rights to the f i e l d . The offshore development model estimates that this payment would be made in 1985 and exceed $600 m i l l i o n i n a l l three cases outlined in table 4.1 since i t s magnitude depends almost e x c l u s i v e l y on sunk costs. The other two p o l i c y systems modelled make no si m i l a r provision for a d i r e c t payment 13 by the government to private producers. The r e s u l t s thus suggest that under the N&L w, the net present value to the producer of changes in assumptions and e f f e c t i v e tax rates i s almost exactly o f f s e t by changes i n the r e l a t i v e importance of the NLPC payment. The royalty and taxation systems modelled also respond d i f f e r e n t l y to changes in the number of platforms used to produce the f i e l d . As long as increases in the i n t e n s i t y of development re s u l t in increases in the net present value of the f i e l d to society, the federal l e g i s l a t i o n seems to provide adequate incentives for the producer to i n s t a l l the additional platforms. However, the same can not be said about the provisions of both versions of the Newfoundland and Labrador l e g i s l a t i o n . As the r e s u l t s reported in tables 4.3 to 4.6 show, the terms of the N&L c and N&L w are more favourable to the producer when the number of platforms used to produce the f i e l d i s small. Two key factors account for this r e s u l t . As long as the i n s t a l l a t i o n of an add i t i o n a l platform increases the r e a l i z e d net present value of the f i e l d , the benefits conferred upon the producer by the conditions r e l a t i n g 104 to NLPC p a r t i c i p a t i o n f a l l as a proportion of t o t a l net ben e f i t s . Another factor applies more generally. The provisions for the s l i d i n g scale r o y a l t y i n both versions of the Newfoundland and Labrador l e g i s l a t i o n are such that the royalty rate r i s e s with the annual production from a given f i e l d . Increases i n the number of platforms used to produce the f i e l d r e s u l t i n higher i n i t i a l rates of production which in turn bring about proportionately greater increases i n the size of the tax burden associated with the s l i d i n g scale royalty. Under the assumptions of cases 1 and 2, these constraints on the p r i v a t e l y optimal i n t e n s i t y of development play a key role i n inducing the producer to i n s t a l l one fewer platform than the number which maximizes the net present value of the f i e l d to society. What are the consequences of extending s p e c i f i c forms of royalty and tax r e l i e f to the producer? As the r e s u l t s of table 4.6 reveal, the postponement of the producer's l i a b i l i t y to the PGRT u n t i l cumulative net operating revenues exceed cumulated c a p i t a l expenditures and the elimination of the s l i d i n g scale royalty restore the producer's incentive to i n s t a l l a t h i r d platform under the assumptions of case 1 and a second platform under the assumptions of case 2, based on the provisions of the N&L c and N&L w. Under the assumptions of a l l cases modelled and the provisions of the federal l e g i s l a t i o n , postponing the producer's l i a b i l i t y to the PGRT and allowing PGRT payments to be deductible for purposes of PIR had no e f f e c t on producer decisions. In such cases, royalty and tax r e l i e f p r i m a r i l y acts as a means by which the government transfers some of i t s revenues to the producer. 105 4.5 Summary Six decision variables were i d e n t i f i e d i n chapter 3's discussion of the offshore development model. The r e s u l t s of sections 4.3 and 4.4 above suggest that these can be broken down into two groups as to t h e i r marginal importance i n the optimization procedure. The four most important decisions have to do with the i n t e n s i t y of development, the type of production system used, the d i s t r i b u t i o n of platforms between reservoirs and the f i r s t period of development. Of less importance are the d i s t r i b u t i o n of platforms over time and the choice of the last period of production from each r e s e r v o i r . Once the f i r s t four variables are at th e i r optimal settings, the net present value of the project to society and the producer generally attained over 90 per cent of i t s maximum value. The remaining portion i s approximately evenly s p l i t between the other two v a r i a b l e s . Tearing apart further the r e s u l t s of the optimization procedure i s d i f f i c u l t . However, the three most important elements of any optimal development strategy seem to be the decision to develop Avalon before Hibernia, the choice of a fixed over a f l o a t i n g system and the decis i o n , when warranted, to use two platforms. A more detailed examination of the p o t e n t i a l for d i s t o r t i o n a r y e f f e c t s by government p o l i c i e s was also undertaken. The r e s u l t s suggest that although a l l three royalty and taxation systems were shown to have dynamic e f f e c t s on producer behaviour, th e i r introduction generally induced the d i s s i p a t i o n of less than 5 per cent of the net present value of the f i e l d . Rapidly r i s i n g marginal costs of extraction and the fact that the o i l p o t e n t i a l l y l e f t i n the ground would be c o s t l y to extract are l a r g e l y responsible for this r e s u l t . In two cases (case 2, N&L c and N&L 106 w), however, the d i s s i p a t i o n of pot e n t i a l net benefits induced by government p o l i c i e s exceeds 13 per cent. It was argued that the provisions for a s l i d i n g scale royalty and higher e f f e c t i v e CIT rates account for the differences with the incentive system i m p l i c i t in the federal l e g i s l a t i o n . The introduction of s p e c i f i c forms of royalty and tax r e l i e f was shown to reduce the d i s t o r t i o n a r y e f f e c t s of government p o l i c i e s . In some instances, however, the r e s u l t i n g increases in the net present value of the project to society were small and r e l i e f acted primarily as a means through which the government transferred some of i t s revenues to the producer. Whether these conclusions hold in the presence of departures from the base case assumptions w i l l be examined in d e t a i l i n chapter 5. 107 9 10 11 12 13 FOOTNOTES The linkages between MACE and the offshore development model are discussed in section 3.4 above. It should be noted that the energy-producing sector of MACE i s solved endogenously over the entire simulation period. For a more complete d e s c r i p t i o n of sources see H e l l i w e l l and MacGregor [1983]. See Canada, National Energy Board [1983, e s p e c i a l l y p.84]. Private and s o c i a l discount rates are assumed to be equal. The o r i g i n a l f e d e r a l - p r o v i n c i a l energy agreements (see Canada, Energy, Mines and Resources [1981]) extended the NORP coverage to a l l o i l produced from the Canada Lands. However, only o i l produced from pools situated within p r o v i n c i a l boundaries and i n i t i a l l y discovered in 1981 or l a t e r was e l i g i b l e to receive NORP. If these same conditions had applied and i f Newfoundland and Labrador were to have exercised j u r i s -d i c t i o n , Hibernia production would t e c h n i c a l l y not have been e l i g i b l e to receive NORP since the f i e l d was i n i t i a l l y discovered in 1979. See, for example, Canada, Energy, Mines and Resources [1981, p.4]. See, for example, Canada [1981, p.2679]. Unless otherwise stated, a l l re s u l t s presented in this chapter are conditional on the assumption that the development of Hibernia starts i n 1985. A more comprehensive study of the implications of delaying the beginning of a c t i v i t i e s i s relegated to chapter 5. As noted in table 3.1, in a l l the relevant figures and tables, A stands for a platform on Avalon, H for one on Hibernia and B for a platform with wells reaching both r e s e r v o i r s . In addition, i t i s not known whether the NLPD and Wilby i m p l i c i t l y used d i f f e r e n t average annual productive e f f i c i e n c i e s for fixed and f l o a t i n g systems as i s the case here; see subsection 3.3.1 above. Po t e n t i a l net benefits f a l l by about 575 m i l l i o n end-1984 d o l l a r s (11.5 per cent) in case 2 and $215 m i l l i o n (17 per cent) in case 3. It should be remembered that the producer must finance a l l c a p i t a l expenditures under the terms of the federal l e g i s l a t i o n and the N&L c. However, 40 per cent of these expenditures are financed by the NLPC under the terms of the N&L w. This i s not s t r i c t l y correct. As mentioned in appendix 3, the federal l e g i s l a t i o n does include provisions for a payment by Petro-Canada to the other int e r e s t holders as a r e s u l t of the 25 per cent back-in arrangement. The l e g i s l a t i o n also s t i p u l a t e s that such a payment is to be made only after production from the f i e l d has started. Estimates derived with the offshore development model suggest that the payment is 108 not l i k e l y to exceed $75 m i l l i o n and should occur i n 1989 or 1990 depending on whether a f l o a t i n g of a fixed production system i s chosen. However, for the purposes of this t h e s i s , Petro-Canada i s considered to be a private producer. Therefore, this payment here takes the form of a transfer among producers and as such i s not allowed to af f e c t the development d e c i s i o n . There are s i g n i f i c a n t exceptions to these general conclusions. In p a r t i c u l a r , note that the addition of a th i r d platform (when warranted) does not add much to the net present value of the project (see figure 4.1 and table 4.6). Repeated increases i n the i n t e n s i t y of development of a given reservoir can have serious repercussions on the magnitude of net benefits (check the re s u l t s for AAA i n figure 4.1). 109 Table 4.1 Some of the Assumptions Underlying Cases 1, 2 and 3 Case 1 - optimistic Case 2 - base Case 3 - pessimistic Reservoir size Avalon: 1066.0 MM barrels Avalon: 800.0 MM barrels Avalon: 800.0 MM barrels Hibernia: 533.0 MM barrels Hibernia: 400.0 MM barrels Hibernia: 400.0 MM barrels I n i t i a l per-welI productivity Avalon: 15.0 M barrels per day Hibernia: 10.0 M barrels per day Avalon: 9.0 M barrels per day Hibernia: 6.0 M barrels per day Avalon: 9.0 M barrels per day Hibernia: 6.0 M barrels per day Capital expenditures as in table 3.1 in real terms; nominal values growing at the Canadian rate of inf l a t i o n 1.5 times that in table 3.1 in real real terms; nominal values growing at the Canadian rate of i n f l a t i o n 2.0 times that in table 3.1 In real real terms; nominal values growing at the Canadian rate of Inflation Operating expenditures as in table 3.1 in real terms; nominal values growing at the Canadian rate of In fI at I on as in table 3.1 in real terms; nominal values growing at the Canadi an rate of I n fI at i on 2.0 times that in table 3.1 in real terms; nominal values growing at the Canadian rate of i n fI at Ion Oil price Nominal price of OPEC oiI (FOB Gulf) Is $US 29 from 1983 to 1986; thereafter falIIng 2 per cent annually in real terms; a l l o i l produced from f i e l d receives NORP in Montreal Nominal price of OPEC oi I (FOB Gulf) is $US 29 from 1983 to 1986; thereafter f a l I i n g 2 per cent annually in real terms; a l l o i l produced from f i e l d receives NORP in Montreal Nominal price of OPEC oiI (FOB Gulf) is $US 29 in 1983;$US 26 from 1984 to 1986; thereafter f a l l i n g 2 per cent annua 11y in real terms; a 11 oiI produced from f i e l d receives NORP in Montreal 110 FIGURE 4.1 NET PRESENT VALUE OF ALTERNATIVE HIBERNIA DEVELOPMENT PLANS IN ABSENCE OF GOVERNMENT POLICIES, BILLIONS END-84$ CASE 1. FIXED PLATFORMS PLATFORM LOCATIONS: A - AVALON H - HIBERNIA B - BOTH Legend A AAHH X AABHH • ABHH H BAH AAA NO. OF PLATFORMS I l l FIGURE 4.2 NET PRESENT VALUE OF ALTERNATIVE HIBERNIA DEVELOPMENT PLANS IN ABSENCE OF GOVERNMENT POUCIES, BILLIONS END-84$ CASE 1. FLOATING PLATFORMS oo I Q CD „ 12 U J t o UJ Q_ PLATFORM LOCATIONS: A - AVALON H - HIBERNIA B - BOTH Legend A AAAA X AAHHH • BAH B ABBHH XX AABBH X- AABHH NO. OF PLATFORMS FIGURE 4 .3 NET PRESENT VALUE OF ALTERNATIVE HIBERNIA DEVELOPMENT PLANS IN ABSENCE OF GOVERNMENT POLICIES, BILLIONS END-84$ CASE 2. FIXED PLATFORMS 3 . 5 H 2 3 NO. OF PLATFORMS PLATFORM LOCATIONS: A - AVALON H - HIBERNIA B - BOTH Legend A AAA X AHH • BAH El ABH AAHH FIGURE 4.4 NET PRESENT VALUE OF ALTERNATIVE HIBERNIA DEVELOPMENT PLANS IN ABSENCE OF GOVERNMENT POLICIES, BILLIONS END-84$ CASE 2. FLOATING PLATFORMS PLATFORM LOCATIONS: A - AVALON H - HIBERNIA B - BOTH Legend A AAA X AAHH • ABBH KI BAH ffi ABH X AABB <S> AABH -1 1 1 1 1 2 3 4 NO. OF PLATFORMS 4 .2H 4 H / I Table 4.2 Net Present Value of Al t e r n a t i v e Hibernia Development Plans in Absence of Government P o l i c i e s , b i l l i o n s end-1984 d o l l a r s Case 3. Fixed and Floating Platforms Production System 1 NPV Fixed NPV Floating Platforms Platforms A 1.26 0.40 AA -1.40 -1.09 AH -0.61 -0.48 B 1.05 -0.30 BB * -1.81 BA -0.36 -1.03 AB -0.32 -1.01 * not applicable 1 A stands for a platform on Avalon, H for one on Hibernia and B for one with wells reaching the two r e s e r v o i r s . AB d i f f e r s from BA in that for the former, the platform on Avalon is i n s t a l l e d before the one producting the two reservoirs while the opposite i s true for BA. 115 Table 4.3 Net Present Value of Alternative Hibernia Development Plans, b i l l i o n s end-1984 dollars Federal Regulations Case 2. Fixed and Floating Platforms NPV Producers NPV Governments Prod. Prod. Prod. NPV w/o PIR w PIR w/o PIR wPIRh PV Pbbl. Pbbl System Avalon Hiber. holiday holiday holiday holiday prod. 1 prod. prod FIXED 2 2 costs rev. A 90-17 * 4.27 1.36 1.47 2.92 2.80 291.49 15.31 29.96 BA 90-09 91-20 4.87 1 .66 1.69 3.21 • 3.19 444.10 19.24 30.21 AAH 90-05 92-10 3.60 0.95 same 2.65 same 513.91 23.66 30.67 AB3 90-08 92-21 4.92 1.69 1.71 3.23 3.21 444.26 19.17 30.24 FLOATING A 89-16 * 3.37 1.01. 1.11 2.36 2.26 238.89 15.92 30.02 BA 89-11 89-12 4.16 1.32 1.38 2.84 2.78 375.56 19.27 30.40 AAH 89-06 91-08 4.03 1.24 same 2.79 same 453.36 21.94 30.82 AB3 89-10 90-12 4.23 1.35 1.42 2.88 2.82 375.78 19.15 30.41 not applicable The present value of production is expressed in millions of end-1984 barrels. The production costs and revenues are expressed in end-1984 dollars per barrel. Revenues are net of field-to-shore transportation costs. Optimal producer choice given the type of production system. Table 4.4 Net Present Value of Alternative Hibernia Development Plans, b i l l i o n s end-1984 d o l l a r s Newfoundland and Labrador Regulations — " c a r r i e d i n t e r e s t " option Case 2. Fixed and Floating Platforms Prod. System FIXED Prod. Avalon Prod. Hibernia NPV NPV Producers NPV Govts. PV prod. 1 Pbbl. prod. costs 2 Pbbl. prod. rev. 2 B AB 90-32 90-07 91- 16 92- 21 4.20 4.90 0.99 0.93 3.21 3.97 307.01 442.51 15.24 19.20 28.93 30.27 A 3 90-17 * 4.27 1.05 3.22 307.01 15.24 28.93 FLOATING A BA AAH 89-16 89-10 89-06 * 89-11 91-08 3.37 4.14 4.03 0.84 0.88 0.64 2.53 3.27 3.39 238.89 372.85 453.36 15.92 19.29 21.94 30.02 30.40 30.82 AB 3 89-10 90-12 4.23 0.91 3.32 375.78 19.15 30.41 * not applicable 1 The present value of production is expressed in m i l l i o n s of end-1984 b a r r e l s . The production costs and revenues are expressed in end-1984 d o l l a r s per b a r r e l . Revenues are net of field-to-shore transportation costs. 3 Optimal producer choice given the type of production system. Table 4.5 Net Present Value of Alternative Hibernia Development Plans, b i l l i o n s end-1984 d o l l a r s Newfoundland and Labrador Regulations — "working i n t e r e s t " option Case 2. Fixed and Floating Platforms Prod. System FIXED Prod. Avalon Prod. Hiber. NPV NPV Producers NPV Govts. PV prod. 1 Pbbl prod. costs Pbbl prod. rev. B AB 90-32 90-07 91- 16 92- 21 4.20 4.90 1.08 0.98 3.12 3.92 307.01 442.51 15.24 19.20 28.93 30.27 A 3 90-17 * 4.27 1.10 3.17 291.49 15.31 29.96 FLOATING A BA AAH 89-16 89-10 89-06 * 89-11 91-08 3.37 4.15 4.03 0.92 0.94 0.71 2.45 3.21 3.31 238.89 372.85 453.36 15.92 19.29 21.94 30.02 30.40 30.82 AB 3 89-10 90-12 4.23 0.96 3.28 372.85 19.29 30.40 * not applicable 1 The present value of production is expressed i n m i l l i o n s of end-1984 b a r r e l s . The production costs and revenues are expressed in end-1984 d o l l a r s per b a r r e l . Revenues are net of field-to-shore transportation. Optimal producer choice given the type of production system. 118 Table 4.6 Optimal Producer Choices Under Various Policy Alternati ves Reg. Prod. Prod. Prod. NPV NPV NPV PV Pbbl Pbbl l System System 2 Av a 1 on Hi ber. Prods. 3 3 Govts. prod. 3 prod. prod. co s t s 5 rev. 5 No govt. ABH 90-08 92-03 15.17 * * 755.94 11.47 31.33 Fed. 6 ABH 90-07 92-02 15.16 5.60 9.57 753.49 11.44 31.56 N&L c AB 90-05 92-22 14.49 3.21 11.28 658.08 9.18 31.20 N&L w AB 90-05 92-22 14.49 3.01 11.47 658.08 9.18 31.20 2 No govt. AB 90-11 92-24 4.94 * * 448.52 19.14 30.16 w/o r e l i e f Fed. 6 AB 90-08 92-21 4.92 1.71 3.21 444.26 19.17 30.24 N&L c A 90-17 4.27 1.05 3.22 291.49 15.31 29.96 N&L w A 90-17 4.27 1.10 3.17 291.49 15.31 29.96 2 Fed. 6 AB 90-08 92-21 4.92 2.22 2.70 444.26 19.17 30.24 w relI e f N&L c AB 90-07 92-21 4.90 1.60 3.29 . 442.51 19.20 30.27 N&L w AB 90-07 92-21 4.90 1.39 3.51 442.51 19.20 30.27 3 No govt. A 90-14 * 1.26 * * 289.06 21.98 26.34 w/o relI e f Fed. A 90-12 * 1.24 0.21 1.03 286.64 22.00 26.37 N&L c A 90-12 * 1.24 0.04 1.21 286.64 22.00 26.37 N&L w A 90-12 * 1.24 0.32 0.92 286.64 22.00 26.37 3 Fed. 6 A 90-12 * 1.24 0.52 0.73 286.64 22.00 26.37 w r e l i e f N&L c A 90-12 * 1.24 0.35 0.90 286.64 22.00 26.37 N&L w A 90-12 * 1.24 0.51 0.74 286.64 22.00 26.37 * not applicable 1 The optimal production system always involves fixed platforms. 2 A stands for a platform on Avalon, H for one on Hibernia and B for a platform with wells reaching the two reservoirs. 3 A l l net present values are expressed in b i l l i o n s of end-1984 dollars. 4 The present value of production is expressed in millions of end-1984 barrels. 5 The production costs and revenues are expressed in end-1984 dollars per barrel. Revenues are net of field-to-shore transportation costs. 6 The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. 119 CHAPTER 5 SENSITIVITY ANALYSIS 5.1 Introduction The previous chapter revealed a few instances where p r i v a t e l y optimal development plans d i f f e r e d from those which maximize the net present value of the f i e l d to society. As we saw, these differences arose because the offshore development model allows the producer to respond r a t i o n a l l y to the introduction of s p e c i f i c royalty and tax regimes. The purpose of this chapter is to examine in a more systematic manner the scope for policy-induced d i s t o r t i o n s i n producer behaviour. Two approaches to testing the robustness of the r e s u l t s reported in chapter 4 have been adopted. The s e n s i t i v i t y analysis undertaken in section 5.2 consists of simulating the consequences of each a l t e r n a t i v e assumption of cases 1 and 3 while holding unchanged the other assumptions of case 2. This exercise w i l l y i e l d information on the e f f e c t s of i n d i v i d u a l changes in the assumptions as well as the endogenous responses that these trigger through the royalty and taxation regimes modelled. The implications of these changes in assumptions on the consequences of the two royalty and tax r e l i e f packages modelled w i l l also be examined. The analysis of section 5.3 departs from that undertaken so far i n th i s thesis in one c r u c i a l way. Up to this point, the analysis has always assumed that any change in conditions was known to the producer when the economics of the development decision were considered. In t h i s section, the offshore development model w i l l be used to trace the e f f e c t s of changes in the assumed attrib u t e s of the f i e l d as well as in economic 120 conditions which were not anticipated at the time the decision to proceed with development and production was taken. P a r t i c u l a r attention w i l l be paid to the consequences of government p o l i c i e s and the provisions for royalty and tax r e l i e f . Section 5.4 discusses the implications of the previous sections' r e s u l t s on the d i s t r i b u t i o n between government and producer of the f i n a n c i a l r i s k s l i k e l y to be associated with the development and production of Hibernia. 5.2 Changes i n the Base Case Assumptions Table 5.1 provides a l i s t of mnemonics and descriptions of each departure from the assumptions of case 2. The three which move the base case towards case 1 are c a l l e d 'favourable changes'. 'Adverse changes' are thus the modifications which move the base case in the d i r e c t i o n of case 3. The consequences of a one-year delay i n the i n i t i a l period of development i s also examined. The nature and impacts of the 'adverse shocks' mentioned in table 5.1 w i l l be discussed i n the next section. Tables 5.2 to 5.4 report the re s u l t s from a limited number of simulations of the offshore development model. Included i n these tables are the development plans that maximize the net present value of the f i e l d (when the project i s assumed to be outside the reach of government p o l i c i e s ) as well as those which are p r i v a t e l y optimal under the provisions of the three p o l i c y regimes modelled. The r e s u l t s of table 5.2 show that i n the absence of government p o l i c i e s , high well pr o d u c t i v i t y (HIGH PROD) increased potential net benefits the most (79 per cent), larger reservoirs (LARGER) the least (34 per cent) with lower c a p i t a l costs ( K l ) , at 55 per cent, almost exactly 121 half-way between the other two. Tables 5.3 and 5.4 reveal that higher c a p i t a l costs (K2) reduces the net present value of the f i e l d by 42 per cent and i s thus the adverse change with the most s i g n i f i c a n t impact. Two other adverse changes have si m i l a r though smaller e f f e c t s . Both higher operating costs (02) and lower o i l prices (LOWER P) reduce po t e n t i a l net benefits by s l i g h t l y more than 25 per cent. F i n a l l y , a one-year delay in the f i r s t period of development (DELAY) r e s u l t s in an 11 per cent f a l l i n the net present value of the f i e l d . Of the seven departures from the base case assumptions discussed above, only one induces a change in the number of platforms which maximizes the net present value of the f i e l d . Under the terms of K2, an A-fixed production system y i e l d s the highest p o t e n t i a l net b e n e f i t s . However, the model suggests that less than 10 per cent of the net present value of the f i e l d would be dissipated i f an AB-fixed system were used instead. A tendency f i r s t encountered in chapter 4 emerges from the results of tables 5.2 to 5.4 when the simulations include the provisions of the p o l i c y regimes modelled. Given a number of platforms, net benefits to the producer generally f a l l faster than the net present value of the f i e l d when conditions are allowed to worsen. This tendency is stronger under the terms of the federal l e g i s l a t i o n and the N&L c since the provisions for the NLPC payment operate to dampen i t s influence under the terms of the N&L w. This i m p l i c i t r e l i a n c e on instruments of taxation which do not f u l l y respond to changes in cost and revenue conditions again raises the prospects of d i s t o r t i o n s induced by government p o l i c i e s . As was suggested i n subsection 4.4.2 above, the model o f f e r s six dimensions along which 122 producers can respond to the introduction of government p o l i c i e s . Four of those are not observed in tables 5.2 to 5.4: both forms of delay, a reversal i n the f i x e d / f l o a t i n g ranking and a change in the optimal d i s t r i b u t i o n of platforms across reservoirs given a number of platforms. The most common form of d i s t o r t i o n encountered i s shutting down production prematurely in the presence of government p o l i c i e s . Although this form of producer response i s observed under a l l p o l i c y regimes modelled and for a l l departures from the base case assumptions, the r e s u l t i n g d i s s i p a t i o n of net benefits never reaches more than 2.5 per cent of the po t e n t i a l value of the f i e l d . In eleven cases, however, the model suggests that the p r i v a t e l y optimal development plans would be based on a number of platforms d i f f e r e n t from that which maximizes the net present value of the f i e l d to society. Under favourable changes in the assumptions, the policy-induced d i s s i p a t i o n of po t e n t i a l net benefits varies between 2 per cent (KI with federal, table 5.2) and more than 9 per cent (HIGH PROD with N&L c and N&L w, table 5.2). In the case of KI under the federal l e g i s l a t i o n , the investment tax c r e d i t , the a v a i l a b i l i t y of development incentive grants and the lower (than under the p r o v i n c i a l l e g i s l a t i o n ) e f f e c t i v e marginal CIT rate are s u f f i c i e n t to make the i n s t a l l a t i o n of a t h i r d fixed platform p r o f i t a b l e even i f doing so s l i g h t l y reduces the net present value of the f i e l d to society. Even though the r e a l market price of the resource i s assumed to f a l l over time, these r e s u l t s suggest that the impact of government p o l i c i e s can be strong enough to induce the producer to t i l t the f i e l d ' s output p r o f i l e towards the present to a degree exceeding that which maximizes pot e n t i a l net benefits to society. 123 It should be pointed out that, i n d i v i d u a l l y , none of the r o y a l t i e s and taxes included i n the federal l e g i s l a t i o n w i l l bring about the r e s u l t discussed above. In fact, this observation can be made about almost every case of policy-induced d i s t o r t i o n s documented in this thesis. This suggests that the consequences of i n d i v i d u a l measures are not s t r i c t l y a dditive: the e f f e c t s of p o l i c y regimes as a whole tend to d i f f e r from the sum of the impacts of each royalty or tax instrument taken on i t s own. Two factors are responsible for this r e s u l t . F i r s t , the producer's payments under the provisions of some r o y a l t i e s and taxes are deductible for the purposes of other instruments of taxation. Second, most r o y a l t i e s and taxes tend to move the p r i v a t e l y optimal so l u t i o n i n the same d i r e c t i o n . In some instances, the combined e f f e c t s of a l l forms of taxation i s strong enough to induce the producer to make a change in the development plan that would not have been p r o f i t a b l e i f the consequences of the r o y a l t i e s and taxes had been simulated i n d i v i d u a l l y . When considering issues related to the e f f i c i e n c y of resource taxation, i t i s thus important to keep in mind the dynamic i n t e r a c t i o n among royalty and tax instruments as well as i t s consequences for producer behaviour. Under KI and the terms of the N&L c and N&L w, the re s u l t s show that a r a t i o n a l producer would opt for a less intensive development pattern. Although many factors contribute to bringing about t h i s r e s u l t , the key role i s again played by the s l i d i n g scale royalty. For example, i n simulations where this form of royalty i s eliminated and the other provisions of the two versions of the Newfoundland and Labrador l e g i s l a t i o n are maintained, an AB-fixed system was shown to be p r i v a t e l y optimal. By reducing the e f f e c t i v e marginal tax rate, the elimination of the s l i d i n g scale royalty here restores the producer's incentive to adopt 124 the development plan which maximizes the net present value of the f i e l d to society. In the presence of the adverse changes considered, policy-induced d i s t o r t i o n s i n the number of platforms used to produce the f i e l d are r e l a t i v e l y more frequent and more systematic across the three p o l i c y regimes modelled. For example, although only the N&L c and N&L w d i s t o r t the producer's decision with respect to the number of platforms i n the case of DELAY (which should not be sur p r i s i n g given the re s u l t s of case 2, reported i n table 5.3), a l l three sets of p o l i c i e s induce the producer to r e l y on an A-fixed system in the presence of both 02 and LOWER P even though an AB-fixed system maximizes the net present value of the f i e l d to society (see table 5.4). Although not evident from an examination of the relevant tables, i n none of the cases considered did the a v a i l a b i l i t y of a PIR holiday under the terms of the federal l e g i s l a t i o n have an impact on producer behaviour. In general, the PIR holiday acted as a r e d i s t r i b u t i v e mechanism through which the government transferred a portion of i t s net benefits to the producer. In some cases, this aspect of the federal l e g i s l a t i o n was also i n s i g n i f i c a n t since the conditions were such that PIR payments were always zero or, at best, n e g l i g i b l e . Since the producer's l i a b i l i t y to PIR i s c l o s e l y linked to the p r o f i t a b i l i t y of i n d i v i d u a l f i e l d s , the re s u l t s reveal that the PIR holiday tends to have i t s smallest r e d i s t r i b u t i v e impacts in the presence of adverse changes in assumptions. O v e r a l l , these re s u l t s suggest that under each p o l i c y regime, the producer faces a marginal f i s c a l cost curve which l i e s above that for the average f i s c a l cost. In some cases, therefore, i t i s in the producer's best in t e r e s t (although not necessarily that of society) to adopt a less 125 intensive development plan and face a lower average tax rate. What are the consequences of the two royalty and tax r e l i e f packages described i n chapter 4 above? As tables 5.2 to 5.4 show, these two r e l i e f packages transfer, on average, approximately 10 per cent of the po t e n t i a l net benefits from the government to the producer under the provisions of the federal l e g i s l a t i o n and the N&L c. In the cases considered, the average size of this transfer f a l l s to about 5 per cent under the N&L w because of the NLPC's assumed p a r t i c i p a t i o n as a f u l l equity partner i n the project (and i t s treatment as a source of government revenues). The r e s u l t s of tables 5.3 and 5.4 also show that, in the face of s p e c i f i c adverse changes in base case assumptions, these two royalty and tax r e l i e f packages restore the producer's incentive to adopt more intensive development plans i n seven of eight cases where this was deemed desirable from society's perspective. In the remaining case (02 under the N&L w, table 5.4), the a v a i l a b i l i t y of the form of r e l i e f modelled i s not s u f f i c i e n t to induce the producer to adopt the more intensive development plan which maximizes the net present value of the f i e l d to society. In this case, the policy-induced d i s s i p a t i o n of po t e n t i a l net benefits remains at s l i g h t l y less than 5 per cent. The r e s u l t s of table 5.2 show that the r e l i e f package modelled restores the producer's incentive to i n s t a l l an AB-fixed production system in the case of HIGH PROD, under the N&L c and N&L w. Predictably, the lower marginal and average tax rates r e s u l t i n g from the a v a i l a b i l i t y of royalty and tax r e l i e f do not curb the producer's desire to r e l y on an AAH-fixed system under the federal l e g i s l a t i o n and in the presence of K l . Table 5.2 also reveals a d i f f e r e n t kind of r e s u l t . In the presence of Kl and under the provisions of the N&L c, the r e l i e f package modelled 126 induces the producer to i n s t a l l three fixed production platforms. Since net benefits to society are maximized by an AB-fixed system, the r e s u l t s suggest that approximately 3 per cent of the po t e n t i a l net present value of the f i e l d would be dissipated i f an AAH-fixed system were used instead. Here, riot only did the a v a i l a b i l i t y of r e l i e f r e s u l t i n the transfer of a share of government revenues to the producer but i t also affected producer behaviour in a way which reduced Hibernia"s po t e n t i a l net benefits to society. F i n a l l y , i n eleven of the cases considered, the s p e c i f i c forms of roy a l t y and tax r e l i e f modelled have no e f f e c t on producer behaviour and thus act primarily as mechanisms of r e d i s t r i b u t i o n . 1 5.3 Adverse Shocks Up to this point, the analysis has been based on the assumption that the time paths of a l l relevant variables and parameters were known by the producer at the time the economics of the development decision were simulated. In this section, I t r y to relax this assumption and introduce some events which, though unexpected at the time the decision to develop was taken, are allowed to a f f e c t the economics of the f i e l d . The consequences of two shocks are examined: the discovery that the two r e s e r v o i r s are smaller and less productive than o r i g i n a l l y anticipated (SMALL/LOW) and a sudden f a l l i n world o i l prices (P DROPS). Table 5.1 contains more detai l e d descriptions of these two adverse shocks. When a shock occurs, the past a c t i v i t i e s of the producer are taken as given. However, i t i s assumed that in the aftermath of the shock, the producer can a l t e r c e r t a i n aspects of the development plan i f i t i s in his best i n t e r e s t s to do so. The model allows these responses to take two 127 forms. F i r s t , the producer may choose d i f f e r e n t f i n a l periods of production for both reservoirs given a type of production system, an i n t e n s i t y of development and platform d i s t r i b u t i o n s (over time and across r e s e r v o i r s ) . In addition, the producer may opt for a d i f f e r e n t i n t e n s i t y of development for a given type of production system. The introduction of government p o l i c i e s w i l l again create a wedge between returns to the producer and those to society. Consequently, responses which are in the producer's s e l f - i n t e r e s t may reduce po t e n t i a l net benefits to society. To r e f l e c t l i k e l y constraints on the speed of producer response, i t i s assumed that even though a l l shocks are simulated to occur in 1988, changes i n the development plan are f i r s t possible only i n 1989. Results from the relevant simulations of the offshore development model are reported in table 5.5 where '(B)' s i g n i f i e s that the construction and i n s t a l l a t i o n a c t i v i t i e s related to the second platform were assumed to stop in 1989. In such cases, the model allowed (when appropriate) a l l expenditures undertaken prior to the termination of a c t i v i t i e s on the second platform to be claimed against the revenues from the f i e l d for purposes of taxation. Although the two shocks have serious repercussions, the r e s u l t s suggest that there i s l i t t l e scope for r a t i o n a l changes in producer behaviour to a f f e c t the magnitude of p o t e n t i a l net be n e f i t s . Under a l l the sets of circumstances reported in table 5.5 and given the assumed i r r e v e r s i b l e nature of a c t i v i t i e s undertaken p r i o r to 1989, more than 95 per cent of the maximum net present value of the f i e l d to both producer and society i s reached without any change in simulated producer behaviour. While i t i s never in anybody's best interests to adjust the number of platforms, changes in the length of the productive l i v e s of both ' 128 res e r v o i r s do increase net benefits accruing to producer and society. However, the gains are less than 5 per cent. The lumpiness of the investment program i s the p r i n c i p a l factor behind this r e s u l t . Once again, the dynamic properties of the po l i c y regimes modelled are shown to be such that, when conditions are allowed to worsen, net benefits accruing to the producer tend to f a l l at a faster rate than does the net present value of the f i e l d to society. For the two adverse shocks simulated, this tendency has i t s strongest e f f e c t for P DROPS (table 5.5) under the terms of the federal l e g i s l a t i o n . In th i s case the best outcome available to the producer involves a p o s i t i o n of net private loss. The introduction of royalty and tax r e l i e f (assumed announced p r i o r to the start of construction a c t i v i t i e s ) operates to redress this imbalance and allows the producer to r e a l i z e a normal return on his investment. Another i n t e r e s t i n g r e s u l t emerges from table 5.5. As shown e a r l i e r , when development and production are simulated under the base case assumptions, an AB-fixed system y i e l d s the highest net present value of the f i e l d to society. In addition, the producer would choose this same development plan under the terms of the federal l e g i s l a t i o n . The same did not apply, however, under the N&L c and N&L w. Under the base case assumptions and the terms of both versions of the Newfoundland and Labrador l e g i s l a t i o n , the re s u l t s suggest that a r a t i o n a l producer would opt for an A-fixed production system and, as a r e s u l t , an estimated 13 per cent of po t e n t i a l net benefits to society would be di s s i p a t e d . However, the consequences of the two adverse shocks considered are such that a single fixed platform on Avalon y i e l d s a higher net present value to society and the producer (even in the presence of the three p o l i c y regimes modelled) than does an AB-fixed system. The re s u l t s of 129 table 5.5 show that for this conclusion to hold, i t i s necessary for the construction and i n s t a l l a t i o n a c t i v i t i e s related to the second platform not to have been undertaken p r i o r to the occurrence of either adverse shock. When this i s the case, the fact that, ex ante, the terms of the N&L c and N&L w d i s t o r t the producer's choice of development plan turns out, ex post, to create a s i t u a t i o n which is preferred by both producer and society. Since the royalty and tax r e l i e f program modelled to apply under the N&L c and N&L w provides the incentives for a r a t i o n a l producer to adopt an AB-fixed production system under the base case assumptions, i t s introduction precludes the emergence of the re s u l t discussed in the previous paragraph. By the time either of the unanticipated shocks occurs, the size and i r r e v e r s i b l e nature of the investment on the second platform undertaken prior to 1989 i s s u f f i c i e n t to make an AB-fixed development desirable from the producer's, as well as society's, perspective. These r e s u l t s draw attention to the l i m i t a t i o n s inherent in any analysis of the consequences of uncertainty which i s cast i n terms of cer t a i n t y equivalents. Keeping i n mind the reservations expressed i n chapter 3 above, Monte Carlo techniques could be used to shed more l i g h t on these issues. A more i n t e r e s t i n g approach, however, would be to recognize e x p l i c i t l y the time- and activity-dependent nature of the uncertainty. For example, i t could take into consideration the fact that uncertainty about the a t t r i b u t e s of a deposit can be reduced by investing i n development a c t i v i t i e s . Such a model would then treat the producer as a r a t i o n a l economic agent who must make decisions with less than complete information but who also r e a l i z e s that, as time goes on and development and production 130 a c t i v i t i e s proceed, he learns more about the attr i b u t e s of the f i e l d and the general economic climate. Not only would i t then be possible for the producer to a l t e r his plans as more information becomes available but he could also take into account the time- and activity-dependent nature of the uncertainty when f i r s t considering the economics of development and production, whether in the presence of government p o l i c i e s or not. An approach similar to the one described in the previous paragraph i s used in a s t y l i z e d model developed in Weitzman [1979] and l a t e r extended i n Roberts and Weitzman [1981]. Modifying this approach to make i t numerically tractable would l i k e l y y i e l d valuable insights into the economics of large-scale projects such as the development and production of Hibernia. However, in this thesis, I have opted for a simpler treatment of the consequences of uncertainty in favour of a broader examination of the impacts of Hibernia on the economy as a whole, and on revenue sharing and f i s c a l equalization, i n p a r t i c u l a r . 5.4 Conclusion What are the implications in terms of the e f f i c i e n c y of resource taxation of changes in assumptions i n the presence of s p e c i f i c royalty and taxation systems? As was suggested i n chapter 4 above, a l l three systems modelled include instruments of taxation which do not f u l l y respond to changes i n cost and revenue conditions. As a r e s u l t , net benefits to the producer tend to f a l l faster than the net present value of the f i e l d when conditions are allowed to worsen, thereby creating the po t e n t i a l for d i s t o r t i o n a r y e f f e c t s by government p o l i c i e s . Results from section 5.2 above also suggest that, in some circumstances, the presence of government p o l i c i e s r e s u l t s i n p r i v a t e l y optimal development plans which are more 131 intensive than those maximizing potential net benefits to society. In a l l cases considered, however, the d i s s i p a t i o n of p o t e n t i a l net benefits induced by government p o l i c i e s never exceeds 15 per cent. Differences in the dynamic properties of the three p o l i c y regimes modelled also emerge from the r e s u l t s of the experiments undertaken in t h i s chapter. In general, as the assumed i n t e n s i t y of development increases, the marginal e f f e c t i v e tax rate i m p l i c i t i n the N&L c and N&L w tends to r i s e faster than that embodied in the federal l e g i s l a t i o n . In some cases, this tendency was strong enough that the provisions of the N&L c and N&L w would d i s t o r t the producer's decision concerning the number of platforms to use in producing Hibernia while the terms of the federal l e g i s l a t i o n would not do so. However, in other cases, the marginal e f f e c t i v e tax rate incorporated in the federal l e g i s l a t i o n would not r i s e fast enough to render p r i v a t e l y unprofitable the construction and i n s t a l l a t i o n of an additional platform even though i t would reduce pot e n t i a l net benefits to society. At low i n t e n s i t i e s of development, the producer's net revenue p o s i t i o n was s l i g h t l y better insulated against changes in assumptions under the terms of both versions of the Newfoundland and Labrador l e g i s l a t i o n . The existence and design of the conditions r e l a t i n g to the NLPC p a r t i c i p a t i o n in the revenues from the f i e l d , and the absence of comparable provisions in the federal l e g i s l a t i o n , are l a r g e l y responsible for this r e s u l t . What are the consequences of the s p e c i f i c royalty and tax r e l i e f packages modelled? In general, these forms of r e l i e f restore the set of producer incentives necessary to bring about the i n s t a l l a t i o n of the number of platforms which maximizes the net present value of the f i e l d to 132 society. In the few cases where this r e s u l t did not obtain, the d i s s i p a t i o n of p o t e n t i a l net benefits was r e l a t i v e l y small but the p o s s i b i l i t y that the introduction of royalty and tax r e l i e f could, by i t s e l f , induce the producer to choose a development plan based on too many platforms could not be discarded. However, in a large number of cases, the s p e c i f i c forms of r e l i e f modelled had no e f f e c t on producer behaviour and thus acted e x c l u s i v e l y as mechanisms of r e d i s t r i b u t i o n , t r a n s f e r r i n g a share of the net benefits from the government to the producer. An issue which has not been explored i n this thesis i s the p o s s i b i l i t y that the introduction of government p o l i c i e s could also induce delays in the f i r s t period of development. Examples coming to mind involve the p o l i c y regimes' provisions for the completion of environmental impact 3 studies preceding the approval of any development plan. The r e s u l t s for DELAY (table 5.3) suggest that the policy-induced d i s s i p a t i o n of p o t e n t i a l net benefits would increase but that the dynamic properties of the royalty and taxation systems modelled would otherwise be unaffected. What have the l a s t two chapters told us about the d i s t r i b u t i o n of the f i n a n c i a l r i s k s associated with the development and production of Hibernia? Simply put, the tendency to tax returns to factors of production inherent in a l l three r o y a l t y and taxation systems modelled implies that downside r i s k s tend to be more heavily borne by the producer than by the government. To say that governments are unaware of this c r i t i c i s m would be u n f a i r . It i s probably with similar thoughts i n mind that the authors of the p o l i c y systems modelled included provisions such as the NLPC payment under the N&L w, the expenditure-related period of exemption from NLPC p a r t i c i p a t i o n under the N&L c and the PIR provisions under the federal 133 l e g i s l a t i o n . However, the analysis of this chapter and the previous one has shown that the dynamic implications of these provisions may prove i n s u f f i c i e n t , under c e r t a i n circumstances, to provide an appropriate balance when s p e c i f i c royalty and tax systems are considered as a whole. This also provides a clue as to why the forms of royalty and tax r e l i e f modelled generally encourage more intensive development when coupled with adverse changes in the base case assumptions. Both r e l i e f packages reduced or eliminated producer l i a b i l i t y to r o y a l t i e s on gross production revenues and made another tax instrument more responsive to re a l development costs. Under such circumstances, a greater proportion of the f i n a n c i a l r i s k s associated with development and production i s borne by the government. A good example of the consequences of this i m p l i c i t r e d i s t r i b u t i o n of r i s k can be found i n table 5.5. As the e f f e c t s of P DROPS r i p p l e through the model, i t becomes apparent that the producer's best strategy under the terms of the federal l e g i s l a t i o n i s simply to continue producing both reservoirs knowing that he w i l l r e g i s t e r a net loss on the a c t i v i t y as a whole. When r e l i e f is a v a i l a b l e , however, the consequences of the unexpected adverse shock are more equally shared between government and producer. As a r e s u l t , i t is again possible for the l a t t e r to r e a l i z e at least a normal return on his investment. As some of the r e s u l t s i n table 5.5 suggest, i t i s important to remember that such an analysis of f i n a n c i a l r i s k and i t s d i s t r i b u t i o n i s limited by the deterministic nature of the offshore development model. An i n t e r e s t i n g way of overcoming some of these l i m i t a t i o n s would be to recast the model in such a way that i t s p e c i f i c a l l y took into consideration the addit i o n a l knowledge acquired by the producer as time and development and production a c t i v i t i e s proceeded. Although such an extension was not undertaken as part of this t h e s i s , i t i s c l e a r l y worthy of consideration. 134 FOOTNOTES 1 See table 5.2: KI (Fed. and N&L w), LARGER ( a l l three), HIGH PROD (Fed.); table 5.3: DELAY (Fed.) and table 5.4: 02 (N&L w), K2 ( a l l three). The removal of this one-year lag does not q u a l i t a t i v e l y a f f e c t any of the r e s u l t s presented i n this section. 3 See Canada [1981, pp.2967 and 2700-2701] and Newfoundland and Labrador [1978, pp.989-993]. Table 5.1 Changes to Base Case Assumptions Mnemonic Description Favourable Changes Kl r e a l c a p i t a l expenditures are as in table 3.1 LARGER reser v o i r sizes are: Avalon: 1066.7 MM barrels Hibernia: 533.3 MM barrels HIGH i n i t i a l per-well p r o d u c t i v i t i e s are: PROD Avalon: 15.0 M barrels per day Hibernia: 10.0 M barrels per day Adverse Changes DELAY development starts one year l a t e r , i . e . , 1986 02 r e a l (annual) operating expenditures are twice the levels shown i n table 3.1 K2 r e a l c a p i t a l expenditures are twice the le v e l s shown i n table 3.1 LOWER P nominal OPEC price of crude o i l i s $US 26 (FOB Gulf) from 1984 to 1986; thereafter f a l l i n g 2 per cent annually i n re a l terms Adverse Shocks SMALL/LOW as development d r i l l i n g progresses i t i s re a l i z e d that the reservoir sizes are: Avalon: 666.7 MM barrels Hibernia: 333.3 MM bar r e l s and that the i n i t i a l per-well p r o d u c t i v i t i e s are Avalon: 7.5 M barrels per day Hibernia: 5.0 M barrels per day P DROPS late i n 1988, the nominal OPEC price of crud o i l (FOB Gulf) f a l l s by 25% 136 Table 5.2 Optimal Producer Choices for Hibernia Development Consequences of Favourable Changes in Assumptions Reg. System Prod. System1 Prod. Av a 1 on Prod. Hiber. NPV2 NPV Prods. 2 NPV Govts. 2 PV prod. 3 Pbbl prod. u costs Pbbl prod. rev. KI No govt. <T A 6 Fed. AB5 90-10 92-25 7.64 * » 448.74 13.78 30.81 w/o relIe f AAH 90-05 92-10 7.46 2.73 4.73 513.91 16.81 31.33 N&L c AB 90-07 92-21 7.60 1.77 5.83 442.51 13.77 30.93 N&L w AB 90-07 92-21 7.60 1.69 5.90 442.51 13.77 30.93 w r e l i e f Fed. 6 AAH 90-05 92-10 7.46 3.29 4.17 513.91 16.81 31.33 N&L c AAH 90-04 92-10 7.43 2.39 4.04 511.54 16.82 31.35 N&L w AB 90-07 92-21 7.60 2.02 5.58 442.51 13.77 30.93 LARGER No govt. Fed. 6 AB 90-18 92-31 6.60 # * 517.43 16.80 29.55 w/o re 1i ef AB 90-13 92-27 6.57 2.26 4.31 51 1.90 16.84 29.67 N&L c AB 90-13 92-27 6.57 1.31 5.25 511.90 16.84 29.67 N&L w AB 90-13 92-27 6.57 1.34 5.23 51 1.90 16.84 29.67 w r e l i e f r A 6 Fed. AB 90-13 92-27 6.57 2.90 3.67 51 1.90 16.84 29.67 - N&L c AB 90-13 92-27 6.57 2.02 4.55 511.90 16.84 29.67 N&L w AB 90-13 92-27 6.57 1 .78 4.79 51 1.90 16.84 29.67 HIGH PROD No govt. C A 6 Fed. AB 90-01 92-17 8.86 » * 554.69 15.03 31 .00 w/o r e l i e f AB 90-01 92-15 8.85 3.42 5.43 552.39 15.02 31.03 N&L c B 90-23 91-11 8.05 1.99 6.06 424.60 10.90 29.86 N&L w B 90-23 91-11 8.05 1.92 6.13 424.60 10.90 29.86 w rel ief C A & Fed. AB 90-01 92-15 8.85 3.98 4.87 552.39 15.02 31.03 N&L c AB 90-00 92-15 8.81 2.88 5.93 549.84 15.03 31.05 N&L w AB 90-00 92-15 8.81 2.34 6.47 549.84 15.03 31.05 * not applicable 1 The optimal production system always involves fixed platforms. 2 A l l net present values are expressed in b i l l i o n s of end-1984 dollars. 3 The present value of production is expressed in millions of end-1984 barrels. 4 The production costs and revenues are expressed in end-1984 dollars per barrel. Revenues are net of field-to-shore transportation costs. A represents a platform on Avalon, H one on Hibernia and B one with wells reaching the two reservoirs. The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. Table 5.3 Optimal Producer Choices for Hibernia Development CASE 2 and DELAY Reg. Prod. i Prod. Prod. NPV2 NPV NPV PV Pbbl Pbbl System System Avalon Hiber. Prods. Govts. prod. 3 prod. prod costs'* rev. CASE 2 No AB 90-11 92-24 4.94 * * 448.52 19.14 30.16 govt. w/o r e l i e f Fed. AB 90-08 92-21 4.92 1.71 3.21 444.26 19.17 30.24 N&L c A 90-17 * 4.27 1.05 3.22 291.49 15.31 29.96 N&L w A 90-17 * 4.27 1.10 3.17 291.49 15.31 29.96 w r e l i e f Fed. 5 AB 90-08 92-21 4.92 2.22 2.70 444.26 19.17 30.24 N&L c AB 90-07 92-21 4.90 1.60 3.29 442.51 19.20 30.27 N&L w AB 90-07 92-21 4.90 1.39 3.51 442.51 19.20 30.27 DELAY No AB 90-12 92-25 4.36 * * 418.20 19.19 29.62 govt. w/o r e l i e f Fed. AB 90-09 92-21 4.34 1.48 2.86 413.90 19.23 29.72 N&L c A 90-18 * 3.82 0.93 2.90 271.79 15.35 29.41 N&L w A 90-18 * 3.82 1.00 2.82 271.79 15.35 29.41 w r e l i e f Fed. 5 AB 90-09 92-21 4.34 1.95 2.39 413.90 19.23 29.72 N&L c AB 90-08 92-21 4.32 1.40 2.92 412.60 19.26 29.74 N&L w AB 90-08 92-21 4.32 1.24 3.08 412.60 19.26 29.74 * not applicable The optimal production system always involves fixed platforms. A l l net present values are expressed in b i l l i o n s of end-1984 d o l l a r s . The present value of production is expressed in m i l l i o n s of end-1984 b a r r e l s . The production costs and revenues are expressed in end-1984 d o l l a r s per b a r r e l . Revenues are net of field-to-shore transportation costs. The d i s t r i b u t i o n of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. to 138 Table 5.4 Optimal Producer Choices for Hibernia Development Consequences of 02, K2 and LOWER P Reg. Prod. Prod. Prod. NPV2 NPV NPV PV Pbbl Pbbl System System1 Av a 1 on Hiber. Prods. 2 Govts. 2 prod. 3 prod. prod. costs' 4 rev. 02 No AB5 90-07 92-15 3.63 » * 439.52 22.09 30.35 govt. w/o r e l i e f Fed. 6 A 90-11 * 3.47 1.15 2.32 285.10 18.00 30.17 N&L c A 90-11 * 3.47 0.79 2.67 285.10 18.00 30.17 N&L w A 90-11 * 3.47 0.88 2.59 285.10 18.00 30.17 w r e l i e f Fed. 6 AB 90-05 92-12 3.59 1.53 2.06 432.02 22.16 30.48 N&L c AB 90-04 92-11 3.55 1.13 2.42 427.48 22.24 30.55 N&L w A 90-11 * 3.47 1.03 2.44 285.10 18.00 30.17 K2 No A 90-19 * 2.86 * * 292.57 19.48 29.25 govt. w/o r e l i e f Fed. 6 A 90-17 * 2.85 0.94 1.91 291.49 19.49 29.29 N&L c A 90-17 * 2.85 0.59 2.27 291.49 19.49 29.29 N&L w A 90-17 * 2.85 0.73 2.12 291.49 19.49 29.29 w r e l i e f U A 6 Fed. A 90-17 * 2.85 1.30 1.56 291.49 19.49 29.29 N&L c A 90-17 * 2.85 0.92 1.94 291.49 19.49 29.29 N&L w A 90-17 * 2.85 0.93 1.93 291.49 19.49 29.29 LOWER P No AB 90-10 92-23 3.65 * * 447.38 18.93 27.08 govt. w/o r e l i e f Fed. 6 A 90-16 * 3.42 1 .17 2.25 290.81 15.14 26.90 N&L c A 90-16 * 3.42 0.82 2.60 290.81 15.14 26.90 N&L w A 90-16 * 3.42 0.91 2.51 290.81 15.14 26.90 w r e l i e f Fed. 6 AB 90-08 92-20 3.63 1.65 1.98 443.90 18.96 27.14 N&L c AB 90-07 92-20 3.61 1.21 2.40 442.15 18.99 27.16 N&L w AB 90-07 92-20 3.61 1 .09 2.53 442.15 18.99 27.16 not appl1 cable The optimal production system always involves fixed platforms. A l l net present values are expressed in b i l l i o n s of end-1984 do l l a r s . The present value of production is expressed in millions of end-1984 barrels. The production costs and revenues are expressed in end-1984 dollars per barrel. Revenues are net of field-to-shore transportation costs. A represents a platform on Avalon, H one on Hibernia and B one with wells reaching both reservoirs. The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. 139 Table 5.5 Net Present Value of Alternative Hibernia Development Plans Consequences of Adverse Shocks Fixed PI atforms Reg. Prod. Prod. Prod. NPV3 NPV NPV PV Pbbl Pbbl System System Avalon Hiber. Prods. 1 Govts. 1 prod. 2 prod. prod. costs 3 rev. 3 SMALL/LOW No AB 90-10 92-21 2.69 * * 372.32 22.99 30.21 govt. A(B) 90-18 * 0.83 # * 243.40 26.53 29.94 w/o r e l i e f Fed.1* AB 90-08 92-19 2.68 0.74 1.93 369.59 23.03 30.28 N&L c A 90-16 • 2.81 0.64 2.17 242.35 18.38 29.99 N&L w A 90-16 * 2.81 0.77 2.05 242.35 18.38 29.99 w r e l i e f Fed. AB 90-08 92-19 2.68 1.22 1.45 369.59 23.03 30.28 N&L c AB 90-06 92-18 2.64 0.89 1.75 365.91 23.13 30.35 N&L w AB 90-06 92-18 2.64 0.85 1.79 365.91 23.13 30.35 P DROPS No AB 90-09 92-20 1.51 * * 445.30 19.19 22.57 govt. A(B) 90-17 * 0.07 » • 291.49 22.14 22.39 w/o re 1 i ef Fed. 4 AB 90-07 92-17 1.49 -0.12 1.61 440.77 19.26 22.64 N&L c A 90-15 * 2.06 0.42 V.64 290.01 15.34 22.43 N&L w A 90-15 * 2.06 0.59 1.47 290.01 15.34 22.43 w re 1i ef Fed.1* AB 90-07 92-17 1.49 0.71 0.78 440.77 19.26 22.64 N&L c AB 90-06 92-17 1 .47 0.49 0.98 438.57 19.31 22.66 N&L w AB 90-06 92-17 1.47 0.58 0.89 438.57 19.31 22.66 not applicable A l l net present values are expressed in b i l l i o n s of end-1984 dollar s . The present value of production is expressed in millions of end-1984 barrels. The production costs and revenues are expressed in end-1984 dollars per barrel. Revenues are net of field-to-shore transportation costs. The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. 140 CHAPTER 6 THE INCIDENCE AND DISTRIBUTION OF ECONOMIC RENTS FROM HIBERNIA 6.1 Introduction While chapters 4 and 5 were primarily concerned with questions r e l a t i n g to the e f f i c i e n c y of resource taxation, the key concerns of t h i s chapter are d i s t r i b u t i o n a l issues. When considering the p o t e n t i a l consequences of Hibernia, such issues f a l l into two categories: the d i s t r i b u t i o n of the all-government share of net revenues and the breakdown of the producer's net returns from the f i e l d between Canadian and foreign shareholders of the companies assumed to form the operating consortium. 1 Since the main focus of the study is here shifted towards d i s t r i b u t i o n a l questions, i t seems appropriate to use a measure of net benefits which takes into consideration a l l the a c t i v i t i e s necessary to bring Hibernia on stream. Economic rents from Hibernia are thus defined as returns to development and production a c t i v i t i e s net of exploration and other pre-development costs, operating costs, economic depreciation, and an after-tax r e n t a l charge as well as a tax opportunity cost on unamortized c a p i t a l . The only difference between a measure of economic rents so defined and the measure of net benefits used in chapters 4 and 5 i s the fact that the former includes exploration and other pre-development costs while the l a t t e r does not. Therefore, for the purposes of t h i s chapter, the offshore development model has been modified to r e f l e c t the e f f e c t s of expenditures on exploration and other pre-development a c t i v i t i e s . In addition, contrary to the analysis of the two previous chapters, these expenditures are now allowed as sources of producer subsidies and deductions from the various r o y a l t i e s and taxes to the 141 maximum extent allowed by the l e g i s l a t i v e provisions. Section 6.2 uses this modified version of the offshore development model i n conjunction with MACE and the provisions of the revenue-sharing 2 . systems discussed in appendix 3 and summarized i n table A3.1 to examine the d i s t r i b u t i o n of the pote n t i a l stock of economic rents i n Hibernia among the many players involved. The eff e c t s of s p e c i f i c forms of royalty and tax r e l i e f are also studied. Conclusions are outlined i n section 6.3. E f f o r t s are also made to compare the d i s t r i b u t i o n of the pote n t i a l rents from the development and production of Hibernia with that p r e v a i l i n g in the Western sedimentary basin. 6.2 Base Case Assumptions and Adverse Changes Estimates of the relevant pre-development expenditure levels are taken from NLPD [1982] and the d e t a i l s r e l a t i n g to participants i n the exploration program from Wilby [1981, pp.92-95]. Although development and production are assumed to proceed under the provisions of the three regulation and taxation systems, pre-development a c t i v i t i e s are modelled 3 to coincide with the events that have occurred since 1979. A comparison of figure 6.1 and table 4.6 reveals that under the base case assumptions, exploration and other pre-development expenditures increase the costs of the project by about 875 m i l l i o n end-1984 d o l l a r s , about 23 per cent of which is borne by producers and the rest by governments. When seen as a whole, the processes of exploration, development and production of the Hibernia f i e l d are thus estimated to y i e l d about 4.1 b i l l i o n end-1984 d o l l a r s i n economic rents, under the assumptions of case 2. 142 Figure 6.1 shows that, under the terms of the federal l e g i s l a t i o n , producers could capture as much as 37 per cent (1.5 b i l l i o n end-1984 d o l l a r s ) of these potential rents. The share accruing to governments would equal about 62 per cent ($2.5 b i l l i o n ) while less than 1 per cent of the rents could be dissipated as a r e s u l t of policy-induced d i s t o r t i o n s in producer behaviour. Under the terms of the N&L c, the r e s u l t s suggest that an A-fixed system would be p r i v a t e l y optimal and thus that s l i g h t l y more than 16 per cent ($0.7 b i l l i o n ) of p o t e n t i a l rents could be d i s s i p a t e d . The share of po t e n t i a l rents captured by producers f a l l s to 21 per cent ($0.9 b i l l i o n ) while the remaining part (62 per cent or $2.5 b i l l i o n ) accrues to governments. The d i s t r i b u t i o n of p o t e n t i a l rents under the N&L w i s s i m i l a r to that p r e v a i l i n g under the N&L c. The same amount of p o t e n t i a l economic rents stands to be dissipated while producers could capture approximately 1 per cent more of these potential rents, at the expense of governments. Reasons behind these differences across p o l i c y regimes were discussed in chapters 4 and 5 above, and w i l l not be repeated here. What can we say about the s p l i t between Canadian and foreign shareholders of what previous chapters have c a l l e d 'the producer'? Under the provisions of the federal l e g i s l a t i o n (see F MAR and F NSA in figure 6.1), s l i g h t l y less than 60 per cent of the producer's share of the economic rents generated by the project flow to Canadian shareholders, about 85 per cent of which is a t t r i b u t a b l e to Petro-Canada. The share accruing to Canadian shareholders is estimated to f a l l to s l i g h t l y less than 29 per cent under the N&L c and reaches i t s lowest point at 27 per cent under the N&L w. 143 D i f f e r e n t treatments extended to the NLPC and Petro-Canada account for most of the observed differences between the re s u l t s that obtain under both versions of the Newfoundland and Labrador l e g i s l a t i o n compared to that under i t s federal counterpart. It should be remembered that Petro-Canada i s here treated as a Canadian-owned producer while the NLPC is seen as an instrument of revenue-generation for i t s parent government.1* How do governments fare? Comparisons across p o l i c y regimes of the positions of federal and p r o v i n c i a l governments are complicated by the fact that d i f f e r e n t development plans are p r i v a t e l y optimal under the two versions of the Newfoundland and Labrador l e g i s l a t i o n , and under the provisions of the federal l e g i s l a t i o n . Keeping this in mind, a look at figure 6.15 reveals that net benefits (from the project as a whole) to Newfoundland and Labrador are estimated to reach their highest l e v e l (about 3.6 b i l l i o n end-1984 d o l l a r s ) under the terms of the federal l e g i s l a t i o n coupled with the provisions of the Nova Scotia Agreement (F NSA). The terms of the N&L w are estimated to y i e l d approximately $1.4 b i l l i o n less to the p r o v i n c i a l treasury. The t h i r d highest p r o v i n c i a l take ($1.9 b i l l i o n ) comes about under the terms of the N&L c while the federal l e g i s l a t i o n coupled with the terms of the Maritime Agreement (F MAR) yi e l d s about $1.4 b i l l i o n to the government of Newfoundland and Labrador. Not s u r p r i s i n g l y , the federal government does best under the terms of the F MAR (about 1.3 b i l l i o n end-1984 d o l l a r s ) . None of the other three revenue-sharing systems leaves Ottawa with as much as 60 per cent of the rents accruing to i t under the F MAR. At approximately $0.7 b i l l i o n , the N&L c i s estimated to of f e r Ottawa i t s second highest take under the base case assumptions. The r e s u l t s suggest that about $0.4 b i l l i o n would accrue to the federal government under the N&L w. F i n a l l y , under the terms of the 144 F NSA, the federal treasury is estimated to o f f e r a net subsidy of about $0.9 b i l l i o n to the development and production of Hibernia. This l a s t r e s u l t comes about because, early i n the l i f e of the project, Ottawa subsidizes development a c t i v i t i e s in a number of ways. PIP and development incentive grants, and the investment tax c r e d i t are the most important sources of federal subsidies. After production has started, the terms of the F NSA are such that the federal government receives only a share of the CIT revenues. Obviously, the use of a p o s i t i v e rate of discount increases the r e l a t i v e importance of the former over the l a t t e r . O v e r a l l , the r e s u l t s suggest that the e f f e c t s of the subsidies on the federal p o s i t i o n dominate those of the revenues. How would these estimates change i f an AB-fixed production system were p r i v a t e l y optimal under the base case assumptions and the provisions of the N&L c and N&L w? To concentrate on the apparent dominance, from the province's net revenue perspective, of the F NSA over the two versions of the Newfoundland and Labrador l e g i s l a t i o n , l e t us assume that the federal government agrees to make a payment to producers which would be s u f f i c i e n t to induce the l a t t e r to use and AB-fixed system under the N&L c and N&L w. In both cases, a payment of approximately 250 m i l l i o n end-1984 d o l l a r s w i l l bring about the desired r e s u l t . The o v e r a l l picture at this point i s thus one where the p r o v i n c i a l treasury c o l l e c t s as much revenues from Hibernia as the provisions of i t s l e g i s l a t i o n allow while any d i s t o r t i o n a r y e f f e c t s that this might have on the producers' decision concerning the number of platforms used to produce the f i e l d are o f f s e t by cash transfers from the federal government. Results from simulations of the offshore development model suggest that, under these conditions, approximately 3.0 b i l l i o n end-1984 d o l l a r s 145 would accrue to St. John's under the N&L w, compared to $2.3 b i l l i o n under the terms of the N&L c. Although differences are smaller than those reported e a r l i e r , the re s u l t s suggest that the terms,of the F NSA are s t i l l f i n a n c i a l l y more advantageous to Newfoundland and Labrador than are the provisions of either version of i t s own l e g i s l a t i o n . The key factors which bring about this result have to do with the sharing of revenues from the CIT and the PGRT, and the conditions surrounding NLPC p a r t i c i p a t i o n i n the a c t i v i t i e s and revenues related to Hibernia. The r e s u l t s of these experiments also suggest that, under the N&L c, the federal government more than recoups i t s payment from the addi t i o n a l revenues r e s u l t i n g from the more intensive development plan adopted by the producers. Rents accruing to Ottawa r i s e by about $100 m i l l i o n a f t e r allowing for the $250 m i l l i o n payment to producers. However, the same does not apply under the N&L w where the federal treasury loses approximately $200 m i l l i o n as a re s u l t of the payment and the switch to a more intensive development plan. The fact that Ottawa does not levy any r o y a l t i e s or taxes against the NLPC's share of the production revenues from the f i e l d is responsible for bringing about this r e s u l t . Although I w i l l return to this point l a t e r , i t i s important to note that the q u a l i t a t i v e nature of the re s u l t s discussed in the l a s t few paragraphs does not hold i n a l l instances. For example, from the province's f i n a n c i a l perspective, both versions of i t s l e g i s l a t i o n dominate the terms of the F NSA under the assumptions of case 1. This suggests that, as the economic rents in the f i e l d are assumed to increase, the net worth to St. John's of the NLPC p a r t i c i p a t i o n under both the N&L c and N&L w r i s e s faster than does that of the province's main addit i o n a l revenue source, the PGRT, under the F NSA. Under the assumptions of case 146 1, this tendency i s thus strong enough for the N&L c and N&L w to leave the government of Newfoundland and Labrador in a stronger f i n a n c i a l p o s i t i o n than would the F NSA. Let us now turn to the consequences of s p e c i f i c forms of royalty and tax r e l i e f under the base case assumptions. Figure 6.2 and table 4.6 reveal the same pattern of e f f e c t s from the extension of r e l i e f to the producer. Under the N&L c and N&L w, not only does the modelled form of r e l i e f transfer revenues from governments to producers but i t also induces the l a t t e r to adopt a more intensive development plan. Ove r a l l , the res u l t s suggest that the estimated economic rents accruing to the producer r i s e by about 500 m i l l i o n end-1984 d o l l a r s under the N&L c and $300 m i l l i o n under the N&L w. As noted e a r l i e r , the extension of the s p e c i f i c form of r e l i e f modelled does not induce any change in the p r i v a t e l y optimal development plan under the federal l e g i s l a t i o n . In this case, the r e l i e f - i n d u c e d transfer of economic rents from governments to producers i s estimated s l i g h t l y to exceed $500 m i l l i o n . Figure 6.2 also shows that these increases in net producer benefits are d i s t r i b u t e d between Canadian and foreign shareholders in approximately the same proportions as the 'ownership' rates of the production rights suggested in appendix 3. What happens to the positions of the two governments when the forms of royalty and tax r e l i e f modelled are extended to the Hibernia producers? A comparison of figures 6.1 and 6.2 reveals that under the terms of the F MAR and F NSA, economic rents accruing to governments f a l l as a r e s u l t of the introduction of the r e l i e f package modelled. Under the F MAR, Ottawa bears a larger share of t h i s f a l l i n rents accruing to governments than does St. John's. The opposite is true under the terms of the F NSA where rents to the federal government are e s s e n t i a l l y unaffected 147 by the extension of the royalty and tax r e l i e f package modelled. Due in large part to the r e l i e f - i n d u c e d increase in the p r i v a t e l y optimal i n t e n s i t y of development, the net f i n a n c i a l p o s i t i o n of the government of Newfoundland and Labrador i s estimated to improve when the r e l i e f package modelled i s included i n the terms of the N&L c and N&L w. However, res u l t s from simulations of the offshore development model suggest that economic rents accruing to the federal government would f a l l i f this s p e c i f i c form of royalty and tax r e l i e f was extended to the producer and the terms of the N&L c or the N&L w were assumed to p r e v a i l . O v e r a l l , these r e s u l t s are sen s i t i v e to assumptions concerning the at t r i b u t e s of the f i e l d and the general economic climate, the terms of the royalty and tax systems modelled and, in p a r t i c u l a r , to the properties of the r e l i e f packages modelled. For example, under the N&L w, part of the royalty and tax r e l i e f flows back to the p r o v i n c i a l government since the NLPC i s subject to the s l i d i n g scale r o y a l t y . The a b o l i t i o n of the l a t t e r simply transfers a portion of the p r o v i n c i a l government's claim against the Hibernia revenues from one instrument of taxation to another. Although in a d i f f e r e n t context, these issues w i l l be discussed again l a t e r . Under the base case assumptions, the ef f e c t s of the r e l i e f packages modelled are not strong enough to a l t e r the rankings of the four revenue-sharing systems based on t h e i r y i e l d s for the two lev e l s of government. Newfoundland and Labrador s t i l l does best under the terms of the F NSA, with estimated rents of about 3.1 b i l l i o n end-1984 d o l l a r s (against $2.8 and $2.2 b i l l i o n under the N&L w and N&L c, r e s p e c t i v e l y ) . St. John's s t i l l does worst under the F MAR where i t i s estimated to receive approximately $1.3 b i l l i o n i n economic rents. 148 The federal government s t i l l does best under the F MAR, receiving an estimated $800 m i l l i o n in rents. Under the N&L c, Ottawa's share of the economic rents from Hibernia i s estimated to reach $550 m i l l i o n ; i t stands at less than $100 m i l l i o n under the N&L w. Again, the F NSA ranks l a s t , leaving Ottawa with a net loss of about $940 m i l l i o n . Although i n t e r e s t i n g , these re s u l t s concerning the d i s t r i b u t i o n a l consequences of royalty and tax r e l i e f are far from t e l l i n g the whole story. The most convincing way of demonstrating this point i s with an example. Let us assume that the r e l i e f package extended to the producer under the terms of the federal l e g i s l a t i o n had involved a reduction i n the basic royalty rate of 5 percentage points (instead of the d e d u c t i b i l i t y of PGRT payments for the purposes of PIR) in addition to the investment-related delay in producer l i a b i l i t y to the PGRT already assumed. Under the base case assumptions and the terms of the F NSA, the extension of this d i f f e r e n t form of royalty and tax r e l i e f i s estimated to reduce the economic rents accruing to St. John's by about 1.1 b i l l i o n end-1984 d o l l a r s (from $3.6 b i l l i o n under the base case assumptions to $2.5 b i l l i o n in the presence of r e l i e f ) . The net f i n a n c i a l p o s i t i o n of the federal government, on the other hand, i s estimated not to be affected by the change i n the r e l i e f package. The e f f e c t s of these changes i n the federal r e l i e f package on the net f i n a n c i a l p o s i t i o n of the Newfoundland and Labrador government are large enough to a l t e r the rankings of the revenue-sharing systems from the province's perspective. Results from simulations of the offshore development model now suggest that under the base case assumptions and in the presence of r e l i e f , economic rents to the government of Newfoundland and Labrador reach th e i r highest value under the terms of the N&L w. The 149 terms of the F NSA are now estimated to y i e l d about 300 m i l l i o n end-1984 do l l a r s less i n economic rents to the p r o v i n c i a l treasury than does the N&L w (about $2.8 b i l l i o n against $2.5 b i l l i o n ) . Two related points emerge from this discussion. F i r s t , given a propitious environment, i t i s possible for one l e v e l of government to insulate i t s e l f i n part from the r e d i s t r i b u t i v e consequences of royalty and tax r e l i e f through the choice of the r e l i e f package i t s e l f . This points to another p i t f a l l i n attempting to determine the source of regulation according to the proposed instruments of taxation: the actions of one l e v e l of government can affect the r e l a t i v e performance of the revenue-sharing systems. 7 Second, i t may shed some l i g h t on the p o s i t i o n taken by the government of Newfoundland and Labrador i n negotiations with Ottawa aimed at resolving the j u r i s d i c t i o n a l dispute. By signing an agreement s i m i l a r to that reached between the federal and Nova Scotia governments, St. John's was aware that i t would e f f e c t i v e l y lose access to a l l leg a l channels through which i t s d i s s a t i s f a c t i o n with subsequent developments could be expressed and acted upon. The p r o v i n c i a l government would then have no enforceable strategy, other than protests to Ottawa, to respond to changes i n the rules of the game i n i t i a t e d by the federal government. Such u n i l a t e r a l actions by Ottawa need not be draconian. The simple extension of c e r t a i n s p e c i f i c forms of royalty and tax r e l i e f i s s u f f i c i e n t to worsen s u b s t a n t i a l l y the net revenue p o s i t i o n of the government of Newfoundland and Labrador. It i s not so much the extension of r e l i e f i t s e l f which brings about this r e s u l t but i t i s the absence of lega l channels through which the p r o v i n c i a l government could help formulate or respond to actions taken by the federal government. 150 Newfoundland and Labrador's insistence on a degree of p r o v i n c i a l control • • ft over offshore a c t i v i t i e s may well be founded on this type of argument. As tables 6.1 and 6.2 show, the offshore development model was also used to study the d i s t r i b u t i o n a l impacts of some of the adverse changes i n assumptions outlined in table 5.1. As far as d i s t r i b u t i o n a l issues are concerned, the re s u l t s from these simulations y i e l d but few insights that were not r e a d i l y apparent from the analysis of chapters 4 and 5 above, and of the preceding parts of this section. The two most important exceptions to this rule are the following. F i r s t , under the terms of the federal l e g i s l a t i o n , when the consequences of adverse changes in assumptions are strong enough to induce the producers to i n s t a l l only one platform, Canadian shareholders are l e f t r e l a t i v e l y better off than th e i r foreign counterparts. The increased r e l a t i v e importance of the p r e f e r e n t i a l treatment of Canadian-owned companies for the purposes of exploration and development incentive grants is l a r g e l y responsible for t h i s r e s u l t . Second, when a government receives r e l a t i v e l y more of i t s revenues from instruments of taxation which do not f u l l y adjust to changes in cost and revenue conditions, i t s share of the rents from Hibernia w i l l f a l l more slowly than that accruing to i t s counterpart when conditions are allowed to worsen. The most s t r i k i n g examples of this tendency can be found under the F NSA where the p r o v i n c i a l p o s i t i o n i s more robust than Ottawa's because a l l basic royalty and PGRT revenues are assumed to accrue to the p r o v i n c i a l government. 151 6.3 Conclusion Although this is s l i g h t l y outside the main focus of this chapter, how does the producer share of the economic rents i n Hibernia compare with that of projects undertaken on the Western sedimentary basin? To obtain an estimate of producer returns on an 'average' crude o i l or natural gas project in non-frontier areas, the equations of MACE's energy-producing sector were solved endogenously to 2036 (when Canada's conventional o i l and gas reserves are assumed to be f u l l y depleted) with the world crude o i l price path assumed in case 2. Results showed that under these conditions, industry captures less than 6 per cent of the producer-plus-government share of the economic rents generated by post-1981 non-frontier o i l and gas production in Canada. This proportion r i s e s to s l i g h t l y less than 9 per cent when the period of analysis i s allowed to extend back to 1947 and the f i r s t s i g n i f i c a n t petroleum development in Canada. Results obtained through simulations of the offshore development model suggest that producers stand to capture between 25 and 37 per cent of the (realized) economic rents in Hibernia under the base case assumptions and the three p o l i c y regimes modelled. 1 0 Even the lowest estimate i s almost three times the estimated producer share of returns to a c t i v i t i e s i n non-frontier areas between 1947 and 2036, and more than four times that estimated for the post-1981 period. As tables 6.1 and 6.2 suggest, even when the consequences of s p e c i f i c departures from the base case assumptions are simulated, the producer share of the economic rents in Hibernia ou t s t r i p s that of 'average developments' on the Western sedimentary basin. In a l l instances reported in this chapter, the extension of royalty and tax r e l i e f to the Hibernia producers increases 152 these d i f f e r e n c e s . Results from the same simulations of the MACE model reveal that, over the period extending from 1947 to 2036, the d i s t r i b u t i o n of the all-government share of the economic rents generated by the development and production of the Western sedimentary basin's o i l and gas resources i s d i s t r i b u t e d approximately 70/30 in favour of p r o v i n c i a l governments. When the time period of analysis i s r e s t r i c t e d to exclude the years prior to 1982, the d i s t r i b u t i o n of the governments' share of rents i s estimated to remain skewed in favour of the provinces but to a lesser degree: 55 per cent against 45 per cent to Ottawa. As reported i n figure 6.1, estimates derived with the offshore development model suggest that only under the terms of the F MAR is the d i s t r i b u t i o n of the all-government share of rents i n Hibernia more t i l t e d in favour of the federal government than either of the two sets of estimates reported i n the previous paragraph. In this case, Ottawa stands to capture almost 51 per cent of the government share of Hibernia rents. In no other case considered does Ottawa's share reach 30 per cent. When the royalty and tax r e l i e f packages modelled are assumed to be extended to the Hibernia producers, Ottawa's share of the rents accruing to governments again reaches i t s highest value (at approximately 40 per cent) under the terms of the F MAR. This time, i n no other case considered does Ottawa's share of the Hibernia rents accruing to governments exceed 22 per cent. As tables 6.1 and 6.2 show, the adverse changes i n the base case assumptions simulated y i e l d s i m i l a r patterns of inter-government d i s t r i b u t i o n of Hibernia rents. The analysis of this chapter leads to two general conclusions about the inter-government d i s t r i b u t i o n of the economic rents in Hibernia. 153 F i r s t , c e r t a i n properties of the proposed revenue-sharing systems and of the Canadian c o n s t i t u t i o n a l setting confer upon one l e v e l of government the a b i l i t y to af f e c t the po s i t i o n of another l e v e l of government without requiring the l a t t e r ' s consent. In some cases, this other l e v e l of government i s l e g a l l y precluded from i n i t i a t i n g any corrective measures. Examples of this were noted under the terms of the F NSA where the extension of a s p e c i f i c form of royalty and tax r e l i e f by the federal government had serious repercussions on the net f i n a n c i a l p o s i t i o n of the Newfoundland and Labrador government to which no avenues of e f f e c t i v e response were a v a i l a b l e . Second, i n a number of cases, the r e s u l t s from simulations of the offshore development model suggest that the net f i n a n c i a l p o s i t i o n of the federal government is better under the provisions of both the N&L c and N&L w than under i t s own l e g i s l a t i o n when the l a t t e r i s coupled with the terms of the Nova Scotia Agreement. In these same cases, the r e s u l t s also show that the reverse applies to the net f i n a n c i a l p o s i t i o n of the Newfoundland and Labrador government: the province i s better o ff f i n a n c i a l l y under the terms of the F NSA than under either versions of i t s own l e g i s l a t i o n . This suggests that there i s room for compromise between the two le v e l s of government on the subject of revenue sharing. The judicious choice of instruments of taxation and of a revenue-sharing system could ensure that both governments equitably reap the rewards (or bear the burden) of the development and production of Hibernia, i r r e s p e c t i v e of the source of j u r i s d i c t i o n . As presently structured, the offshore development model assumes that none of the Nova Scotia Agreement's p r o v i n c i a l f i s c a l capacity constraints are ever met over the course of Hibernia's productive l i f e . Since 154 Newfoundland and Labrador's per capita income was reported to be 60.8 per cent that of Ontario i n 1978 1 1 and i t s unemployment rate c o n s i s t e n t l y exceeds the national average, i t seems appropriate to assume that the existence of such constraints would not ma t e r i a l l y a f f e c t the province's net receipts from Hibernia. This s i t u a t i o n could change dramatically i f other f i e l d s in the v i c i n i t y of Newfoundland and Labrador were brought on stream or i f other large projects.such as hydro-electric developments i n Labrador were 1 2 . undertaken. In such circumstances, i t is l i k e l y that some of the Nova Scotia Agreement's f i s c a l capacity constraints would be binding, thus causing any subsequent developments to carry less generous terms, from the province's perspective. Furthermore, i f some of these projects were undertaken during the productive l i f e of Hibernia, they could induce changes, detrimental to Newfoundland and Labrador, in the d i s t r i b u t i o n of the all-government share of the economic rents in Hibernia i t s e l f . This raises the p o s s i b i l i t y that the government of Newfoundland and Labrador's strong objections to the terms of the Nova Scotia Agreement are in part based on i t s treatment of the revenues from the five b i l l i o n t h b arrel of crude o i l extracted from the Grand Banks and not on the terms i t of f e r s to Hibernia per se. The analysis of the la s t three chapters treats governments as benevolent landlords who capture a share of the economic rents generated by a c t i v i t i e s undertaken within t h e i r j u r i s d i c t i o n s . In doing so, I have f a i l e d to ask an important question: given royalty and taxation systems, what are the incentives for governments to o f f e r the s p e c i f i c forms of royalty and tax r e l i e f modelled? If a government seeks to maximize i t s net revenues from s p e c i f i c projects then the extension of r e l i e f i s only 155 r a t i o n a l i f i t i n c r e a s e s net b e n e f i t s a c c r u i n g to t h a t government. Under such c o n d i t i o n s , r e s u l t s from the o f f s h o r e development model s u g g e s t t h a t a number o f the s i m u l a t e d s i t u a t i o n s o f f e r no i n c e n t i v e s f o r governments to e x t e n d any form of r o y a l t y and t a x r e l i e f , l e t a l o n e the s p e c i f i c packages m o d e l l e d . These i n c l u d e i n s t a n c e s where the a v a i l a b i l i t y 1 3 o f r e l i e f has l i t t l e or no e f f e c t on s i m u l a t e d p r o d u c e r b e h a v i o u r as w e l l as c a s e s where p r o d u c e r s respond t o r e l i e f by c h o o s i n g a development p l a n based on a l a r g e r number o f p l a t f o r m s . 1 1 * I f , however, the u t i l i t y f u n c t i o n s a t t r i b u t a b l e t o governments a r e b r o a d e r i n scope t h e n the economic r a t i o n a l e f o r r e l i e f a c q u i r e s a d i f f e r e n t c h a r a c t e r . A l t h o u g h the a n a l y s i s does not c a r r y t h e s e i s s u e s any f u r t h e r , I f e e l i t would have been a d i s s e r v i c e t o the r e s e a r c h p r o j e c t not to m e n t i o n t h i s i m p o r t a n t l i m i t a t i o n . 156 FOOTNOTES Appendix 3 gives some of the possible compositions of the operating consortium for Hibernia. These systems are concerned with the d i s t r i b u t i o n of the all-government share of Hibernia revenues among the relevant governments, given a royal t y and taxation system. As discussed e a r l i e r , both versions of the Newfoundland and Labrador l e g i s l a t i o n are assumed to double as roya l t y and taxation systems as well as revenue-sharing systems. A l l estimates of pre-development expenditures used i n th i s thesis are reported i n 'SUBROUTINE C0NS7', appendix 4. Reasons for proceeding in this manner are outlined in appendix 3. The figures and tables of this chapter show a constant (negative) stock of net benefits accruing to the governments of other provinces. This is due to the fact that governments of the provinces from which crude o i l i s currently produced (mainly Alberta) have allowed companies involved i n the exploration, deli n e a t i o n and appraisal of the Hibernia f i e l d to claim t h e i r offshore expenditures against income earned within the boundaries of their respective j u r i s d i c t i o n s (see Wilby [1981, pp.21 and 95]). This practice i s assumed to end when a c t i v i t i e s related to development and production begin. The magnitude of this net subsidy to the Hibernia producers w i l l thus be constant across p o l i c y regimes and invariant to changes in base case assumptions. It is here assumed that the provisions of the royalty and tax r e l i e f packages assumed to p r e v a i l under the N&L c and N&L w are unchanged. Although this p o s s i b i l i t y has not been examined, such measures may provoke r e t a l i a t o r y actions from the other l e v e l of government i f i t has the l e g i s l a t i v e authority to do so. For an overview of other issues related to the control of offshore a c t i v i t i e s , see The F i n a n c i a l Post [February 5, 1983, p.3]. Since some of the o i l produced i n Canada does not receive i t s opportunity cost ( i . e . , the world crude o i l p r i c e ) , Canadian consumers capture some of the resource rents. Had these been added to the producer-plus-government share, the proportion of rents accruing to industry would have been even lower. MACE's treatment of Petro-Canada i s the same as that adopted i n this t h e s i s . See NLPD [1980, p.46]. S t a t i s t i c s for subsequent years show a s l i g h t worsening of Newfoundland and Labrador's r e l a t i v e p o s i t i o n , to about 60.0 per cent of Ontario's and 61.8 per cent of national per capita income. 157 These issues are important since the terms of the Nova Scotia Agreement are designed to apply to a l l o i l and gas development projects i n the offshore area u n t i l , at l e a s t , the year 2024. See Canada, Energy, Mines and Resources [1982a, pp.1 and 18]. See, for example, K2 under F MAR and 02 under N&L w (table 6.1). See, for example, LOWER P under F MAR and N&L w (table 6.2). FIGURE 6.1 DISTRIBUTION O F ECONOMIC RENTS FROM HIBERNIA D E V E L O P M E N T UNDER ALTERNATIVE REGULATION A N D R E V E N U E - S H A R I N G S Y S T E M S B A S E C A S E . OPTIMAL P R O D U C E R CHOICES CO I O Ld CD (A UJ LY. O O CJ 4.5 4 3.5 3 2.5 2 H 1.5 1 0.5 H 0 -0.5 -1 R E N T -MAXIMIZING SOLUTION AB: 4 .067 L e g e n d CANADIAN PRODS • FOREIGN PRODS FEDERAL GOVT N&L GOVT a OTHER PROV GOVTS K2 TOTAL RENTS REGULATION A N D R E V E N U E - S H A R I N G S Y S T E M S Ln 0 0 FIGURE 6.2 DISTRIBUTION OF ECONOMIC RENTS FROM HIBERNIA D E V E L O P M E N T UNDER ALTERNATIVE REGULATION A N D R E V E N U E - S H A R I N G S Y S T E M S B A S E C A S E WITH RELIEF. OPTIMAL P R O D U C E R CHOICES oo I o z U J CD oo O REGULATION A N D R E V E N U E - S H A R I N G S Y S T E M S L e g e n d e3 CANADIAN PRODS • FOREIGN PRODS • i FEDERAL GOVT ED N&L GOVT • OTHER PROV GOVTS E3 TOTAL RENTS Table 6.1 Economic Rents from Hibernia Development Optimal Producer Choices Consequences of 02 and K2 Reg. Prod. NPV2 2 NPV NPV2 NPV2 NPV2 NPV2 System System Fore i gn Domest i c Fed. N&L other Prods. Prods. Govt. Govt. Prov. Govts 02 No govt. AB 2.75 * * * * * w/o r e l i e f F MAR3 A 2.60 0.38 0.58 0.83 0.93 -0.11 F NSA3 A 2.60 0.38 0.58 -0.54 2.29 -0.11 N&L c A 2.60 0.37 0.22 0.53 1.58 -0.11 N&L w A 2.60 0.25 0.23 0.45 1.78 -0.11 w r e l i e f F MAR3 AB 2.72 0.53 0.80 0.18 1.32 -0.11 F NSA3 AB 2.72 0.53 0.80 -1.26 2.75 -0.11 N&L c AB 2.68 0.69 0.25 0.19 1.66 -0.11 N&L w A 2.60 0.59 0.24 0.10 1.77 -0.11 K2 No govt. A 1.99 * * » * * w/o r e l i e f F MAR3 A 1.98 0.26 0.48 0.46 0.88 -0.11 F NSA3 A 1.98 0.26 0.48 -0.96 2.31 -0.11 N&L c A 1.98 0.19 0.21 0.34 1.36 -0.11 N&L w A 1.98 0.32 0.22 0.03 1.52 -0.11 w r e l i e f F MAR3 A 1.98 0.44 0.66 0.14 0.85 -0.1 1 F NSA3 A 1.98 0.44 0.66 -0.96 1.96 -0.11 N&L c A 1.98 0.49 0.23 0.02 1.35 -0.11 N&L w A 1.98 0.50 0.24 -0.16 1.52 -0.11 * not applicable 1 The production system always involves fixed platforms. 2 AlI net present values are expressed in b i l l i o n s of end-1984 dollars. 3 The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. Table 6.2 Economic Rents from Hibernia Development Optimal Producer Choices Consequences of LOWER P and DELAY Reg. Prod. NPV2 NPV2 NPV2 NPV2 NPV2 NPV2 System System1 Foreign Domest i c Fed. N&L other Prods. Prods. Govt. Govt. Prov. Govts LOWER P No govt. AB 2.78 • * * * * w/o r e l i e f F MAR A 2.56 0.39 0.58 0.81 0.88 -0.11 F NSA A 2.56 0.39 0.58 -0.53 2.23 -0.11 N&L c A 2.56 0.41 0.22 0.51 1.53 -0.11 N&L w A 2.56 0.49 0.23 0.24 1.71 -0.11 w r e l i e f F MAR AB F NSA AB N&L c AB N&L w AB 2.77 0.60 2.77 0.60 2.75 0.75 2.75 0.65 0.86 0.21 0.86 -1.22 0.26 0.19 0.25 -0.19 1.21 -0.11 2.64 -0.11 1.65 -0.11 2.16 -0.11 DELAY No govt. AB 3.47 * * * • * w/o r e l i e f F MAR AB 3.45 0.50 0.77 1.05 1.24 -0.1 1 F NSA AB 3.45 0.50 0.77 -0.98 3.26 -0.11 N&L c A 2.93 0.49 0.23 0.60 1.72 -0.1 1 N&L w A 2.93 0.56 0.24 0.33 1.91 -0.11 w r e l i e f F MAR AB 3.45 0.74 1 .01 0.58 1.23 -0.11 F NSA AB 3.45 0.74 1.01 -0.98 2.79 -0.11 N&L c AB 3.43 • 0.92 0.27 0.40 1.95 -0.11 N&L w AB 3.43 0.78 0.26 -0.01 2.51 -0.11 not applicable The production system always involves fixed platforms. A l l net present values are expressed in b i l l i o n s of end-1984 dollars. The distribution of the net present value between producers and governments incorporates the effects of the three-consecutive-year PIR holiday. 162 CHAPTER 7 MACROECONOMIC CONSEQUENCES 7.1 Introduction This chapter and the next o f f e r a d i f f e r e n t perspective on the economics of the development and production of Hibernia. So far, the analysis has been mostly concerned with microeconomic issues related to the development decision and the consequences of government p o l i c i e s . It i s now time to widen the scope of the analysis and look at the pot e n t i a l impact of the project on the economy as a whole. In doing so, two d i f f e r e n t sets of issues w i l l be examined. Chapter 8 explores the l i k e l y consequences of offshore o i l production on f i s c a l equalization and the d i s t r i b u t i o n of the economic rents generated by the production and consumption of o i l and natural gas i n Canada. The present chapter, on the other hand, is concerned with the role of Hibernia i n the national economy. As was argued e a r l i e r , an appreciation of the macroeconomic consequences of Hibernia requires an explanation of the role of energy i n the Canadian economy. Since the MACE model provides such a representation, the linkages between the two models are once again exploited to derive a consistent view of the implications for the Canadian economy of a new domestic source of crude o i l . The analysis of the chapter proceeds i n two related d i r e c t i o n s . Section 7.2 gives a general overview of the macroeconomic consequences of the development and production of Hibernia. In p a r t i c u l a r , the analysis seeks to document the d i f f e r e n t e f f e c t s of the construction and production phases on the national economy. A few experiments w i l l also be undertaken to show the consequences of more intensive development plans 163 made desirable as a re s u l t of d i f f e r e n t assumed paths of future world o i l p r i c e s . In the la s t decade, there emerged a new branch of economic l i t e r a t u r e which is relevant to the problem at hand. Motivated by the discovery and subsequent production of s i g n i f i c a n t deposits of non-renewable resources, i t sought to examine the eff e c t s on the int e r n a t i o n a l competitiveness of the non-related industries of countries i n which these discoveries occurred. Section 7.3 provides a b r i e f review of this l i t e r a t u r e and compares i t s conclusions with the consequences of Hibernia as represented by MACE. F i n a l l y , section 7.4 contains a b r i e f statement of conclusions. 7.2 Hibernia and the National Economy This section presents and discusses r e s u l t s obtained from j o i n t simulations of MACE and the offshore development model over the 1985 to 1996 period. The development and production of Hibernia i s in general simulated under the same circumstances assumed to p r e v a i l i n chapter 4's case 2 and the provisions of the federal l e g i s l a t i o n and the Nova Scotia Agreement. The construction period for a two-fixed-platform production system thus extends from 1985 to 1994 with more than 99 per cent of the estimated c a p i t a l expenditures being undertaken by the end of 1991. Therefore, for the purposes of this chapter, the period extending from 1985 to 1991 w i l l be c a l l e d the 'construction period'. Production begins in 1990 and peaks two years l a t e r . During the construction period, the ef f e c t s of Hibernia on the national economy are la r g e l y channelled through i t s impact on energy investment. The net impacts of Hibernia on r e a l energy investment depicted 164 i n figure 7.1 translate into increases of about 3.8 to 6.0 per cent above control levels during the three peak years of construction. These correspond to increases of 1.2 to 2 per cent of aggregate investment since energy investment is projected to be s l i g h t l y less than h a l f of investment i n the energy-using sector during that period. The economy-wide e f f e c t s are higher s t i l l since investment i n the energy-using sector i t s e l f r i s e s between 0.57 and 0.96 per cent above control levels i n the late 1980s. These e f f e c t s are less than one-half those projected for the now defunct Alsands project, as reported i n H e l l i w e l l , McRae et a l . [1983, pp.51-53]. Although part of this difference i s no doubt a t t r i b u t a b l e to changes i n external assumptions i n MACE, the larger part of the explanation rests with the comparatively smaller c a p i t a l expenditure estimates associated with Hibernia. Figure 7.2 shows the estimated e f f e c t s of Hibernia on r e a l GNP for three d i f f e r e n t cases. For the time being, l e t us concentrate on the impact of the construction phase under the base case assumptions. The net ef f e c t of Hibernia i s to boost r e a l GNP by 0.30 to 0.37 per cent above control levels during the peak years of construction. Although this increased l e v e l of economic a c t i v i t y a t t r a c t s new entrants to the labour market, employment r i s e s faster s t i l l . As a r e s u l t , the measured unemployment rate f a l l s by as much as 0.13 percentage points in 1988. The increased l e v e l of economic a c t i v i t y is accompanied by increases i n the general rate of price i n f l a t i o n . By the end of the 1980s, the rate of change of the absorption price index is almost 0.17 percentage points above i t s control value. O v e r a l l , the proportionate increases i n the i n f l a t i o n rate are approximately one-third as large as the re a l output gains. S i m i l a r l y , the output price l e v e l increases throughout the 165 construction period, although s l i g h t l y more than does the price of absorption, as shown in figure 7.3. The monetary tightness induced by the higher i n f l a t i o n rates causes short-term nominal interest rates to r i s e by as much as 20 basis points i n 1988 and 1989 (some 1.8 per cent above control l e v e l s ) . Even though increases in r e a l interest rates are less than h a l f this much, c a p i t a l inflows are large enough to induce a s l i g h t appreciation of the Canadian d o l l a r (about 0.04 per cent on average), which moderates the i n f l a t i o n a r y pressures in the domestic economy. By 1989, however, the price of foreign exchange has begun to r i s e above control levels as the induced c a p i t a l inflows r e s u l t in r i s i n g i n t e r e s t and divident payments to foreigners (up an average of 3.2 per cent over the 1989-1991 period). These increases i n in t e r e s t and dividend payments to foreigners account for differences in the time-paths of the Gross Domestic Product (GDP) and GNP. The output of the energy-using sector ( r e a l GDP plus net energy imports, at factor cost) r i s e s 0.32 to 0.41 per cent above control l e v e l s during the peak years of construction, s l i g h t l y stronger than the growth of r e a l GNP. The i n i t a l appreciation of the Canadian d o l l a r causes a f a l l i n the p r i c e of imported goods and services excluding energy. This, combined with the higher rates of domestic i n f l a t i o n and the import leakages induced by the higher l e v e l s of r e a l GNP leads to increased r e a l non-energy imports throughout the construction period. Figure 7.4 reveals that the stronger Canadian d o l l a r and the increased domestic i n f l a t i o n rate also combine to cause increases in the price of non-energy exports. This reduces the competitiveness of Canadian non-energy goods and services on world markets, which re s u l t s in a steady erosion of the l e v e l of r e a l non-energy exports u n t i l the beginning of the production phase. A d d i t i o n a l l y , as 166 suggested e a r l i e r , the c a p i t a l inflows induced by the higher i n t e r e s t rates create add i t i o n a l imports i n the form of interest and dividend payments to foreigners. The stronger Canadian d o l l a r and the higher l e v e l of re a l economic a c t i v i t y also cause an increase i n r e a l domestic expenditures on energy, some of which takes the form of additional imports of crude o i l . 1 Since Hibernia does not re s u l t i n increased Canadian energy exports, the balance of trade i n energy worsens throughout the 1985-1989 period, f a l l i n g some $102 m i l l i o n (11.3 per cent) below control l e v e l s i n 1989. U n t i l the beginning of production a c t i v i t i e s , a l l of these factors contribute to a worsening of the d e f i c i t on the current account of the balance of payments. By the end of 1989, the balance of trade i s about $1.7 b i l l i o n (13.6 per cent) below control l e v e l s . As the construction a c t i v i t i e s wind down, the investment accelerator e f f e c t s i n the energy-using sector of MACE create a slump i n r e a l economic a c t i v i t y . Although r e a l GNP i s higher with Hibernia throughout the 1985 to 1996 period, i t s rate of growth f a l l s below control levels i n 1990 and 1991. This post-boom hangover i s of short duration as the Hibernia production reaches i t s peak i n 1992 and proceeds to displace greater quantities of imported crude o i l . The slump induced by Hibernia is both 2 smaller and of shorter duration than that projected for Alsands. Two factors explain this r e s u l t . F i r s t , as noted e a r l i e r , the c a p i t a l expenditures for Hibernia are lower than those associated with Alsands. Flows of production from Hibernia are also assumed to be greater than those projected for Alsands. Once the production from Hibernia comes on stream, the impact of the project i s pri m a r i l y f e l t through i t s e f f e c t s on crude o i l imports. Real 167 energy imports are down an average of about 10 per cent throughout the seven-year period for which the macroeconomic consequences of the production of Hibernia are charted. As a r e s u l t , the balance of trade i n energy improves from 1990 on and i s about $4 b i l l i o n above control levels by the end of the simulation period. This improvement i n the energy trade balance is accompanied by a continued appreciation of the Canadian d o l l a r as the price of foreign exchange f a l l s throughout the 1991-1996 period. It is almost 1.2 per cent below control levels by the end of the simulation period. A comparison of these r e s u l t s with those of the 1985-1991 period reveals that the impact of Hibernia production on the exchange rate is more than 10 times that registered during the construction period. This strengthening of the Canadian d o l l a r reduces the aggregate price of energy to the energy-using sector p r i n c i p a l l y through i t s impact on crude o i l p r i c e s . Although this tends to reduce investment in the 3 energy-producing sector (down by s l i g h t l y less than 0.01 per cent i n 1995 and 1996), i t tends to encourage the su b s t i t u t i o n of c a p i t a l i n favour of energy i n the energy-capital bundle and of labour i n favour of 'energized c a p i t a l ' i n MACE's outer production function for the energy-using sector. Real expenditures on energy are thus above control l e v e l s from 1990 to 1996, by as much as 0.36 per cent at the end of the period. The increase i n domestic production of crude o i l stimulates r e a l income and spending. By the end of the simulation period, r e a l private sector wealth i s 0.06 per cent above control l e v e l s and r e a l personal consumption expenditures are up by 0.85 per cent. However, the portion of Hibernia revenues accruing to governments i s assumed to be saved since r e a l government spending is exogenous to MACE. Thus, net government balances improve by as much as $3.3 b i l l i o n by the end of the simulation 168 period. More than 50 per cent of this amount can be attributed to increased revenues from domestic o i l and gas production. In addition, through accelerator e f f e c t s , r e a l investment in the energy-using sector i s up by an average of 0.6 per cent after 1991. O v e r a l l , the rate of growth of r e a l GNP is higher by 0.07 per cent, on average, during the 1992-1996 period. Real GNP is thus more than 0.5 per cent above control levels at the end of the simulation period. This increased l e v e l of economic a c t i v i t y also boosts employment. The measured unemployment rate f a l l s throughout the production period and is 0.12 percentage points below control levels in 1996. These re s u l t s a l l suggest that the income e f f e c t s associated with the higher levels of economic a c t i v i t y o u t s t r i p the s u b s t i t u t i o n e f f e c t s induced by the lower r e l a t i v e energy prices as both employment and r e a l investment in the energy-using sector increase during the production period. This time, however, the higher levels of economic a c t i v i t y are not accompanied by increases in the general rate of price i n f l a t i o n . The continuing appreciation of the Canadian d o l l a r implies a decrease in the rate of change of the price of non-energy imports, which, in turn, exerts downward pressure on the rate of change of the absorption price index. This in turn reduces the rate of growth of nominal wages, and therefore exerts downward pressure on the output price index. This tendency i s reinforced by the f a l l i n g energy prices which also feed through to the output price index. The l a t t e r f a l l s throughout the production period and is about 0.85 per cent below control l e v e l s in 1996. The reduction in the absorption p r i c e index i s s i m i l a r , though s l i g h t l y l arger, involving a decrease of about 1 per cent by the end of the simulation period. The general rate of i n f l a t i o n i s thus on average about 0.25 percentage points 169 lower during the 1992-1996 period. This f a l l in the rate of price i n f l a t i o n , combined with the steady appreciation of the Canadian d o l l a r noted e a r l i e r , r e s u l t s i n lower r e a l and nominal interest rates from 1992 on. Nominal rates drop by as much as 23 basis points (2.05per cent) in 1994. This f a l l i n interest rates c u r t a i l s c a p i t a l inflows which then reduce imports in the form of i n t e r e s t and dividend payments to foreigners. Differences in the time-paths of GDP and GNP are hence reversed from that observed during the construction phase. Real GDP plus net energy imports (at factor cost) i s thus s l i g h t l y less than 0.4 per cent above control l e v e l s at the end of the simulation period, compared to 0.5 per cent for r e a l GNP. An appreciation of the Canadian d o l l a r w i l l , c e t e r i s paribus, tend to reduce the competitiveness of the domestic industry on world markets and bring about a f a l l i n non-energy exports. In MACE, Canadian producers are estimated to respond to an increase in the value of the d o l l a r by reducing the price of non-energy exports to counter p a r t i a l l y the erosion of t h e i r competitive p o s i t i o n i n world markets. A f a l l in the output price index, on the other hand, is perceived by Canadian producers as an opportunity to improve t h e i r p o s i t i o n i n world markets and also exerts a downward pressure on the price of non-energy exports. In MACE, the price of non-energy exports (PXNE i n figure 7.4) thus responds p a r t i a l l y to Canadian output prices and p a r t i a l l y to world trade prices expressed in Canadian d o l l a r s . Any r e l a t i v e strengthening of the Canadian d o l l a r (which i s revealed by a reduction in PFX r e l a t i v e to PQ) w i l l lead to a net decrease in the price of non-energy exports r e l a t i v e to the o v e r a l l domestic output price index, and an increase r e l a t i v e to the price of world exports expressed i n Canadian d o l l a r s . Foreign demand for 170 Canadian non-energy exports (XNE i n f igure 7.4) would therefore be reduced. As f igure 7.3 r e v e a l s , Hibern ia ra i ses the output pr ice index above c o n t r o l l eve ls and induces a s l i g h t apprec ia t ion of the Canadian d o l l a r during most of the construct ion p e r i o d . Figure 7.3 shows that the lower value for PFX and the higher value for PQ combine to make PFX/PQ c o n s i s t e n t l y lower than c o n t r o l , by amounts ranging from -0.03 to -0.50 per cent. Although th i s r e su l t s in a decrease of the pr ice of non-energy exports r e l a t i v e to the output pr i ce index, f igure 7.4 reveals that the former is nonetheless above contro l l eve l s during the cons truct ion p e r i o d . Since the proport ionate increase in the pr i ce of non-energy exports exceeds the proport ionate decrease in export volumes, non-energy export revenues (XNE*PXNE in f igure 7.4) are above contro l l eve l s u n t i l the end of the cons truct ion p e r i o d . A f t e r 1991, the induced changes i n the output pr ice index and the pr i ce of fore ign exchange are s u f f i c i e n t to p u l l the pr ice of non-energy exports below contro l l e v e l s . Nonetheless, since the pr i ce of foreign exchange f a l l s proport ionate ly more than the output p r i c e , the pr ice of non-energy exports increases s l i g h t l y r e l a t i v e to world trade pr ices expressed in Canadian d o l l a r s . The downward ef fect on non-energy export volumes is muted by the reduct ion i n Canadian non-energy export p r i c e s . The reduct ion i n non-energy export volumes can be deferred for an i n i t i a l period because the r e l a t i v e pr ice e f fects (which take time to b u i l d up) can be more than of f se t by the e f fects of short-term d i s e q u i l i b r i u m , represent ing greater non-price s e l l i n g e f f o r t s by domestic producers f inding themselves with excess ive ly high i n v e n t o r i e s . As f igure 7.4 shows, th i s l a t t e r e f fect is 171 s u f f i c i e n t to hold non-energy export volumes s l i g h t l y above control levels (on average by 0.17 per cent over the 1992-1996 period) for the f i r s t few years of production. 4 The stronger Canadian d o l l a r and the r i s e in r e a l income lev e l s generate an increase in r e a l non-energy imports (up by an average of more than 0.58 per cent between 1990 and 1996). The o v e r a l l e f f e c t of these changes is a s l i g h t worsening of the balance of trade for non-energy goods and services. This o f f s e t s , in part, the improvement registered on energy trade. The gains recorded on the o v e r a l l trade balance are t y p i c a l l y between 75 and 90 per cent of those for energy alone. To contrast the impacts of the construction a c t i v i t i e s with those of production, separate simulations of the two periods were undertaken. The r e s u l t s thus obtained confirmed tendencies discussed e a r l i e r . The addi t i o n a l energy investment incurred because of the Hibernia development i n i t i a l l y stimulates both economic growth and i n f l a t i o n . However, the post-boom hangover is much more severe i f one assumes that the production of Hibernia's reserves of crude o i l does not ensue. Eventually, the hangover ef f e c t s are strong enough to reduce r e a l GNP below control l e v e l s . If one assumes that the reserves of the Hibernia f i e l d can be brought on stream at zero cost, the e f f e c t s of the production a c t i v i t i e s are s l i g h t l y magnified. For example, r e a l GNP in 1996 is about 1.7 b i l l i o n 1971 d o l l a r s above control levels i f only the production a c t i v i t i e s are considered, an increase of about 0.5 b i l l i o n 1971 d o l l a r s over the r e s u l t s of the simulations including both construction and production a c t i v i t i e s . Simulations were also undertaken to document the macroeconomic consequences of faster growing world o i l prices and the corresponding 172 changes in optimal project design. The question which was addressed i s the following: w i l l the sympathetic changes i n macroeconomic variables induced by a more intensive development of Hibernia be s u f f i c i e n t to off s e t the sta g f l a t i o n a r y e f f e c t s of faster growing world o i l prices? The offshore development model was used i n conjunction with MACE to i d e n t i f y two sets of assumptions about the future path of world o i l prices which made the i n s t a l l a t i o n of a t h i r d platform marginally p r o f i t a b l e . The f i r s t case required a continued r e a l growth of 1.5 per cent in world o i l prices s t a r t i n g i n 1985. A l t e r n a t i v e l y , r e a l o i l prices growing at 2.0 per cent after 1986 also made a development pattern based on three fixed platforms more a t t r a c t i v e . Figure 7.2 allows us to compare the simulated e f f e c t s of these two al t e r n a t i v e s p e c i f i c a t i o n s on re a l GNP with those discussed e a r l i e r . The resu l t s are c l e a r . The higher levels of r e a l economic a c t i v i t y induced by the more intensive development patterns are not s u f f i c i e n t to of f s e t the decreases in re a l GNP r e s u l t i n g from the assumed faster growth in r e a l o i l p r i c e s . S i m i l a r l y , gains on the i n f l a t i o n front were reduced and often reversed under the al t e r n a t i v e s p e c i f i c a t i o n s outlined above.^ Why do these re s u l t s emerge? A few reasons suggest themselves. F i r s t , Hibernia is a 'small' project r e l a t i v e " t o the Canadian economy. Second, i t s output of crude o i l i s but a small f r a c t i o n of t o t a l Canadian o i l production (and consumption). F i n a l l y , the additional platform increases Hibernia production only after 1991 and even then, less than 25 per cent more crude o i l is extracted over the relevant period. It i s also suggested that the thrust of these r e s u l t s would not be altered i f the time horizon of the analysis were extended. As table 4.3 t e l l s us, an AAH-fixed production system produces less than 15 per cent more r e a l reserves than does i t s 173 AB-fixed counterpart. Simulations were also undertaken to compare the macroeconomic consequences of d i f f e r e n t regulation and taxation systems as well as a l t e r n a t i v e revenue-sharing arrangements. Results showed that neither the d i r e c t i o n nor the magnitude of the changes in the macroeconomic variables induced by the development and production of Hibernia was sensitive to the choice of f i s c a l environment. This r e s u l t i s in part due to the l e v e l of aggregation which characterizes the structure of MACE. Had i t been possible to keep track of developments in Newfoundland and Labrador separately, the r e s u l t s would probably show a greater s e n s i t i v i t y on the part of the p r o v i n c i a l economy to the choice of f i s c a l environment. 7.3 Resource Discoveries and the 'Dutch Disease' The discovery and e x p l o i t a t i o n of s i g n i f i c a n t resource deposits are l i k e l y to have an impact on the national economy. S i m i l a r l y , sharp increases in the value of an e x i s t i n g stock of resources w i l l have macroeconomic consequences. The discovery and e x p l o i t a t i o n prospects of many important resource deposits in some Western European countries and A u s t r a l i a , as well as the OPEC-led o i l price shocks of the 1970s raised a number of empirical and t h e o r e t i c a l issues of interest to macroeconomists. Thus an economic l i t e r a t u r e on 'The Dutch Disease 1 or 'Booming Sector Economics' appeared i n the mid-1970s and has grown i n s i z e and s o p h i s t i c a t i o n ever since. In general, the s t a t i c model used to examine these issues i s that of a small open economy defined over three sectors: a booming sector, a lagging sector and a sector producing a non-tradeable good. Both the booming and lagging sectors produce goods which are traded on world 174 markets and imports are assumed to be perfect substitutes for domestically-produced importables. Production is modelled to occur through the i n t e r a c t i o n of a factor s p e c i f i c to each sector (sometimes c a l l e d 'natural resources' i n the booming sector, and a form of ' c a p i t a l ' s p e c i f i c to each of the other two sectors), and a factor mobile across a l l sectors, 'labour'. It is usually assumed that the nation's stock of factors is fixed. Thus, there i s no e x p l i c i t savings-investment behaviour on the part of economic agents and factors are assumed to be i n t e r n a t i o n a l l y immobile. 'Labour' moves across the three sectors to e q u i l i b r a t e the wage rate and ensure f u l l employment in the domestic 7 economy. Q Let there now be a discovery of 'natural resources'. The immediate e f f e c t of the boom is to increase the returns to the factors employed in that sector. In turn, this boosts the demand for the three goods since a l l are assumed to be normal. At th i s stage, Corden [1982] and Corden and Neary [1982] d i s t i n g u i s h between two e f f e c t s . A spending e f f e c t is caused by the expansion of the demand for non-tradeables. At constant pric e s , this outward s h i f t of the demand curve creates excess demand in the market for the non-traded good. Its r e l a t i v e price must r i s e (a r e a l apprecia-tion) since, by d e f i n i t i o n , demand for this good must be met domestical-9 l y . To produce this additional output, 'labour' i s drawn from the lagging sector as the wage rate ( i n terms of tradeables) r i s e s . Thus, c e t e r i s paribus, employment in the lagging sector f a l l s , as does i t s output l e v e l . There is also a two-part resource movement e f f e c t . The discovery of 'natural resources' induces an increase i n the marginal product of 'labour' in the booming sector. To equalize the wage rate across sectors, 'labour' moves out of both lagging and non-tradeable sectors and into the 175 booming sector. The supply curves for both sectors experiencing a f a l l i n 'labour' employment thus s h i f t inward and th e i r output levels decrease. At constant r e l a t i v e p r i c e s , the inward s h i f t of the supply curve causes excess demand to emerge, once again, in the market for the non-traded good. As the l a t t e r ' s r e l a t i v e p r i c e r i s e s , a d d i t i o n a l downward pressure i s put on 'labour' employment (and thus output) in the lagging sector. In this simple r e a l model, the output of the lagging sector f a l l s , that of the booming sector r i s e s (by d e f i n i t i o n ) , and the net e f f e c t on the non-tradeable sector i s unclear since spending and resource movement ef f e c t s operate to o f f s e t one another. Because of the structure of the model, the e f f e c t s on sectoral 'labour' employment are in the same d i r e c t i o n as those on output and the same can be said about the returns to s p e c i f i c factors. Most contributions in this f i e l d r e l y on assumptions about capital-labour r a t i o s in the various sectors to derive Rybczynski-type propositions characterizing the f i n a l outcome. 1 0 Over the years, this model has been extended in a number of d i r e c -t i o n s . 1 1 Among those are the modification of the model to include the dynamics of the adjustment process and the treatment of 'natural resources' as an intermediate input instead of a f i n a l good (Bruno and Sachs [1982]), the i n c l u s i o n of a monetary sector (Neary [1982]), the modification of the model for use i n computer simulations (Stoeckel [1979] and other studies using the Au s t r a l i a n ORANI model mentioned therein), the treatment of c a p i t a l as a mobile factor of production (Corden and Neary [1982]) and the allowance for endogenous terms of trade e f f e c t s (Buiter and Purvis [1983]). 176 A l l i n a l l , the conclusions of these studies tend to be quite s i m i l a r . A resource boom is accompanied by an appreciation of the domestic currency, an increase i n the domestic price l e v e l ( i f the model i s dynamic, the domestic i n f l a t i o n rate) and a 'squeeze' of the lagging sector. It should be noted, however, that these r e s u l t s are derived i n absence of any po l i c y response on the part of f i s c a l and/or monetary a u t h o r i t i e s . Such considerations are outside the scope of most of these studies since the models on which they are based are t y p i c a l l y defined i n re a l terms and do not encompass a government sector. Even i f these models were modified to include f i s c a l and monetary a u t h o r i t i e s , i t i s u n l i k e l y that p o l i c y responses could play a s i g n i f i c a n t role in abating the consequences of the 'Dutch Disease' since these models assume that conditions of f u l l employment always p r e v a i l . Corden [1981] and Neary [1982] explore some of these issues i n greater d e t a i l . However, Ellman [1977] uses the Dutch experience to discuss some of the constraints faced by governments and central banks when trying to accommodate r e a l supply-side shocks such as resource booms. To f a c i l i t a t e comparisons with other studies ', I have chosen to examine the consequences of Hibernia under the assumption that no change in f i s c a l and monetary p o l i c y accompany i t s development and production. Within the framework of MACE, the discussion of issues related to the 'Dutch Disease' departs s l i g h t l y from the above. The output of the energy-using sector consists of a single good which i s consumed domestically and traded on world markets. This semi-tradeable good is modelled to be imperfectly substitutable for non-energy imports. The estimated e l a s t i c i t y of su b s t i t u t i o n between domestic and foreign output 177 on world markets is d i f f e r e n t from that for non-energy imports. The supply sector of MACE assigns a special role to 'natural resources'. These are used in the energy-producing sector, in conjunction with c a p i t a l to produce energy, a factor of production in MACE's nested production structure. Once c a p i t a l is in place in one sector or the other, i t can not be moved across sectors. There are, however, p o s s i b i l i t i e s for adjusting the factor proportions, but those are limited by p a r t i a l vintage e f f e c t s in the capital-energy bundle and by the q u a s i - f i x i t y of a l l factors of production. In p r i n c i p l e , labour i s employed in both sectors, although in the version of MACE which I have used, a l l labour is concentrated i n the energy-using sector. Subsequent experiments with a version in which energy employment is separately modelled show that the s p l i t does not make a material d i f f e r e n c e , p r i n c i p a l l y because very l i t t l e labour i s employed d i r e c t l y in the operations phase of the energy industry. For example, in 1982, about 175 thousand individuals were employed in the operations phase of the energy industry, less than 2 per cent of t o t a l employment i n Canada. Section 7.2 above was structured so that a discussion of issues related to the 'Dutch Disease' could proceed at a r e l a t i v e l y fast pace. How do the r e s u l t s described above compare with those obtained from the simulation of the development and production of Hibernia using MACE and the offshore development model? During the construction phase, the investment boom i n the energy-producing sector r e s u l t s in a higher l e v e l of economic a c t i v i t y , which is accompanied by an increase in the general rate of i n f l a t i o n . For reasons outlined in the previous section, an appreciation of the Canadian d o l l a r also ensues as do increases in the demand for a l l factors of production. Nonetheless, a basic manifestation 178 of the 'Dutch Disease' can be observed: r e a l non-energy exports f a l l throughout the period. When the production from Hibernia comes on stream, however, the 12 nature of the r e s u l t s change. As we have seen in the previous subsection, the production of Hibernia induces a higher l e v e l of economic a c t i v i t y and a continued appreciation of the Canadian d o l l a r . This time, however, the appreciation is strong enough to induce a f a l l in the price of energy and a decrease in the output price l e v e l , magnifying the downward pressure on the absorption price l e v e l . What are the e f f e c t s on factor employment and non-energy exports during the production phase? As argued in section 7.2 above, the income ef f e c t s dominate the s u b s t i t u t i o n e f f e c t s generated by the lower r e l a t i v e energy prices and the demand for a l l factors of production r i s e s . In addition, the induced downward pressure on the Canadian-dollar price of non-energy exports i s s u f f i c i e n t l y large to o f f s e t the effects of the appreciation of the Canadian d o l l a r and r e a l non-energy exports r i s e above control levels after the f i r s t two years of production. 7.4 Conclusion What have we learned about the l i k e l y consequences of the development and production of Hibernia on the national economy? Five main conclusions emerge from the analysis undertaken in this chapter. F i r s t , development and production generally cause small but sympathetic movements in most macroeconomic va r i a b l e s . For example, Hibernia adds less than 0.1 per cent to the average growth rate of r e a l GNP over the 1985-1996 period. Second, the o v e r a l l impacts tend to be more sympathetic and larger during the production period than during the construction phase. This 179 r e s u l t can be attributed in part to the fact that, unlike the construction period, the increased levels of economic a c t i v i t y are not accompanied by higher rates of i n f l a t i o n during the production period. This leads d i r e c t l y to issues related to the 'Dutch Disease'. The r e s u l t s of the j o i n t simulations of MACE and the offshore development model suggest that r e a l non-energy exports would f a l l during construction. Although these reductions tend to dampen the r e a l income gains, r e a l GNP is s t i l l above control l e v e l s throughout the e n t i r e period. The r e s u l t s suggest, however, that the flow of production from Hibernia exerts downward pressure on the output price and the absorption p r i c e . Although the production period i s also characterized by a continuously appreciating Canadian d o l l a r , the drop in the output price i s large enough to enhance the competitiveness of Canadian non-energy goods and services on world markets, so that r e a l non-energy exports r i s e above control levels after 1991. A form of the 'Dutch Disease' can thus be associated with the investment boom i n the energy-producing sector during the construction period. Later, however, when the production from Hibernia reduces the r e l a t i v e price of energy, a factor of production in the energy-using sector, the r e s u l t i n g gains on the i n f l a t i o n front are s u f f i c i e n t to eliminate the d e t e r i o r a t i o n of the i n t e r n a t i o n a l competitiveness of Canadian producers imposed by the f a l l i n the price of foreign exchange. The evidence presented i n t h i s chapter also reinforces the conclusions of chapter 4 on the robustness of the choice of an AB-fixed production system. In cases for which r e s u l t s were reported in this chapter, the a d d i t i o n a l gains associated with a more intensive development pattern were never large enough to o f f s e t the s t a g f l a t i o n a r y e f f e c t s of 180 the higher r e a l o i l prices which made the i n s t a l l a t i o n of the t h i r d platform p r o f i t a b l e . F i n a l l y , i t was argued that the simulated macroeconomic consequences of the development and production of Hibernia were not s e n s i t i v e to the choice of regulation and taxation system or of revenue-sharing mechanism. 181 FOOTNOTES 1 Movements in the exchange rate a f f e c t Canadian o i l prices since the new o i l reference price depends on the world price expressed in units of Canadian currency. 2 See H e l l i w e l l , McRae et a l . [1983, Figure 10.2], 3 . . . Investment i n the energy-producing sector i s down since the f a l l i n Canadian o i l prices exceeds that of the absorption price and thus r e a l producer netbacks f a l l . This tends to reduce Canadian o i l production from conventional sources (down an average of about 0.1 per cent between 1985 and 1996). Although natural gas prices are t i e d to o i l prices i n Canada, gas production from conventional sources r i s e s s l i g h t l y to meet the increased demand during the period under study. Gas producers thus perceive the additional demand as providing the opportunity to s e l l quantities of otherwise shut-in reserves. The Hibernia production also increases exports in the form of i n t e r e s t and dividend payments to Canadians as a re s u l t of i t s e f f e c t s on the stock of foreign reserves. 5 A l l three simulations include the same assumptions about the evolution of the world economy. The e f f e c t s would have been magnified had the model allowed faster growing world o i l prices to dampen the growth prospects of Canada's trading partners. For a discussion of the linkages between the e f f e c t s of higher energy prices on the world economy and Canadian economic performance, see H e l l i w e l l and MacGregor [1983], The acronym 'Dutch Disease' was coined early on when the e f f e c t s on the Dutch economy of the discovery and e x p l o i t a t i o n of a huge onshore deposit of natural gas were f i r s t studied. See Corden [1982, pp.2-3]. 7 A more detai l e d outline of the basic model can be found in Corden [1982] on which this short account is based. The boom can take a number of other forms, see Corden and Neary [1982, pp.829 and 839-841]. I have chosen to elaborate on this one because of i t s relevance to the rest of the t h e s i s . q Although the nature of the re s u l t s do not change, the r e a l appreciation takes a d i f f e r e n t form depending on whether fixed or f l o a t i n g exchange rates are assumed to p r e v a i l . On this point, see Corden [1982, pp.7-8] and Harberger [1983, pp.1-2]. 1 0 See, for example, Snape [1977] and Corden and Neary [1982]. 1 1 Eastwood and Venables [1982] use an elegant five-equation macrodynamic model to examine the e f f e c t s of a resource discovery taking the form of a win d f a l l of foreign exchange. Contrary to models where i t is treated as a windfall of foreign exchange, a boom in the form of an increase in the price of o i l has d i f f e r e n t consequences in MACE. For a more complete discussion of this case, see H e l l i w e l l and MacGregor [1983]. FIGURE 7.1 THE IMPACT OF HIBERNIA O N ENERGY INVESTMENT, MILLIONS 1971 D O L L A R S 700-| YEARS 183 FIGURE 7.2 CHANGES IN REAL GNP UNDER ALTERNATIVE PROJECT SPECIFICATIONS, BILLIONS 1971 DOLLARS & 4 4 4 & £ * 4?> S> >?> •?> Legend A CASE 2 - AB X 1.5% 87+ - AAH • 1% 85+ - AAH YEARS FIGURE 7.3 PER CENT C H A N G E S IN CERTAIN K E Y VARIABLES INDUCED BY THE D E V E L O P M E N T OF HIBERNIA 1.8-1 1.5-1.2-0.9-Legend A PFX x P Q • PFX/PQ B PA S RS YEARS FIGURE 7.4 PER CENT CHANGES IN REAL 1971 AND NOMINAL NON-ENERGY EXPORTS INDUCED BY THE DEVELOPMENT OF HIBERNIA 0.45 -| Legend A XNE X PXNE • XNE*PXNE YEARS 186 CHAPTER 8 HIBERNIA, FISCAL EQUALIZATION AND ENERGY RENTS IN CANADA 8.1 Introduction In addition to the macroeconomic impacts discussed in chapter 7, the development and production of Hibernia is l i k e l y to a f f e c t the d i s t r i b u -t i o n of energy revenues within the Canadian federation through i t s implications for f i s c a l e q ualization. In p a r t i c u l a r , i t has elsewhere been suggested that the Canadian equalization system currently i n e f f e c t contains "major dis i n c e n t i v e s for have-not provinces to develop tax bases i n natural resources" (Boadway, F l a t t e r s and Leblanc [1983, p.179]). 1 Since Newfoundland and Labrador i s currently a net re c i p i e n t of equaliza-t i o n payments (and thus a have-not province, in the sense used above) and since the development and production of Hibernia would broaden some of the province's tax bases in natural resources, one of the key tasks of this chapter is to provide some evidence on the v a l i d i t y of this hypothesis. Sections 8.2 and 8.3 are s p e c i f i c a l l y concerned with the role of Hibernia in f i s c a l e q ualization. A number of approaches to equali z a t i o n have been suggested and implemented over the years, and the provisions of four of them are described and modelled. The offshore development model i s then used in conjunction with MACE to determine the e f f e c t s of the pot e n t i a l increase in Newfoundland and Labrador's energy revenues on these a l t e r n a t i v e systems of f i s c a l e q ualization. Because of the aggregate structure of MACE, i t is possible to obtain endogenous estimates of the e f f e c t s of Hibernia on the numerous equaliza-t i o n accounts dealing with energy revenues. E f f o r t s have been made, 187 however, to derive a more complete representation of Newfoundland and Labrador's p o s i t i o n based on exogenous estimates for the non-energy equaliza t i o n accounts. Given a few rules of thumb and a revenue-sharing system, i t is then possible to examine the changes i n the province's t o t a l revenue p o s i t i o n within each of the equalization systems modelled. At the same time, i t i s possible to examine the e f f e c t s of Hibernia on f i s c a l e q u a l i z a t i o n for the other provinces and for the federal treasury. Section 8.4 brings the r e s u l t s of the previous section to bear on MACE's estimates of the economic rents generated by the production and consumption of o i l and natural gas i n Canada. It i s then possible to derive measures of the rents generated by the development and production of Hibernia accruing to Newfoundland and Labrador, the other provinces and the country as a whole. 8.2 Alternative Approaches to F i s c a l E q u a l i z a t i o n The evolution of the p r i n c i p l e s and practice of f i s c a l e q u a l i z a t i o n 2 i n Canada has been documented i n d e t a i l elsewhere and need not be discussed here. Rather, the next few pages contain b r i e f descriptions of the four a l t e r n a t i v e systems of equalization that have been modelled. The Canadian f i s c a l equalization system i n ef f e c t during the 1977-1982 period has elsewhere been c a l l e d the representative national 3 average standard (RNAS). In pr a c t i c e , each province's e q u a l i z a t i o n account was broken down into revenue sources, the number of which tended to vary over the years. If a province's p o t e n t i a l revenues from a given tax source (assessed at national average tax rates) was less than i t s population share of the national tax base for the same source (again assessed at national average tax r a t e s ) , then the province was said to 188 have a 'deficiency' on this revenue source. S i m i l a r l y , a province registered an 'excess' on any given revenue source i f i t s p o t e n t i a l revenues from that source exceeded i t s population share of the national tax base. For each province, the sum of excesses across a l l revenue sources was subtracted from the sum of d e f i c i e n c i e s , and the r e s u l t , i f p o s i t i v e , was the equalization entitlement of that province for the year i n question. The system, however, was asymmetric since 'negative' entitlements ( t o t a l excesses greater than t o t a l d e f i c i e n c i e s ) did not flow back into the system. Rather, they were simply ignored and the federal government undertook the financing of a l l ( p o s i t i v e ) entitlements out of i t s general revenues. Because of the dramatic increases i n energy prices during the early 1970s, energy revenues received special treatment i n the provisions of the RNAS. Thus, only 50 per cent of most non-renewable resource revenues accruing to p r o v i n c i a l governments were allowed to enter the equalization formulae. Four notable exceptions to th i s rule were part of the RNAS and have also been modelled. F i r s t , beginning i n 1981, p r o v i n c i a l government revenues from the sale of Crown leases do not enter any of the c a l c u l a -tions. Second, the system does not d i f f e r e n t i a t e revenues from the p r o v i n c i a l corporation income tax by source, but rather equalizes a l l of them at 100 per cent. Third, the p r o f i t s of p r o v i n c i a l Crown corporations are included in the p r o v i n c i a l corporation income tax base. F i n a l l y , through the 'personal income override', the RNAS for a l l intents and purposes guaranteed that Ontario never received any (posi t i v e ) equaliza-tion entitlement for which i t may otherwise have been e l i g i b l e . However, the implications of the provision which stipulated that energy revenues 189 account for a maximum of one-third of a l l equalization payments have been ignored in the following a n a l y s i s . The present equalization system is due to be i n e f f e c t from 1982 to 1987, and w i l l be referred to as the representative fiv e province standard (RFPS). 4 The RFPS maintains a number of the provisions that were included in the RNAS, such as the d i v i s i o n of equalization accounts into a number of revenue sources, the practice of r e l y i n g on national average tax rates, the i n c l u s i o n of the operating p r o f i t s of p r o v i n c i a l l y owned Crown corporations in the p r o v i n c i a l corporation income tax base, and the asymmetric nature of the system in general. However, the two systems d i f f e r in a number of other respects, some of which are important for the purposes of this t h e s i s . F i r s t , excesses and d e f i c i e n c i e s are now determined by comparing each province's p o t e n t i a l per capita revenues from every source against the corresponding average per capita measures for the f i v e provinces in the standard. M u l t i p l y i n g the t o t a l per capita d e f i c i e n c i e s for a province by i t s t o t a l population w i l l then y i e l d that province's equalization entitlement for the year in question. Second, p r o v i n c i a l revenues from the sale of Crown leases now enter the equalization formulae and 100 per cent of a l l relevant p r o v i n c i a l energy revenues are subject to equalization. However, the t o t a l equaliza-ti o n entitlements w i l l be constrained to grow at an annual rate no larger than the growth of nominal GNP i n 1982-1983. Third, the system provides for a minimum l e v e l of payments. For example, a province whose f i s c a l capacity i s less than 70 per cent of the national average would never see i t s current equalization entitlement f a l l to less than 95 per cent of i t s previous year's entitlement. 5 190 Although the RFPS also includes provisions for ' t r a n s i t i o n a l arrange-ments' and 'population recovery adjustment payments', these have not been modelled. As was mentioned e a r l i e r , both the RNAS and RFPS allow excesses i n some revenue sources to o f f s e t d e f i c i e n c i e s i n others, subject to the constraint that equalization entitlements never become negative. It i s thus important to consider the tradeoffs between energy and other revenue sources when tr y i n g to capture the e f f e c t s of a sudden increase i n energy revenues accruing to a province currently receiving equalization payments. Since MACE is a small, highly aggregated model of the national economy, i t does not provide estimates of po t e n t i a l p r o v i n c i a l revenues from most sources. The exception to this general rule rests with o i l and gas revenues. Here, the structure of MACE's energy-producing sector i s such that estimates of p r o v i n c i a l o i l and gas revenues by source can be derived. Each province's excesses and d e f i c i e n c i e s for these sources can thus be endogenously determined. Nonetheless, capturing the p o t e n t i a l e f f e c t s of Hibernia revenues within the RNAS and the RFPS requires a more complete chara t e r i z a t i o n of Newfoundland and Labrador's equalization account. Assumptions r e l a t i n g to po t e n t i a l equalization entitlements in 1982 and the role of revenues from the p r o v i n c i a l corporation income tax within the RNAS and the RFPS were taken from Perry [1982, tables 4 and 6]. Under ^the RNAS, i t is assumed, when appropriate, that the p o t e n t i a l entitlements of Newfoundland and Labrador remain at th e i r 1982 l e v e l ( i n r e a l terms) throughout the 1982-2036 projection period. S i m i l a r l y , when the provisions of the RFPS were modelled, i t was assumed that the GNP growth rate c e i l i n g applied to the t o t a l d e f i c i e n c i e s a r i s i n g from p r o v i n c i a l o i l and gas 191 revenues, as necessary. The t h i r d f i s c a l equalization system modelled is a variant of the scheme suggested i n Boadway, F l a t t e r s and Leblanc (BFL) [1983]. Simply put, the system equalizes a portion (assumed, as in BFL [1983], to be 25 per cent) of a l l p r o v i n c i a l o i l and gas revenues. As presently modelled, the BFL system treats p r o v i n c i a l corporation income tax revenues from o i l and gas ventures and the p r o f i t s of p r o v i n c i a l Crown corporations i n the same fashion as i t does r o y a l t i e s and other p r o v i n c i a l revenues from the a c t i v i t i e s of the petroleum industry. The BFL system is also assumed to share the asymmetric nature of the RNAS and the RFPS. However, since the o r i g i n a l proposal was s t r i c t l y concerned with the role of p r o v i n c i a l o i l and gas revenues within unspecified systems of f i s c a l e q ualization, I have chosen to concentrate on that aspect of the analysis. P o t e n t i a l excesses and d e f i c i e n c i e s on other revenue sources have thus been ignored. As was suggested in the l a s t few pages, the three f i s c a l e q u a l i z a t i o n systems described above r e l y on the general revenues of the federal government to fund a l l (pos i t i v e ) entitlements. In the t r a d i t i o n of Courchene's 'Equalization Balance Sheets', the r e s u l t s reported i n the next subsection are net of each province's contribution as a source of federal revenues. Estimates of the p r o v i n c i a l d i s t r i b u t i o n of t h i s f i s c a l burden were taken from Courchene and Copplestone [1980, Table 2, Panel A and footnote a]. The fourth system of f i s c a l equalization modelled i s an i n t e r -p r o v i n c i a l o i l and gas revenue sharing pool (RSP). The version modelled c l o s e l y follows the d e s c r i p t i o n provided in H e l l i w e l l and Scott [1981, e s p e c i a l l y chapter 5]. The RSP d i f f e r s from the other three systems 192 modelled p r i m a r i l y because i t forces the o i l and gas t i e r of the e q u a l i z a t i o n system to be s e l f - f i n a n c i n g . The governments of the producing provinces are assumed to put a f r a c t i o n of t h e i r actual o i l and gas revenues into a common pool, out of which each province draws i t s population share. To f a c i l i t a t e comparisons with the BFL system, i t has been assumed that 25 per cent of a l l p r o v i n c i a l o i l and gas revenues are equalized. 8.3 Equalization and the Revenues from Hibernia Tables 8.1 through 8.4 report estimates of the net present value to the provinces and the federal government of the equalization of p r o v i n c i a l o i l and gas revenues. In i n t e r p r e t i n g the r e s u l t s , i t i s useful to note that MACE's modelling of f i s c a l e qualization begins with calendar year 1974. In a l l cases, i t has been assumed that the RNAS is in e f f e c t u n t i l the end of 1981. After that, the provisions of the d i f f e r e n t systems are included in the simulation runs which extend through to 2036, when Canada's conventional reserves of o i l and gas are projected to be f u l l y depleted. To set the stage for the analysis that follows, i t is useful to compare the implications of the four systems modelled in the absence of Hibernia. An important difference between the RNAS and the RFPS emerges from tables 8.1 to 8.4. Although 100 per cent of p r o v i n c i a l o i l and gas revenues are included in the RFPS, the e f f e c t i v e degree of coverage extended to these revenues has f a l l e n . This is due to the fact that Alberta, where about 85 per cent of the Canadian crude o i l and natural gas production takes place, is not included in the standard and i t s revenues do not enter the equalization formulae. As tables 8.1 and 8.3 show, the 193 net ef fect of the switch from RNAS to RFPS is a decrease of about 63 per cent in the post-1981 net present value of the e q u a l i z a t i o n enti t lements of 'have not' provinces . The asymmetric nature of the two systems implies that claims against the federal treasury f a l l by a s i m i l a r amount. By extens ion, the ch ie f b e n e f i c i a r i e s of th is change are the res idents of the most populous 'have' province , Ontar io . In comparison to the RFPS, the prov i s ions of the BFL reduce the proport ion of p r o v i n c i a l o i l and gas revenues which enter the e q u a l i z a t i o n formulae by three -quarters , but also broaden the tax base since revenues from a l l provinces are now inc luded . In genera l , the net e f fects of the BFL are s i m i l a r to those of the RFPS though s l i g h t l y weaker: the net present value of post-1981 e q u a l i z a t i o n entit lements is now estimated to f a l l by 51 per cent for 'have not' provinces . In a d d i t i o n , changes i n the treatment of the p r o v i n c i a l corporat ion income tax base imply that 'have not' provinces with a comparatively high proport ion of th is tax base ( e . g . , Quebec) are more favourably treated under the terms of the BFL. Manitoba i s the province whose p o s i t i o n i s most negat ive ly affected by the provis ions of the RFPS and, in p a r t i c u l a r , the BFL. This i s l a r g e l y due to Manitoba's s p e c i a l s tatus: i t i s the only 'have not' province which present ly c o l l e c t s s i g n i f i c a n t amounts of o i l and gas revenues. As table 8.3 shows, the i n c l u s i o n of a greater proport ion of such revenues (a l a RFPS) or c e r t a i n changes in the treatment of p r o v i n c i a l corporat ion income tax revenues (a l a BFL) w i l l decrease the net present value of Manitoba's e q u a l i z a t i o n entit lements from o i l and gas revenues. By removing the asymmetric nature of the system, the RSP sh i f t s the burden of e q u a l i z i n g o i l and gas revenues towards the producing provinces . As table 8.4 suggests, Ontario becomes a r e c i p i e n t province and 194 the residents of Alberta bear a s u b s t a n t i a l l y larger share of the costs of equalization. In general, the provisions of the RSP leave the t r a d i t i o n a l 'have not' provinces in better positions than the RFPS or the BFL, but s t i l l f a l l short of the RNAS. Again, differences from the RNAS and RFPS i n the treatment of p r o v i n c i a l corporation income tax revenues tend to leave 'have not' provinces with a comparatively high proportion of this tax base in a s l i g h t l y better p o s i t i o n . Before turning to the consequences for f i s c a l equalization of the Hibernia development and production, a few of the features of tables 8.1 to 8.7 should be explained. For the purposes of this chapter, i t has been assumed that the royalty and tax r e l i e f package discussed in chapters 4 and 5 above would be extended to the Hibernia producers under the terms of the N&L c and N&L w. As the r e s u l t s presented in these chapters have shown, the consequences of this a d d i t i o n a l assumption are such that an AB-fixed production system i s now simulated to be p r i v a t e l y optimal under the assumptions of case 2 and the provisions of a l l the royalty and tax systems modelled. The r e s u l t i n g asymmetrical treatment of the p o l i c y regimes in question also has some implications for the d i s t r i b u t i o n of the 7 all-government share of the net revenues from Hibernia. However, in the present context, these issues are of secondary importance since the federal government bears the larger share of the burden of this form of r e l i e f under the N&L c and N&L w. In this chapter, the key issues concern the e f f e c t s of f i s c a l equalization on given structures of revenue flows to the p r o v i n c i a l treasury. Proceeding in the fashion outlined above of f e r s the advantage of eliminating differences across revenue-sharing systems i n the e f f e c t s of f i s c a l equalization that could arise only because of differences in project s i z e . 195 The designation ' f u l l ' under the RNAS and RFPS headings refers to cases where i t was assumed that the p o t e n t i a l equalization entitlements of Newfoundland and Labrador would always be large enough to o f f s e t f u l l y a l l excesses on the relevant o i l and gas revenue sources. S i m i l a r l y , for the RNAS, ' l i m i t ' refers to cases where the p o t e n t i a l entitlements of Newfoundland and Labrador were constrained to grow no faster than the general rate of i n f l a t i o n . For the RFPS, '95%' and '90%' denote cases for 8 which the minimum payment lev e l s discussed e a r l i e r are assumed to apply. The r e s u l t s reported in table 8.1 suggest that, in the absence of Hibernia production, Newfoundland and Labrador would be a net r e c i p i e n t of e q u a l i z a t i o n payments (at least on o i l and gas revenue sources) under a l l of the f i s c a l equalization systems modelled. These re s u l t s also show that in the presence of Hibernia, the marginal contribution of equalization to the f i n a n c i a l p o s i t i o n of the Newfoundland and Labrador government i s negative. In some cases (most frequently encountered under the RFPS), this tendency is strong enough to transform Newfoundland and Labrador into a net contributor to f i s c a l e q u a l i z a t i o n . The r e s u l t s presented in table 8.1 suggest that the reductions in the net present value of equalization entitlements to Newfoundland and Labrador tend to be the highest under the provisions of the RFPS. Two features account for t h i s . F i r s t , contrary to the other three systems modelled, 100 per cent of a l l p r o v i n c i a l o i l and gas revenues enter the RFPS' equaliz a t i o n formulae. Second, any equalization system which seeks to r a i s e the p o s i t i o n of 'have not' provinces up to a v a r i a b l e standard w i l l treat these provinces harshly when the i r governments experience increases in revenues i f t h e i r p o s i t i o n i s not considered in the d e f i n i t i o n of the standard. Again, the RFPS stood alone among the four 196 e q u a l i z a t i o n systems modelled in displaying this c h a r a c t e r i s t i c . However, the available evidence suggests that the RFPS' provision of minimum l e v e l s of payments could s u b s t a n t i a l l y c u r t a i l the p o t e n t i a l reductions in the net present value of equalization to Newfoundland and Labrador. These r e s u l t s , nonetheless, lend considerable support to the hypothesis outlined in the f i r s t paragraph of this chapter. As we have seen, of the four f i s c a l equalization systems modelled, the RFPS con s i s t e n t l y reduces the net present value of equalization to Newfoundland and Labrador by the largest amount when the development and production of Hibernia are simulated. Whether these e f f e c t s are strong enough for Hibernia ever to induce a net worsening of Newfoundland and Labrador's f i n a n c i a l p o s i t i o n can not r e a d i l y be determined from the r e s u l t s reported i n table 8.1. However, the analysis undertaken i n the next section i s designed to shed some l i g h t on this type of issue. Given a revenue-sharing system, the provisions of the RNAS tend to r e d i s t r i b u t e a smaller proportion of the p r o v i n c i a l government's revenues from Hibernia than does the RFPS. This r e s u l t i s a t t r i b u t a b l e , i n large part, to the fact that a smaller proportion of the relevant revenues i s e l i g i b l e for equalization. The only revenue-sharing system for which this r e s u l t does not hold (the N&L w) i n fact confirms the importance of the factor outlined in the previous sentence. Under the terms of the N&L w, a substantial portion of the Hibernia revenues accruing to the p r o v i n c i a l treasury do so as a r e s u l t of the NLPC's p a r t i c i p a t i o n i n development and production a c t i v i t i e s . As noted e a r l i e r , 100 per cent of the operating p r o f i t s of such p r o v i n c i a l Crown corporations enter the equalization formulae under the RNAS. The r e s u l t s reported i n table 8.1 also show that the ' l i m i t ' imposed on the terms of the RNAS has n e g l i g i b l e consequences 197 under a l l of the revenue-sharing systems modelled. A comparison of the consequences of Newfoundland and Labrador's p o s i t i o n und er the BFL and the RSP suggests that differences between si m i l a r 'net' and 'gross' equalization systems are r e l a t i v e l y minor for 'have not' provinces with a small population base. However, these differences would be magnified with increases in either the proportion of p r o v i n c i a l revenues subject to equalization or the proportion of federal taxpayers r e s i d i n g in the 'have not' province experiencing a boost in o i l and gas revenues. In addition, as the r e s u l t s for the N&L c and N&L w in table 8.1 show, attempts by the governments of 'have not' provinces to s h i f t i n th e i r favour the d i s t r i b u t i o n of net revenues from projects s i m i l a r to Hibernia through the use of p r o v i n c i a l Crown corporations are constrained by the impacts of such actions on f i s c a l e qualization. The r e s u l t s for the N&L w demonstrate that this e f f e c t i s stronger when p r o v i n c i a l Crown corporations become f u l l equity partners i n s p e c i f i c projects. In some instances (the RNAS), this i s p a r t l y due to the fact that a greater proportion of the p r o f i t s of these Crown corporations are subject to eq u a l i z a t i o n . More important, however, i s the fact that i t i s the operating p r o f i t s of such corporations which enter the e q u a l i z a t i o n formulae. Their a c t i v i t i e s during the construction period are thus not subsidized through f i s c a l e qualization in any of the systems modelled. The r e s u l t s presented in table 8.2 suggest that the net present value of equalization to the federal government con s i s t e n t l y reaches i t s highest point under the provisions of the RFPS, with the obvious exception of the RSP. This i s p a r t l y because the p o t e n t i a l revenues from Hibernia translate into much lower equalization entitlements for Newfoundland and Labrador, 198 and since the l a t t e r i s not one of the provinces which defines the standard, this generates l i t t l e i n the way of additional equalization Q entitlements for the other 'have not' provinces. E f f e c t s of the development and production of Hibernia on the net present value of equaliza t i o n to the other provinces generally follow the same pattern as those on the federal treasury. As for the consequences under the terms of the RSP, tables 8.3 and 8.4 t e l l us that they vary according to the province's share of the country's population. A point which i s not evident i n tables 8.1 to 8.4 must be made. The development and production of ad d i t i o n a l o i l and gas deposits from which the government of Newfoundland and Labrador would obtain d i r e c t revenues would l i k e l y have d i f f e r e n t implications than the above under the provisions of the RNAS, RFPS and BFL. Because of the asymmetric feature of these 'gross' revenue systems, the equalization entitlements of a given province can not continue to f a l l once t o t a l excesses equal t o t a l d e f i c i e n c i e s . Any p r o v i n c i a l government revenues derived from the development and production of additional f i e l d s would thus face much smaller p o t e n t i a l equalization entitlements and, consequently, translate into smaller reductions i n the net present value of equalization for Newfoundland and Labrador. 8.4 Hibernia and the D i s t r i b u t i o n of O i l and Gas Rents i n Canada This section focuses on the r e l a t i o n s h i p between the re s u l t s of sections 6.2, 7.2 and 8.3 above. Tables 8.5 to 8.7 report estimates of the l e v e l and d i s t r i b u t i o n of economic rents generated by the production and consumption of o i l and gas in Canada for a number of d i f f e r e n t cases. Since MACE and the offshore development model calculate economic r e n t s 1 0 199 i n the same manner, the i r r e s u l t s can be r e a d i l y aggregated. However, i t is useful to remember that exploration and other pre-development expenditures related to Hibernia are accounted for in the energy-producing sector of MACE up to the end of 1983. The d i s t r i b u t i o n of the economic rents among the provinces i s determined as follows. It i s assumed that a given province receives any rents captured by i t s government as a r e s u l t of the production of o i l and gas within i t s boundaries, i t s population share of the economic rents accruing to the federal government and Canadian producers, as well as the consumer rents accruing to i t s residents. The estimates in tables 8.5 to 8.7 also r e f l e c t the net e f f e c t s of f i s c a l equalization on the d i s t r i b u t i o n of o i l and gas revenues accruing to p r o v i n c i a l governments. Table 8.5 shows that the development and production of Hibernia r e s u l t s in a net increase of about 3.7 b i l l i o n end-1984 d o l l a r s i n the o i l and gas rents accruing to Canadians under the base case assumptions and the terms of the federal l e g i s l a t i o n . 1 1 This amount i s s l i g h t l y i n f e r i o r to the $4.1 b i l l i o n a t t r i b u t a b l e to the project i t s e l f since i t incoporates the e f f e c t s of the increased energy consumption and, i n p a r t i c u l a r , of the Hibernia-induced revaluation of the o i l and gas reserves of the Western sedimentary basin documented in section 7.2 above. O v e r a l l , these two e f f e c t s thus reduce the magnitude of the economic rents accruing to Canadians from o i l and gas by about $400 m i l l i o n . What do tables 8.5 to 8.7 t e l l us about the impact of Hibernia on the i n t e r - p r o v i n c i a l d i s t r i b u t i o n of these rents? Let us f i r s t concentrate on Newfoundland and Labrador. The r e s u l t s reported i n table 8.5 are consistent with those presented in table 8.1. The net e f f e c t of f i s c a l 200 equalization on the p o s i t i o n of Newfoundland and Labrador is to r e d i s t r i b u t e (to the residents of other provinces) some of the rents from Hibernia accruing to that province's government under a l l of the revenue-sharing systems modelled. As expected, given the res u l t s presented in the last section, the net impacts of the BFL and the RSP on the province's p o s i t i o n are quite s i m i l a r . Their provisions are such as to leave with the residents of Newfoundland and Labrador the greatest proportion of the Hibernia rents accruing to that province's government under a l l the revenue-sharing systems modelled. Nonetheless, the r e s u l t s suggest that almost 50 per cent of these rents could be r e d i s t r i b u t e d i f the terms of the N&L w were to apply. Obviously, these r e s u l t s depend c r i t i c a l l y on the proportion of p r o v i n c i a l o i l and gas revenues assumed to enter the equalization formulae. With the exception of the N&L w under the RNAS, the res u l t s show that the provisions of the RFPS r e d i s t r i b u t e the largest proportion of the Hibernia rents accruing to the government of Newfoundland and Labrador. Even when the '95%' l i m i t i s assumed to apply, more than 50 per cent of Newfoundland and Labrador's share of the Hibernia rents are r e d i s t r i b u t e d under a l l of the.revenue-sharing systems modelled. As table 8.5 shows, when the ' f u l l ' impact of the RFPS i s allowed to be f e l t , three of the revenue-sharing systems (F NSA, N&L c and N&L w) are estimated to leave the residents of Newfoundland and Labrador f i n a n c i a l l y worse o f f with Hibernia than without. That this r e s u l t i s reversed when the minimum payments constraints are imposed again t e s t i f i e s to the i r importance to Newfoundland and Labrador. Ove r a l l , the r e s u l t s from simulations including the provisions of the RFPS provide strong support to the hypothesis 201 advanced i n sect ion 8.1 above: the terms of the RFPS do contain important d i s i n c e n t i v e s for 'have not' provinces to develop tax bases in natura l resources . As the analys i s has shown, these d i s incent ive s ex is t in a l l of the revenue-sharing systems modelled but are p a r t i c u l a r l y strong under the RFPS. Although the key factors which under l ie the resu l t s obtained in t h i s sec t ion have already been discussed in sect ion 8.3 above, l e t me emphasize one: in a l l of the e q u a l i z a t i o n systems modelled, p r o v i n c i a l government revenues (or , in some ins tances , operat ing p r o f i t s ) and not rents are being equa l i zed . Since the relevant Hibernia revenues are not assumed to flow c o s t l e s s l y to the government of Newfoundland and Labrador, a l l the e q u a l i z a t i o n systems modelled w i l l tend to r e d i s t r i b u t e a greater proport ion of economic rents than of the revenues underlying i t . However, th is ignores , as does the rest of the a n a l y s i s , the d i s t r i b u t i o n a l and a l l o c a t i v e consequences of any rent-seeking migrat ion to Newfoundland and Labrador induced by the development and production of H i b e r n i a . The r e s u l t s reported in table 8.5 also reveal that under three of the e q u a l i z a t i o n systems modelled (RNAS, BFL, RSP), the res idents of Newfoundland and Labrador are f i n a n c i a l l y better of f under the terms of the N&L c than when the provis ions of the N&L w are assumed to p r e v a i l . Under the same set of assumptions, but in the absence of f i s c a l e q u a l i z a t i o n , the re su l t s presented in chapter 6 above supported a d i f f e r e n t conc lus ion: from the province 's perspec t ive , the terms of the N&L w were f i n a n c i a l l y pre ferrab le to those of the N&L c. This r e v e r s a l i n the rankings (from Newfoundland and Labrador's perspect ive) of the two r o y a l t y and taxat ion qua revenue-sharing systems is due to a fact that was discussed in the previous sec t ion: the operat ing p r o f i t s of the NLPC are 202 subject to equalization. Sometimes a greater proportion of these p r o f i t s enters the equalization formulae than do other types of provincial 1 3 government revenues from o i l and gas but more importantly, the a c t i v i t i e s of the NLPC are not subsidized by any of the equalization sytems during the construction period. Why do we observe that Newfoundland and Labrador is s t i l l better off f i n a n c i a l l y with the N&L w than with the N&L c under the two ' l i m i t ' RFPS cases considered? The answer to this question i s closely linked to that of another puzzle contained in table 8.5: why does the RFPS redistribute substantially less of the province's rents under the F NSA than under the N&L c when the other equalization systems modelled treat these two revenue-sharing systems almost i d e n t i c a l l y ? The terms of the N&L c are such that the bulk of the province's revenues from Hibernia accrue only after the investment-related time period during which the NLPC draws no revenues from the f i e l d has passed. By then, the wedge between the province's assumed 'potential' equalization entitlements and the assumed minimum payment levels i s much larger than i t was e a r l i e r in the productive l i f e of the f i e l d and thus r e l a t i v e l y more of the province's revenues (and hence rents) from Hibernia are redistributed. The pattern of revenues accruing to Newfoundland and Labrador under the F NSA and the N&L w follows more closely the production p r o f i l e for the f i e l d : i t shows an early peak followed by a period of gradual decline. During the early years of production, the wedge between the 'potential' size of equalization payments and the minimum payment levels i s smaller and thus less of the province's Hibernia revenues are redistributed through equalization. 203 What are the consequences of the development and production of Hibernia for the other provinces? One conclusion c l e a r l y emerges from the r e s u l t s of tables 8.6 and 8.7. For provinces other than Newfoundland and Labrador, the most important issue i s not how the economic rents from Hibernia are shared between producer and government, nor between the two l e v e l s of government concerned, nor even what kind of equalization system i s presumed to p r e v a i l . Rather, the largest impact comes primarily through the development and production of the f i e l d ' s reserves. As tables 8.6 and 8.7 show, once the f i e l d is assumed to be developed and produced, changes in any aspects of the rules governing the d i s t r i b u t i o n of the revenues from the f i e l d have r e l a t i v e l y small e f f e c t s . 8.5 Conclusion The r e s u l t s obtained in this chapter are s e n s i t i v e to two factors which have yet to be discussed. F i r s t , i f a greater share of Canada's population were to reside i n Newfoundland and Labrador then, c e t e r i s paribus, the aggregate r e d i s t r i b u t i o n a l impacts reported above would have been r e l a t i v e l y smaller. This would ar i s e in part because a greater share of the rents accruing to the federal government and to Canadian shareholders of companies i n the operating consortium would have flowed to Newfoundland and Labrador. More importantly, the terms of a l l the equalization systems modelled are such that the higher the population of the province experiencing an increase in o i l and gas revenues, the lower the portion of a given stock of energy revenues accruing to i t s government that would be r e d i s t r i b u t e d , everything else held equal. Second, the nature and the role of the wedge between the 'potential' and 'minimum' equalization payments increase the importance of the assumptions 204 concerning the future path of price i n f l a t i o n i n Canada. Keeping i n mind the reservations expressed i n the previous paragraph, the following general conclusions are supported by the results presented in this chapter. F i s c a l equalization w i l l play an important role i n the determination of the ultimate d i s t r i b u t i o n of the stock of economic rents in Hibernia. As tables 8.1 and 8.5 have shown, the design of the equaliza t i o n system i s at least as important to Newfoundland and Labrador as are the provisions of the revenue-sharing system. Results from simulations of MACE and the offshore development model co n s i s t e n t l y show that less than 50 per cent of the Hibernia rents accruing to the p r o v i n c i a l government remain with the residents of Newfoundland and Labrador under the provisions of the equalization system currently i n ef f e c t (the RFPS). In support of the hypothesis presented i n the introduction to this chapter, the evidence obtained in the last two sections does show the existence i n the RFPS of important disincentives for 'have not' provinces to develop tax bases i n natural resources. 205 FOOTNOTES See also Courchene [1983, pp.471-472]. The interested reader i s referred to Canada, Parliamentary Task Force on Federal-Provincial F i s c a l Arrangements [1981], Courchene and Copplestone [1980], Economic Council of Canada [1982], Perry [1982] and the references given therein. Much of the terminology used in this chapter has been taken from Courchene [1983]. The f i v e provinces in question are B r i t i s h Columbia, Saskatchewan, Manitoba, Ontario and Quebec. The corresponding l i m i t s are 90 per cent for a province whose f i s c a l capacity i s between 70 and 85 per cent of the national average, and 85 per cent for any other province currently e l i g i b l e to receive equalization payments. Although f i s c a l equalization in Canada i s dealt with on a f i s c a l year basis, the r e s u l t s reported in this chapter r e f l e c t the fact that both MACE and the offshore development model are based on calendar years. See section 6.2, and figures 6.1 and 6.2 above. The i n d i r e c t e f f e c t s of Hibernia on other sources of p r o v i n c i a l government revenues are ignored in this thesis. Consideration of such issues would magnify the po t e n t i a l reductions in equalization payments flowing to Newfoundland and Labrador. However, as we s h a l l see l a t e r , the structure of c e r t a i n systems (RNAS and, i n p a r t i c u l a r , RFPS) would tend to moderate t h i s tendency. Additional entitlements to other 'have not' provinces w i l l only be generated i f Newfoundland becomes a 'have' province (for e q u a l i z a t i o n purposes) at a time when the GNP growth rate c e i l i n g would otherwise have been binding. For a d e s c r i p t i o n of the operational d e f i n i t i o n of economic rents used i n this t h e s i s , see section 6.1 above. Economic rents accruing to consumers of o i l and natural gas products are the compensated consumers' surpluses between world and Canadian p r i c e s . Consumers do not d i r e c t l y capture any add i t i o n a l rents from Hibernia since i t s production replaced an equivalent flow of imported o i l and was priced at world-equivalent l e v e l s . As section 6.2 above showed, the increase is smaller under the terms of the Newfoundland and Labrador l e g i s l a t i o n since more of the rents generated by Hibernia accrue to foreign-owned producers. 206 As Courchene [1983, p.472] suggests, such situations w i l l be exacerbated by the need for the p r o v i n c i a l government to finance i n f r a s t r u c t u r e developments necessary to the project, expenditures which are ignored by the provisions of a l l of the equalization systems modelled and not included in the r e s u l t s reported in this chapter. See the re s u l t s for the N&L w under the RNAS in table 8.5. Table 8.1 Net Present Value of Equalization to Newfoundland and Labrador O i l and Gas Revenues, b i l l i o n s end-1984 d o l l a r s Equalization System No Hibernia F MAR F NSA H i b e r n i a 1 N&L c N&L w to 1981 - RNAS 0.88 * * * * to 2036 - RNAS2 f u l l l i m i t 1.94 * 1.29 1.29 0.29 0.29 0.92 0.92 -0.56 -0.55 li m i t -RFPS 2 f u l l 95% 90% 1.29 * * -0.05 0.12 0.02 -2.57 -0.56 -0.90 -1.36 -0.46 -0.76 -4.50 -0.67 -1.05 BFL 1.44 1.12 0.49 0.81 0.02 RSP 1.59 1.26 0.63 0.95 0.17 * not applicable These estimates are based on an assumed AB-fixed production system. To make th i s production system p r i v a t e l y optimal under the N&L c and N&L w, i t has been assumed that the s p e c i f i c forms of royalty and tax r e l i e f discussed i n chapters 4 and 5 above are extended to the producer. 2 These estimates r e f l e c t the potential effects of Hibernia revenues on exogenous estimates of Newfoundland and Labrador's equalization entitlements. Table 8.2 Net Present Value of Equalization to the Federal Government O i l and Gas Revenues, b i l l i o n s end-1984 d o l l a r s Equalization No H i b e r n i a 1 System Hibernia F MAR F NSA N&L c N&L w to 1981 - RNAS -18.7 * * * * to 2036 - RNAS2 f u l l -41.0 -40.6 -40.0 -40.4 -39.7 l i m i t * -40.6 -40.0 -40.4 -39.7 RFPS 2 f u l l -27.1 -25.8 -23.2 -24.2 -21.1 l i m i t - 95% * -26.0 -25.3 -25.1 -24.9 90% * -25.9 -24.9 -24.8 -24.5 BFL -29.5 -29.2 -28.8 -29.0 -28.5 RSP -18.7 -18.7 -18.7 -18.7 -18.7 * not applicable These estimates are based on an assumed AB-fixed production system. To make this production system pr i v a t e l y optimal under the N&L c and N&L w, i t has been assumed that the s p e c i f i c forms of royalty and tax r e l i e f discussed i n chapters 4 and 5 above are extended to the producer. 2 These estimates r e f l e c t the potential effects of Hibernia revenues on exogenous estimates of Newfoundland and Labrador's equalization entitlements. Table 8.3 Net Present Value of Equalization to Other 'Have Not' Provinces O i l and Gas Revenues, b i l l i o n s end- 1984 d o l l a r s 1 to RNAS RFPS BFL RSP 1981 f u l l l i m i t f u l l 95% 90% MARITIMES2 2.43 No * 5.35 * 3.57 * * 4.03 4.52 Hibernia F MAR * 5.41 5.41 3.64 3.63 3.64 4.06 4.54 F NSA * 5.52 5.52 3.76 3.66 3.69 4.12 4.59 N&L c * 5.46 5.46 3.67 3.62 3.64 4.09 4.56 N&L w * 5.65 5.65 3.81 3.64 3.66 4.17 4.62 QUEBEC 8.11 No * 17.68 * 11.96 * * 13.66 16.18 Hibernia F MAR * 17.94 13.89 12.28 12.24 12.27 13.79 16.26 F NSA * 18.39 18.39 12.88 12.40 12.48 14.06 16.43 N&L c * 18.13 18.13 12.48 12.26 12.34 13.92 16.34 N&L w * 18.81 18.81 13.23 12.32 12.42 14.26 16.56 MANITOBA 1.12 No * 2.51 * 1.36 * * 0.63 2.31 Hibernia F MAR * 2.55 2.55 1.41 1.40 1.41 0.63 2.32 F NSA * 2.62 2.62 1.50 1.43 1.44 0.65 2.35 N&L c * 2.58 2.58 1.45 1.42 1.43 0.64 2.33 N&L w * 2.69 2.69 1.57 1.43 1.44 0.66 2.37 * not applicable 1 These estimates are based on an assumed AB-fixed production system. To make th i s production system privately optimal under the N&L c and N&L w, i t has been assumed that the s p e c i f i c fo of royalty and tax r e l i e f discussed in chapters 4 and 5 above are extended to the producer. 2 MARITIMES refers to the provinces of Prince Edward Island, New Brunswick and Nova Scotia. 210 Table 8.4 Net Present Value of Equalization to 'Have' Provinces l Oil and Gas Revenues, b i l l i o n s end-1984 dollars to RNAS RFPS BFL RSP 1981 f ul I 1 imit ful 1 95$ 90% ONTARIO -7.27 No * -15.93 • -10.54 * * -11.46 3.13 Hibernia F MAR * -15.76 -15.76 -10.02 -10.09 -10.05 -11.36 3.24 F NSA * -15.55 -15.55 -9.03 -9.82 -9.67 -11.20 3.46 N&L c * -15.71 -15.71 -9.41 -9.77 -9.65 -11.28 3.35 N&L w * -15.42 -15.42 -8.18 -9.69 -9.54 -11.08 3.63 SASKATCHEWAN -0.63 No * -1.38 * -0.91 * * -0.99 -1.20 Hibernia F MAR * -1.37 -1.37 -0.87 -0.88 -0.87 -0.99 -1.18 F NSA • -1.35 -1.35 -0.78 -0.85 -1.16 -0.97 -0.84 N&L c * -1.36 -1.36 -0.82 -0.85 -0.84 -0.98 -1.17 N&L w * -1.34 -1.34 -0.71 -0.84 -0.83 -0.96 -1.14 ALBERTA -2.25 No * -4.92 * -3.26 * * -3.54 -25.08 Hi berni a F MAR * -4.87 -4.87 -3.10 -3.12 -3.10 -3.51 -25.01 F NSA * -4.81 -4.81 -2.79 -3.03 -2.99 -3.46 -24.96 N&L c * -4.85 -4.85 -2.91 -3.02 -2.98 -3.49 -24.98 N&L w * -4.76 -4.76 -2.53 -2.99 -2.95 -3.42 -24.90 B.C. -2.39 No * -5.24 * -3.47 * * -3.77 -1 .46 Hi bernia F MAR * -5.19 -5.19 -3.30 -3.32 -3.31 -3.74 -1.43 F NSA * -5.19 -5.19 -2.97 -3.23 -3.19 -3.69 -1.36 N&L c * -5.17 -5.17 -3.10 -3.21 -3.17 -3.71 -1 .39 N&L w * -5.07 -5.07 -2.69 -3.19 -3.14 -3.65 -1.30 not applicable These estimates are based on an assumed AB-fixed production system. To make t h i s production system privately optimal under the N&L c and N&L w, i t has been assumed that the specific forms of royalty and tax r e l i e f discussed in chapters 4 and 5 above are extended to the producer. Table 8.5 Economic Rents from O i l and Gas Resources, b i l l i o n s end-1984 d o l l a r s Canada and Newfoundland and Labrador Equalization System No Hibernia NEWFOUNDLAND and LABRADOR to 1981 - RNAS 3.11 F MAR Hibernia F NSA N&L c N&L w to 2036 - no equal. (after 1981) 5.46 6.87 9.05 7.67 8.33 to 2036 - RNAS f u l l l i m i t 6.52 * 7.28 7.28 8.46 8.46 7.71 7.71 6.89 6.90 li m i t -RFPS f u l l .95% 90% 5.87 * * 5.95 6.12 6.02 5.60 7.62 7.28 5.43 6.33 6.03 2.95 6.78 6.40 BFL RSP 6.02 6.17 7.11 7.25 8.67 8.81 7.60 7.74 7.48 7.62 CANADA' to 1981 to 2036 * 1 227.9 491.3 * 495.0 * 495.0 * 494.3 * 494.5 not applicable These estimates are based on an assumed AB-fixed production system. To make this production system privately optimal under the N&L c and N&L w, i t has been assumed that the s p e c i f i c forms of royalty and tax r e l i e f discussed in chapters 4 and 5 above are extended to the producer. Economic rents accruing to Canadians are ins e n s i t i v e to the choice of equalization system. Table 8.6 Economic Rents from O i l and Gas Resources, b i l l i o n s end-1984 do l l a r s Other ' 'Have Not' Provinces to RNAS RFPS BFL RSP 1981 f u l l l i m i t f u l l 95% 90% MARITIMES2 8.99 No * 18.80 * 17.03 * * 17.48 17.98 Hibernia F MAR * 19.03 19.03 17.27 17.26 17.26 17.69 18.17 F NSA * 19.00 19.00 17.23 17.14 17.15 17.60 18.06 N&L c * 18.99 18.99 17.19 17.15 17.16 17.62 18.09 N&L w * 19.14 19.14 17.31 17.13 17.15 17.66 18.11 QUEBEC 31.30 No * 69.32 * 63.59 * * 65.29 67.82 Hibernia F MAR * 70.25 70.25 64.59 64.55 64.57 66.10 68.57 F NSA * 70.11 70.11 64.60 64.12 64.20 65.78 68.15 N&L c * 70.04 70.04 64.38 64.17 64.24 65.83 68.25 N&L w * 70.59 70.59 65.02 64.10 64.20 66.04 68.34 MANITOBA 6.01 No * 14.46 * 13.31 * * 12.57 14.25 Hibernia F MAR * 14.61 14.61 13.46 13.46 13.46 12.69 14.37 F NSA * 14.58 14.58 13.46 13.39 13.40 12.61 14.31 N&L c * 14.57 14.57 13.44 13.41 13.42 12.63 14.32 N&L w * 14.66 14.66 13.54 13.40 13.41 12.63 14.34 * not applicable These estimates are based on an assumed AB-fixed production system. To make th i s production system privately optimal under the N&Lc and N&L w, i t has been assumed that the s p e c i f i c forms of royalty and tax r e l i e f discussed i n chapters 4 and 5 above are extended to the producer. 2 MARITIMES refers to the provinces of Prince Edward Island, New Brunswick and Nova Scotia. 213 Table 8.7 Economic Rents from Oi I and Gas Resources, b i l l i o n s end-1984 dollars 'Have' Provinces 1 to RNAS RFPS BFL RSP 1981 f u l l l imit f u l l 95$ 90% ONTARIO 32.74 No * 76.52 * 81.91 * * 81.00 95.59 Hibernia F MAR * 77.56 77.56 83.30 83.23 83.27 81.95 96.55 F NSA * 76.97 76.97 83.50 82.70 82.84 81.32 95.99 N&L c * 77.08 77.08 83.37 83.01 83.14 81.50 96.13 N&L w * 77.20 77.19 84.43 82.92 83.07 81.53 96.25 SASKATCHEWAN 14.05 No * 28.01 * 28.48 * *• 28.40 28.19 Hibernia F MAR * 28.11 28.11 28.61 28.60 28.61 28.49 28.29 F NSA * 28.04 28.04 28.60 28.54 28.55 28.42 28.23 N&L c * 28.05 28.05 28.60 28.57 28.58 28.44 28.25 N&L w * 28.06 28.06 28.69