Canadian Natural Resources Limited Suite 2100, 855 2nd Street SW, Calgary, Alberta, T2P 4J8 T F

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1 October 30, 2015 Alberta Royalty Review Panel th Floor, North Petroleum Plaza Street Edmonton, Alberta T5K 2G6 Sent via royaltyreviewpanel@gov.ab.ca RE: Canadian Natural Resources Limited Canadian Natural Resources Limited (Canadian Natural) appreciates the opportunity to provide input to the Alberta Royalty Review Panel. The core challenge facing the Alberta Royalty Review Panel is to ensure that there is a competitive royalty framework that maximizes the full value provided by the oil and natural gas industry, including jobs, economic benefits, and government revenues. To realize this full value, Alberta will need to attract and maintain ongoing investment in the oil and natural gas industry. The work of the panel is an opportunity to consider ideas and proposals from Albertans to optimize the fiscal terms and regulatory framework which maximizes the full value for Albertans, including jobs, economic benefits and government revenues. The panel also needs to ensure that oil and natural gas companies can make a competitive investment return that attracts and maintains investment which provides value for Albertans. This submission is intended to provide constructive ideas to support the important work of the panel. Canadian Natural looks forward to continued engagement with the panel and the Alberta Government as ideas are considered and refined in the coming months. Working together, we hope to achieve a competitive fiscal and regulatory environment that will benefit Albertans through jobs and government revenues for years to come by ensuring a healthy oil and natural gas industry. Introduction Abundant, affordable, and reliable energy is essential to modern life. Many independent analysts expect demand for oil and natural gas to grow in order to meet this demand. Canada and, particularly, Alberta are blessed with ample energy resources that can help meet Canada s and the world s needs. The oil and natural gas industry, however, has changed with technology breakthroughs; especially horizontal drilling and hydraulic fracturing that has now made the United States a major supplier of lower cost shale oil and natural gas. As a result, there is a lot more oil and natural gas available to meet global demand, and Alberta has become a high cost supplier due to the nature of our oil and natural gas resources. Canadian Natural Resources Limited Suite 2100, 855 2nd Street SW, Calgary, Alberta, T2P 4J8 T F

2 Alberta needs to create a fiscal, regulatory and environmental regime focused on being competitive in a changing global marketplace. A competitive regime will allow industry to maintain and grow investment while creating jobs and benefits for all Albertans. There are many factors that drive industry s return on capital, which attracts investment and creates jobs. Canadian Natural has a role in managing costs and to a certain extent controls operational and capital costs. To address increasing costs, Canadian Natural has been focused on reducing costs and improving the way we do business. The Alberta Government determines fiscal terms and regulations, which are also important factors influencing competitiveness and return on capital. The one factor that Canadian Natural or the government cannot control is geology and the nature of our resources. With technology breakthroughs, U.S. shale oil and natural gas is lower cost than the majority of Alberta s resources, providing these regions with an inherent competitive advantage over Alberta. Introduction to Canadian Natural Canadian Natural is a large independent oil and natural gas producer, and is proud to be a Canadian company based in Alberta. We take pride in delivering energy to Canada and the world in a safe, effective, efficient, and environmentally responsible manner. Canadian Natural is an Alberta-based company with more than 7,000 employees, with operations spread across 90 communities in the province. Canadian Natural is a balanced company with operations in all aspects of the industry, including natural gas, conventional and heavy oil, oil sands, upgrading and refining. This makes Canadian Natural a proxy for the oil and natural gas industry in Alberta. In 2014, Canadian Natural was able to create 74,000 person-years worth of work in Alberta and paid more than $2.4 billion to the Alberta Government in royalties, land sales, crown leases and corporate taxes. Opportunities for Alberta Canadian Natural takes pride in what we do, and in the province and country that we call home. Alberta has long led the country in job opportunities and economic growth. Industry and previous governments have done a poor job of educating Albertans on the full economic benefits that the oil and natural gas industry provides as well as how the royalty system works in Alberta. As an industry, however, we are proud of working hard and turning this province s abundant resource wealth into energy that has made the world a better place to live and created a better life for the vast majority of Albertans. We are proud of the innovation and technology that have allowed us to improve our operations, becoming more effective and efficient over time. We take pride in leaving our natural environment as good as, or better than, when we arrived. We take pride in constantly working to improve our environmental performance, not only to meet world-leading regulations, but because this is our home. Canadian Natural Resources Limited Page 2 of 14

3 Despite the significant challenges facing industry, Alberta has a lot of advantages that give good reason for optimism. We have a large resource base of long-life, low-decline assets in the oil sands, strong unconventional natural gas assets in the Deep Basin and Montney, as well as mature assets that continue to provide new opportunities to create economic activity and employ a large number of Albertans. We also have a highly skilled workforce that has proven our ability to be innovative and leverage technology to create value for all Albertans. Innovation continues to unlock new opportunities by building off traditional strengths and mature assets. For example, Canadian Natural has used advanced polymer flooding techniques at our Pelican Lake operations since The process uses a non-toxic polymer solution to improve resource recovery. In so doing, Canadian Natural plans to recover four times more oil than originally anticipated, while generating additional jobs and government revenues for many years, all from what was a mature and declining field. Our proven ingenuity has the potential to serve Alberta well. Technology and innovation should deliver reduced costs, increased productivity, and improved environmental performance. Innovation can also develop new products and services that leverage traditional oil and natural gas strengths in order to create new and diverse opportunities for our province. For Alberta to realize the opportunities created by its large resource base there needs to be a fiscal and regulatory environment that is competitive with U.S. shale oil and natural gas that recognizes the inherent geologic advantages U.S. resources have compared to Alberta. If we can seize this opportunity to create a competitive fiscal and regulatory environment, the oil and natural gas industry will benefit Albertans through long-term jobs and government revenues. A competitive fiscal and regulatory environment will position Alberta to maintain and create high skills jobs as well as help meet increased global demand for our oil and natural gas products. The Alberta Government is well positioned to help Canada achieve tidewater access so that Alberta s energy can receive world prices. There is a significant opportunity to generate increased government revenues, but also to attract more investment to Alberta. Drivers for Investment There is a direct connection between the jobs created in Alberta and the investment the oil and natural gas industry makes in developing resources in Alberta. More investment in the oil and natural gas industry creates jobs and delivers more production, which also results in increased royalty revenues as well as more corporate and personal tax revenues. Industry needs to provide a strong return on capital employed to attract investment, which in turn creates jobs and prosperity for the province. If returns on investment are eroded, investment goes to competing jurisdictions, and jobs and government revenues are lost. Canadian Natural Resources Limited Page 3 of 14

4 Alberta is a High Cost Jurisdiction for Oil and Natural Gas Development Alberta s oil and natural gas industry as a whole has demonstrated poor returns even in the recent high oil price environment of 2013 and 2014 with crude oil prices of US$98/bbl and US$93/bbl WTI respectively. Industry return on capital employed was low, ranking 65 th out of 67 industrial sectors in Canada despite high oil prices. 1 Industry is now even more challenged to deliver good returns in today s low-price environment. Return on Investment (%) Return on Capital Erosion Senior Independents average (HSE,CVE,SU,APA,APC,CNQ,DVN,NXY,TLM,ECA) (Source: BMO Capital Markets) $120 $100 $80 $60 $40 $20 $0 Price of Oil (WTI, US$/bbl) Interestingly, this graph demonstrates that industry realized better returns in 2004 than 2013 even though prices were much lower in This erosion of returns in a high commodity price environment is a global trend as costs have gone up in all areas of the world. Cost increases have been significant over the last decade and have negatively impacted industry s returns. For instance, Canadian Natural has faced dramatic cost increases since 2004 driving down overall returns on capital even at higher prices. Since 2004, Canadian Natural has realized a 49% increase in revenue per barrel of oil equivalent (BOE), net of transportation. By means of comparison, Alberta s Consumer Price Index increased by 24% over the same period. The following table shows that over the last decade, Canadian Natural s many other costs in Alberta increased considerably more than revenues. 1 Statistics Canada reports average return on capital employed by sector. Source: Canadian Natural Resources Limited Page 4 of 14

5 Driver for return Factor change relative Determining factor to revenue (2004 vs per BOE) Labour 7.4x Global and local inflation, industry has some ability to control Iron Ore Price* 9.9x Market-driven Copper Price 1.9x Market-driven Fuel 1.3x Market-driven Power & Communications 1.5x Market-driven Lease Rentals 4.9x Market and Government controls Property Taxes 5.2x Government controls Royalties 2.5x Government controls Regulator Fees 3.2x Government controls Taxes Paid 32.9x Government controls *Iron ore is a base material to manufacture all steel components used in the industry. This means that over the last decade labour costs grew 7.4 times more than revenues, Alberta corporate taxes paid grew 32.9 times, and royalties grew 2.5 times. The table demonstrates that since 2004, return on capital has been eroded by rising capital and operating costs, increased regulatory costs, and deteriorating fiscal terms including multiple changes to royalties. As commodity prices rose, the overall cost for oil and natural gas development increased. Royalties, for instance, are subject to a sliding scale, which means that rates increase with price and production rate and as can be seen from the chart increased much faster than the oil and natural gas prices. This is not a surprise and is one of the strengths of the royalty system that should provide Albertans confidence that the royalty system works. Labour costs also provide a clear example of cost increases following rising commodity prices. At first glance the dramatic increase in labour costs could be interpreted as low productivity and poor management by oil and natural gas companies and suppliers, and increasing regulatory burdens. If we take operating costs as an example, when commodity prices are high, the economic returns justify developing smaller oil and natural gas reservoirs often having wells that produce at lower production rates, increasing production royalties, employment, and economic benefits for Alberta. However, every well requires the same number of operators and service provider staff to maintain production regardless of its productivity. Subsequently, this type of activity and the increased number of wells requires more labour per barrel and in this way, increased labour costs can be a function of increased prices as demonstrated in the following chart. Canadian Natural Resources Limited Page 5 of 14

6 Canadian Natural - Labour Costs 22 Production Rate Labour 21 20% % Source: Canadian Natural Internal Data Year Production Rate (BOE/Well/Day) Labour ($/BOE) A similar dynamic exists for costs like lease rentals and property taxes. These costs remain relatively stable per well, but as industry develops lower rate wells, these costs consume a greater proportion of revenues generated. That said, additional activity can be beneficial to both the industry and the province because it generates jobs, royalties, and taxes for Alberta. This is why it is important for royalty curves to be designed in a way that ensures competitive rates at both low and high commodity prices to optimize Alberta s total economic benefits. The current system saw royalties increase 2.5 times that of prices in a high price environment, one could argue increasing too much. As seen in the above graph, the production rate per well has dropped by 20% since 2009, and the labour cost as a percentage of cost per BOE has increased 20%. Evidently, labour productivity has not declined and wage rates have not risen out of control. It is a function of drilling low rate wells that are economic at high prices, providing increased royalties, taxes and employment for Albertans. Working Together to Create and Maintain Jobs To attract and maintain investment, industry and the province must find ways to deal with these increased costs and reduced returns. To this end, Canadian Natural has been focused on reducing costs and improving the way we do business for several years. Cost saving efforts at Canadian Natural include: reduction in costs related to improved productivity, material cost reductions, right-scoping, as well as technology, innovation adoption, contractors and employees. These are factors over which we have the most control. Canadian Natural Resources Limited Page 6 of 14

7 These efforts have delivered major improvements in costs to drill and complete wells across several areas of operation. For instance, Canadian Natural has realized a 24% cost reduction for drilling in the deep basin (natural gas): 7 Canadian Natural Deep Basin Natural Gas Drilling Program Cost Reductions Drilling Costs ($millions) Industry has also made considerable progress in controlling capital costs for major projects. For instance, Canadian Natural expects capital costs for Horizon Expansion (Phase 2/3) to be in line with costs for Phase 1, even though commodity prices have been higher in the Phase 2/3 construction period. Major Capital Projects - Cost Control $100,000 $89,000 $85,000 - $95,000 $80,000 $60,000 $40,000 $20,000 $0 Horizon Phase 1 ( ) Horizon Phase 2/3 ( ) $ Per Flowing Barrel This is not a surprise as industry returns on capital have been very poor and industry has taken many steps to control costs. For instance, industry now builds larger projects in smaller phases to gain better cost control, productivity, and with less demand on the labour pool. The chart below shows how mining and upgrader projects have spread out their demand for labour in recent expansions. Canadian Natural Resources Limited Page 7 of 14

8 Canadian Natural does not support concepts purporting to use the royalty system to restrict activity in an effort to control costs. Industry itself has already taken and continues to take steps to control costs. It will also have the unintended consequences of stopping a significant segment of resource development at higher prices, resulting in lost jobs, royalty revenues and taxes for Alberta. Such efforts are unlikely to deliver the desired effect and may cause significant disincentives to future investment. Investment decisions are best determined by return on capital and market forces. Government determines fiscal terms and regulations, which are major factors influencing competitiveness and return on capital. There have been significant increases in costs associated with taxes, royalties, and regulator fees. Given the current challenges, it is very important to achieve improved regulatory process and fiscal policy outcomes. As it stands, Alberta s existing royalty rates are generally higher than those in neighbouring British Columbia and Saskatchewan. Furthermore, the U.S. shale oil and natural gas industry has been very effective at seizing opportunities to generate greater returns, attract greater investment and create more jobs in the United States. This has put Alberta at a competitive disadvantage not only with producers in the United States but also with other provinces. Alberta has the opportunity now to improve the fiscal and regulatory terms for Alberta s oil and natural gas industry in order to attract and maintain investment that provides the associated jobs and indirect benefits to all Albertans. Canadian Natural appreciates this opportunity to work together with the panel and government to do so. Canadian Natural Resources Limited Page 8 of 14

9 Key Royalty Principles The Royalty Review panel has been tasked with assessing Alberta s royalty framework with respect to four objectives: 1) To provide optimal returns to Albertans as owners of the resource. 2) To continue to encourage industry investment. 3) To encourage diversification opportunities such as value-added processing, innovation or other forms of investment in Alberta. 4) And to support responsible development of the resource To satisfy these objectives, Alberta s royalty framework should be guided by the following principles: Competitive: The royalty system should be competitive with other jurisdictions to attract and maintain private sector investment. It should also respect and protect existing investment decisions. To do so, Alberta s royalty system must allow industry to earn a competitive return on investment. o The royalty system should also recognize that the majority of Alberta s resources are at an inherent geologic and cost disadvantage compared to other jurisdictions, in particular U.S. shale oil and natural gas. To ignore this disadvantage may result in the wrong outcome and put Alberta jobs at risk. Responsive: Current royalty systems automatically adjust in response to changes in price and production rate over the life cycle of a well/project. This system works well, however the royalty take at high prices needs to reflect the increasing cost burden that accompanies a rise in commodity prices. Innovative: Royalty systems should be forward-looking and flexible in order to adapt to and incent the development of new plays and application of new technologies. In this way, an effective royalty system can promote the development of new resources, improve resource conservation by maximizing recovery, and encourage enhanced recovery technology. Predictable: Provide confidence to Albertans, industry, and investors that royalty rates will be predictable and responsive to market factors to ensure competitiveness in a changing global marketplace. Industry has made significant and long-term investments in Alberta based on established fiscal terms. Changes to fiscal terms should enhance predictability and competitiveness for existing investment and encourage future investment. Comprehensive: Consider royalties, corporate taxes, municipal property taxes, greenhouse gas charges, and industry employment as a whole. The royalty system should also consider the life cycle of oil and natural gas investment, including the higher cost of capital for private sector investors. Canadian Natural Resources Limited Page 9 of 14

10 Policy Recommendations Guided by these principles, Canadian Natural is providing the following ideas for the Alberta Royalty Review Panel s consideration. Canadian Natural looks forward to continued engagement with the panel and the Alberta Government as ideas are considered and refined in the coming months. Recommendations for overall industry competitiveness: 1. Consider opportunities to ensure a competitive fiscal and regulatory environment To maintain and create jobs, Alberta will need to balance potential changes to the royalty framework with the need to attract and maintain investment in the oil and natural gas industry. This balance will need to consider the cumulative impact of regulatory and fiscal changes, including recent increases to corporate taxes and the carbon levy. The cumulative impact of regulatory and fiscal changes includes property taxes, lease rentals, corporate taxes, and regulatory fees. The inherent geologic resource disadvantage of Alberta s resources versus U.S. shale oil and natural gas should also be fully taken into account. Recommendations for conventional crude oil and natural gas: 1. Recognize core features of the existing royalty framework Following recent changes in 2010, the current framework is now well-understood by industry. Alberta should be cautious about substantial changes again so soon, which risk unnecessary disruption, increased uncertainty, and additional cost for both industry and government. The current royalty framework is already responsive to price fluctuations and is calibrated to production rate. Significant investment has been made based on the existing royalty framework. Any changes should not adversely impact the economic basis of existing investments. 2. Conserve programs that maximize value for deep drilling and emerging technology, which improve stability and confidence for investment The following programs should be made permanent features of the royalty framework: New Well Royalty Rate (NWRR), Natural Gas Deep Drilling Program (NGDDP), and Horizontal Oil New Well Royalty Rate (HONWRR). These programs will incent activity that creates jobs and long-term revenue for Alberta. Many of these programs were originally intended to become permanent features of the royalty framework. The timelines for resource development are long, and making these programs permanent allows industry to invest with confidence that royalty rates will be predictable and responsive to market factors. Canadian Natural Resources Limited Page 10 of 14

11 Specific royalty programs for the development of new plays and technology should be periodically reviewed to ensure their effectiveness, and any adjustments should be made with adequate consultation and notice. 3. Simplify programs with a focus on incenting innovation and maximizing resource recovery Optimize existing base curves and features, while looking for enhancements, transparency and simplification. Introduce a measured depth factor adjustment to the base oil royalty calculation similar to the one used in the base gas royalty calculation that would treat hydrocarbon products in the same manner. This will increase reserves and economic benefits by incenting longer, more complex drilling that minimizes the environmental footprint. An incentive program to promote re-stimulation of existing well bores would encourage putting mature assets to work in a way that would generate revenue for both government and industry while prolonging the life of the reservoir and reducing the environmental footprint Evaluate combining some existing programs to deliver the same outcomes while driving administrative efficiencies for industry and government. o Consider combining the Horizontal Gas New Well Royalty Rate and Horizontal Oil New Well Royalty Rate programs. This would help to harmonize product treatment. Continue to collaborate with industry in working out simplifications to the Gas Cost Allowance (GCA) program. 4. Consider opportunities to enhance the royalty framework with a focus on incenting innovation across all aspects of the oil and natural gas industry and promoting responsible development which will increase reserves and economic benefits to Alberta. Create a program for mature assets to maximize the value of existing operations for industry and government. For instance, mature oil assets with high water-to-oil ratios inherently have much higher operating costs. At high commodity prices, high operating costs combine with high, sliding scale royalty rates to erode returns. A royalty program that accommodates the unique nature of mature assets can optimize returns to the province by encouraging industry to continue investing in existing operations. This maintains existing jobs and provides opportunity to advance technology and innovation, while limiting inactive well inventory. o As an example, this type of program at our Nipisi field would allow us to invest in technology and innovation to recover nearly 500 million barrels of oil remaining that would otherwise be left behind. These programs will result in extending the life of the field, creating long-term jobs, tax revenues, and lease rentals for Albertans with the opportunity for future innovative options. Canadian Natural Resources Limited Page 11 of 14

12 Change the Natural Gas Deep Drilling Program to treat oil and natural gas the same. Furthermore, remove the vertical depth requirement to qualify for deep drilling programs. Allow activities related to abandonment and reclamation to obtain royalty credit. In so doing, the royalty system could help reduce inactive wells and abandonment liabilities. Apply a sliding scale royalty to natural gas plant liquids, which would be consistent with the treatment of other products and would encourage efficient processing. Create an innovation royalty credit for technology adoption that improves environmental performance and/or resource recovery. Create an infrastructure royalty credit for industry contribution to public infrastructure, including roads and high-load corridors. These suggested programs to incent innovative recovery and abandonments will extend the life of many mature fields, providing full economic value (jobs, taxes, indirect and induced) for generations to come in Alberta. Alberta receives many economic benefits beyond royalties from the oil and natural gas industry activity including land sale revenues, employment, lease rentals and corporate taxes. These must be incorporated into the evaluation of the proposed royalty changes and it is not necessary to have offsetting royalty increases to compensate for amended royalty programs. The existing sliding scale royalty regime adjusts royalty rates based on both commodity prices and production rates. o Wells with low production rates have marginal economics but help maximize resource recovery and provide excellent employment opportunities in Alberta. As a result, the royalty rates on these wells should remain unchanged, and in fact, there is a strong argument that the royalty rates on these wells should be lowered to maintain employment. o Wells with high production rates do pay high royalties (up to 40%) at both low and high commodity prices. Wells with the highest production rates are likely to be newly drilled wells and therefore provide greater economic benefits for the province from drilling activity, facility fabrication and construction, as well as incremental production and operating staff. The royalty rates on these wells should also remain unchanged to ensure the economic viability of new drilling activity in Alberta. o There may be an opportunity to adjust the minimum royalty rate in the sliding scale on wells that produce at reasonable production rates when commodity prices are higher. Any changes must be carefully considered to ensure that drilling activity is not impacted, resource recovery is maximized and jobs are not lost. Canadian Natural Resources Limited Page 12 of 14

13 Recommendations for oil sands: 1. Continuation of the overall project-based, revenue minus costs bitumen royalty framework and the underlying principles of the generic oil sands royalty (OSR) regime The overall royalty framework and its underlying principles are supported by industry, and the oil sands sliding scale royalty calculation is already responsive to commodity price fluctuations. Preserving fiscal certainty and stability for industry is important to encourage future oil sands investment. Substantial investment has been made based on the existing royalty regime. Any royalty regime changes should be made on a go-forward basis and should not adversely impact the economic basis of existing investment. Review of the oil sands sliding scale royalty calculation to replace the WTI/$CDN oil price marker with the Western Canadian Select (WCS) oil price marker. This would better match the oil sands project royalty calculation with the oil sands project revenues received. 2. The Bitumen Valuation Methodology (BVM) for the royalty pricing of non-arm s-length bitumen dispositions should be principle-based, transparent and continue to use WCS as the oil price marker Consider including project oil quality adjustments for total acid number (TAN) and sulphur in the BVM royalty pricing methodology in addition to project density to more appropriately reflect the market value of the bitumen produced. Consider elimination of the BVM Floor Price provision to align royalty treatment with the market value of bitumen. 3. Consider opportunities to enhance the oil sands royalty regime with a focus on incenting innovation, value-added processing, and responsible development Provide additional flexibility for the OSR recognition of research and innovation costs Encourage value-added processing through the oil sands royalty regime for integrated projects which are producing synthetic-crude oil or partially upgraded bitumen. Provide a mechanism for the recognition of otherwise OSR eligible abandonment and reclamation costs that have been incurred for a post-production OSR project. 4. Recognition under the oil sands royalty regime of all principle-based costs Review of current ineligible costs, including the Joint Canada-Alberta Oil Sands Environmental Monitoring program which should be considered eligible based upon the underlying principles of the oil sands royalty regime. The oil sands royalty regime should recognize all new principle-based costs such as those relating to any new Alberta or Federal climate change rules. Increase the time-period rules for the recognition of all prior historical project costs. These costs form the basis for economic decisions which drive cost-effective, responsible and staged oil sands development. Canadian Natural Resources Limited Page 13 of 14

14 Recommendations for energy literacy and education: 1. Industry and the Government of Alberta should ensure that Albertans are well informed with respect to the full value the oil and natural gas industry generates for the province including jobs, economic benefits (direct, indirect, and induced), as well as government revenues (royalties, land sales, surface rentals, corporate and municipal taxes and carbon levies). Conclusion The challenge facing Alberta is to ensure we have a competitive royalty framework that maximizes the full value provided by the oil and natural gas industry, including jobs, economic benefits, and government revenues. To realize this full value, Alberta will need to be able to attract and maintain ongoing investment in the oil and natural gas industry. While the industry is challenged in the current environment and we do have inherent geologic disadvantages to U.S. shale oil and natural gas, Alberta does have a lot going for it. And if this royalty review ensures a predictable and durable royalty framework that attracts and maintains investment in the diverse set of resource development options, then Albertans will benefit through jobs and government revenues for years to come. Canadian Natural looks forward to continued engagement with the panel and the Alberta Government as ideas are considered and refined in the coming months. Canadian Natural Resources Limited Page 14 of 14