Wednesday, November 13, 2013

On shortsighted assumptions

Time for a true or false pop quiz. Is the following a self-evident statement of economic fact?
"A capital asset which is not currently being exploited has a value of zero for all purposes."
I only ask because that seems to be the fundamental assumption behind Andrew Leach's cost-benefit analysis comparing raw bitumen mining to upgrading. And unfortunately, Leach's viewpoint seems to fit all too well with the current resource management philosophy of provincial and federal governments alike.

Here's Leach's conclusion as to a hypothetical set of developments - one involving an extraction project alone, one an attached upgrader:
On a per-barrel basis, the numbers are equally ambiguous – in fact, you’d probably say that the upgrader looks better. Revenues per barrel of bitumen extracted are higher with the upgrader, at an average of $80.80 per barrel vs. $62.93 for the mining project alone. Average costs (capital, debt, and operating costs combined) are higher for the integrated project, at $43 per barrel of bitumen produced and upgraded versus $29.15 for the mine, while royalties and taxes are similar at around $19 per barrel of produced bitumen in both cases. The result is that the upgrader earns higher cumulative cash flows, by $4.10, per barrel of bitumen produced.
There’s also a trick in the per-barrel numbers above – the project with an upgrader earns higher cash flow per barrel, but it produces far fewer barrels—1.7 billion fewer. So, over the life of the two projects, the total royalties and taxes collected from mining and upgrading combined versus bitumen extraction alone would be lower by $36.6 billion, while the profits to the producer would be lower by $13.4 billion. Combined, for a similar capital investment and with similar associated jobs, the bitumen extraction project returns $50 billion more in royalties, taxes, and profits.
But how much of a "trick" is it to recognize that the upgrader project leaves an additional 1.7 billion barrels of oil in the ground to be produced - providing an opportunity for further development once the single proposed project is in its operations phase?

That question is particularly important in light of the Cons' usual message around oil transportation. The Harper line is of course that every drop of oil will ultimately be squeezed out of the tar sands - and if anybody questions a particular pipeline or tanker traffic scheme, the Cons will instead approve a balloon-and-catapult system to launch dilbit in the general direction of Shenzhen, with the resulting splashback covering the entire northern hemisphere to be explained away by a vigorous chant of "ethical oil!".

By the same token, if it's true that accessible tar sands reserves will ultimately be fully developed (with some public policy desire to brand Canada as an "energy superpower" serving as an excuse to bridge gaps in actual demand), then the appropriate means of evaluating the resulting benefit is precisely the per-barrel calculation rejected by Leach - even if it takes somewhat longer to get there.

Alternatively (and more plausibly), one can ask whether other developments might make further extraction uneconomical at some point in the future. But surely the risk of changed economic conditions represents at most a basis for partially discounting the value of reserves in the ground - not a valid reason to assign them a giant zero, or consider any acknowledgement of their existence as a "trick".

Unfortunately, far too many people seem willing to assume our land and resources have no value in their current state - resulting in our accepting minimal royalties and massive environmental damage as the price of immediate extraction. And while it may not be easy to assign an exact price to that which doesn't get ripped out of the ground, it's not at all difficult to see how the zero-value assumption is wrong on its face.

[Edit: fixed typo.]


  1. Dennis Bevington9:03 a.m.

    An excellent analysis of our short sighted policy.Read my speech on Hansard, 1255 pm on last Thursday on this topic, as part of the Keystone Debate

  2. Thanks for the note.

    And for those looking for the speech, it's available here. Of particular note, I'll echo Dennis' statement as to the value of developing our own cleaner upgraders rather than depending on the Koch's U.S. infrastructure.

  3. And that's not even getting into the (eg environmental) costs associated with ripping the stuff out of the ground. While there are also costs associated with upgrading, I doubt they're as great. For one thing, after you've used water for extracting bitumen, refining oil from bitumen may be among the few things you can still use it for.

    What I'm getting at is that smaller projects would have advantages in things like "still having some drinking water", "some wildlife not being full of arsenic", "fewer local people dying of cancer" and so on. Of course these costs never get into the accounting.

  4. Greg,

    Thanks for reading my piece. I see how you can to your initial paragraph, but I disagree with some of your takeaway. Your comment that the un-produced barrels on the intgrated site would still have value is absolutely valid. The point you make, extended to labour markets, I believe supports my point. For example, most studies of "job creation" through upgrading assume (at least implicitly) that you can add a producing facility to the economy at no opportunity costs (i.e. that the labour used to upgrade those barrels was otherwise idle). The ideal model (to answer both your comment and the broader point I am trying to make) would be a fully integrated model of the oil sands sector within the Canadian economy, which you could run out for decades, and test the implications of turning switches on and off. I don't have one of those (yet) and if I did, it would be such a black box that people would be unlikely to believe the results anyway. So, what did I do? I looked at two investments, with two dimensions (capital and production horizon) held constant. By definition, other dimensions won't necessarily be constant between the projects and you've pointed out one of those.

    On the question of opportunity cost, I think there's a valid issue as to whether we actually have reserve scarcity in the sense that barrels in the ground would command much of a shadow value. Given the volume of leased and unleased land, I think you could argue it either way. The problem with managing oil sands is not really one of managing a scarce resource in the "running out of oil" sense - it's managing a resource which we likely won't ever physically exhaust.

    I'll do a lease-level calculation in the future and see if I can run the integrated facility out an extra couple of decades to levelize total produced barrels and initial investment.