Alberta Modernized Royalty Framework: C* Winners and Losers

February 15, 2016 by

Editor’s Note: While VISAGE rebranded to VERDAZO in April 2016, we haven’t changed the VISAGE name in our previous blog posts. We’re proud of our decade of work as VISAGE and that lives on within these blogs. Enjoy.

With recent information released about the Revenue Minus Cost (RMC) approach of the Alberta Modernized Royalty Framework (MRF), there has been much discussion within the industry about the C* capital cost calculation. At VISAGE we have been donating our time and resources to industry associations to provide analytic insights into the C* calculation. Today I will share with you my own analysis and shed some light on the plays that are likely to be winners or losers of the C* calculation. My motive is to offer statistical insight, fuel discussion and explore opportunities that may minimize unfair advantages, or disadvantages, to any particular plays, and operators.

C* = a1 × (TVD) + a2 × (TVD – Vdeep) + a3 × (TVD × TLL)

The C* formula calculates the Drilling and Completion Capital Cost Allowance that can be recovered during the pre-payout 5% royalty period. A nice summary can be found in the GLJ blog The Modified Royalty Framework: What We Know and Don’t Know.  It is worth mentioning that if C* is based solely on Drilling and Completion costs it will typically only account for 70 to 80% of the total capital costs of a well… perhaps that is a topic for another blog? In the meantime I will calculate C* using a1 = 800, a2 = 4500, a3 = 0.6 and V deep = 2250 meters. … these are estimates being used by some groups in the industry until the final values are published.

At a quick glance the C* calculation has a strong correlation to the Drilling and Completion (D+C) costs available in CDL’s (Canadian Discovery Limited) Well Completion and Frac Database. The equation has a slope of 0.95 suggesting that C* underestimates Drilling and Completion costs by about 5 %. However, on an aggregate basis the sum of the C* values are 3% higher than the sum of the D+C costs for all 2,786 wells.1---royalty-C-vs-D+C-Cost

The distribution of C* is also very similar to the distribution of D+C Costs, with Mean values (of probit best fit regressions) falling within 4% of one another. The two charts discussed thus far suggest that the C* calculation is a good proxy for D+C Costs …. for some plays yes, and for some plays no…

2---royalty-Probit-Distribu

If you look at the average C* value, as a percentage of D+C Costs, by Resource Play Group (excluding groups with < 20 wells) you will see that there are three groups where C* is on average significantly higher than the D+C costs. A total of seven groups appear to have their D+C Costs at least 5% underrepresented by C*. Looking at the entire dataset, 60% of wells have a C* value that is greater than 100% of the D+C costs (mostly attributable to the large well counts in the Deep Basin and Cardium plays).

3---Royalty

If we look at this from another perspective, showing distributions of the material ($) difference between D+C costs and C* by Resource Play Group, we can get a sense of how many wells are not adequately represented by C*. The following chart shows a comparison of the main “Winner” plays (denoted with a diamond symbol) and the main “Loser” plays (denoted with an X symbol).

4---Royalty

The chart above emphasizes the wells where D+C costs are far in excess of C* values (i.e. those to the right of the red vertical line). The three biggest “Loser” Resource Play Groups on this chart are:

  1. Charlie Lake: has high completion costs but falls below the V deep threshold, thus does not get the same HZ length completion cost considerations as a deeper play.
  2. Montney/Doig Gas: has much higher completion costs that are underrepresented by [a3 x (TVD x TLL)], Part 3 of the C* equation.
  3. Duvernay Gas: has much higher completion costs that are underrepresented by [a3 x (TVD x TLL)], Part 3 of the C* equation.

Here are some stats that might help put some of this into perspective:

Winner-Loser-Comparison2
Part 3 of the C* equation [a3  x (TVD x TLL)] attempts to recognize that costs associated with completing lateral sections of horizontal wells increases with depth. The data suggests that it may not adequately represent completion costs of shallower plays (e.g. Charlie Lake), or plays with higher proppant use and associated costs (e.g. Montney/Doig Gas and Duvernay). It further suggests that any horizontal wells that do not use expensive completion techniques could be over-compensated by this part of the equation.

You would expect that any good analysis will deliver insights that lead to more questions… like:

  • Should C* include a factor/proxy that better accounts for completion costs? Perhaps an [a4 x (Tonnes of Proppant)] consideration?
  • Are there reasons why proppant should not be used as a proxy for completion costs?
  • Should depth be de-emphasized in favour of more emphasis on completion costs?
  • Should HZ length be considered independently from depth, to better accommodate horizontal wells without significant completion costs?
  • Could the previous ideas/questions minimize unfair advantages, or disadvantages to any particular play … where one size better fits all?
  • Are the most attractive plays for investment expected to have higher completion costs?
  • Will ‘strategic overlays’ and ‘special allowances’ deal with situations where the C* formula cannot adequately represent the costs of a well?
  • Is the industry trending towards higher proppant for faster payout and higher EUR?
  • Should we encourage faster payout to shorten the RMC (Royalty Minus Cost) 5% royalty period?
  • Would faster payouts encourage capital reinvestment and improve provincial royalty revenues?
  • Will the companies be required to submit accurate cost information to help the government with annual re-calibrations?

While there are dozens of additional analyses that I have done, they all result in a similar narrative and the same kinds of questions as above. At VISAGE we’ll continue to work with our industry peers to ask questions, perform analyses and improve the understanding of what C* means for everyone involved. If you have suggestions please let us know.


The Data Used in this Analysis

The Western Canadian Sedimentary Basin has a richness of data not found anywhere else in the world. One of those datasets which allows us to include Drilling and Completion Costs in our analyses is Canadian Discovery Limited’s Well Completion and Frac Database . Their cost data is often called into question as it is derived from data that is submitted to the government by operators. Perhaps operators should consider the benefits of having this data available for these kinds of analyses and make efforts to submit more reliable data? Regardless, in our experience, and verified by dozens of clients, the cost information in the Well Completion and Frac Database is considered to be a reasonable proxy for actual costs and is statistically representative in larger datasets.

For this analyses, we used Alberta wells spudded in 2013 and 2014, with oil and/or gas production, that had D+C Costs populated in the Well Completion and Frac Database.

The C* parameters used in the calculation were a1 = 800, a2 = 4500, a3 = 0.6 and V deep = 2250 meters

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Production data: IHS Information Hub

Completion and Frac Data: Well Completions and Frac Database from Canadian Discovery

Analysis: VISAGE

Thanks for reading. We welcome your questions and suggestions for future blogs.

Some other blogs you may find of interest:

About VISAGE – visual analytics for the petroleum industry VISAGE analytics software equips operators and analysts in the petroleum industry to make the most valuable and timely decisions possible. VISAGE brings together public and proprietary oil and gas data from multiple sources for easy to use interactive analysis.