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Opportunity Lost? Alberta is Facing Short and Long Term Financial Challenges, Despite its Oil Wealth

February 25, 2013
Alicia Macdonald

Alicia Macdonald
Senior Economist
Forecasting and Analysis

Todd Crawford

Todd A. Crawford
Senior Economist
Forecasting and Analysis

The economy in Alberta is booming—investment in its energy sector is skyrocketing, labour shortages abound, and its wages are growing much faster than the national average. But scratch the surface of Alberta’s boom and one quickly realizes that the province is grappling with significant challenges. In the short-term, the considerable discount on heavy Canadian crude oil prices has led to a marked drop in provincial royalty revenues and has the potential to curtail energy-related investment in the province. Furthermore, the issue on how wealth generated from extracting non-renewable resources will be shared with future generations remains unsettled. Finally, despite the fact that its economy is doing well, Canada’s richest province is facing a $4 billion budget deficit—a clear indication that now is the time to rethink Alberta’s fiscal framework.

Five years ago, crude oil prices were on the rise. “Peak oil” was the theme of the day, and the oil sands were projected to play an increasingly important role in the North American market. But circumstances have changed and hydraulic fracturing and directional drilling techniques have opened up vast reserves in shale and tight oil plays previously considered uneconomic. As a result, North America finds itself awash in oil but without the pipeline capacity to get its new production to the Gulf Coast refineries. The lack of pipeline capacity is causing WTI oil prices to trade at a discount to other global benchmarks. (See chart “Canadian Crude Price Far Below International Benchmarks”). The situation is worse north of the border, with further pipeline constraints causing Western Canadian Select (a benchmark price for Alberta oil) to trade about $25-35 below WTI, a discount that is expected to continue until additional pipeline capacity is constructed. The large discount on Alberta oil is negatively impacting government resource royalties, corporate profits and is bringing the actual price received by producers very close to the break-even price point for production in some parts of the oil sands. As a result, the billions of investment dollars expected to flow into Alberta over the next 10 to 20 years could be at risk.

Chart "Canadian Crude Price Far Below International Benchmarks"

In the long-term, Alberta faces the challenge of how to share the resource wealth of today with future generations. The Alberta Heritage Savings Trust Fund was established to save about 30 per cent of oil and gas revenues for the province’s long-term future. Unfortunately, for nearly two decades, the real value of this fund has not increased much as successive governments did not contribute in any meaningful way to the fund. The latest estimate from the government pegged the value of the Heritage Fund at $16.1 billion and it earned $653 million in the first half of fiscal 2012-13. If the province had continued to devote 30 per cent of resource royalties to the fund and, assuming the investment income was withdrawn only during periods of intense budgetary pressure, the value of the fund today could be close to $100 billion. Using the implicit interest rate from its latest earnings, a Heritage Fund worth $100 billion would have generated $4.1 billion in income over the first half of this fiscal year.

The government should once again redirect a significant portion of its annual oil and gas royalties to the Heritage Fund while only drawing on the annual investment earnings in times of real need so that both current and future generations benefit from the province’s vast energy resources. Currently Alberta finances about 30 per cent of its budget with oil and gas revenues—a huge portion of the budget to be financed with such a volatile revenue stream. By directing more of that revenue to the Heritage Fund and supplementing the revenue loss with other taxes, the province would have a much steadier revenue flow helping to mitigate the boom-bust budget cycle.

While there are many ways to generate additional revenues, a sales tax makes the most sense for Alberta. Sales taxes result in fewer disincentives and distortions than income taxes and thus have less negative impact on the smooth functioning of the economy. Although the sales tax burden falls disproportionately on those that spend a large share of their income on necessities, this social inequality can be overcome with tax credits and exemptions for basic requirements. The Government of Alberta estimates that a five per cent sales tax (harmonized with the GST) would generate between $5 and $6 billion depending on how the tax and offsets were structured. A five per cent sales tax would more than wipe out the current deficit, leave Alberta in a competitive position relative to the other provinces and provide some much needed stability to government revenues.

Oil and gas are the source of a significant share of Alberta’s wealth, but they are also the source of many of its fiscal problems. Additional pipeline capacity to move Alberta production to market is crucially needed to ensure producers get a fair market price and to continue to attract large-scale investment to the province. Alberta should also devote some of its resource royalties to the Heritage Fund to ensure that the prosperity from oil and gas extraction will be a reality for Albertans long after production peaks. And Alberta needs to stop relying so heavily on royalty revenues to fund its general expenditures. A sales tax is the right policy choice to provide some much-needed stability to government revenues in Alberta.

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Opportunity Lost? Alberta Is Facing Short- and Long-Term Financial Challenges Despite Its Oil Wealth

 


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