Sunday, April 3, 2011

Fulton and Rasmussen on Potash

I do not think anyone can disagree with the conclusion of Murray Fulton and Ken Rasmussen that Saskatchewan should “proceed with a thoughtful and deliberate process that ensures that the province is the long-term beneficiary of this asset.”

The provincial opposition is advocating a royalty review process to achieve that goal. The government and potash companies claim that the appropriate “process” is to simply leave royalties unchanged.

It would be interesting to know how Fulton and Rasmussen think that potash royalties should be structured. However, their recent StarPhoenix op-ed is more an attempt to clarify the debate. Unfortunately, it muddies several key points.

Potash Production Tax
[The royalty] regime establishes a production floor in the years 2001 and 2002 and uses this floor as the base for two tax rates - one for existing production and another for ‘new’ production. Potash production above the 2001-02 ‘floor’ is afforded a reduced production tax rate.
In fact, sales above the 2001-2002 average receive a complete exemption from the profit tax component of the potash production tax system. Such sales could still be subject to base payments, except there is also a ten-year base-payment holiday on production from mine expansions since 2005.

In any case, the base payment formula is $12.33 per ton of K2O minus Crown and freehold royalties (at least 2% of sales) and the Saskatchewan Resource Credit (1% of sales). As long as potash prices exceed $400 per K2O ton, the base payment is zero (3% of $400 is $12). The provincial budget indicates that this price was $570 last year and projects that it will be $645 this year.

So, companies will pay neither component of the potash production tax on sales above the 2001-2002 average. In other words, the “reduced production tax rate” is zero. As my last StarPhoenix op-ed noted, these sales will be subject only to Crown royalties and the resource surcharge – about a nickel per dollar of “new” sales.

Revenue Share
In the three years from 2001 to 2003, the industry produced about $4.9 billion worth of potash, and the province collected about $465 million in production taxes - an average rate of about 9.4 per cent. From 2004 to 2007, the production was higher at about $7.1 billion and production taxes were also higher at $746 million, an average rate of 10.5 per cent.
In the last three years for which data are available (from 2007 to 2009), the value of potash production was much higher, at about $13.5 billion, and production taxes were about $1.6 billion, an average of 12 per cent. These data do not include corporate income taxes or corporation capital tax resource surcharges, simply because the payments made by potash companies cannot be isolated within the total collections.
Fulton and Rasmussen seem to be citing the “Sales” and “Royalty/Tax” figures from page 31 of the Ministry of Energy and Resources 2009-10 Annual Report. (If so, the revenue figures include Crown royalties as well as potash production tax.)

The way they present these figures creates the impression that the province’s revenue share has grown from 9.4% to 10.5% to 12%. However, it appears that the first figure is understated and the last figure is overstated.

“Royalty/Tax” for 2001, 2002 and 2003 actually adds up to $475 million (179.7 + 175.1 + 120.2 = 475), which is 9.6% of “Sales” (1,622 + 1,718 + 1,632 = 4,972). “Royalty/Tax” for 2007, 2008 and 2009 actually adds up to $1.5 billion (348.3 + 1,364 – 183.9 = 1,528.4), which is 11.3% of “Sales” (3,056 + 7,386 + 3,067 = 13,509). So, the percentages should be 9.6%, 10.5% and 11.3%, much less of an increase.

While provincial budgets do not break down the resource surcharge between different resources, it is set as a flat percentage of sales. It had been 3.6% of potash sales, but was cut to 3.3% in 2006, 3.1% in 2007 and 3.0% in 2008.

Including this surcharge, the revenue percentage barely edged up from 13.2% to 14.4%. In fact, it had been 15.0% back in 2000 (199.3/1,744 = 11.4% + 3.6%).

Provincial revenue, as a share of output, should have increased dramatically. While Crown royalties and the resource surcharge are flat percentages of production and sales, the potash production tax is based on mine profits, which skyrocketed. The revenue share failed to increase because of inflated writeoffs against, and exemptions from, this tax.

To look at the same numbers a different way, Saskatchewan potash sales rose by $8.5 billion between the 2001-2003 period and the 2007-2009 period. This rise was due to higher prices, since the same volume was sold during both three-year periods: 25 million K2O tons.

Some of this increase was needed to cover higher extraction costs, but most was a windfall that should have gone to the resource owners. In fact, provincial potash revenues (excluding the surcharge) rose by just $1.1 billion, capturing about one-eighth of the extra revenue (or nearly one-sixth including the surcharge).

Do we want expansion and growth in the industry, or are we willing to accept that future expansion of the potash industry will occur elsewhere and thus set a high royalty rate that will capture more short-term revenue?
There certainly can be a tradeoff between private investment and public revenue in setting royalty rates. (For the rest of this post, “royalties” refers to the whole provincial royalty and tax regime, rather than just Crown royalties.) Over the years, I have argued that Saskatchewan should be prepared to collect more revenue from a somewhat lower volume of oil and gas extraction.

However, there is no evidence that Saskatchewan faces this tradeoff regarding potash. Companies presumably do aim to expand productive capacity where total costs and risks are lowest.

But royalties are only one component of total costs. Saskatchewan’s rich reserves, established mine shafts, good infrastructure, proximity to the US market, etc. provide huge cost advantages. The province can charge substantially higher royalties than other jurisdictions and remain competitive for new investment.

To determine how far royalties could be raised without affecting investment, one must compare total costs and risks between potash jurisdictions. Defenders of the current royalty regime have been keen to cite CRU’s Potash Cost Report as indicating that Saskatchewan’s royalties are relatively high, but have neglected to mention its findings regarding overall costs.

PotashCorp is already more than doubling the capacity of its New Brunswick mine. It is doubtful that further investment could be redirected from Saskatchewan to New Brunswick.

Do Fulton and Rasmussen believe that higher Saskatchewan royalties would prompt the multinational potash companies to instead invest in Russia, Belarus, Brazil or China? After that, we are down to countries with below 2% of global reserves, according to the US Geological Survey.

In the past, governments have adjusted rates abruptly, resulting in the need for pro-rationing fees, followed by constitutional challenges, followed by nationalization and then privatization, all at a terrible cost to the province.
It is important to clarify that the abrupt adjustment was a guarantee of ultra-low rates to promote investment. In response, the industry over-expanded in the 1960s. Prorationing was then needed to limit production and support prices. As prices improved, the government had to implement new fees and taxes to collect more revenue than the ultra-low Crown royalties.

The past mistake that Saskatchewan should avoid repeating is keeping royalties too low. Unfortunately, the government has committed to ultra-low royalties forever on sales above the 2001-2002 average. Sooner or later, it will have to renege on this unwise commitment.

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