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Flexible Royalties are the key to Oil and Gas Exploration

The recent oil and gas boom has been an education for a lot of people. Including regulators.

Designing oil and gas laws is not easy business. Especially when it comes to setting royalty rates.

The petro-world has seen all sorts of developments on this front over the last several years. Governments lowering royalties to attract investment, like in the U.K North Sea and Colombia. Governments raising royalties to grab a bigger piece of the pie, such as in Alberta and Kazakhstan (and the U.K. North Sea, funny enough).

There have been winners and losers from this "royalty readjustment" scramble. Colombia has seen its petroleum sector skyrocket on the back of a simpler and lower royalty structure. Ditto the U.S. Gulf of Mexico.

Alberta had a tougher go, introducing stiffer royalties immediately before a crash in natural gas prices (western Canada is a gas basin when it comes down to it), to the significant detriment of gas drilling here.

Governments seem to be learning an important lesson. One size doesn't fit all when it comes to royalties.

The most successful regimes are often the most flexible. Structures that recognize not all wells are created equal in terms of drilling cost, local infrastructure, and even local commodities pricing, and tailor royalty rules accordingly to meet the needs of each particular play within a basin.

Witness the Mineral and Energy Board of Louisiana this week announcing it will consider special incentives for conventional oil and gas drilling in the south of the state.

With shale gas having taken off in the Haynesville of northwestern Louisiana, conventional plays in the south are suffering. Nearly 150 rigs are working in the north, with only 35 drilling down south.

The Board realizes conventional plays can't compete with shale gas straight up. So they're shifting the playing field. The incentives would likely take the form of rebates, where companies drilling southern wells could write off drilling costs against royalties or taxes. Alberta has been using similar measures to help drillers working deep plays in the province.

This has the potential to re-vitalize Louisiana's conventional oil and gas. Lower royalties mean improved well economics. And improved economics attract drilling.

Countries like Argentina have been taking steps to implement differential pricing in order to encourage drilling in more difficult areas. This week, the country's Neuquen province announced preparations for a third oil and gas licensing round, with particular focus on shale and tight gas in the area.

One issue with unconventional gas in Argentina is the pricing regime. Government controls implemented in 2002 essentially cap gas prices near $2 per mcf.

Recognizing that such prices will be tough for shale gas developers, Neuquen is encouraging potential bidders on gas licenses to make use of the "Gas Plus" program.

Gas Plus was created two years ago, allowing gas producers to apply on a case-by-case basis for higher sale prices. The program has allowed some Argentinean producers to achieve prices up to $5 per mcf, a level where shale gas could work.

This kind of price flexibility will allow for more development than a rigid, flat-rate system would. As with royalties, you need to bring the right tool for the job at hand.
Hopefully this kind of "open-ended" approach catches on elsewhere.

By. Dave Forest of Notela Resources

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