How to Sup with Devilish Partners

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As the 21st century dawned, there was an almost unnoticed change in the practice of Canadian resource companies. Corporations quietly stopped partnering with government in the financing of large-scale projects. Why did politicians suddenly get out of business? Simply put, the resource sector did not need them any longer thanks to high commodity prices, which meant that money for massive projects such as pipelines and oil-sands plants could be raised on the commercial markets.

However, the current weakness in commodity prices — if it is long-lasting — raises the possibility that public investment in private Canadian enterprises could return with a vengeance, especially when it comes to heavy oil projects that require higher prices for profitability. Judging from the past, this isn’t necessarily a good thing.

In the 14th century, people observed that “when one sups with the devil, one best have a long spoon.” It would be wise to remember this adage if the slump in commodity prices causes corporations and governments to consider, once again, business partnerships. But if resource-sector history does repeat itself, it does not have to do so with the same pathologies. In other words, it is time to look at past experiences to review its lessons.

As a start to this re-examination, this article looks at the creation of two heavy-oil upgraders in Saskatchewan that were built to stimulate development of the local oil industry while creating jobs and maximizing royalty income. I had a ring-side seat for some of the events described in this article while serving as Director of Communications for Saskatchewan’s Crown Investments Corporation — the province’s holding company for commercial Crown corporations and investments. I can tell you the projects in question were both deemed “good” for the long term when conceived in the 1980s. Furthermore, public policy objectives were met by both upgraders, which both eventually contributed mightily to the growth and profitability of their private-sector operators. And yet, in both cases, the financial viability of the province was threatened along with the existence of the companies that partnered with government. As a result, these two cases illustrates how a partnership between public and private interests can deliver mutual benefits while being dangerous at the same time.

THE PAST ROAD TO PARTNERSHIP

Following Imperial Oil’s discovery at Leduc, Alberta in 1946, Saskatchewan politicians had reason to take the following lament of the prophet Isaiah to heart: “Woe to those who call evil good, and good evil; Who substitute darkness for light and light for darkness; Who substitute bitter for sweet and sweet for bitter!” Like Alberta, Saskatchewan possessed massive oil deposits. But unlike Alberta, most of Saskatchewan’s oil was heavy. Oil molecules are a mixture of carbon and hydrogen. Alberta’s light crudes contained lots of hydrogen and relatively little carbon. Saskatchewan’s heavy crudes contained lots of carbon and less hydrogen. This made Saskatchewan’s heavy crudes slow and difficult to pump, almost impossible to transport in pipelines, and impossible to refine in Canadian refineries, which is why Saskatchewan’s oil reserves generated more frustration than jobs or royalties for over three decades.

Prospects for heavy oil began to change in the early 1980s. OPEC and the Iranian Revolution drove up oil prices as horizontal drilling techniques made heavy oil cheaper to harvest. As a result, it suddenly became profitable to produce heavy oil. But markets were changing at the same time. Heating oil was replaced by natural gas in furnaces. Transport problems were growing worse as supplies of diluent tightened. For Saskatchewan’s political leaders, the glimmering moment of opportunity seemed a mirage. But there was a solution: upgraders could bring Alberta-type prosperity to Saskatchewan. Technology had been developed to change the composition of the oil molecule. Carbon atoms could be stripped out, or hydrogen atoms could be added. The upgraded synthetic crude could be easily transported and easily refined into a full range of petroleum products.

Creating upgrading capacity could turn Saskatchewan’s heavy crude from low-value sludge into a valuable resource that generated jobs and royalties. But there was a catch. Upgrading involved heating oil under pressure. This carries inherent technical risks. Heavy oil upgraders were also massive capital projects. A 50,000 barrel per day upgrader costs in excess of $1.5 billion. With their risk/reward profile, it was impossible for a private corporation to raise the required capital on the commercial market.

Enter the politicians. Financial viability depends on the gap in the price between heavy crude oil and the upgraded synthetic crude — or “the differential.” Upgrading became commercially viable when the differential was over six dollars per barrel. This could be expected when oil prices exceeded $30 per barrel, which was achieved following the 1979 revolution in Iran. As a result, by 1980, every politician sitting in the Saskatchewan legislature, regardless of party, agreed that the province needed upgraders. They also agreed that the upgraders needed to be operated by the private sector backed with substantial government support.

After a few false starts, the Progressive Conservative government headed by Premier Grant Devine settled on the two logical private-sector partners. The only substantive critique of the Conservative upgrader endeavours coming from the opposition New Democratic Party was that things were not moving along fast enough.

CASE ONE: THE NEWGRADE UPGRADER

The province’s first upgrader partnership was with Regina-based Consumers Co-operative Refinery Limited (CCRL). The venture is owned by Federated Co-operatives Limited (FCL), which is owned by member retail co-operatives across western Canada. CCRL’s Regina refinery supplied co-op service stations with gasoline and diesel and supplie3ed CL with dividends that were key to keeping the retail co-operative system solvent. This partnership offered a powerful synergy. Integrating the upgrader with the existing refinery cut capital costs in half. However, member retail co-operatives saw no benefit to them. The upgrader would result in a change in the feedstock of the CCRL refinery from Alberta light crude to Saskatchewan heavy. Profitability was projected to be marginal. Simply put, the co-ops saw the proposed upgrader as a highly risky venture that could threaten their refinery, which is why FCL management was ordered to proceed only if CCRL had operating control, invested no money, had an equal ownership share, and was fully protected from all technical and financial risk.

In 1984, the Saskatchewan government agreed to these terms. The proposed upgrader would be 80 per cent financed by debt guaranteed by the federal and provincial governments. Saskatchewan and CCRL would provide the remaining 20 per cent of capital costs through equity — but CCRL’s equity share would be advanced by the province, with repayment coming from upgrader profits. After this financing deal was struck, detailed planning began. But then in 1985, oil prices collapsed.

For the foreseeable future, financial projections showed that the project would not even service its debt load. FCL informed the Saskatchewan government that it would not proceed. The province responded by proposing amendments to the agreement that ensured CCRL would make a small profit even if the project was losing money. On this basis, CCRL/FCL signed on. Celebratory press conferences were held, engineering and site development work proceeded, and the negotiations on the final detailed agreements stalled. A year later, $80 million had been spent while the project was mired in acrimony between the partners. FCL management managed to bring the negotiations to a conclusion with some election-eve political hardball.

Construction began late in 1986. The upgrader was completed on time and on budget in November of 1988. That’s when things went seriously wrong. Low oil prices and the resulting narrow differential resulted in the project hemorrhaging cash. A series of fires, explosions and releases of toxic gas alarmed people in nearby Regina residential neighbourhoods. Government officials blamed the problems on incompetent CCRL management. CCRL, in turn, accused the government of pushing it into premature operation for political reasons. The governance structure created deadlock and acrimony on the NewGrade board. As the project teetered on collapse, the Saskatchewan government began making unilateral cash injections in order to prevent a default on the project’s debt and a call on the loan guarantees.

In 1991, Grant Devine’s Progressive Conservative government was defeated by Roy Romanow’s New Democratic Party. The new administration insisted that the terms of the upgrader agreement be renegotiated. CCRL/FCL management refused. The government responded by appointing a Commission of Inquiry composed of retired Supreme Court Justice Hon. Willard Estey, who recommended that FCL, Saskatchewan and Ottawa all contribute significant amounts to pay down project debt to a level that could be supported by cash flow generated by the upgrader. The proposed injections were seen by everyone as “kiss good-bye” money advanced in the hope of preventing the project’s collapse. FCL management, standing on the sanctity of contract, refused to contribute. The Saskatchewan government passed legislation giving itself unilateral power to rewrite the agreements (see selected provisions of Bill 90 [1993] — an act to protect the financial viability of NewGrade Energy — at the end of this article).

In response, FCL threatened to move its corporate head office from Saskatchewan. Both FCL and the government aggressively blamed the other side for the impasse and acrimony. In August 1993, Premier Romanow and FCL President Vern Leland spent three days secretly locked in a Saskatoon hotel negotiating an armistice. After agreement was reached, it took another year to secure federal participation. When the dust settled, Saskatchewan renounced any claim on its $235 million investment in the upgrader and injected another $75 million. FCL matched the $75 million and, for the first time, assumed some responsibility for any future cash deficiencies. The federal government paid $125 million in order to escape its loan guarantee commitments. The financial restructuring stabilized the upgrader’s finances such that NewGrade was able to service its debt without further assistance from its owners in most years through to the new century.

As oil prices then began to increase, the upgrader became profitable. By 2004, NewGrade was very profitable. The debt was repaid and the project divided over $120 million in positive cash flow between the two owners. By 2007, CCRL/FCL wanted to launch a major expansion. However, it wanted to do so without its governmental partner. Saskatchewan was bought out for $325 million.

CASE 2: THE BI-PROVINCIAL UPGRADER

Back in the 80s, the other obvious potential government partner to operate a new upgrader was Husky Oil, which had recently been “Canadianized” after being purchased by Nova Corporation (formerly Alberta Gas Trunk Line). Husky was the largest producer of heavy oil in western Canada, with operations straddling the Alberta/Saskatchewan border around Lloydminster. Unlike CCRL/FCL, Husky was an enthusiastic proponent, because an upgrader would significantly enhance the value and profitability of its existing production operations. Husky was willing to proceed with an upgrader that, as a standalone plant, operated on a break-even basis. For Husky, even a money-losing upgrader was a good investment so long as the increased profits from oil production exceeded any losses from the upgrader.

Husky’s only problem with the proposed partnership was the size, risk and financial projections of the proposed upgrader. The project was too large for the company to finance internally. And by itself, an upgrader was too marginal and risky to attract outside capital. In 1984, as federal Energy Minister Jean Chrétien was running for the national Liberal leadership, Canada, Saskatchewan and Alberta agreed to provide loan guarantees to cover the $1.5 billion capital cost of the project. The upgrader was expected to pay its own way, with government making financing possible by assuming risk.

A few months later, Brian Mulroney’s Progressive Conservative government was elected. Pat Carney, the new Energy Minister, announced that the new government would not be bound by the commitments of the old. The upgrader project would be studied. In the meantime, she confirmed general support for the project and requested that Husky continue with design and engineering work. The review process was a slow-moving train. Two years passed, during which time Husky spent $80 million on engineering and design work. Another $200 million was spent on drilling oil wells whose only market could be a new upgrader. Husky was out on a limb when the federal government finally said “no.”

By this time, of course, the 1985 drop in oil had made the initial agreement irrelevant, because there was now no hope of the upgrader being constructed without a government subsidy. An upgrader built with borrowed money would inevitably default. For Husky, the existence of an upgrader, regardless of who owned or operated it, was the key to making its heavy oil investments profitable. The company attempted, without success, to entice other heavy oil producers such as Imperial Oil to join the venture. At one point, Husky even proposed that the three governments build and operate an upgrader as a publicly owned utility. This had no appeal for the politicians.

Breaking the impasse was tied to the federal electoral cycle. In 1988, the City of Lloydminster was represented on the Alberta side by Deputy Prime Minister Don Mazankowski and on the Saskatchewan side by Western Economic Diversification Minister Bill McKnight. The impending election brought a new willingness on the part of the federal government to proceed. The resulting deal abandoned any notion of government-guaranteed debt. Instead, Husky and the three governments agreed to pay for construction and start-up losses with equity. The required government subsidy was hidden in internal cash flow projections that predicted a negative rate of return on this “equity investment.”

Construction began in 1989 and was completed in 1993. The Bi-Provincial Upgrader was completed on time, but over budget. The four partners received two cash calls to cover the overruns. All four contributed to the first call. Saskatchewan, under the new Romanow NDP government, refused to contribute to the second. Its share was paid by Husky and Canada. When operations commenced, so did losses. The $50 million provided for start-up losses was quickly burned, leading to another cash call on the partners. Again, Saskatchewan refused to participate. The losses continued at a rate of $3 million per month, leading to yet another call. This time all governments balked. Alberta and Canada then proposed to sell their equity share to Husky for 6.5 cents on the dollar, expecting the non-compliant Saskatchewan to follow suit. Instead, Saskatchewan exercised its contractual rights to buy equity from its former partners. When the dust settled, Husky and Saskatchewan were equal partners. It should be noted, however, that the Husky of 1995 was not the same Husky that entered the project. Husky’s owner, Nova, had been unable to raise its share of the capital costs. As a result, over the construction period, Nova lost control of Husky to Hutchison Whampoa, a Hong Kong conglomerate headed by Li Ka-shing.

Resolution of start-up problems soon made the Bi-Provincial Upgrader cash-flow positive in a modest way. By 1998, Husky wanted to expand. As a precondition to expansion, however, it bought out Saskatchewan’s equity share to become the sole owner. As oil prices improved in the 21st century, the expanded Bi-Provincial Upgrader became a major profit centre for Husky as well as serving as the market for its own heavy oil production.

DOING BUSINESS WITH GOVERNMENT

Partnering with business is often seen by politicians as a good way to achieve public policy objectives. However, the nature of public expectations, not to mention the nature of politicians, can impose strange and unusual demands on a government’s private-sector partner. In the cases outlined above, one good example of this can be found in the area of hiring and procurement.

The construction and operation of both the NewGrade and Bi-Provincial Upgraders were conducted by the management of the private-sector partner, which was overseen by a board composed of representatives from all partners. Procurement and hiring decisions were made for commercial reasons. However, significant numbers of people and corporations argued that government participation conferred upon them the right, as citizens, to have access to contracts or jobs. Many individuals had difficulty differentiating cabinet ministers’ offices from human resources departments. More seriously, government participation in the project dragged both projects into a quagmire over whether government policies towards union recognition and employment equity should apply to upgrader construction. Many potential suppliers were even more aggressive. For example, the President of the Regina-based steel manufacturer IPSCO told Saskatchewan’s Economic Minister that NewGrade’s practice of buying pipe based on the project’s design specification rather than on his company’s product line “borders on scandal.”

In the Bi-Provincial case, the most serious, sustained and intense squabbling was initiated by government officials. The upgrader was built on the Saskatchewan side of the inter-provincial border. As a result, the very fact of Alberta’s financial participation became contested. Both provincial governments were aggressively vigilant in their efforts to capture employment and procurement benefits for their own provinces. Where an employee lived often appeared to be more important to government than the skill set brought to the job. At one point, the negotiations for Bi-Provincial almost ran aground because of rulings by the Saskatchewan Highway Traffic Board. This regulatory agency ruled that because the Saskatchewan government was investing in the facility, trucking feedstock should be a prerogative of Saskatchewan-based trucking companies. The Board reluctantly conceded that Alberta truckers had the right to carry Alberta oil three kilometres into Saskatchewan, but insisted that only Saskatchewan truckers could carry Saskatchewan oil. The resulting dispute escalated to the two Premiers for resolution.

In addition to complexities in hiring and procurement, the two cases show that government involvement complicates the environmental assessment, monitoring and enforcement process. On the one hand, environmentalists who are naturally skeptical of large petro-chemical plants pointed to government financial participation as being intrinsically conflictual with government’s regulatory role. On the other hand, particularly in the case of the very conflictual relationship between CCRL/FCL and the Saskatchewan government, there were allegations that the government used its regulatory authority in pursuit of political or economic objectives. In one case, such allegations were supported by the courts.

GOVERNMENT DUPLICITY

When the original agreements-in-principle for the upgraders were signed in 1984, it was believed that the upgraders could generate enough cash flow to cover operating costs and the cost of capital. Government was required to assume risk rather than provide a subsidy. A year later, the drop in oil prices changed this. If the upgraders were to be built, a subsidy was required.

NewGrade was projected to cost $780 million for construction and start-up losses. Of this, $155 million was to come from equity and $635 million from debt guaranteed by government. The financial projections suggested that equity was “kiss-goodbye money” and that the project could generate enough cash flow to support debt of about $350 million. NewGrade had difficulty finding lenders, even with the promise of the loan guarantees from both the Canadian and Saskatchewan governments. The conditions that would trigger a call on the loan guarantees were defined with extraordinary precision.

The 1984 agreement called for Bi-Provincial to be constructed exclusively with government-guaranteed debt. By 1988, it was clear that the upgrader could not support a significant debt load. As a result, Husky and the three governments financed the project completely with equity. It was initially expected to cost $1.5 billion but overruns raised this to $1.9 billion. Financial projections predicted the upgrader would generate $1.1 billion in positive cash flow from operations over its life. Thus, when the project was launched, it was expected and predicted that the four partners would lose $400 million. The cost overruns raised this projected loss to $800 million.

In both cases, bleak financial projections were the reason government needed to be involved. If the upgraders had been projected to make profits from the beginning, government participation would not have been needed. Government brought to the partnership the ability to raise large amounts of capital through non-commercial means and invest it in ways not commercially justified.

For the Saskatchewan government, the upgraders would cost money. The benefits would come elsewhere — in the oil patch. In 1987, the year before “oil-in” at NewGrade, Saskatchewan produced 35 million barrels of heavy crude. Two decades later, 94 million barrels was pumped. Every barrel of the increased production was processed through the NewGrade or Bi-Provincial Upgrader.

The Saskatchewan government had a good case for supporting upgrader construction even when the facilities, as standalone ventures, would lose money. But it did not make this case. Instead, it lied. The government’s contributions to the upgraders were presented as an “investment,” even thought it was clear to decision-makers that the investments in question would lose money. In other words, investment was a code word for subsidy.

There are two possible explanations for this governmental lie. The first is noble. If the projections were wrong, and if oil prices unexpectedly improved, structuring subsidy as investment would allow provincial taxpayers to receive some reward. The second explanation is less charitable. By presenting subsidy as investment, the government was able to conceal its subsidy. During the construction period, the province’s expenditures were balanced by the creation of an asset on the other side of the ledger. Telling the truth would have required the government to justify its support for upgraders as a choice made when it was making other choices to increase taxes and cut programs.

The charade that subsidy was investment ended the day the upgraders began production. The anticipated losses became real and flowed through to the province’s books as investment losses and write-downs of the equity investments. A defensible subsidy for public policy reasons was transformed into a “bad investment.” Media began to automatically use the adjective “money-guzzling” in front of the word “upgrader.” Federal and provincial auditors weighed in to document financial losses. Changes in political administration meant that the government itself joined in the condemnation of the upgrader projects. The new Romanow administration used the “money-guzzling” upgraders as a symbol of the Devine government’s fiscal incompetence. In the case of Bi-Provincial, the federal and Alberta governments joined in as Chrétien replaced Mulroney and Klein replaced Getty.

This type of commercial investment had a major impact on the way these losses unfolded. Equity investments lose money over time, as project losses are incorporated on a pro-rata basis to the government’s books. Accounting was one reason Saskatchewan refused to sell its stake in Bi-Provincial in step with Canada and Alberta. The province’s financial plan incorporated a series of write-downs. And a sudden write-down of the entire investment would have disrupted the province’s financial and deficit projections.

The effect of loan guarantees was even more nefarious than non-performing equity investments. For government, the potential losses can suddenly become actual in total and immediately. In the early 1990s, Saskatchewan faced the prospect of being forced to honour NewGrade’s loan guarantees when it lacked both the cash and borrowing capacity to do so. A triggering of the loan guarantees threatened to trigger a catastrophic scenario for the province. The Devine administration responded by unilaterally injecting cash into NewGrade to prevent a call on the loan guarantees. The Romanow administration responded by using the full measure of governmental authority to compel CCRL/FCL to change the terms of its contractual agreements.

In the 1980s, the Saskatchewan government opted for short-term expediency by hiding the true nature of its support for the upgraders. This had the long-term effect of destroying the credibility of the projects themselves. In the process, significant damage was done to the reputations of the government’s private-sector partners, CCRL/FCL and Husky.

BEWARE OPPORTUNISTIC PARTNERS

 While NewGrade was being negotiated, a strange thing happened. The Saskatchewan government’s basic duplicity about its investment fooled even itself. Through to mid-1985, responsibility for the negotiations rested with the Department of Energy and Mines. The mandate was to ensure that an upgrader was created as long as the cost to the government did not exceed the expected increase in oil royalties. But CCRL/FCL wanted no part of the project. It was eventually convinced to participate with the following assurances:

  • It would not have to invest anything.
  • It would have complete operating control to protect the integrity of the existing refinery.
  • It would be protected from any technical, commercial or financial risk.
  • And it would receive a guaranteed profit for participation regardless of whether the upgrader itself was profitable.

Despite these assurances, the government transferred responsibility for the project to the Crown Investments Corporation (CIC), which had the mandate to manage the partnership as an investment. CIC officials were appalled by the terms, which bore little relationship to a normal commercial partnership. But nobody told them it was not intended to be one. As a result, in the detailed negotiations for the final project and operating agreements, CIC officials attempted to “win back” what had been “lost” in the original negotiations. The management of CCRL/FCL interpreted this as governmental duplicity and bad faith. The result was a partnership marked by pathological levels of distrust and acrimony.

The problems created by institutional silos within government are made worse by rapid personnel change. During the Devine administration, NewGrade had six responsible ministers in eight years. In the first term of the Romanow administration, another four ministers paraded through the portfolio. Because politicians discount commitments made by their predecessors, this rapid ministerial turnover had results more significant than a simple loss of institutional memory.

The tendency of governments to lose track of their commitments becomes even more pronounced when there is a change in administration. Each legislature is sovereign within the scope of its constitutional jurisdiction and can change any law made by its predecessor. When the Mulroney government replaced Trudeau’s, the new administration blithely told Husky, Saskatchewan and Alberta that it did not consider itself bound by the Bi-Provincial Agreement. When the Romanow government replaced Devine’s in Saskatchewan, similar nonchalance was displayed in “declining to participate” in partnership cash calls.

The tendency of government to be cavalier — or even actively antagonistic — towards commitments made by its predecessors becomes even more dangerous when combined with government’s ability to legislate. When CCRL/FCL refused to negotiate changes to the NewGrade project and operating agreements, the Saskatchewan government passed legislation giving itself the power to unilaterally change any provision in these agreements. CCRL/FCL’s management very reluctantly agreed to new terms that violated the fundamental conditions upon which they entered the partnership.

LESSONS LEARNED

For business, Saskatchewan’s two heavy oil upgraders show that government can be a dangerous, duplicitous and opportunistic partner — one with powers that most commercial partners do not possess. Even if government strives to be a good partner, its very presence can politicize operations. Scrutiny from both the media and the legislative opposition is increased. All manner of people assume they have rights and privileges that they would never dream of asserting without government participation. It is no accident that when oil prices increased, both Husky and CCRL/FCL made an exit by government a precondition of expansion. They had had their fill of government as a business partner.

So should business avoid seeking or accepting government as a partner? If it can be avoided, that advice is probably sound most of the time. However, government can raise large amounts of capital through non-commercial mechanisms. And it can assume risk and provide funds for public policy reasons without regard for commercial targets. It can thus be a partner of last resort. Further, some of the features that make government difficult to deal with can present unexpected windfalls. For example, the new administrations of Jean Chrétien and Ralph Klein abruptly decided to abandon Bi-Provincial just as it was overcoming its initial start-up problems. Blame for the loss could be heaped on their predecessors. Both Husky and Saskatchewan benefitted dramatically from the abrupt, politically driven decision to sell equity at 6.5 cents on the dollar.

Simply put, if a company has a project that will be solid in the long term, but cannot raise the money on the commercial market, then government can be an appropriate partner. But based on the past experiences of Husky and CCRL/FCL, I’d urge companies in this position to:

  • Make sure the project is worth the risk, because government participation in a joint venture can destroy business.
  • Ensure that government partners avoid duplicity when structuring public-sector involvement. Allowing the government to be deceitful about subsidies makes its participation easier in the short term, but inevitable “losses” will eventually cause the government to behave erratically and dangerously.
  • Make sure that the government has money in the venture first. At NewGrade, the $80 million in design and engineering work was advanced by the Saskatchewan government. At Bi-Provincial, a similar amount was advanced by Husky. This differential position made a huge difference in whether governments remembered their commitments.

Last but not least, if you decide to take on a government partner, I’d advise all concerned to buckle down and prepare for a wild ride.

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