The Alberta government is spending more but enjoying it less after accepting industry projections of a steady decline ahead in natural gas production. While hiking spending by 10.7% to help services from schools to sewers catch up with growth lubricated by oilsands development, the province braced for erosion of gas as its biggest revenue earner.

Budget forecasts anticipate a C$3.9 billion (US$3.3 billion), 33% drop in oil and gas income over the next three years due to changing production, flat prices and falling mineral rights sales. Alberta's gravy train, nonrenewable resource revenue that covers about one-third of the budget, and fuels celebrated annual surpluses, is forecast to thin down to C$7.8 billion (US$6.6 billion) by the 2009-10 fiscal year from C$11.7 billion (US$10 billion) in the 2006-07 term that ended March 31.

Compared to the record C$14.3 billion (US$12.2 billion) set in 2005-06, annual provincial resource revenue is expected to drop by C$6.5 billion or 45% in three years. Current, 2007-08 fiscal year oil and gas income is expected to be C$10.3 billion, down C$4 billion or 28% from the 2005-06 peak.

"This decline reflects more than just energy prices," said budget documents tabled in the provincial legislature by Finance Minister Lyle Oberg. "It also reflects expected lower production levels, lower land (mineral rights) license and lease sales, increased production and processing costs and an increased share of oil royalties paid on bitumen rather than conventional or synthetic crude oil."

Alberta natural gas production, which generates about two-thirds of provincial resource income, is dropping by an average 1.4% a year, and there is no end in sight to the erosion, the documents say. Annual gas royalties are forecast to fall to C$4.6 billion by 2009-10. That will be down by C$1.4 billion or 23% from C$6 billion expected this year, and C$3.8 billion or 45% off the 2005-06 peak of C$8.4 billion.

Alberta government royalty policy amplifies gas revenue declines by reducing rates when output goes down as an incentive for industry to extract the last reserves from aging fields rather than abandon wells prematurely. Only a shrinking minority of Alberta's 92,000 gas wells still pay maximum rates set in a range of 25-30% by 1970s royalty increases that founded the current financial structure of the government and services heavily concentrated at the provincial level.

The government estimates 89% of Alberta gas wells currently pay the "low-productivity rate," which is a sliding royalty scale that drops to 5% as output dwindles. The fastest-growing new gas production source, coalbed methane, qualifies for the low end of the royalty scale because developments use large numbers of small wells. Royalty policies are also forecast to cause a drop in provincial oil revenues even though industry production is rising.

The provincial estimate for the anticipated overall decline rate of total gas production masks a harder reality in the composition and revenue-generating capability of the Alberta industry.

Conventional gas output, currently about 13.4 Bcf/d, is forecast to drop by 11.5% over the next three years into a range of 12.6 Bcf/d. Coalbed methane production is projected to increase six-fold to 1.2 Bcf/d. The result will be growing reliance on shrinking production from a more expensive supply source, leaving less earnings for industry and reduced royalties for the government.

Oil is not expected to make up for the gas erosion. Alberta oil royalties are forecast to dip to C$2 billion in 2009-10, down by C$1.8 billion or 47% from a peak C$3.8 billion last year.

The slippage is mostly owed to a wrinkle in the province's oilsands "generic fiscal regime," enacted to nudge projects into construction during 1990s spells of poor energy prices. The regime not only limits royalties to a nominal 1% until plant construction expenses are paid off, then 25% of net revenues after production costs, plus a return about equal to current long-term interest rates. All new developments in the C$100 billion-plus project lineup that formed under the incentive policy only pay royalties on their initial output of molasses-like, discount-priced bitumen.

The generic regime also gave the industry's old Fort McMurray mainstays, the Suncor and Syncrude plants, rights to switch to paying the bitumen-only royalty from bygone practices of sharing revenues from upgraded, refinery-ready light synthetic oil. Suncor is making the change. Syncrude plans to make a formal decision soon whether to switch.

The province predicts bitumen will continue to fetch an average 50% less than oilsands plants' finished product of synthetic crude, which is priced on a par with refinery-ready light oil and sometimes receives a premium. Oilsands royalties are forecast to drop to C$1.2 billion in 2009-10, down by C$1.2 billion or 50% from a peak C$2.4 billion last year.

The net effect for the province is that bitumen production is going up by 50% to nearly two million b/d, but royalties are dropping by 50% over the next three years. Mineral rights sales are down by two-thirds after an industry oilsands rush snapped up 95% of bitumen deposits shallow enough to mine and nearly half of formations tapped by "in-situ" underground extraction methods.

After peaking at C$3.5 billion in 2005-06, rights auctions are forecast to fetch C$1-1.2 billion a year through 20009-10. The official provincial share of total oil and gas production revenues is hovering at 19%, below the government stated target range of 20-25%, the budget documents say. The share could rise or fall after a royalty review that starts public hearings April 23.

Pressure is mounting for the review to find a new formula that lets the industry stay healthy yet also protects government resource revenues.

The production and revenue trends prompted the provincial treasurer to sound a warning. "The government recognizes we can't maintain the present pace of operating funding increases," Oberg said. "Funding for operating expenses and capital must be sustainable and fiscally responsible if Alberta is to maintain its prosperity."

Provincial energy price predictions are in the middle of the range of Canadian industry expectations. The budget forecasts gas will average C$6.75/gigajoule (US$6/MMBtu) this year, C$6.50 (US$5.80) in 2008-09 and C$6.25 (US$5.58) in 2009-10. Alberta's official expectations for oil are US$58/bbl this year, $54.25 in 2008-09 and $52.50 in 2009-10.

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