In Alberta, once the Crown royalty rate for any well’s gas and gas by-product production in a particular month has been determined (“Royalty Rates”), the Crown calculates the actual royalty due from the producing company by multiplying this royalty rate by the price of the gas or gas by-product and subtracting allowable deductions (“Deductions from Freehold Royalties”). The price of the gas or gas by-products is determined by the Alberta Resource Development Department based on a ‘reference price’ equal to the weighted average price of all gas and gas by-products actually sold in the Province during the previous month, less an intra-Alberta transportation allowance. 

Prior to the de-regulation of Canadian natural gas markets in the mid-1980's, most natural gas was sold under long-term 20- or 25-year gas contracts. These contracts provided a measure of certainty to producers in terms of their future profits and to end users in terms of their costs. De-regulation has resulted in the virtual disappearance of long term contracts and the sale of most gas under short term contracts or on the ‘spot market’. Concurrently, financial markets have developed in which contracts to buy or sell gas (and oil) in the future at specified prices are actively traded. Many producers consider it prudent business practice to ‘hedge’ their actual gas sales in these commodities markets. Hedging strategies, used wisely, allow an oil company to protect its future oil or gas production revenue from unpredictable oil and gas price fluctuations, and allow an end user of the oil or gas to fix its future costs at predictable levels. Used unwisely for speculative purposes, hedging can be a financial disaster for either the oil company or the end user. 

For instance, the weighted average price of Alberta gas in January of 2000 was $2.83/Gigajoule (Gj). Thereafter, average Alberta gas prices increased each month to $4.77/Gj in July, 2000. In August of 2000, the weighted average price of Alberta gas declined to $4.29/Gj. Some producing companies mis-interpreted these price changes, thought that the price of gas had peaked, and either committed to contracts for future sale at these prices or hedged a significant portion of their future production on financial markets at the prices that were then available for future gas sales. These companies have been unable to take full advantage of the subsequent doubling in gas prices (in December of 2000, the weighted average Alberta gas price had increased to $8.64/Gj). 

The Alberta Crown does not concern itself with the individual sales contracts or hedging practices of producing companies operating in the Province. The reference prices calculated by the Alberta Department of Resource Development take into account only actual sales, and producers pay Crown royalties based on weighted average Alberta prices irrespective of whether the producing company sells, or effectively sells through hedging in financial markets, at prices above or below the prices deemed for Crown royalty purposes. 

Freehold lease agreements typically do not require royalties to be paid to freehold owners based on weighted average Alberta prices, but on the ‘current market value’ of the gas and gas by-products at the well head or on the leased lands. Freeholders typically assume that their oil company-lessee will sell their gas for the best price it can achieve in the marketplace. But a producer selling a portion of its gas production under short term gas contracts at prices below the deemed price for Alberta Crown royalty purposes can minimize its overall royalty obligation by manipulating its contracts so as to allocate its low priced gas contracts to freehold gas production. Anecdotal evidence indicates that some producing companies are not only manipulating their gas contracts in this manner, but are paying royalties to freehold owners based on net prices after taking into account their hedging losses in financial markets.

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