Back to the Future

Posted: April 7, 2020

Why the Railroad Commission Must Begin Imposing Production Quotas

Background (Economics) 

In case you missed our last post, Disaster on the Horizon, there is an enormous, unavoidable issue looming on the horizon for the oil and gas industry – global oil storage reaching capacity. Once this occurs, prices will begin to plummet further than they have already. With producers oversupplying a market with diminished demand, there is no floor for how low prices can fall. 

It is a two pronged problem: the COVID-19 pandemic has dramatically diminished global oil demand while both Saudi Arabia and Russia have promised to flood the market with additional production. Bottom line, the world is already oversupplied and things are about to get worse. With the world increasingly oversupplied, producers are still flooding storage facilities in hopes for a future with higher prices. When these facilities become full, experts predict a slide to $10 oil, the lowest it has been in the 21st century. With a global pandemic controlling demand into the foreseeable future, there appears to be only one solution: solve the supply problem that is currently plaguing the oil industry. 

Why Production MUST Be Cut

Put simply: production MUST be cut to stabilize prices.  

With the COVID-19 pandemic showing no signs of global relief, it doesn’t matter how cheap crude is. If people are not driving, flying or consuming anything aside from the bare essentials, there is no demand boost from low prices [1]. The only way to bring supply and demand back into balance is to reduce supply by shutting-in production. 

Let us dig a little deeper into how oversupply became such an issue. When the cornonavirus starting reducing demand for global oil, it would make sense that the world’s oil producers would start to slow production to ensure a supply/demand balance. The problem is, this was just before the OPEC production cut negotiations in Vienna fell apart (March 5, 2020). When this occurred, Russia refused to take part in the requested production cuts. Three days later, Saudi Arabia declared a price war by threatening to oversupply the market by almost 3 million bpd prompting Russia to promise it would add some 300,000 (up to 500,000) bpd to current production rates [1]. While 0.3-0.5 million is nowhere near the almost 3 million bpd Saudi Arabia threatened to add to the market, Russia’s refusal to cooperate on the cuts was widely seen as the move that triggered Saudi Arabia’s response [2]. 

Ironically, Saudi Arabia and Russia are the world’s second and third largest oil producers respectively and experts tend to ignore the top dog – the United States. The effect of  U.S. shale changing the balance of global oil power became evident gradually. As OPEC and Russia kept cutting production, prices kept refusing to rise. This was due in part to diminished demand outlooks but also because U.S. shale producers continued to pump more and more oil. While OPEC+ was cutting, shale boomers were boosting [2]. Unfortunately, they were warned back in 2017 when Continental’s Harold Hamm said when prices rebounded, that U.S. shale should be careful not to drill itself into the ground. But here is history repeating itself. Only this time it’s worse because the world is gripped by a deadly pandemic [2]. 

Who Has the Power

It is clear there is a supply problem and the only solution is to cut production. While the Saudi and Russian governments have the power to cut production in their respective countries, who has the power in the United States? Is it the President? Nope! Is it the people? Nope! Each individual producer in the United States has the sole power to shut in their production…unless they operate in Texas. 

In Texas, the Railroad Commission is the state agency that regulates the oil and gas industry, gas utilities, pipeline safety, safety in the liquefied petroleum gas industry, and surface coal and uranium mining [3]. Under Texas state law, the Railroad Commission has the authority to order how much oil a lease can produce in an attempt to help ease the glut and to help prices [6]. Many are arguing that prices have dropped to unsustainable levels that threaten the future of the Texas oil and gas industry and thus the Railroad Commission must step in [4]. While such discussion of production cuts have been firmly opposed by the powerful American Petroleum Institute, two oil and gas producers active in the Permian Basin (Parsley Energy and Pioneer Natural Resources) have formally asked the Railroad Commission of Texas to hold what’s called an emergency market demand hearing that could produce a mandatory cut in oil and gas production in Texas [6]. 

Not only has the use of such power seen limited use over the years, the Railroad Commission has not enforced such limitations in nearly 40 years. The first time such power was utilized was on August 14th, 1930 when the Railroad Commission issued the first Statewide Proration Order to limit the production of the state to 750,000 barrels per day [5]. The order cut over 50,000 barrels of production from the previous year and was based on the reasonable market demand formula [5]. At this time, the East Texas Field was producing one million barrels of oil per day, one-third of the entire nation’s production, and the price of oil dropped to 10 cents per barrel [6]. The price drop led to civil unrest involving threats of blowing up wells and pipelines [4]. 

The last time such restrictions were enforced was on March 29, 1972 when the Railroad Commission again issued a Statewide Proration Order to limit production to satisfy market demand [4]. Although production hit a peak of 365 days per year in the same year, the Commission still had to intervene in a time of need to save a struggling industry. 

The current environment is not nearly as tumultuous as the 1930’s when the stock market crash led to the decade-long Great Depression, but parallels can be drawn. With overproduction plunging the price of oil and no bottom in site, action must be taken and must be taken soon. While the Railroad Commission is the only domestic governing body that has the immediate power to prorate production, other states and nations need to follow suit if there is any hope in saving this drowning industry. 

Time For Action

The United States has refused to play ball for years and that needs to change. Russia and Saudi Arabia are tired of continuing to cut production while the United States continues to pump. Since President Trump’s talks with major domestic oil companies failed to initiate measures to save the industry, it is time to take action. The only way to get prices under control is for the world to work together to shut in production and bring supply under control. The United States can no longer remain idle and expect others to save a crucial industry to the national economy. It is time to work together and begin to cut production.  

This starts with the Texas Railroad Commission, the only entity in the United States that has the power to significantly cut production now. Luckily, one of Texas Railroad Commissioners, Ryan Sitton, has already discussed with Russian Energy Minister, Alexander Novak, the prospect of taking 10 million barrels per day off the global oil markets [7]. While these talks will most likely not initiate action until after the planned OPEC+ meeting this Thursday, the ball is in motion. Unfortunately, several analysts have suggested that any OPEC action would be too little, too late, with demand unlikely to snap back anytime soon due to the pandemic; but a 10 million bpd cut, however, would go a long way to stabilizing the oil market [6]. While it appears the weakest companies will be weeded out and we will be left with only the strongest, most efficient, and more resilient companies with better technology and better preparedness for future market volatility; actions must be taken immediately before it is too late for even the strongest and most resilient. 

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