Pro – Or No – Rationing? Shale Mag Oil & Gas

There is really only one subject currently occupying the undivided attention of each and every person affected in any way by the oil and gas industry. To write about anything else would be about as nonsensical as trading favorite recipes during the final moments on the Titanic. This industry has undoubtedly weathered challenging conditions many times during its 160-year history, but the present ordeal seems like it must be the worst, mostly because it is happening to us now. 

A squabble between Russia and Saudi Arabia and other OPEC nations regarding production rates that led to flooding the global market with an excess supply of crude oil (with a substantial assist from the U.S. and our own continued record-setting production volumes), combined with a jaw-dropping collapse in demand caused by the COVID-19 pandemic, has delivered an unprecedented gut punch to the industry. Crude oil and natural gas prices are trading at levels not seen in decades. Companies have abruptly and drastically cut, if not completely eliminated, their drilling budgets and have laid off significant percentages of their personnel. As has always been the case in past downturns, companies will be filing for bankruptcy protection, and many will never come back. 

The deeper question being asked during the current collapse, unlike in any past downturn, is — will we return to past demand levels? Or, will the demand curve, and likewise the supply curve, now start to move in a different direction … down? Of course, in the middle of any drama — or, in this case, more like trauma — it is easy to be drawn to hyperbole. When thinking with a cooler head, it is difficult to conceive of a world that will not still be heavily dependent on oil and natural gas to power its economic engine. In other words, it is likely still the case that the more apt adage for our present circumstance is “this, too, shall pass,” rather than “the end is near.”

Nevertheless, the suddenness and severity of the current collapse has many industry leaders frightened for their literal survival and has triggered a call by some for a return to proration (i.e., imposing limits on production through government regulation). In fact, the Texas Railroad Commission (RRC) convened a 10-hour hearing on April 14 to consider the respective arguments for and against cutting future production by government order. 

In Texas, it certainly has been done before. In the 1930s, in response to the collapse in crude oil prices caused by the flood of oil being produced by the enormous East Texas field, the RRC first imposed allowables, in an effort to restore equilibrium to supply and demand. For the next forty years, because Texas represented such a significant percentage of both U.S. and global production (and the RRC was recognized as being the most effective oil and gas regulatory agency in the world), proration did, in fact, keep crude oil prices stable. In the 1970s, however, with the advent of OPEC on the world stage, Texas no longer held the same influence over global crude oil prices, so there was no longer a reason to limit production. Consequently, there has been no proration in Texas for almost 50 years.

The April 16 RRC hearing could be viewed as, “desperate times call for desperate measures.” Those calling for a return to yesteryear and the RRC’s proration rules see no end in sight for the double-whammy of excess supply and collapse in demand. They believe that drastic curtailments in production in Texas, combined with cuts recently agreed to by Russia, Saudi Arabia, Mexico and others are the only way to keep the entire domestic industry from imploding. Not wanting to suffer separately by voluntarily cutting their own production rates, these companies want all producers to be subject to the same rules issued by the RRC. In an independent-minded state like Texas and an entrepreneurial industry like this one, it is a little confusing and counterintuitive to see these calls for affirmative government intervention. 

Not surprisingly, there are many others opposed to the idea of proration, and they also let their voices be heard during the RRC hearing. Some believe that there is no crisis grave enough to justify inviting more government regulation. Some wondered to what extent cutting production in Texas would do other than hurt Texas producers, unless every other producing state in the U.S. does likewise. Some predicted that, by the time the RRC can reach a decision on proration rules and actually implement them, the current crisis will have passed, so the opportunity for any potential benefit from such rules will have also passed. Along those same lines, some more specifically described how the market will likely react to the current circumstances, arguing that government intervention would be an unnecessary and potentially adverse step. They pointed out that, given the lack of storage capacity, the reduction in global demand, and the overall drop in global prices, production will necessarily have to be cut significantly anyway, as a practical matter — in other words, there is no need for government to artificially create a scenario that will eventually develop on its own. Some pointed out the obvious, yet important, point that the RRC hasn’t enforced allowables in 50 years; there is no longer any institutional knowledge or actual experience in the subject, so the learning curve now would likely be long and steep.

So, what to do? As Twitter, Facebook and the media remind us daily, leaders are damned if they do and damned if they don’t. If you take significant action in a crisis, are you wise because you’re decisive or imprudent because you’re impulsive? If you fail to take action, are you cool, collected and able to withstand pressure — or are you paralyzed with fear? 

There are companies literally fighting for their very existence during this meltdown. Their position on prorationing is likely a function of what they believe will be most beneficial to their continued financial health. But what is the best overall policy for Texas? 

Before the current crisis, the problem in the industry that was receiving the most attention was excessive natural gas flaring. If the RRC were to impose limits on flaring, to what extent might a concomitant benefit be a reduction in crude oil production? In order to reduce the production of the associated gas being flared, companies would likely have to substantially reduce, or even shut-in, the oil production creating the excess production in associated gas. Might a much more focused and limited rule from the RRC regarding flaring have the effect of accomplishing the benefits of proration without actually having to engage in proration?