The Texas Railroad Commission (RRC) met in open conference on Tuesday, May 5 and put the idea of prorating Texas crude oil production to bed for good. An order to implement proration prepared by Commissioner Ryan Sitton was withdrawn and never acted on, with Commissioner Sitton proclaiming, “proration is dead.” Chairman Wayne Christian then moved to dismiss the complaint by Pioneer Natural Resources and Parsley Energy to “determine reasonable market demand for oil in the state of Texas”, with a second on that motion by Commissioner Christi Craddick. The motion to dismiss the complaint passed on a 2-1 vote, with Commissioner Sitton voting against the motion because, he said, the assessment of market demand called for in the complaint was not conducted.
Thus ends the month-long saga that was set in motion on March 30 with the filing of the complaint by Pioneer and Parsley. The potential for the implementation of production limits in Texas gained international attention and included a day-long public (virtual) hearing by the RRC on April 14 watched around the world in which over 50 companies and individuals submitted written and oral testimony. As the process played out, however, oil and gas companies in Texas were swiftly going about the painful business of reducing crude oil production.
While the Texas Alliance of Energy Producers certainly has members who favored proration, the official position of the association as determined by the Board of Directors in a conference call on Tuesday, April 7 was that deep production cuts would take place as a result of market forces, and therefore proration would be unnecessary and ineffective at best and harmful at worst.
Most of the rationale for the implementation of production cuts by order of the state of Texas had a worthy counterpoint. First and foremost, if the primary argument in favor of proration was to adjust Texas crude oil production downward in an attempt to align it with demand, which had collapsed under the weight of the COVID-19 pandemic, there was little doubt that production would fall, and do so in a hurry, in response to crashing demand, lower prices and pinched access to markets.
A recurring theme among supporters of proration and Commissioner Sitton, in particular, is that action should be taken in response to unprecedented disruption in crude oil markets, leaving the impression that if the Railroad Commission doesn’t act to limit production then no “action” will be taken. That, as they say, is poppycock. Action is and will be taken, but by individual operators rather than the government, and, in fact, companies have and will act before the government can manage to get its act together. Under the most optimistic assessments, proration could not have begun before June 1, and even that would have been a tall order.
Further, it is unclear what the “assessment of market demand” called for in the verified complaint by Parsley and Pioneer might look like, or how long it would take. Was a study to be undertaken within the Commission, or by a firm engaged by the Commission, either of which would take time? Or, was the assessment of current market demand simply to have been the best guess of three elected officials? The answer to that question appears to be ‘yes’, as the order indicates that by its adoption the Commission finds that production is occurring in excess of market demand, and that ‘waste’ is taking place as a result. However, no study or data is included to support that finding. Who is to say the 20% figure is correct? And actually the order makes no reference to that 20% or any other figure, so it may be that had it passed, the requested determination of market demand would have been carried out thereafter, but again, the clock would have been ticking. And all the while, operators will have already been going about the painful process of reducing crude oil production.
Adding yet more time to the implementation of proration is the conditional nature of the proration order. Sitton did at least acknowledge that proration in Texas alone would have been insufficient to move the needle on crude oil pricing, a point we made from the start, and our assessment was that to do so would have also put Texas at a competitive disadvantage with other states. Thus, according to the proposed proration order production cuts would not have been implemented absent “Complimentary Proration Measures” by other states and non-OPEC+ countries to the tune of at least four million barrels per day. Had the order passed, it would not have been implemented until some mishmash of other states and countries went through the same process — which most had not yet even begun to do — to come up with four million barrels per day. And what are other states to do? Had they moved to prorate, would that have been conditional as well? Why would other states implement proration with certainty while the Texas order is conditional?
Proration turns into game theory at that point and it seems unlikely that the conditions required for actual implementation of the Texas order would be accomplished within six months, much less one month. And all the while, operators will have been going about the business of adjusting crude oil production to current market circumstances.
Before COVID-19 turned the world upside down, Texas crude oil production comprised roughly 5% of global production. All Texas production would not have been subject to proration as smaller operators would have been excluded. Proration might have ultimately lowered Texas production by, say, 900,000 bpd — less than 1% of global production, and about 7% of U.S. national production. This is why unilateral action by Texas would be insufficient.
There is no disagreement on the notion that crude oil production should fall in response to lower demand and falling prices. And guess what — IT IS. And in a hurry. While official reliable production data will not be available for months to come, anecdotal information suggests production is falling much faster in Texas and other U.S. states than most had expected. A 20% decline in Texas production from peak levels achieved in the first quarter 2020 would amount to more than a million barrels per day, and astoundingly, it is at least possible that may occur by the end of the month of May or shortly thereafter. North Dakota is reporting production declines of nearly 30% in early May, while a Reuters study suggests production declines of as much as 10% have already occurred in the U.S. and Canada. In Texas, that would amount to production declines of well over 500,000 bpd in early May. The idea that production only declines in Texas and beyond as a result of a government order to do so is just silly, and the question must be asked: why is a 20% production decline mandated by the government somehow better or preferable to a market-imposed production decline of 20%?
Yes, it may have been the case that the 20% upon order of the Texas Railroad Commission would have been “immediate” — but only upon implementation, which would be months away at best. The job will be done long before then.
Perhaps supporters would argue that state-mandated production restrictions keep operators from responding “too soon” to upward movements in the price of crude oil (the order would only have been lifted when global demand returned to at least 85 million barrels per day). What if that doesn’t take place for a year? Longer than a year? Struggling operators would be handcuffed, and prohibited from taking advantage of a somewhat higher price based on steady, but perhaps slow, improvements in demand. That alone could determine whether companies survive or not.
The arguments for proration simply do not stand up under careful analysis and scrutiny. Even under the assumption proration could have been implemented in time to actually matter (which is to say before markets will have already done the job), governments do a poor job of managing markets, and there is little reason to suspect it would be different this time around.
Finally, the concept of “economic waste” is a specious one and reveals the true motivation behind any attempt to prorate production in the state of Texas, which is to limit production in order to reduce supply relative to current demand. Even if the economic waste theory had any real basis in economics — which it does not — production during a transitional period of time in which supply is responding to the rapid onset of drastically changing market conditions cannot be considered waste. The market’s very purpose is to align production and consumption (supply and demand), and the so-called “economic waste” is eliminated as a part of that process.
In this context, waste can and should only be considered the loss of extracted crude oil to future use. Under no circumstances does that definition apply here. Each barrel extracted either moves into the marketplace or into storage and each barrel not extracted remains available for extraction in the future.
If eliminating waste were truly the focus of the argument for proration rather than to simply substitute the Commission’s judgment for that of the market to restrict production to support prices, why was no such assessment of market demand undertaken by the RRC or requested by individual companies for natural gas in recent years? Natural gas is the poster child for actual waste — flaring to facilitate crude oil production, rendering it unavailable for future use — never mind the fact that natural gas production growth in Texas has occurred outside the natural gas market because it comes as a result of growth in crude oil production rather than supply and demand for the gas.
Commissioner Sitton and most other supporters of proration in Texas (there are a few notable exceptions) clearly have the best interests of the industry at heart, and for that, they deserve respect and commendation. But all supporters of a healthy and viable Texas oil and gas industry should fear the ability by a future commission that is hostile to the continued development of oil and gas resources in the state to restrict production by a simple majority vote of three elected statewide officials.