Gas prices have dropped significantly over the last couple of weeks. This is largely due to the drop in oil price we have seen across the globe — which is itself partly due to the coronavirus pandemic and partially due to the Saudi-Russian oil supply war happening within the Organization of the Petroleum Exporting Countries (OPEC).
Texas, as the energy capital of America, finds itself smack-dab in the middle of these phenomena.
But the economic worries are compounding. As the economy slows and the Texas Rainy Day Fund balance’s likely decline lies ahead, regulators and industry stakeholders alike are looking for options to cushion the blow to Texas’ thriving economy.
One option is the proration of oil production.
On Monday, the presidents of two Texas-based independent oil and gas companies, Parsley Energy and Pioneer Natural Resources — who employ over 500 and over 2,300 people, respectively — filed an appeal for the Railroad Commission (RRC) to explore prorating its oil production. Many independent producers have had to furlough vast numbers of their workers as the price of oil has dropped.
Effectively, this would serve as an artificial price increase caused by the reduction of supply levels by the regulatory body. Such a maneuver is designed to stabilize the price of oil to a “manageable” level.
Railroad Commissioner Ryan Sitton — who was recently upset in his Republican primary reelection campaign — wrote an op-ed on March 20, lobbying for the RRC to utilize pro-rationing schedules, also known as prorating.
Sitton endorsed a 10 percent cut for America’s oil production, paired with a Saudi/Russian 10 percent cut from its pre-supply war levels — a plan which Sitton says would “stabilize oil prices in the mid-$30s.”
He added, “With other governments manipulating oil markets, it’s fair to ask: Why shouldn’t our government step in to try to reinstate a more market-based approach? It would still mean hard times for oil companies and low gasoline prices for consumers, but it would stave off a total oil industry meltdown.”
In 2019, Texas produced nearly 1.5 billion barrels of oil (bbl) and 6.2 billion thousand cubic feet (Mcf) of natural gas.
The price of oil is currently sitting just above $20 bbl.
Such a motion has not been enacted in Texas in 50 years, since the oil embargo in the early 1970s. Back then, the drastic supply increase caused prices to drop below $20 bbl — sparking the implementation of the crude oil export ban which lasted until 2015.
The proration in 1973 sparked an oil production decrease of over 260 percent from 1974 to 2007 — when production began ramping back up due to hydraulic fracturing developments.
Wayne Christian, chairman of the RRC, stated his concerns with the idea in a press release.
“First, Texas does not operate in a vacuum. If we prorate our oil, there is no guarantee other nations, or even states will follow suit.”
Getting other countries to comply or cooperate is a common problem in the world right now, especially as China’s role in starting the pandemic is compounded by dishonesty throughout its development.
Saudi Arabia and Russia are the United States’ two biggest energy production competitors, and their cooperation should not be considered a given.
Christian’s other concern centers on the time elapsed since proration was utilized.
“From a practical standpoint, the railroad commission has not prorated oil in over forty years; we do not have staff at the agency with experience in this process and our IT capabilities to handle this process are limited at best.”
Further adding to this problem is the recommended 10-person limit on gatherings throughout the state intended to prevent the spread of coronavirus.
With Texas producing 40 percent of its output, the United States has recently become the largest oil and natural gas producer in the world — producing an average of 12.8 million bbl per day during the last three months of 2019.
At a time when gas prices are abnormally low, consumers might be wary of any effort that would increase prices. From the perspective of the producers — who have been producing at historic highs — to turn a profit, revenues must outpace expenses. And with the dramatic price drop, the forecasts which drive production and employment decisions are now radically different from just a short time ago.
However, numerous independent producers have “hedged” their prices out, meaning that what they are making per barrel is set for a few months — also known as a “swap.”
This creates price stability, protecting producers from dramatic price dips and consumers from price increases — at least for a set time period. At the end of the negotiated period, another deal is drawn up based on the latest forecasts.
Pioneer, however, reportedly used a more complicated form of hedging called three-way collars — settling at a 54 percent hedge. Three-way collars are a bit cheaper of an option for producers than swaps. The three-way collars strategy, instead of locking prices into one set price, creates a price window with a ceiling price, a floor price, and a subfloor price.
This option provides a bit more flexibility to both the producer and purchaser but still protects against dramatic market changes.
Neither of these hedging strategies, however, can fully protect a company — especially these independent producers who already run on thin margins — if prices fall too far. And with the influx of foreign oil production into the market and decreased demand as travel dramatically decreases, many of these companies are left holding the bag. But such is the price of doing business in the profitable-but-risky oil and gas industry.
The protection hedging does offer can only last so long as the duration that has been drawn up. Once that expires, the newest forecasts — which will take into significant account the latest price decline — will yield a far less profitable hedge.
Texas Oil & Gas Association (TXOGA) president Todd Staples issued the following rebuke to those who want to see proration instituted: “Our industry has proven nimble and innovative during challenging times, and we remain confident we can do so now. Recent suggestions that Texas should impose mandatory limits on the production of oil and gas in the state to stabilize the current market turmoil will likely result in other producers replacing curtailed Texas volumes.”
“Proration is not a remedy TXOGA members are seeking, as it would disadvantage Texas, its producers, mineral owners, and taxing entities. Regulatory certainty and stability are essential elements in managing during these difficult times. While individual members may differ on approaches, TXOGA members remain committed to free-market solutions,” he concluded.
Speaking more broadly on market conditions, Ed Longanecker, president of Texas Independent Producers and Royalty Owners Association (TIPRO), told The Texan, “With billions of people in lockdown globally, we have seen a significant drop in demand. This coupled with the deliberate move by Saudi Arabia to flood world markets with oil is causing an unprecedented level of strain on both domestic and international producers. This is unsustainable and not without potential consequences for those seeking to harm the U.S. oil and gas industry.”
About the production reduction independent operators are turning to in response, Longanecker added, “There are a variety of efforts underway to address the extreme challenges facing our industry. We encourage President Trump to continue with diplomatic efforts to help stabilize world oil markets while considering other options available through the Executive Branch to protect domestic oil and gas producers.”
According to RRC staff, the commission has 10 days to hold a hearing on proration. That is a small window of time to organize and implement a strategy — regarding a practice that hasn’t been done in 40 years and on which no working knowledge exists in the regulatory body.
And that doesn’t account for the logistics of an all-remote meeting which is not the norm for the RRC.
Over 360,000 Texans are employed by the oil and gas industry, but massive layoffs are already underway in the Permian Basin.
The smaller producers believe proration to be a stopgap measure which may help save more of their employees from layoffs — or the bankruptcy of the entire company.
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Brad Johnson is an Ohio native who graduated from the University of Cincinnati in 2017. He is an avid sports fan who most enjoys watching his favorite teams continue their title drought throughout his cognizant lifetime. In his free time, you may find Brad watching and quoting Monty Python productions.