The last three months have been a rollercoaster for the oil and gas industry. Oil prices have taken a beating, falling from around $70 a barrel to under $20 a barrel due to a combination of a fall in demand from the ongoing COVID-19 pandemic and a price war between Saudi Arabia and Russia.
Given the economic pain being experienced, it’s not surprising that people have been looking around for a quick fix. On May 20th, the North Dakota state government held a hearing to consider one such idea: proration. Proration involves a government mandated reduction in the amount of oil produced in order to reduce supply and raise oil prices. Proration was once commonly used by my home state of Texas, but fell into disuse many decades ago.
Now, however, advocates of proration have reemerged in several states. Oklahoma has made some moves in this direction. And last month Texas briefly considered the idea before ultimately rejecting it.
Having just gone through a battle over proration in my own state, I feel compelled to warn any state that considers this of just how bad an idea proration would be as a response to the current crisis. Proration would be an administrative nightmare, and could do long term damage to the integrity of any state’s oil market without achieving any of its stated objectives.
There is a reason states like Texas that once used proration have long since abandoned the practice. During the middle decades of the twentieth century Texas had a commanding presence in the world oil market, and at one point was the biggest oil producer in the world. In those circumstances, Texas regulators had some ability to affect the price of oil by controlling production levels. Now, though, Texas accounts for only five percent of world oil production. No U.S. state has a big enough market share to raise the price of oil appreciably through production cuts.
Proration is not needed to reduce overall oil production. The falling price of oil itself will accomplish that. The process will be painful, but proration would not lessen that pain, only transfer it from some producers to others. If left to the market, cuts will be concentrated among the least efficient and profitable producers, whereas with government action less politically favored groups are likely to be hit hardest.
This is not the first time the oil and gas industry has faced substantial price declines, and it won’t be the last. Oil prices fell substantially in 1986, in 1998 and 1999, after 9/11 and during the Great Recession. Most recently, in 2014 prices plummeted below what the expert community believed to be the price necessary for U.S. tight oil projects to be profitable. American producers, facing tight or negative margins, responded by innovating aggressively. This drove the breakeven point down almost 40 percent from 2014 to 2019.
Proration would also send a bad signal about the United States’ commitment to the market system that has made our oil and gas industry so strong in the first place. As Benjamin Zycher of the American Enterprise Institute has noted, the pursuit of an “explicit cartelization” of oil markets would position the United States as an “implicit member of OPEC” and could harm the willingness of companies to invest in the state going forward.
During times of crisis, the temptation for politicians to “just do something” is understandable. But proration is not the right something.
Image credit: Thaiview