No, the Railroad Commission should not cut production
Will the Railroad Commission of Texas kowtow to Pioneer Natural Resources Co. and Parsley Energy Inc. and cut production across Texas in order to reduce supply and increase prices? Really? In the face of a global recession? The companies’ executives say that to do so would protect employment. For whom?
The shale oil producers, commonly referred to as frackers, are the highest-cost producers in the global oil market. They have always been vulnerable to a very predictable price war led by low-cost producers. The 2014-16 price war cost the U.S. oil industry 300-plus bankruptcies, more than $250 billion in lost capital and 250,000 jobs.
Following the December 2016 truce among OPEC members and Russia that ended the price war, former Saudi oil minister Ali Al-Naimi anticipated the breakdown of the cartel and the current price war, famously stating, “The unfortunate part is we tend to cheat.”
When the oil export ban was lifted at the demand of frackers, the U.S. oil market had no further market barriers. Had the ban not been lifted, U.S. refiners would have had incentives to retool to process the lighter crude oils from the shale plays. Today, the U.S. exports as much as 3 million barrels per day of these light crudes into the world market. Oil that costs as much as $40 per barrel at the wellhead to produce is competing head-to-head with oil that costs as little as $5 per barrel. The network economics are complete. What happens at one node impacts another. What happens in Riyadh impacts the Permian.
Can the Railroad Commission reduce production in Texas? Yes. Will it save jobs? No. Will it raise oil prices? No. The Financial Times reports that U.S. producers have engaged in direct discussions with OPEC ministers. I hope not.
President Dwight D. Eisenhower recognized the strategic danger of depending on foreign crude. He refused to commit the U.S. military in 1956 to assist Britain, France and Israel in recovering the Suez Canal. He is reported to have said “Let them boil in their own oil.” Further, he instituted an oil import quota restricting imports to no more than 12 percent of domestic production.
Consequently, the U.S. domestic oil industry enjoyed oil prices approximately double the world oil price for the duration of the quota, which was ended by President Richard Nixon, who was worried about inflation and ending the need for the Railroad Commission to manage a market that faced other federally imposed restrictions, such as price controls.
The Railroad Commission’s control of production “worked,” but only because the U.S. market was really well-insulated from the foreign suppliers. That is not the case today.
In context, at pre-virus levels, the U.S. consumed approximately 18 million barrels per day of crude oil, produced approximately 12.5 million barrels per day and exported 3 million barrels per day. This does not add up to energy independence. Texas produced approximately 4.5 million barrels per day.
Suppose the Railroad Commission cuts Texas production by 25 percent. Less production requires fewer workers. Marginal producers will sprint to the bankruptcy courts. Of course, fire sales of properties to better-capitalized competitors will also result, and the job losses will become permanent.
Will the price of oil in Texas increase? Unlikely. Even assuming that the Permian players could raise prices, the reality is that refiners would still be buying cheaper imported oil because that is what they need. The U.S. export market would literally dry up, and the Permian producers would have lots of oil they could not move at the higher price.
But world oil consumption was already down by 800,000 barrels per day in the warmest January on record. The U.S.-led trade war has resulted in less international commerce and less fuel consumption. Now comes the direct impact of the virus, at least 500,000 barrels per day due to lower airline consumption.
Why does this matter in a 100 million-barrel-per-day market? Our research shows that for a 1 percent increase in quantity supplied to the market, the price will fall 25 percent. With the Saudis adding oil and demand falling — China’s consumption is devastated — the surplus today is much more than 1 percent. The price of oil has been in the freefall everyone expected. And now, no one across the globe has any short-term prospects of filling up their tanks and taking a road trip.
President Donald Trump has heralded the oil price collapse as “good for the consumer, gasoline prices are coming down,” and earlier likened low oil prices to a tax decrease. Every elected official in Washington, D.C., knows rising prices at the pump are poison for re-election.
If the Texas Railroad Commission kowtows and cuts production, the commissioners will join the executives of Pioneer and Parsley in a very special infamy.
Ed Hirs is an energy fellow and lecturer in the Department of Economics at the College of Liberal Arts and Social Sciences at the University of Houston.