Like all industries, oil & gas is a slave to the laws of supply and demand. It dictates the boom-bust cycles that govern the fortunes of this most cyclical of industries. That we are in the midst of a historic supply glut is a given. This will remain so, given that OPEC has failed to set a production quota and given the obstacles to such quotas more generally. As it stands, producers are simply on the wrong side of supply and demand.
This has been the pattern since the industry’s earliest days in late-1850s Titusville. Against all odds, enterprising risk-takers struck oil. Practically overnight, a quiet Pennsylvania backwater became a veritable boom town, with prospectors flowing in to strike it rich. And practically overnight, the boom ended. Supply, as it often would, exceeded storage capacity. This cycle would repeat itself over the coming decades.
Depression-era Texas is where things finally came to a head. Practically no one thought East Texas had mineral potential. But like Titusville, what had been a backwater was suddenly awash in prospectors looking to strike it rich. Exuberance exceeded common sense. Predictably, too much was produced. In 1926, oil in Texas was as high as $1.85 per barrel. By May 1931, it had plummeted anywhere between $0.02 and $0.15 per barrel! At the time, production costs averaged around $0.80 per barrel.
After a brief flirtation with voluntary production curtailments, Texas Governor Ross Sterling declared that East Texas was in a state of open rebellion and dispatched the National Guard and Texas Rangers to forcefully shut down production. These proration orders, while heavy-handed, stabilized the price of oil. Calls grew for general allocation of production quotas – prorationing – and the Texas Railroad Commission – which was and is in charge of regulating oil production in Texas – had its mandate expanded to prevent “economic waste.”
Yet this stabilization proved to be short-lived. Quotas were too high and even still, “hot oil” produced above the quota was smuggled out of state. 1933 was a repeat of 1931. Coordination beyond the state level was needed; it came in the form of President Roosevelt and his New Deal legislation. Through a convoluted process, a system evolved that had its roots in mandatory quotas enforced from Washington but that ultimately took the form of voluntary state-federal cooperation whereby states would generally hew to recommended quotas set in D.C. States could theoretically overproduce, but generally showed restraint lest other states retaliate by doing the same.
At around the same time, knowledge of reservoirs developed and regulatory bodies became more professional and technically adept. Indeed, the basic structure of oil & gas regulation was developed at this time. The regulatory systems tended to share some basic functions: 1) the prevention of waste – in the form of excessive surface encumbrances, damage to reservoir energy, or waste characterized by over-investment in drilling – and 2) to protect the correlative rights of working interest holders by giving them the opportunity to recover their fair share of the reservoir, a necessity given the adverse incentives of the unmodified rule of capture.
The tools used to accomplish these goals invariably involve spacing rules, which in turn establish the amount of wells permitted on geographically-defined spacing units. A few jurisdictions also have allowables, which set a production cap on a per-well or field-wide basis over a given term. Historically, this system was also used to ensure a level of production consistent with market demand. However, market-demand prorationing is now a historic artifact.
And that is where the history segues into the present moment.
The modern-day regulatory system is simply ill-suited to regulate our way out of the present supply glut. Politically, it is not even on the agenda and today’s economic orthodoxies differ radically from those of yesteryear. Nor would it be a particularly good idea if it were possible. Oil & gas players are far more sophisticated actors compared to the wildcatters and independents of the Depression-era. Careful, rational deliberation is involved in the process of capital allocation and it is this process that will dictate a reduction in drilling to the point where supply more accurately reflects demand. In short, the free market appears sufficiently suited to rein in unprofitable production, as evinced by reduced rig counts and the lagging but inevitable effect of well production declines.
More significantly, the oil & gas markets differ radically from those of the 1930s. They are truly globalized. Commodities are traded at world prices. Where production and consumption was once more a regional affair, today complicated supply chains link producers to end markets, sometimes separated by entire oceans. In this globalized marketplace, the amount of players has proliferated, and so market power among sellers is greatly dispersed. And this is precisely why a theoretical prorationing scheme to cut back production in the US would not work.
This is what OPEC tried for years. The result was a high oil price which rendered previously uneconomic reservoirs viable for competitors to exploit. Saudi Arabia’s restraint kept the price high at the cost of its market share. Were the US to try a similar scheme, it would find that other producers have an incentive to free ride by upping their own output. This would always be so absent some viable means of punishing cheaters.
In this light, and in hindsight, it is hardly surprising that OPEC did not set a quota, especially given that some members wanted reduced production while others wanted to keep the wells pumping. As a practical matter, OPEC is currently irrelevant given its internal divisions. And given the abundance of players on the supply side – North America, OPEC, and Russia – the prospect of coordination among players remains elusive. Prisoner’s dilemma rules apply, and the greater the number of players, the greater the likelihood of diverging interests, the greater the obstacles to successful enforcement, and the greater the prospect of free-riding.
Consequently, economics rather than man-made quotas will be what ushers the end of this supply glut.
|Daniel Yergin, The Prize. New York: Simon & Schuster, 1990. 244 – 259.|
|John S. Low et. al., Cases and Materials on Oil and Gas Law. 5th Ed. St. Paul: Thomson/West, 2008. 134 – 136.|