(Bloomberg Opinion) -- The Texas Railroad Commission has been petitioned to go back in time.
The commission just held a marathon hearing on whether it ought to do something it hasn’t done in almost 50 years: organize curbs on the state's oil output. I say “organize” because cuts are happening anyway; there’s simply no choice when the Covid-19 crisis has wiped out maybe a third of global oil demand. Several companies, including large frackers such as Pioneer Natural Resources Co., have called on the commission to “pro-ration” production to support oil prices.
A recurring theme was “waste.” The person who raised it most often, outgoing commissioner Ryan Sitton, even parodied himself repeating the word in a video clip doing the rounds on social media.
Clearly, this isn’t your grandfather’s oil market — a point reinforced by James Mann, attorney for the Texas Pipeline Association and formerly a commission employee in the 1970s. He observed that the folks familiar with the data-intensive work of apportioning quotas for thousands upon thousands of wells across the state were no longer contractually employed, so to speak:
They’re all dead now. Everybody that knew how to do the arithmetic is gone.
When I spoke with Mann the day after the hearing, he recounted other ways in which the world has changed. “Waste,” for example, meant actual waste when it was first used to justify pro-rationing. In the early 1930s, a swarm of wildcatters drawn by the gushing East Texas field sought to out-pump their neighbors, regardless of what the market could absorb. Plus ça change, as they say in Midland. Back then, though, “oil was coming out the ground with no place for it to go; they were putting it in dirt pits and leaky wooden tanks,” as Mann says. A lot of oil soaked into the ground or evaporated — waste in its very worst sense.
That can’t happen today provided regulators do their job. If oil is running out of places to go, then futures prices will tell you ahead of time and wells will get shut in, with the weakest usually going first. Rather than a physical issue, “waste” today is a euphemism for lost money. As James Teague, co-CEO of Enterprise Products Partners LP, put it bluntly: “I think I’d define waste as inefficient producers continuing to produce at a time like this.”
Speaking of which, much concern was expressed about the fate of smaller producers, in particular. There are over 2,900 producers that account for less than 10% of Texas’ output, according to Matt Gallagher, CEO of Parsley Energy Inc. This implies that, at best, they produce almost 1 million barrels of oil equivalent per day in aggregate but just a few hundred each on average. The vast majority of wells in Texas are dribblers rather than gushers:
Bernstein Research estimates that when oil is at $25, a typical marginal well needs to produce 12 barrels a day just to break even, before counting any natural gas. Two-thirds of Texas’ wells produce less than 10 barrels a day equivalent, including gas, and benchmark West Texas Intermediate crude crashed below $13 on Monday morning. And low prices are only one problem; several small producers complained about getting shut out of pipelines, tanks and refineries altogether as those businesses prioritize bigger companies.
The inescapable truth is that scale economies are vital in this business. Even before Covid-19 hit, the economic case for sinking money, water, labor and power into lifting maybe just one truckload of oil every other day from a backyard was hardly compelling.
Yet the idea of bowing to that reality is anathema. Advocates argue shutting down these wells even temporarily could leave them unable to start up again, wasting the remaining oil and gas. But this presupposes the remainder has positive economic value, an increasingly dubious proposition in an oil market barreling toward peak demand. Factoring in the cost of decommissioning these wells only reinforces this math but, ironically, avoiding that cost also reinforces the desire to cling on.
Pro-rationing would reinforce this further, especially if smaller producers were made exempt. It would mean more-efficient wells subsidizing higher-cost ones. Any number of factors may explain why there is such concern to preserve this part of the industry. Immediate impacts such as unpaid bills and layoffs often loom larger than considerations of long-term viability. Moreover, sheer numbers matter more than scale when it comes to one thing: Barrels don’t vote, people do.
Zooming out, the state’s pro-rationing debate is a fractal, with the pattern repeating. Most obviously, OPEC+ tries to do the same thing at the global level, just as Texas used to. By holding cheaper barrels off the market, countries such as Saudi Arabia leave room for higher-cost ones, raising the price overall. OPEC+ does this for similar reasons. Like the small producers in Texas, countries such as Saudi Arabia and Russia have economic models that simply wouldn’t work too well if oil was priced like a regular commodity.
Oil’s centrality to development over the past century made it indispensable, and demand both ubiquitous and inelastic. Combine that with the geographic concentration of resources, and the result is an edifice of political and economic structures built on the back of this miracle substance. The oil “market” is just different.
But it is becoming less different. That’s the underlying reason for the commission’s virtual gathering this week. Covid-19 is like a fever dream of all the pressures that were bearing down on oil already. The last time Texas was pro-rationing, in the early 1970s, the conventional wisdom on resources and their fast-approaching exhaustion was captured in reports like “The Limits to Growth”. Such ideas supported both OPEC’s power and the notion it was better to ration oil supply and conserve resources — even under those Texas backyards — in the expectation prices would only rise in the future.
Today, we know we won’t run out of oil. Mann makes the excellent point that the sheer “capability of oil production” holds prices down today rather than physical barrels being poured into bathtubs for want of a buyer. Capital markets have run out of patience with the industry’s current business model of high and often inefficient growth. There’s simply no economic justification for having thousands of operators with all their associated overhead. Meanwhile, the planet is running out of capacity to absorb oil’s emissions. Demand for oil remains high, but is no longer as inelastic as it was. That trend will intensify.
It is striking that this enormous, vital market is now dominated by a shale industry that couldn’t pay a decent return even before Covid-19 showed up, and two sclerotic petro-states, Saudi Arabia and Russia, living off their foreign exchange reserves. These are the edifices built for a different time of dependable demand and managed supply.
We are transitioning, painfully and chaotically, to a market with more competition, both between producers fighting for market share (and geopolitical influence) and between oil itself and encroaching rival energy sources. The edifices aren’t built for that and must reconfigure or fall. Like oil itself, the Texas Railroad Commission simply cannot deliver all that is being asked of it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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