In response to falling economic demand caused by COVID-19 and the subsequent public health measures, oil prices in the United States have plummeted, putting many oil and natural gas producers in grave danger.
In response, regulatory commissions in several states, including the North Dakota Industrial Commission, are debating a policy known as “prorationing” – a government-forced oil production cut in an effort to balance supply and demand. But as history tells us, we should rely on the free market to address this crisis, not government intervention.
The Oil Downturn of 2015-16 Says No to Prorationing
In 2015, the price of oil collapsed, and production decreased approximately 1 million barrels per day (mb/d) between April 2015 and July 2016. In response, the oil and natural gas industry reduced investment, laid off thousands of workers, and some companies went bankrupt. Yet, despite all this damage, the industry survived the cutthroat competition and came back with a vengeance, adding 4.2 mb/d, and if counting for the replenishment of production declines, more than 7.5 million mb/d. That’s more than the oil exports of Saudi Arabia and more than that of Iraq and Kuwait combined.
Why the success? Because no state regulatory commission adopted prorationing, despite all the “economic losses” as prices declined more than 70%. Prorationing would have prevented the shale industry from making the necessary adjustments that unleashed the innovation and efficiency gains that enabled them to bring about one of the largest oil production increases in history in a short period.
In difficult times, it was the pressure of free market competition that made shale producers stronger and more efficient and made the U.S. the largest oil producer in the world and one of the top exporters.
Proration Doesn’t Enhance Efficiency Nor Reduce Costs
Looking back at history of the global oil industry, market management by John Rockefeller and the Seven Sisters (including Chevron and ExxonMobil) achieved three goals: reduction of physical waste, enhancement of efficiency, and reduction of costs. Proration doesn’t achieve any of these goals.
There is no physical waste now except the natural gas flaring that is officially permitted by these same commissions. It doesn’t enhance efficiency because it applies a one-size-fits-all jacket on producers while exempting smaller ones. Efficient producers are punished exactly the same way as inefficient producers with a universal forced production cut, denying the free market’s power of weeding out the weak.
Additionally, producers will be busy meeting the legal requirements of proration and lose focus on cost reduction and efficiency improvement. Prorationing doesn’t reduce costs as much as it eliminates the incentives to do so. Meanwhile, commissions will be busy trying to monitor and enforce prorationing instead of serving the industry.
Historical Evidence Does Not Support Proration
Many supporters of prorationing have cited the success of Texas and Oklahoma from the 1930s to 1970s, but this ignores two historical facts that don’t apply today.
First, both states used the National Guard to enforce proration orders when courts ruled against the commissions. Does anyone really think that’s a good idea of resources amid the COVID-19 pandemic? Second, the only reason why these commissions succeeded in managing prorationing is because they were shielded from international competition by the Seven Sisters’ cartel that controlled most of the global oil market. Commissions have even shielded the Seven Sisters from the competition of American independent producers.
It’s worth noting that commissions have no legal jurisdiction over U.S. oil imports and exports. As OPEC+ has limited market power compared to the Seven Sisters, they cannot help the commissions achieve the results they had in the past. There is not a case for prorationing right now, even within the context of global cooperation.
Owners of Resources Can Cut Production as They Wish
Private ownership of oil resources makes the U.S. different from every other country in the world. OPEC+ members are able to manage market volatility because their oil resources are owned by the state and operated by a national oil company. They’re free to do whatever they want with their own resources, decisions are easier to make, and they don’t have to spend money on monitoring and enforcement.
What we see in the U.S., the beacon of free markets, are proposed efforts by legal entities such as the North Dakota Industrial Commission that are telling the private owners of the resources what to do. That makes OPEC+ members, with all the ills of their political and economic systems, more consistent with their principles than U.S. state regulators.
As commissions in the U.S. need financial and technical resources to implement prorationing, Saudi Arabia does not have to spend an additional penny on monitoring its own compliance. In other words, prorationing increases costs in the U.S., while production cuts by OPEC+ member’s do not. U.S. producers must be able to decide on production cuts on their own, exactly like OPEC+ members. They shouldn’t be forced to cut production while international competitors do as they wish.
Anas Alhajji is an independent energy markets expert and advises governments, companies, financial institutions and investors on various energy markets issues.