A Texas-based oil cartel?

OPEC's decision (really Saudi Arabia's decision with the acquiescence of other OPEC members) was that, going forward, as the world's low-cost producer, the Saudis would unilaterally set their own production goal and then let the rest of the world, including other higher-cost OPEC producers, adapt their own production levels to that target. The initial goal for Saudi Arabia was to be 10 million barrels per day. In addition, a secondary goal of 30 MMb/d was put forward for all OPEC members, with some squabbling about the rightful allocation for Iran.

While much news copy emanated from this policy change, as well as an announcement by Dr. Daniel Yergin that US shale oil producers would now collectively take on the role of global swing producer, there has been little discussion of exactly how US shale producers could assume that dubious mantle. (When it comes to concerted action by US independents, the old term "herding cats" comes to mind.)

I believe that this geopolitical change is not a triumph of free market economics over a cartel or even a latter day manifestation of the efficacy of Adam Smith's "invisible hand." Rather, I believe we will see the emergence of active, direct, regulatory action to ration domestic production. The primary driver will be the need to meet the same response times evinced by the defunct OPEC/Saudi system. That system was famous for the tendency of OPEC members, including Saudi Arabia, to cheat on their allocations. For example, current Saudi production exceeds 10.6 MMb/d.

For students of history, there was an active, US-based, pro-rationing system put in place by the Texas Railroad Commission prior to the emergence of OPEC. At a time when the US was a major producer and exporter of crude oil, that system operated for a number of years to maintain oil prices by rationing production. The state-level legislation enabling that system did not die with the birth of OPEC in 1960. Rather, at a time of domestic shortages, it entered what we might call a state of suspended animation where the Texas Railroad Commissioners routinely announced they would permit unrestrained production.

Now, in a time of surplus, the enabling legislation is still on the Texas books. With the bulk of shale oil production centered in Texas, it seems likely that we could be in line for another round of "managed" supply, courtesy of the Lone Star State. Basically, any two of the three statewide elected commissioners can instruct Texas producers to limit production. That would certainly solve the time lag problem inherent in our preferred free market solution. However, I suspect that the Texas Railroad Commission itself would prefer a free market solution as would virtually all energy economists.

The devil is in the details. It has taken from November of last year until today to see a slight downturn in US shale oil production despite a halving of the price of oil and the onset of ruinous economics for new incremental production. In order to function as a swing producer, volume changes need to be made in a matter of days and weeks, not in eight months.

In order for there to be a renaissance of US pro-rationing, at least three features will be necessary.

• First, the three commissioners of the Texas Railroad Commission will need to vote on a pro-rationing formula and, if successful, notify the Texas shale oil producers of their decision.
• Secondly, Texas will need an updated enforcement mechanism. When pro-rationing was originally instituted, it was enforced by the business end of a rifle held by a Texas national guardsman. A return to that methodology would be difficult to manage in the current political environment. Nevertheless, some sort of viable enforcement mechanism, perhaps based on fines, will be a necessity.
• Finally, some level of direct or indirect agreement with North Dakota and other US shale oil producing states will be required. Such interstate compacts have been used in the past whereby states can coordinate their actions to produce some greater good. But this would probably involve decision making in a less than transparent manner.

A word or two about possible alternatives:

The ad hoc system currently in effect of letting the domestic market discover an equilibrium price and volume by weeding out the weakest producers and their bankers will work, but only with an untenable lag time. The Saudi system we hope to replace was much quicker. A Saudi/OPEC decision to open or close a figurative valve was something that consistently produced results within 90 days or less.

Alternatively, some sort of federal rationing system might be put in place, such as that used by Harold Ickes during World War II or more recently in the late 1970s after the Arab Oil Embargo. While those events were designed to deal with shortages, the basic mechanism would function for surpluses. Given the political environment, neither major party will want the honor of championing that particular cause. However, after the 2016 elections, Congress might very well promote some sort of bilateral regulatory solution. However, the federal approach has not always resulted in the mitigation of all shortages, as anyone old enough to remember the gasoline lines of the seventies can attest.

Finally, we may end up with a hybrid system whereby the US and Saudi Arabia agree to coordinate production goals in order to meet a commonly agreed upon estimate of world demand. That would then be linked to production allocations for the US and possibly for all of North America. The recent visit of King Salmon to the US coupled with a premise floated in an OPEC publication, which roiled the stock market, might provide the context for such an option being proposed. Stranger things have happened.

So, if an orderly, relatively non-volatile, crude oil market is the collective goal, then we, the supposed champions of free markets, may be reinstituting a cartel structure, actively in the domestic case and more passively in the international context. Certainly the three structures mentioned above would all qualify for that moniker. The irony of replacing an international oil cartel led by Saudi Arabia with a new and improved American version led by Texas should not be lost on anyone.

As Mark Twain famously quipped, "History doesn't repeat itself, but it surely rhymes a lot."

ABOUT THE AUTHOR

Eric Smith is a Professor of Practice at the A. B. Freeman School of Business at Tulane University in New Orleans. He also serves as the Associate Director of the Tulane Energy Institute.