The Oil Industry Doesn’t Need Government Protection

The stalwart free-market conservatives of West Texas are suddenly high on big government.

An oil pump in Texas
Eric Gay / AP

In 2008, a record-breaking spike in oil prices sent gasoline above $4 a gallon for months. Since then, world crude-oil production has increased by an astonishing 15 percent. Even more astonishing, nearly 90 percent of that increase has come from just one small region mostly in West Texas—the Permian Basin—which extends hardly a few hundred miles from the old oil towns of Odessa and Midland.

West Texas is remote, severe, and often bleak—a land of rugged frontiers and self-reliance. The Republican Tea Party wave of 2010 and 2012 was fueled in no small part by the people who live there, and their undying hostility to government intervention.

How the world turns. Just last week, many of these free-market stalwarts appeared before the Texas Railroad Commission—the state’s oil and gas regulator—practically begging for government intervention to limit oil production.

We’ve seen this before. In 1986, after Saudi Arabia doubled production and sent oil prices into a tailspin, Texas producers got clobbered. They put enormous pressure on government to limit both oil production and oil imports. But their usual political allies, such as conservative Senator Phil Gramm of Texas, refused to intervene. In Houston, bankruptcies soared along with unemployment, while property values fell all over Texas—the precipitating trigger of the savings-and-loan crisis of the late 1980s.

But despite—or more accurately, because of—the government’s refusal to intervene, the Texas economy jumped back as if suspended from a bungee cord, innovating and diversifying. Texas soon became the industrial engine of the American economy. Officials in Texas and Washington, D.C., should bear this history in mind today, as should the stalwart conservatives of West Texas. Protectionism poisons industries in distress by slowing down the efficient reallocation of resources precisely when it is most needed.

American oil producers should have seen the current crisis coming long ago. They were already in trouble before this horrible year even started. Production in the Permian basin continued to boom well past the point that anyone thought sustainable. By the middle of last year, Texas oil producers were wasting enough natural gas (which is released as oil is extracted) to power 4 million homes, because the market for natural gas was too saturated to absorb it. New capital began to dry up just as crushing debt payments were coming due. Then, earlier this year, Russia and OPEC failed to reach an agreement on production, and the Saudis launched a price war just as they had in the mid-1980s. Meanwhile, the COVID-19 pandemic has wiped out an unimaginable 20 percent of world demand.

All of this has led to the most dramatic crash in the history of oil prices. On Monday, contracts for oil delivery in May hit negative $40 a barrel. Refineries are starting to shut down around the country, just as storage is reaching full capacity, creating a catastrophic downstream blockage. Oil tankers full to the brim are stalled at sea. With demand at oil wells essentially negative, Texas producers are facing mass bankruptcy, and are now asking for one of the things that is most anathema to a free-market conservative: a government-created cartel.

In response to the perceived abuses of John D. Rockefeller’s Standard Oil Trust, the Sherman Act of 1890 prohibited restraints on competition (such as price-fixing). But the Progressive and New Deal movements elevated such restraints to central tools of public policy, and shielded them from the antitrust laws.

Government-created cartels have generally had a dreary record since, but the one managed for half a century by the Texas Railroad Commission is still fondly remembered in West Texas. When the Texas oil boom started in the early 20th century, rampant competition led to violent price swings and social unrest. In the midst of the Great Depression, the Railroad Commission stabilized the market by imposing quotas on oil production, a classic cartel scheme known as proration. From the 1930s until the ’70s, Texas was the world’s swing oil producer, ramping production up or scaling it down to keep prices stable. All that time, the Texas Railroad Commission was in effect managing the world price of oil.

Not surprisingly, when Saudi Arabia replaced Texas as the world’s swing producer, it used the Texas Railroad Commission as the model for OPEC, the Organization of the Petroleum Exporting Countries.

The Railroad Commission stopped managing production in the early 1970s, just as a deregulatory wave hit the U.S. energy and transportation sectors, and as Texas lost its swing-producer status. In the decades that followed, Texas seemed to pass “peak oil,” and production began a slow but steady decline.

In the meantime, robust production in the Middle East and elsewhere put downward pressure on both oil prices and investments in new capacity. As a result, the world had little excess capacity to accommodate the sudden rise of China as a major economic power. In 1998, crude oil traded as low as $11 a barrel, adjusted for inflation. Then prices started rising and just kept rising, reaching $140 in the middle of 2008. Rising energy prices all but guaranteed a recession, but because a serious imbalance had crept into the world financial system, the result was a global financial meltdown.

Oil prices crashed early in the financial crisis, but quickly rebounded, and remained high for several more years—enough time for one wily old Texan to test a theory that would revolutionize U.S. oil production. George Mitchell had long been convinced that two old technologies—hydraulic fracturing and horizontal drilling—could be married to produce vast quantities of oil from formations long thought inaccessible or depleted, particularly in shale rock. The new wells were a lot more expensive to start up, and required a lot more fracking than a vertical well, but they also proved far more productive.

Oil prices stayed high for long enough for these new oil wells to start popping up all across the Permian Basin. Led by independent oil companies, many of them firms with just a few dozen employees, the U.S. added the equivalent of a second Iran to world oil production in just a few years. By the time prices finally started falling in 2014, America had nearly doubled its oil production, but the Texans still weren’t done. They would go on to add much more production—the equivalent of the United Arab Emirates on top of Iran—and world prices began to fall precipitously. They reached nearly $30 a barrel in 2016, and have seesawed since.

As the U.S. has once again become the world’s leading oil producer, it has used its strategic leverage over Saudi Arabia, the world’s second-biggest producer, to keep OPEC output within bounds favorable to U.S. interests—high enough to ensure low gasoline prices and buttress U.S. sanctions against Iran, but low enough to keep prices from crashing.

However, the world’s third-biggest producer, Russia, has little incentive to advance America’s strategic objectives. Part of what led the rupture of coordination within OPEC is that Russia doesn’t want to give up further market share at the same time that Americans continue to increase production, heedless of all consequences.

But America can’t agree to any production targets, high or low, because American oil production is not in the hands of the national government—unlike all other major oil-producing nations, with the exception of Canada. President Donald Trump announced that he had reached agreement with OPEC and Russia to ramp down production, but all he can really do is report on supply reductions that are already happening in response to market forces.

Perhaps the best argument in favor of government intervention comes from Bob McNally, a former energy adviser to George W. Bush. McNally argues that the world needs a swing producer to keep oil prices stable. In a recent report he argues:

Oil prices are naturally prone to wild boom and bust price swings. Oil’s intrinsic, extreme volatility arises from very low supply and demand elasticities and limited storage. Oil is a must-have commodity for which there are no scalable substitutes. On the supply side, oil production requires long lead times and copious amounts of up-front capital. Once flowing, operating costs are low and shut in costs are high. Storage can help smooth out temporary imbalances in supply and demand, but storage is neither unlimited nor costless. […] Even the most free-market countries cannot tolerate boom and bust price cycles for a commodity that is tantamount to economic lifeblood.

Booms and busts are both bad for the economy, McNally says, and one leads to the other. A bust wipes out producers, which helps assure that when markets pick back up, the supply is insufficient, leading to spiking prices and a new production boom.

According to Kevin Sparks, president of Discovery Operating, an independent producer in the Permian, allowing market forces to wreak havoc now will hurt independent producers most, harming the freest part of the market, while favoring the major oil companies. Sparks says the major oil companies are a big part of the problem—with deep pockets, they continued to expand production in the Permian over the past year as ready sources of capital dried up for the independents, exacerbating the problem of oversupply in an already-saturated market. As for free markets, this staunch conservative says, “We don’t operate in a free market now.”

That may all be true. Until the fracking boom, private companies (mostly in the U.S. and Canada) accounted for less than 10 percent of world production—the rest was in the hands of national governments. But a strong case can be made that this is the main reason the oil sector is so volatile. It was Saudi Arabia and then Iran that unsheathed the oil weapon against Israel’s allies in the 1970s. It was Saudi Arabia that suddenly ramped up production in the mid-1980s, to enforce cartel discipline on other OPEC members and inhibit further development by non-OPEC producers, sending the Texas economy into a tailspin. It was OPEC and other national oil companies that failed to invest in new development during the 1990s, leaving them unable to accommodate new demand from China.

In any case, proration wouldn’t have much, if any, impact on world prices, because it would only partly reduce Texas production. It could motivate the Russians and OPEC to further reduce output by helping protect their market share—but that would in effect make Texas a member of OPEC, which would be strategically incoherent and deeply unprincipled. Meanwhile, the main impact would be to transfer costs from inefficient producers to efficient ones, in effect punishing the latter.

Reports suggest that the Trump administration is considering limits on imports, such as tariffs. That’s an even worse idea. It would be devastating for refineries, many of which rely on foreign imports for legal as well as technical reasons. And it would have impacts throughout the economy, hurting the competitiveness of U.S. industry.

These precedents will lead other sectors of the economy to start asking for government protection every time they hit the downstroke of a business cycle. This would hurt everyone, including oil producers. As Benjamin Zycher of the American Enterprise Institute warned the Railroad Commission last week, “efficiencies in production will become less important relative to the ability to obtain favors from government officials.”

If the government wants to help producers, it should focus on their real problem, which is not that they’re producing too much, but that they’re producing at a loss on the sunk costs of major investments. That can be addressed short-term by easing oil producers’ access to emergency COVID-19 credit programs, as Senator Ted Cruz of Texas has asked the administration to do, and long-term by easing tax rules on loss carryforwards and carrybacks to better reflect the cyclical nature of the industry and to ensure adequate continued investment in exploration and development—the best hedge against a catastrophic price rise down the road.

Another major problem is that producers are bound by the typical mineral-lease contract to keep producing or risk having the lease terminated. Temporarily preserving those leases (as Oklahoma recently did) will badly distort the market for mineral royalties, just as rent control badly distorts the rental market in places like New York City, but at least it would eliminate a strong incentive to keep producing at the worst possible time.

Meanwhile, U.S. foreign policy should push the world’s major national oil companies to embrace market-based reforms like those undertaken by Norway and Mexico, for reasons that go well beyond energy. National oil companies favor dictatorships, entail massive corruption, and are a source of strategic instability. Countries with proper energy markets are more likely to be democratic, protect private rights, and foment peace and prosperity. There is a reason the fracking boom happened only in America, despite the presence of shale oil all over the world.

Not for the first time, Texans will soon be glad that their plea for help was refused.