The combination of the COVID-19 pandemic and the Saudi-Russia price war is wreaking havoc on global demand for crude oil, flooding the market with cheap crude and pushing prices to the low $20/bbl range. In response to these events, the Railroad Commission of Texas (RRC) is weighing whether to cap—or proration—crude oil output in an effort to boost prices (the RRC has not prorated the production of crude oil since 1973). But, would such a decision, if mandated, really work?

The consideration for a statewide limit on crude production came after two of the top producers in the Permian Basin, Parsley Energy and Pioneer Natural Resources, filed with the RRC a Motion Requesting a Market Demand Hearing and Market Demand Order for May 2020 production, arguing that the oil price war and COVID-19 have created disruptions that have surpassed the “merely extraordinary”.

"By itself, Texas proration will do little to affect the stability of the oil market as Texas only produces 5 MMbbl/d, so a coordinated global effort would need to be undertaken."

Parsley Energy told Reuters that it wants a comprehensive solution that might also include tariffs on imported foreign oil in an effort to help domestic producers. Coincidentally, the Oklahoma Energy Producers Alliance has urged the state’s regulator to also place limits on crude production.

Major trade groups like the American Petroleum Institute (API) and the Texas Oil and Gas Association have been on the record opposing the idea of limiting crude production in the state, advocating for free market solutions instead. Some producers, namely ExxonMobil and Occidental Petroleum, have also come out voicing opposition to any measures that would curtail crude oil production in Texas.

The RRC said it will hold an emergency, virtual hearing on April 14. Public comments can be submitted using online instructions. Witnesses for the hearing will include supporters, opponents, academics and statisticians.

Crude Oil Supply-Demand Imbalance

Independent analysis provided by the RRC shows current world crude oil demand at approximately 86 million barrels per day (MMbbl/d) and supply of 104 MMbbl/d, equaling an oversupply of about 18 MMbbl/d (or about 20% of oversupply). The two primary factors affecting that 86 MMbbl/d demand number: jet fuel is currently seeing about a 70% drop in demand and on-road transportation fuels (i.e., gasoline and diesel) is calculated at about a 30% drop in demand, according to the RRC’s modeling.

The above demand calculation represents the largest delta in crude supply-demand in history, the RRC’s model noted. Typically, looking at supply-demand curves over the last 40 years, a +/- 2% delta between curves is typical. For reference, the 1974-1975 oil embargo resulted in a difference of 5%-6%.

A 90-day shelter-in-place would see demand fall to about 70-75 MMbbl/d, the RRC’s model shows. This would likely result in about 25% of global wells needing to be shut in as storage facilities would be filled to the brim at this point. Current U.S. storage is currently at about 360 MMbbl (300 MMbbl standard and 60 MMbbl strategic reserve).

"The number of rigs laying down in the prolific Permian Basin has an immediate impact on reducing costs; however, we won’t see the true effects on production levels for about three to six months."

It’s hard to tell when storage facilities would fill up, but it’s safe to assume that it’ll mirror other locations. At that current rate, assuming global storage of 1.3 billion barrels and current levels, it would take at least 70 days to fill up existing space from the end of March 2020. Factors that could affect crude storage constraints would be foreign imports and whether there could be strategic buying in the future to lower inventory levels, according to the RRC.

Speed Of Recovery

The speed of recovery (the point at which demand will be back to pre-COVID-19 levels) depends on the duration of shelter-in-place measures and how long they will last, according to the RRC. The RRC’s model calculated four scenarios from March 31, 2020:

• 30 days shelter-in-place – Recovery in August 2020
• 60 days shelter-in-place – Recovery in March 2021
• 90 days shelter-in-place – Recovery in November 2021
• 120 days shelter-in-place – Recovery in June 2022

To get a more exact model, we’d need to analyze each region separately as all have different demand curves due to various stages of COVID-19.

The number of rigs laying down in the prolific Permian Basin has an immediate impact on reducing costs; however, we won’t see the true effects on production levels for about three to six months. This has a knock-on effect as it’ll take time to ramp up production again when demand increases and, thus, we could easily see a price spike if demand outpaces supply at some point. A 3-4% overdemand jump could see prices spike over $100/bbl, according to the RRC’s model.

Summary

The RRC doesn’t have the power to shut-in specific wells per se (more on the producer level). And, it’ll take a two-thirds vote to approve a proration mandate of some degree. By itself, Texas proration will do little to affect the stability of the oil market as Texas only produces 5 MMbbl/d, so a coordinated global effort would need to be undertaken. 

Irrespective of a prorationing mandate by the RRC, the magnitude of the current situation due to COVID-19, the OPEC/Russia price war and weak energy commodity pricing will likely result in more bankruptcies and/or restructuring by E&Ps (both large and small independents), their midstream company counterparts and related oilfield service companies, as they try to stabilize balance sheet strength and find creative ways to maintain liquidity. Upstream, midstream and oilfield service companies should prepare now for counterparties that may be seeking or considering bankruptcy protection.