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Lessons from Proration: Texas and OPEC?

OPEC. Just the mere mention of the organization brings to mind an array of perceptions, facts and descriptions, depending on the audience. To some, it is an organization of foreign nations that are all major oil producers. To others, it is a group of sovereign states that ignore US law. Still others call to mind past OPEC decisions, which have often been contrary to the interests of the United States. Then there are those recalling more technical descriptions: thinking of OPEC as a group dominated by Middle Eastern oil producing nations headquartered in Vienna. Yet, one of the more intriguing facts regarding OPEC, and perhaps one of the greatest ironies of energy geopolitics, is that OPEC’s oil management approach actually originated in the United States. Specifically, Texas.

In the mid 1920’s, Texas was the center of oil production in the United States. Knowing the consequences of the boom-and-bust cycles in oil, Texas attempted to better manage the cycle with voluntary production cuts by major producers during times of low prices. This system did little to control production, as everyone had an interest to produce more oil as soon as prices rose. The voluntary approach only lasted a few years and in 1931 the Texas legislature gave the Railroad Commission power to regulate production. Their reasoning was that oil was a public resource and a glut of supply hurt the royalties that the state should receive, and therefore the Railroad Commission had the right to regulate production. Thus, the idea of government intervention and production quotas began.

Proration was the main way the Texas Railroad Commission regulated production. Proration is an approach to maintaining stability in pricing. Its approach is to determine maximum potential production and then require everyone to produce at the same rate but at a level lower than the maximum potential capacity. This meant that the Texas Railroad Commission determined the production levels of every oil well in the state of Texas. The Texas Railroad Commission maintained this model until 1972. That’s when the flaws in Proration started to crack.

The façade of Proration was exposed to the world in 1972. Why? What happened? Did OPEC, an organization of foreign nations, discover this flaw? As it turns out, it was simple human nature. The underlying structure of Proration was to assure that the maximum potential capacity of each well was never actually achieved. That’s why the quota for the Proration calculation was always an amount lower than the maximum capacity. By 1972, US production was below demand and imports were increasing. To help diminish this increase in imports, Texas suspended Proration. But to the surprise of those in the energy industry and government, Texas production did not come close to the reported maximum potential output. Drillers had gamed the system and had inflated production potential for years.

When the US ended Proration in 1972, OPEC was puzzled when Texas oil producers were unable to hit the production levels of the quota used for the Proration calculation. As mentioned earlier the oil producers would inflate potential production levels in order to maximize the production under Proration. The ending of Proration in 1972 exposed OPEC to the lie on which Proration was based. OPEC noticed that the US did not have the spare capacity that it claimed. That came back to hurt the US when the Arab nations announced an oil embargo in 1973 in response to the US support for Israel in the Yom Kippur War. Eventually cooler heads prevailed. Yet has the issue of mythical spare capacity caught up to OPEC today?

For most of OPEC’s history the basis of quotas has been potential maximum production. This has especially been true for Saudi Arabia. Throughout the history of OPEC, Saudi Arabia has always told the world that it had a million plus barrels per day of spare capacity. From the oil fields to the technical expertise at ARAMCO, it seemed Saudi Arabia’s spare capacity was likely true, until recently. Recently, Saudi Arabia has struggled to meet the production targets set out by OPEC. This has surprised the markets since they are supposed to have over a million barrels a day spare capacity. Saudi Arabia’s difficulty meeting OPEC production targets combined with its warnings about the shrinking spare capacity of global markets could be a harbinger of the disappearing spare capacity. Hopefully it will not be as impactful as when OPEC realized the spare capacity in Texas was just a mirage in the deserts of West Texas.

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