Pain in the Oil Patch

Pain in the Oil Patch

Borrowing from the Fed is the best of mostly bad rescue ideas.

U.S. oil prices on Monday plunged to an 18-year low of $20 a barrel, and some analysts think they could go much lower. A decade ago low gas prices were a windfall for the U.S. economy, but Americans are now driving less and America is now the world’s leading oil producer. All of which has politicians looking to help American shale producers, and it’s worth sorting the good from the bad.

The oil patch is getting smacked with a double whammy—the demand shock of Covid-19 and the supply shock of Saudi Arabia’s price war with Russia. Oil demand is now expected to drop by as much as 14 million barrels per day—about as much as China’s total consumption—in the second quarter.

The Saudis plan to increase production by as much as 25%, which is prompting other Organization of the Petroleum Exporting Countries members to open their spigots. Oil investors and CEOs are having deja vu from 2015 when the Saudis flooded the market to break American shale producers. Prices plunged to $30 a barrel, and more than 100 North American producers filed for bankruptcy in 2015 and 2016.

Many were acquired by private equity firms or larger producers, and the survivors became more efficient. Each well in West Texas’s Permian and Oklahoma’s Anadarko shale basins produce about four times more oil as five years ago, according to the Energy Information Administration. Productivity in North Dakota’s Bakken has tripled.

The U.S. became the world’s largest oil producer and accounted for nearly all new supply in 2018. In March the U.S. was still pumping 13 million barrels a day, about 50% more than in 2016 and 150% more than 2011. American producers are resilient, and many have bought hedges against falling prices.

President Trump last month ordered the Energy Department to top off the U.S. Strategic Petroleum Reserve, but Congress didn’t provide the funding in its $2.2 trillion relief bill to do so. Producers are scrounging for places to store their excess supply, including tankers off the coast, and by one commodity firm’s calculation about 10% of the world’s daily oil consumption is sitting in storage.

Most large producers have announced cuts in dividends and capital spending, but some smaller ones have borrowed heavily, encouraged by prolonged low interest rates and high risk appetite by investors. Many shale companies before the coronavirus were struggling to make debt payments, and more than three dozen filed for bankruptcy last year. Yet no investor or CEO could have predicted a pandemic shock, and some are asking the White House for assistance that they don’t want to label a bailout. Some ideas have merit but many could produce unintended adverse side effects.

Start with Continental Resources founder Harold Hamm’s suggestion of antidumping duties on foreign oil. This would raise gasoline prices without benefitting shale producers. The U.S. imports heavy crude because many refineries can’t process lighter shale that is often exported to countries like Canada and India that can. Tariffs could also boomerang if foreign producers retaliate by further increasing production.

A better response is diplomacy to convince Saudi Crown Prince Mohammed bin Salman to stop his game of chicken with Russia, which is also undermining national oil producer Aramco and his strategy to modernize the Kingdom’s economy. Secretary of State Mike Pompeo has tried but so far failed.

An especially bad idea would have the Texas Railroad Commission impose production quotas, which the state last did in the 1970s. But this would punish the most efficient producers and prop up the weaklings. Quotas would be hard to enforce and violate the property rights of producers, leaseholders and mineral-rights owners. Texas can’t control global oil prices in any case, and state quotas would encourage higher production in other regions like the Bakken. Quotas would also signal to Saudi Arabia and Russia they are winning the price war.

Some oil CEOs are soliciting direct government grants and loans, but this is sure to invite political controversy. Would companies with more workers receive larger loans? Recall how government-rescued banks and Detroit auto-makers became objects of public scorn after the financial crisis. If Democrats wouldn’t fund purchases to the national oil reserve without new subsidies for wind and solar power, they sure won’t agree to grants for oil and gas.

A better idea is to let producers that were solvent before the virus borrow against good collateral from the Federal Reserve’s new liquidity vehicles that are open to all comers. This would ensure some market accountability as companies with higher-valued assets and better balance sheets could ride out the Covid-19 shock. U.S. producers have shown they are resilient and should rebound once the coronavirus passes.

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