Hot Oil

“Texas [has] the absolute dominant control of the world price of petroleum and its products.”
– Texas Railroad Commissioner Colonel Ernest O. Thompson, 1935

Even at the depth of the Great Depression, oil producers were always paid a positive price for their product. But on April 20 of this year, the price of West Texas Intermediate oil traded for negative prices, reaching a record low of negative \$37.86. While oil prices have largely recovered at the time of writing, negative prices indicate deep underlying problems with the oil market. Currently, OPEC+ coordinates with Russia, Mexico, and other oil producing nations to set production quotas and balance supply and demand. Their systematic reduction in oil production prevented the collapse in prices that the United States saw, and the Brent oil contract, a global benchmark, continued to trade for positive prices (on the same day West Texas Intermediate reached subterranean prices, Brent Oil traded for +\$17.36, a spread of over $50). In response to the US disaster, oil producers called for the Texas Railroad Commission (TRC) to regulate oil production to try and balance American oil markets.¹

Yet the Texas Railroad Commissioners maintained that plunging prices would reduce production and balance the market on their own. It is true that US producers, facing negative prices, have rapidly reduced production. But with prices rising, production may return quickly, setting the stage for another crash.

To prevent this outcome, we need a market proration system that ties oil production to oil demand. This would not be new for the Texas Railroad Commission. From the 1930s until 1972, it was a regulatory approach the TRC invented and implemented successfully. Today, it would require the United States to join OPEC+, and set US oil production jointly with other major producers. This could be done by reviving the federalized system of state production regulations coordinated by the Interstate Oil Compact Commission.

The benefits of this kind of change would be myriad: the boom and bust cycles of oil production and prices could be dampened, investment in green technologies could be encouraged, and the decline in the oil industry could be better managed to avoid the collapses seen in other communities reliant on extractive industry, like coal.

The history of the Texas Railroad Commission

In 1845, Texas joined the United States. As it was a separate nation and not a territory when it became part of the country, Congress allowed Texas to retain control over its public lands, rather than them falling under the jurisdiction of the federal government. These state lands could be used to encourage railroad development and oil would be found under much of these public lands. The vast terrain of the new state made market access difficult, and private railroad companies were reluctant to lay track, fearing that the returns on remote lines would not warrant the degree of investment required to build them. Because of sparse settlement, they also faced little competition, and private companies were expected to set high rates for travel. The Texas Railroad Commission was formed in 1891 to mitigate these concerns.²³ While the Texas oil boom would only come a decade later, oil was discovered as early as 1866. Because it was transported on rail and later through pipelines, the Texas Railroad Commission’s regulatory authority over oil expanded to regulate the pipelines as common carriers. As oil production increased, the Texas Railroad Commission mandate was expanded again to include conservation and the responsible extraction of Texas’s natural resources.

The particular relationship between oil and the laws developed to govern its extraction created a number of problems. Because oil is liquid, a landowner may pump enough to extract oil originally located outside of the boundaries of their property. Rights to oil—and other migratory resources like water, gas, and game animals—are governed by the “law of capture,” which states that oil is the property of whoever first “captures” it. Overpumping to get at migratory oil was encouraged by the law of capture, which led to damage in the oil field. The law of capture incentivized faster depletion because individual producers preferred to pump in the present rather than conserve the oil for other producers later.

To ensure that oil fields would be viable for longer into the future, the proration system was developed in 1919 to reduce oil production. Wells that could run for an entire month were limited to a few days of operations to reduce production across the board. If one producer wanted to pump more or less, they could trade the right to produce with other producers, keeping total production for a field unchanged.⁴

By the next decade, the proration system gained a new economic rationale. The East Texas Oil field, discovered in 1930, covered 140,000 acres, spanned five counties, and held five and a half billion barrels of oil. The land was owned by smallholders who would become the bulk of small-time oil producers, or “independents.” Oil surged out of the field, flooding an oil market already languishing from the Great Depression. Prices collapsed from above a dollar to about a quarter per barrel.⁵

Prorationing was the only way to save the industry and keep the precious natural resource from being quickly exhausted. In April 1931, the first proration order was passed, limiting production per well to 1000 barrels per day. Courts struck the order down as price-fixing, and the situation in the East Texas Oil Field deteriorated further. Despite orders limiting production, Texan independents continued to pump, causing prices to drop below a quarter per barrel. Following Oklahoma’s lead, the Governor sent in the National Guard to enforce the orders to restrain production.⁶

At the time of the 1932 Presidential election, Texas was one of the most Democratic states in the Union, and Roosevelt carried all of its 254 counties. While Texans were enthusiastic about the Democratic wave, they were wary of the prospect for greater federal control of the oil industry under Harold Ickes and the New Deal. State interests were able to block direct federal control, and a decentralized system developed, with the federal government providing restrictions on any oil produced in excess of state production limits (so-called “hot oil”) to allow states to effectively set their own proration orders.

Section 9c of the National Industrial Recovery Act of 1933 supported state efforts to restrict production by prohibiting the shipment of hot oil across state lines. Given their power to regulate interstate but not intrastate trade under the Commerce Clause of the US Constitution, the federal government supported state efforts to regulate oil production through police powers—by blocking shipments that exceeded state quotas. While the National Recovery Act was struck down as unconstitutional, the hot oil provisions were revived with the Connolly Hot Oil Act of 1935. This legislation is still in force and available for the federal government to support state level proration efforts today.⁷

The market proration system continued to play an essential role during the Second World War. Because proration generated spare capacity, the Texas Railroad Commission could simply allow producers to produce as much as they liked, turning on the spigots to grease the wheels and power the engines of the Arsenal of Democracy.⁸

The TRC tried to solicit countries like Mexico and Venezuela to coordinate prorationing after World War II but was not successful.⁹ And in 1960, OPEC formed, modeled on the successes of the Texas Railroad Commission, and with the direct input of former TRC engineers. By 1972, oil supply in existing fields was declining while oil demand had surged in the postwar boom. Once demand outstripped supply for Texas oil, allowable production was set to one hundred percent and the era of the TRC’s control was effectively over. In a classic case of regulatory capture, once the TRC was no longer in charge of prorationing, it became primarily concerned with serving the interests of the Texas oil business. The TRC’s support for deregulation began in the 1970s and continues today. After the end of prorationing in 1972, the TRC, like the IOCC today, retired from its position of leadership in the oil industry to become simply an industry representative, captured by the sector they were meant to regulate.¹⁰

During its golden age, the Texas Railroad Commission was successful at using regulation to make Texas more prosperous and to conserve Texas’s natural resources. Before prorationing, producers were lucky to get ten percent of the oil in a reservoir, but in the 1980s, experts estimated that eighty percent of the oil in the East Texas oil fields could be recovered, a massive conservation success. Price stability under the TRC proration system is striking compared to the volatility and instability that has prevailed in American oil markets since 1972 (culminating in the negative price fiasco of April 2020).¹¹ In 1957, economist Erich Zimmerman suggested that price volatility before proration deterred exploration.¹² The prorationing system therefore encouraged exploration, excess capacity, and lower prices in equilibrium.

Thanks to the work of postwar petroleum engineer William Murray, the proration system and the regulatory system it encouraged also virtually eliminated “flaring,” an environmentally harmful practice of burning the natural gas released as a byproduct of oil extraction. Due to the deregulation of the 1970s, methane emission from the oil and gas industry today is sixty percent higher than previously estimated by the Environmental Protection Agency.¹³

Back to the future?

To better understand the economic benefits of a proration system, we can turn to the writings of New Deal economist Gardiner Means. In an analysis conducted for the Department of Agriculture on the causes and consequences of the Great Depression on the Agricultural Adjustment Act, Means distinguished between market prices and administered prices. The former are set in impersonal markets that follow standard models of unfettered competition, while the latter are determined by companies who set the quantity of production and the price of the final product. During the depression, Means showed that prices for agricultural products (market prices) collapsed while production in agriculture remained high, resulting in a market glut. By contrast, prices for agricultural machinery (administered prices) fell little, but production rapidly declined. Reasoning that price cuts would not dramatically increase sales because demand was low, these machinery firms chose to cut production while keeping administered prices relatively unchanged in order to preserve profitability.¹⁴¹⁵

In order to avoid the sort of plummeting prices and excessive production characteristic of market priced industries, Means proposed a series of production restrictions in the agricultural sector. At the time of his writing, his insights were not applied to oil markets. But in the figure from Means below, showing the relation of price and production drop from 1929 to 1933, we see that, as market prices, petroleum prices fell rapidly during the Great Depression, almost as much as agricultural commodities and more than food products or leather.

Overproduction relative to market demand could have caused the price to collapse, and surges in demand could have caused them to spike. By setting quotas according to market demand, the proration system was able to reduce price fluctuations and stabilize the oil industry.¹⁶

Similar reasoning could be fruitfully applied to today’s oil market. During the oil bust which occurred in the first quarter of 2020, the demand curve shifted inward and the market cleared at a drastically lower price. As oil producers could not influence the price, they chose between producing and selling at low prices, or halting production. Some may have been perversely incentivized to produce more to avoid bankruptcy until demand recovers, contributing to the growing glut. This process continued until the prices sank low enough that some wells were uneconomical to operate or some producers went bankrupt. At least twenty shale oil producers have gone bankrupt through the summer, including Chesapeake Energy, a major player in the industry and a member of the Fortune 500.¹⁷ As demand recovers and price increases accelerate, we can expect remaining producers to reap windfall profits. New producers will enter the market, as memory of the bust fades and the euphoria of an oil boom gains steam. But eventually, like night follows day, an oil bust will return.

Texas produced forty-five percent of US oil in 1953, and made up forty-two percent of US production in February 2020. It can easily return to its role as leader of a prorationing system. The environmental and economic benefits of proration are indispensable. As the world’s leading oil producer, the United States should return to the framework set up by the Connolly Hot Oil Act and coordinate a pro-ration framework with state regulatory agencies (with the Texas Railroad Commission taking the lead). It should join OPEC+ and coordinate with other large producers like Saudi Arabia and Russia. As an active member, the United States could encourage oil production cuts across the board, multiplying the beneficial climate effects. The United States should be a hawkish member of OPEC+ to encourage lowered production, higher prices, and increased adoption of green technologies. This is the final act of oil’s story, and we can make sure the American oil industry rides into the sunset the right way.