Exploring Oil Proration In Texas, And Beyond

By Jim Rice, John Brannan and Katy Lukaszewski
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Law360 (April 24, 2020, 5:39 PM EDT) --
Jim Rice
Jim Rice
John Brannan
John Brannan
Katy Lukaszewski
Katy Lukaszewski
As the novel coronavirus continues to spread, and market conditions continue to deteriorate, we are helping our clients navigate the potential consequences to energy markets and attendant legal risks. We recently noted that the Texas Railroad Commission, or RRC, made public comments with respect to potential proration of oil production in Texas, which is within the RRC's jurisdiction and authority to do.

On March 30, Pioneer Natural Resources USA Inc. and Parsley Energy Inc. jointly filed a motion with the RRC requesting a market demand hearing and market demand order effective for May 2020 production.

The motion requested that the RRC conduct a hearing (1) to determine whether waste of oil and gas is taking place in Texas or is reasonably imminent and, if so, to adopt an order to prevent waste, and (2) to inquire as to the reasonable market demand for oil pursuant to Section 85.058 of the Texas Natural Resources Code, and to issue any order, effective for May 2020 production, as the RRC may deem appropriate in response to its findings. 

The RRC held an open meeting via teleconference on April 14 to consider the motion. Some key points from that meeting, along with potential next steps for the RRC in the consideration of the motion, are discussed below.

Open Meeting of the RRC Regarding Potential Texas Oil Proration

The RRC permitted comments on the March 30 motion to be posted in advance of the April 14 meeting, and several industry constituents, including producers, trade associations and mineral owners, provided such comments.

Leading up to the meeting, on April 12, several major oil producers, including Saudi Arabia and Russia, agreed to production cuts of 9.7 million barrels of oil per day.[1] On April 13, the U.S. Energy Information Administration released a drilling productivity report showing a drop in U.S. oil output, suggesting that U.S. operators had already begun to curtail production in light of current market conditions.[2]

On April 15, the day after the meeting, the International Energy Association released an oil market report that projected the demand for crude would drop drastically in April,[3] and the Wall Street Journal published an article discussing the impact that the drop in demand, lack of storage and the resulting glut of oil could have on the crude futures — possibly even resulting in negative pricing.[4]

It was in the midst of these industry developments that the RRC commissioners met with Pioneer, Parsley and other industry commenters to discuss whether Texas should enact prorationing. After each of the RRC commissioners provided opening comments, the meeting proceeded to testimony from the petitioners, Pioneer and Parsley Energy.

In his remarks, Scott D. Sheffield, chairman and CEO of Pioneer, proposed that the RRC implement oil prorationing in the form of a 1 million barrels of oil per day production cut in May (with the possibility of such production cuts being extended on a month-to-month basis) and noted that such curtailment of production could be implemented in the form of a blanket 20% production cut applied on a producer-by-producer basis.

In response to questioning by the RRC commissioners, Sheffield noted that the recently announced production cuts by Russia, Saudi Arabia and other major oil producing countries would not be sufficient to offset price declines and decreasing storage capacity, and therefore more cuts would be needed. He noted that he always envisioned Pioneer's prorationing proposal being enacted as part of that next round of production cuts enacted by OPEC+, and to include other states, such as North Dakota and Oklahoma.

Following Sheffield's testimony and supporting testimony from Matt Gallagher, president and CEO of Parsley Energy, the RRC commissioners elicited input from dozens of interested parties that submitted comments to the RRC on the motion. Interested parties testifying against implementation of oil prorationing measures included Marathon Oil Corp., Enterprise Products Partners LP, the Texas Oil and Gas Association, the Texas Alliance of Energy Producers, the Texas Independent Producers and Royalty Owners Association, Diamondback Energy Inc. and the American Petroleum Institute.

Testimony in favor of prorationing measures was submitted by several interested parties, including Latigo Petroleum Inc., Texland Petroleum LP, Discovery Operating Inc. and Elevation Resources LLC. In addition, several interested parties submitted neutral testimony on the subject of prorationing at the meeting, including Plains All American Pipeline LP and University Lands.

Arguments in Favor of Prorationing

Sheffield's testimony included a summary of the arguments in favor of prorationing as follows (each of these points was also addressed in the testimony or comments submitted by interested parties who voiced their support for prorationing in Texas):

  • Prorationing prevents waste (this argument is necessary to make applicable the appropriate provisions of the Texas statutes that would arguably permit the RRC to enact a prorationing order).

  • Prorationing provides pricing support to protect the oil and gas industry from collapse, the general theory being that these cuts will reduce oversupply and eventually lead to a rise in prices.

  • Prorationing preserves Texas's production gains, limiting steep production declines and the likelihood of a reversion to the U.S. importing the majority of its oil.

  • Prorationing maintains diversity of operators in Texas.

  • Prorationing protects small and medium-size producers from being treated unfairly due to market access disparities.

A large portion of the testimony of third parties submitted in favor of prorationing focused on the equitable treatment of small and medium-size producers. These parties tended to argue that a blanket prorationing order would help equalize the playing field between these producers and larger, integrated oil companies, and prevent these producers from being crowded out of the limited market for oil production created through demand erosion following the outbreak of the COVID-19 pandemic.

Advocates also noted that one of the potential positive effects of prorationing would be a reduction in flaring. In addition, those supporting proration offered some testimony that the form of production curtailment could be based on a percentage of production implemented on a field-by-field basis (as opposed to the producer-by-producer method proposed by Pioneer). We note that the prior proration implemented by the RRC was on the lease level; there is no precedent for cuts on the producer level in Texas.

Interestingly, similar to Sheffield's testimony, other third parties in favor of prorationing made clear that they would support such measures only in conjunction with cuts by other oil-producing countries, states and, possibly, the federal government. This may be in reference to the recent remarks made by President Donald Trump regarding potential reductions in U.S. oil production in connection with assisting in the negotiation of the OPEC+ production cuts.[5]

Whether the federal government has the ability to require producers to curtail production on a national basis is an open question, as there is no express statutory framework for an action of this nature. Thus, any attempt to do so at the federal level could lead to constitutional and other challenges.

Arguments Against Prorationing

Included in many of the arguments against prorationing are the following (each of these points was also addressed in the testimony or comments submitted by interested parties that voiced their opposition to prorationing in Texas):

  • Prorationing impedes the free market and disfavors survival of the fittest.

  • According to recent reports (including the EIA report), companies are already being forced to cut production in response to market forces (i.e., the free market is working).

  • Unilateral cuts by Texas, without cuts by other states, would damage the Texas economy.

  • OPEC will expect future participation in production cuts.

The third party testimony offered against prorationing measures was largely centered on the preservation of the free market economy and the negative effects on the Texas economy caused by unilateral action.

Many detractors also made the point that the industry is already seeing 40% to 50% reductions in capital budgets and a decline in production in reaction to market forces, so such government-mandated cuts are unnecessary; the free market, according to these commenters, is already doing its job. Opponents also pointed out that production cuts would likely lead to a wave of job losses across the oil and gas industry, not just on the producer side but from service providers and other related constituencies as well.

Post-Meeting Road Map

The RRC discussed oil prorationing further at its open meeting on April 21. At that meeting, Commissioner Ryan Sitton indicated that he was ready to vote in favor of a proration proposal that included a 20% cut on Texas oil production starting on June 1 (applied on an operator-by-operator basis), dependent on an additional 4 million barrels of oil per day production cut by other U.S. states, Canada and OPEC+ countries.

However, the other commissioners indicated that they wanted to defer voting on this proposal, pending the RRC gathering additional information, including further research into the RRC's legal ability to effect a prorationing order as proposed by Sitton, and further discussions with other oil producing states and countries.

Sitton indicated that he would be putting his prorationing proposal up for vote at the RRC's next open meeting on May 5. If the RRC were to move forward with implementing prorationing measures, it would seem that both sides of the prorationing debate would expect to see some form of coordination with other oil-producing states with respect to similar production curtailment measures (i.e., avoid unilateral action by the state of Texas on the matter).

Regardless, whether the RRC will take any regulatory action on the matter remains unresolved and, in any event, will require a majority vote among the three commissioners following consideration of the testimony provided at the April 14 meeting and other written comments submitted to the RRC.

Jim Rice is a partner and John Brannan III and Katy Lukaszewski are associates at Sidley Austin LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] https://www.nytimes.com/2020/04/13/business/economy/coronavirus-oil-opec-trump.html.

[2] https://www.eia.gov/petroleum/drilling/.

[3] https://www.wsj.com/articles/oil-demand-projected-to-fall-by-record-amount-11586940434.

[4] https://www.wsj.com/articles/glutted-oil-markets-next-worry-subzero-prices-11586943001.

[5] https://www.nytimes.com/2020/04/12/business/energy-environment/opec-russia-saudi-arabia-oil-coronavirus.html.​​​

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