In Responding To Low Oil Prices, Patience Is A Virtue

Posted on Sat 05/23/2020 by


By Nicolas Loris ~

Sometimes the preferred policy solution is to do nothing at all.

Take the oil industry, for instance, where many of the proposals from federal and state policymakers would have done far more harm than good by distorting markets and harming consumers.

Platforms producing oil stand in the North Sea over the Johan Sverdrup oil field where Norway’s Equinor is producing around 350,000 barrels per day on Dec. 3, 2019. (Photo: Tom Little/ AFP/Getty Images)

America’s oil producers are by no means out of the woods yet, but the improved outlook offers a lesson in policy patience.

When COVID-19 caused a significant drop in travel and production of goods, oil prices plummeted. Because the U.S. is the world’s largest oil producer, the drastic market change resulted in sudden and significant economic hardship for drillers, refiners, and supporting companies. According to an analysis from BW Research, the industry shed nearly 1 million jobs in April alone.

Policymakers scrambled for ways to boost prices. The Trump administration considered tariffs on imported oil, a bailout that would have resulted in a partial government stake in the companies, or creating some sort of alliance with Saudi Arabia.

Texas regulators considered mandating production cuts. As well-intentioned as those proposals might be to help people and communities who are suffering, thankfully, none of those ideas has thus far come to fruition.

Instead, what we’re seeing is the market at work.

As places around the world ease their lockdown restrictions, transportation and oil use is up.

At the same time, U.S. shale producers have rapidly and significantly curtailed production. Suppliers decreased production where possible, ceasing new drilling and shutting in existing production. Shutting in effectively results in producers constraining the supply from a specific site.

However, shutting in production takes time and may not always be the most prudent thing to do. Even if producers are operating at a loss, it might be worthwhile to bring in some money rather than shutting down production and opening it up again.

Elizabeth Gerbel, CEO of the oil and gas consulting firm E.A.G. Services, told NPR recently, “[I]t is almost guaranteed you will have to invest more money in the well to get it to produce at the same level.”

U.S. crude oil futures are above $30 per barrel, and while that’s no cause for popping corks on champagne bottles, it’s a far rosier outlook than a few weeks ago.

Toward the end of April, oil futures prices went negative for the first time in history. What does that mean exactly? Oil is a globally traded commodity, and the reference price for trading is set through benchmarks. The main U.S. benchmark is West Texas Intermediate, and Cushing, Oklahoma, is the physical delivery location for futures contracts.

Cushing has a storage capacity of 90 million barrels. With a substantial glut in the market, inventories filled up quickly. Some traders who owned May futures contracts were in a bind, as the contracts were about to expire, and they had no space to take the actual physical delivery of the oil.

In order to find someone who could, traders had to pay them, sending the price into negative territory.

And let’s not forget the precipitous one-third drop in demand (30 million barrels per day) was preceded by a price war between Russia and Saudi Arabia.

In March, Russia refused to agree to OPEC+ production cuts, hoping to harm American producers. OPEC+ comprises traditional OPEC members, but also other major producers, such as Russia, Mexico, and Kazakhstan. Saudi Arabia responded in kind by discounting its oil sales. In the midst of the demand-side effects of the pandemic, the two countries agreed to end the price war in early April.

To combat the price war and the pandemic, policymakers considered tariffs on Saudi and Russian oil.

The Texas Railroad Commission listened to more than 10 hours of testimony from various stakeholders and policy experts on the merits of mandated production cuts. So far, cooler heads have prevailed, though the ideas remain on the table.

It’s doubtful those measures would help the companies because the actions won’t have any meaningful impact on boosting oil prices. Therefore, the oil companies struggling will be in the same financial position, but the tariffs and government-mandated cuts would place additional burdens on other companies—not to mention on American households through higher prices.

Tariffs on imported oil would cripple the domestic refining industry. Open markets have been beneficial to both the extraction and refining industries because they have better matched different crudes with refining capabilities around the world.

Increased supplies of crude and refined-petroleum markets lower prices for consumers. Furthermore, rewarding certain companies with preferential treatment means companies would dedicate more resources to protecting and expanding that treatment, not to mention it would give the government a new source of revenue.

Government-mandated production cuts would have deleterious effects, as well.

As the American Energy Alliance and Heritage Action for America noted in a statement of principles document, “Broad government-mandated production cuts would hit indiscriminately, forcing cuts from both efficient and inefficient wells or producers, thus propping up weaker players and disrupting the functioning of the oil industry at precisely the moment when it needs to be at its competitive best.”

Beyond the immediate adverse effects, more intervention would have long-lasting negative effects on the energy markets by giving the government more control over how resources are allocated.

Decisions that should be left to the private sector and determined by price signals would instead be decided by the federal government. In fact, we already see those problems in one form or another with government ownership of natural resources on federal lands and waters.

With regard to the pandemic, Americans deserve a policy response that protects public health and the well-being of all Americans. In times of crises, we want our leaders to act quickly and decisively.

But the best action may be to take no action. In the case of the policy response to oil markets, patience thus far has paid off.

Nicolas Loris is an economist, and he focuses on energy, environmental and regulatory issues as the Herbert and Joyce Morgan Fellow at  The Heritage Foundation .

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