Lessons from Oklahoma's Government Intervention in Natural Gas Markets

Dean Foreman
Posted February 3, 2021

This past year saw Oklahoma officials pursue a unique experiment – reducing how much natural gas production would be permitted from a well, called “natural gas production prorationing.” 

This may be about to change. The intervention has been costly for the state and suggests that governments should exercise more caution when considering actions that could affect markets.

Regulations to prevent wasting resources have been on the books for decades, and Texas has something similar. However, through its Corporation Commission, Oklahoma was the only state that imposed more stringent natural gas production limits last year. The state also increased its efforts to enforce those rules in response to market conditions associated with the COVID-19 recession – that is, strong supply, weak demand and low prices for natural gas.

It’s looking like a mistake.  In 2019, Oklahoma produced 8.7 billion cubic feet per day (bcf/d) of natural gas marketed production, which was 8.7% of the U.S. total of 100 bcf/d, per the U.S. Energy Information Administration (EIA).  Both were record highs.

By October 2020 (latest EIA data), Oklahoma’s production decreased by 21.2% year-on-year (y/y) to 7.1 bcf/d, or 7.3% of the U.S. total. That was the largest percentage decrease and loss of market share by any natural gas-producing state.  By contrast, Ohio, New Mexico and West Virginia’s natural gas marketed production and share of the U.S. market increased despite the many challenges of 2020.

Over the past year, I testified for API in Texas, North Dakota and Oklahoma concerning production prorationing of natural gas and/or oil. There’s a lot of history on this, dating back to the early days of conventional oil & gas production and the protection of correlative rights.  That’s not the main concern today.  Many states still have legacy regulations to prevent the physical and/or economic waste of oil and natural gas production, and prorationing is a formulaic way to determine how much is permitted to be produced from a given well.  Making prorationing so stringent as to materially lower production on a statewide basis like this, however, tends to have the largest impact on the most prolific and productive wells and fields – and consequently also reduces the profitability of existing wells and future drilling.

One might compare total drilling activity, side-by-side, for Oklahoma and Texas and see that both lost roughly 60% of their activity from April 1 through year-end 2020. However, for natural gas-directed drilling activity, Texas saw a 17.4% decrease in rigs while Oklahoma was left with zero rigs drilling for natural gas as of January 29, 2021, per Baker Hughes. That’s a big deal when industry’s productivity and competitiveness depend on achieving a critical mass of scale and learning-by-doing.

Moreover, Oklahoma severance tax collections fell by $121.3 million or 54% y/y in the third quarter of 2020 (latest) per the U.S. Census Bureau. Although the decrease reflected a combination of lower prices and prorationed volumes, the idling of Oklahoma gas drilling does not bode well for natural gas industry jobs in the state, infrastructure investments or the state’s consumers, who historically have counted on price-advantaged feedstocks. 

Specifically, in the fourth quarter of 2020 and so far in January 2021, Oklahoma’s average natural gas spot price was below that at Henry Hub, Louisiana, by around $0.20 per million British Thermal Units (mmBtu) – on par with the pricing at natural gas trading hubs across north Texas. By comparison, the historical (2010 to 2019) average discount for natural gas at Oklahoma natural gas hubs was $0.27 per mmBtu below Henry Hub and $0.13 per mmBtu below north Texas, adjusted for price inflation.  

Consequently, recent Oklahoma natural gas prices have been insufficient to compensate for the incremental cost of pipeline transportation to Gulf Coast markets. In turn, this suggests that Oklahoma consumers recently paid relatively more than they have historically, and as the state’s production has fallen (and there is less gas available to export other states) Oklahoma’s interstate natural gas deliveries could come under additional pressure. 

How much of the decreases in production and drilling activity might be attributed to production prorationing?  It’s significant. When we analyze changes in Oklahoma’s natural gas production between March and November 2020, we saw wells that were completely shut-in for one or more months – generally a last resort for any producer – showed the largest decreases, likely in response to low prices at the time.  However, from natural gas wells that produced continually through 2020 but decreased by more than could be attributed to natural production declines (that is, a standard deviation or more above the mean), we observed that lower production due to prorationing appeared to significantly impact large natural gas wells and producers. 

In short, API believes the drop-off in Oklahoma’s production and the demise of its drilling activity substantially reflect consequences of its decision to limit production in the state, rather than letting the competitive market sort it out, allowing the state’s most promising wells and producers to compete with those of other states on their economic merits.

It also is often said that it’s easier to implement a regulation than it is to relax or remove one. While the Oklahoma Corporation Commission can see through transparent attempts to distort markets, it’s still not a given that it will ease the natural gas prorationing regulations, since stakeholders have remained divided on the issue.

The current reality is that the stakes for Oklahoma couldn’t be higher for the state to participate in an economic recovery and compete in U.S. and global natural gas markets going forward.