As you may be aware, the Railroad Commission of Texas has taken up consideration of prorationing. Commissioner Ryan Sitton, sympathetic to the view that organic supply cuts do not adequately address overproduction, has proposed an order that would require operators to cut production by 20 percent from October 2019 baseline levels. With Commissioner Wayne Christian indicating opposition to the proposed order, proponents of prorationing face an uphill battle. However, if storage issues and low prices continue for months on end, an initial vote against prorationing may not be the end of the matter.

Under Sitton’s proposal, penalties would amount to $1,000 per barrel of excess production, but operators producing less than 1,000 barrels per day in January 2020 would be exempted. The order would be conditioned on similar actions by other states and countries that cumulatively, in addition to previously announced OPEC+ reductions, reduce production by 4 million barrels per day from certain late-2019 levels. Notably, the order would implement cuts at the operator level rather than at the field level, the mode in a previous era of conventional extraction.

Other state regulatory bodies and agencies managing state and federal lands have begun wrestling with overproduction issues, with some having already passed orders that may allow shut-ins or extensions and grant other relief. (The Oklahoma Corporation Commission, North Dakota Industrial Commission, New Mexico State Land Office, Texas General Land Office, and Bureau of Land Management have each issued orders, made announcements, or delivered guidance in response to industry conditions.)

The mechanics of any prorationing order could prompt strategic responses by operators. For example, operators wishing to avoid restrictions – particularly operators with hedge coverage – could divest assets. Indeed, any party selling or buying assets could be impacted by such an order. An argument could be made that some proportionate percentage of the prorationing allotment held by an assignor should pass with the asset to an assignee. But if the transaction documents do not expressly provide for this, the assignor may continue to claim its entire prior proration allotment. The order currently proposed does not address the possibility that production allotments may “run with” operatorship and transfer to substitute operators. Given the novelty of these issues, parties working on PSAs, acreage trades, and other transactions should pay special attention to this issue in their deal documents.

Operators may also attempt to spin off operatorship or assets to affiliated entities or acquire new assets in the name of affiliated entities. While the commissioners surely do not intend for producers to be able to circumvent restrictions with sham transactions, they probably do not want to create barriers to entry, either. Commissioner Sitton’s proposed order does not contemplate new P-5 operators. If prorationing establishes a benchmark based on some date-specific level of production, exceptions to that benchmark for new participants may be fair if the participant is not affiliated with an existing operator. Of course, if a new participant is only loosely affiliated with an existing producer, the issue of whether the new participant should be exempted is less clear-cut.

Other issues could arise with respect to small producers exempted from restrictions. For example, some parties might attempt to sell wells or assign operatorship to exempt operators. It appears that under Commissioner Sitton’s proposed order, small operators are exempted permanently, creating the possibility that they could acquire production from restricted parties without subjecting that production to any prorationing restrictions. Even if this bug is fixed, restricted parties could identify small producers that have capacity to acquire inventory without losing their prorationing exemption, and then assign less-economic acreage and wells to those producers, perhaps keeping an override.

More questions remain. One is whether such restrictions should apply to the P-5 operator, as proposed by Commissioner Sitton, or should pass through to the working-interest owners. The answer, naturally, could result in winners and losers. The application of restrictions to P-5 operators might create numerous disagreements among true beneficial working-interest owners regarding the proper allocation of a proration allotment as between different properties. On the other hand, title and beneficial working-interest ownership are a black box to the Railroad Commission. Management and enforcement of restrictions based on beneficial ownership would be a much messier process and would require reliance on self-reported title data, much like the permitting process.

The commissioners have also discussed the possibility of imposing restrictions on venting and flaring, which might cut supply while mitigating waste and addressing environmental complaints. This course of action remains a possibility. One possibility is that the Commission could limit prorationing to wells that flare gas.

Even if the commissioners initially choose not to curtail production, sustained storage issues and fluid geopolitics may force them to revisit the issue. Alternatively, if the commissioners introduce prorationing, the regulatory landscape may shift early and often in reaction to price movements and actions (or lack thereof) by other states and countries.