Boomtowns return: Decontrolling the oil price fuels U.S. drilling frenzy

In March 1971, the Texas Railroad Commission removed the restriction that limited the amount of crude that an operator could produce. This was good for U.S. oil companies, but it created a situation that enabled OPEC, specifically Saudi Arabia, to control worldwide benchmark prices by increasing or decreasing production. In October 1973, the Arab Oil Embargo pushed prices for crude and gasoline up sharply, Fig. 1. Although the embargo lasted about six months, it shook the West’s sense of security and threatened its way of life.

Fig. 1. The Arab Oil Embargo started a chain reaction that would reach a crescendo in 1981, with a record-high U.S. rig count.

After the embargo, the U.S. government imposed price controls on domestically produced oil, in an attempt to lessen the impact of the 1973-1974 price increase. The legislation caused U.S. consumers of crude oil to pay 48% more for imports, as compared to domestic supplies. It severely penalized U.S. producers, which received less for their products. Holding prices artificially low discouraged domestic drilling, and it stalled efforts to reduce consumption by increasing automobile and industrial fuel efficiencies.

Starting in March 1974, oil prices remained relatively stable, hovering in the $12-$14 range until 1978, when events in Iran and Iraq kicked off another round of price increases. During 1978-1979, crude prices increased to $20/bbl, and on June 1, 1979, U.S. President Jimmy Carter lifted price controls to “increase production and reduce the U.S.’s vulnerability to foreign supplies.” In 1980, Iraq invaded Iran, and prices spiked to $35/bbl.

Free market system takes control. The price decontrol, combined with the bitter memory of the embargo just four years earlier, kicked off an oilfield boom in the U.S. reminiscent of earlier times. Starting in 1978, newly created independent oil companies, financed by selling interests in limited partnerships, begin leasing activities in Oklahoma and Texas with unbridled optimism. The competition to secure drilling rights was so intense between rival companies, that the standard royalty rate paid by producers increased to 3/16, compared to the long-held industry standard of one-eighth.

In Oklahoma City, officials at Penn Square Bank (PSB) were forecasting that oil would reach $100/bbl in the near future, and suggested that virtually any lease or oil producing property was a good investment. The bank started making high-risk energy loans during the late 1970s and early 1980s. Between 1974 and 1982, the bank's assets increased 15 times to $525 million, and its deposits swelled from $29 million to more than $450 million. Many in the established banking community considered PSB’s lending practices “irresponsible.”

Flush with capital, these fledgling “fund companies” started drilling on their newly acquired acreage. The competition for rigs and services was intense, and price escalation ensued. Experienced engineers and geologists were in high demand, and details surrounding producing properties and offsetting lease plays were guarded closely. This frenzy of activity was heightened further by the rush to commence operations on leases that typically would expire in three years. Having paid record-high bonuses for these drilling rights, start-up companies wanted to ensure that they did not lose this investment through non-activity.

U.S. rotary rig count rockets upward. The lifting of federal controls, plus escalating commodity prices and support from the banking industry, started a drilling boom in the U.S. of unprecedented proportions. Starting in 1978, the rig court for the year averaged 2,259 working units. The count slipped back slightly in 1979 to an average of 2,177 rigs but in 1980, the combination of favorable economic and political factors pushed the rig count up dramatically to 2,910. In 1981, the U.S. rig count spiked to an average of 3,970 units for the year, and hit an all-time high of 4,530 on Dec. 28, 1981. The crude oil price also peaked at the end of 1981, reaching $37/bbl.

Boom turns to bust. History has shown that most oilfield boom cycles are followed by subsequent busts of equal proportions and, this proved true for the 1978-1982 cycle. The event that initiated the collapse occurred in July 1982, when Penn Square Bank failed, due to highly questionable lending practices. The ripple effect caused approximately 139 other banks in Oklahoma to fail, and led to the collapse of Continental Illinois National Bank, which had to write off $500 million in loans purchased from PSB. The banks’ collapse coincided with the 1980s oil glut, caused mainly by OPEC increasing daily production rates and flooding the market with crude. Although the U.S. rig count remained relatively high for the next several years, the excess amount of crude on the market reduced drilling activity, and by 1985 the count stood at 1,980, 50% less than the high-water mark in 1981.

About the Authors

Craig Fleming

World Oil

Craig Fleming Craig.Fleming@WorldOil.com