To explain these facts, we reformulate Hotelling’s classic model of exhaustible resource extraction as a drilling problem: firms choose when to drill, but production from existing wells is constrained by reservoir pressure, which decays as oil is extracted. This prediction is now known as the ”Hotelling rule” (Krautkraemer, 1998). From my analysis, it doesn't make sense that the price of oil should depend on Hotelling's rule instead of the traditional supply and demand models. First, that markets are efficient. Both paths in fact satisfy the Hotelling rule. �W!K�,��]�����D鮨���謁u�T�Ju�K���?پw��f��K���)��[O�l�e���������V��y������ϛ�VS0����槇�}}�A ��eI�YZW:��yZ�%�� �E�Jݧ���{� �1�v��j�jW$��;���1����)K@������7M�l�1ۼZݯᆲi�������n��]�ְ��En��=Xx7����+���W\��5�&-Za�v�̇�O�9m������ a�2����)6ۼ*�wӡ��T�F?��e�=��.N�=�Mހq�c��َ��3�Nrw6gX �b�L6xw.#�I>�n��(�i�'*�s0�f������.�N�%��n"D���Lw_N�X&8b?�Ύe�gu=��'�`ۻ�ME�_8`�����:A Y���&w�{��[J8���R�rq0�#�;�B�J�HO>L�:D9u�CW�ubcT��b,�X�L��EӪ# q}v�@ ����Ӛy���_���|��M�.���no"���JA�� ��O_��26 ��"pmw%%�����x��I��!����PQ[��ν�. (max 2 MiB). x�}ɖ���_�Sʳh���S&�t������H�ZxC2@������jvG� T My guess is that about \$10/barrel is the value in the ground, though I might well be wrong. The Hotelling rule states that the nominal price of oil will increase at the nominal rate of interest. It doesn't enjoin anything. Or, we can take a quick qualitative approach and get the same answer: The Rule just sets out what the most economically efficient path would be. Participants on this site seemed to be evenly split on the issue. ��Y�p[0��#䂦Di�)�'��i��@A�y����x��V��ތKt!�{����v��?B���:������ܱߛ%�u���GJr��䣽��Mq���T. The model implies a modified Hotelling rule for drilling revenues net of costs, explains why the production constraint typically binds, and rationalizes regional production peaks and observed patterns of prices, drilling, and production following demand and supply shocks. After posting this question, I realized that there was quite a bit of controversy surrounding the use of Hotelling's Rule to estimate the price of oil. Hotelling’s rule has been perceived as both outdated and relevant, during the last decades. x�b```f``�d`a`�X� ʀ �@1V �``dp``q��������Y(�x��� C�C��F >� La\���g~���@ �YA�gώ33v�������2��s‘Nծ�cJF��mʂ�����IRVY6ge�����=��y�Z����2���`���������<5�(Q�P[��S���ʌc�B’�*�2���4 �,&t�� @��B?�4�C�����A�Ɛ��T�{h��CJRהo�޴3HT�2Hl�� D� (⋗ I also highlight some theoretical and empirical issues that need further attention. How helpful is Hotelling's Rule in determining the price of oil? Areas of Focus: Energy Markets It would be easy enough to subject the question to simple quantitative analysis - get the time-series of historical oil prices and away we go. 2. However, only one of these can be optimal given demand and the initial stock of oil. Using a state-level panel data set on US oil exploitation, this paper reexamines the relationship between the extraction rent and the depletion of crude oil reserves. This seems a little bit mysterious. oil and mineral development and cutting timber on certain gov- ernment lands have this justification, as have also closed seasons for fish and game and statutes forbidding certain highly efficient means of catching fish. Hotelling's rule defines the net price path as a function of time while maximizing economic rent in the time of fully extracting a non-renewable natural resource. This basic rule forms the theoretical core of the economics of nonrenewable resources, is present in one form or another in every modern paper on nonrenewable r… Figure 2.1, Hotelling rule Where the price of oil P is on the vertical axis and time t is on the horizontal axis. To explain these facts, we reformulate Hotelling’s (1931) classic model of exhaustible resource extraction as a drilling problem: rms choose when to drill, but production from existing wells is constrained by reservoir pressure, which decays as oil is extracted. Equilibrium in the assets market requires that their rates of return be such that their owners are just willing to hold on to them rather than invest elsewhere. Years from now, when the Middle East is out of oil, companies will shift to drilling less accessible and more expensive oil, increasing the prices of oil for the consumer. In an efficient exploitation of a non-renewable and non-augmentable resource, the percentage change in net-price per unit of time should equal the discount rate in order to maximise the present value of the resource capital over the extraction period. Hotelling’s theory proposes that the only time holders of nonrenewable resources should produce their commodities is when the revenue generated from them can exceed that from other financial instruments. A model of oil supply from known reserves is developed to incorporate geological and engineering principles in the oil field operator's decision problem. The Hotelling rule states that the nominal price of oil will increase at the nominal rate of interest. The model implies a modified Hotelling rule for drilling revenues net of costs, explains why the production constraint typically binds, … 264 0 obj <<98F313FCDBDEAC4995ECF21E38F5469A>]/Info 253 0 R/Filter/FlateDecode/W[1 3 1]/Index[254 28]/DecodeParms<>/Size 282/Prev 1619096/Type/XRef>>stream 254 0 obj <> endobj Nonrenewable Resources and the Hotelling Rule. For example, when fracking was "new," its use was limited, making the impact on the oil industry negligible. In our reformulated model, a modied Hotelling Rule holds: whenever drilling occurs, the discounted revenue stream that ows to the marginal well, net of the marginal drilling cost, rises at the rate of interest. %PDF-1.5 %���� Dynamic management of an exhaustible resource, the Hotelling rule and the empirical economics of oil prices. However, as fracking became more widely used, the oil entering the market increased, affecting the price of oil (and, originally, causing concern for OPEC). ��l��pr������L�:{�"^7��=�;?�'^��A�@�G�@8�4X�X;�����U�2 zG�r/ۏVK���]�� III. Oil production from existing wells within an oil field is isolated from the drilling of new wells. Hotelling Meets Darcy: A New Model of Oil Extraction Charles F. Mason and Klaas van ’t Veld* January 15, 2013 Abstract For decades resource economists have relied on the seminal Hotelling paper to model extraction and price paths, despite overwhelming evidence of the empirical limitations of the approach. Oil is a nonrenewable (exhaustible) resource—that is, a resource that does not regenerate over time. Hotelling’s rule is based on the assumption of no uncertainty and perfect competition. The emphasis is put on how those factors can potentially help bridge the gap between the basic Hotelling's rule of natural resource exploitation and the historical behaviour of the flow price of a number of resources. Hotelling’s rule states that the. and, originally, causing concern for OPEC. How much of that is royalty, and how much is extraction cost? x�bbd```b``��� �� D���H�e 2�Dj.�q��$�� ���&F�>�^F����}0 KT Hotelling rule, economic responses and oil prices Gideon Fishelson The traditional Hotelling model is applied to explain the stability of oil prices in the 1960s and in the second half of the 1970s. Abstract es. For example, it relies on an assumption of perfect foreknowledge; whereas, in the real world, we have previously-unanticipated innovation that radically changes both industry's cost structures, and the amount of known reserves - as your fracking example illustrates. Hotelling's theory is used by economists to attempt to predict the price of oil and other nonrenewable resources, based on prevailing interest rates. By using our site, you acknowledge that you have read and understand our Cookie Policy, Privacy Policy, and our Terms of Service. Moreover, oil as well as other minerals come in different grades. the \Hotelling rule" that resource prices (or, more properly, in-situ values) should rise at the rate of interest, often nding that the rule fails to hold. How much of that is royalty, and how much is extraction cost? In addition, the speculation and storage behavior along with the perception of a future supply shortage may lead to the price spikes. Review of Economics and Statistics 92 (2), Oil is an exhaustible resource. The general objective has been to empirically analyze how Hotelling’s rule has predicted the crude oil price development over the last 100 years and if the rule can work as a framework to predict future resource prices. Because the amount of oil produced was small, supply (for the most part) remained constant; businesses would also be incentivized to raise prices to market levels, increasing their profit margins. Also known as Hotelling’s rule, the theory makes several assumptions. Hotelling’s drafts, as well as his correspondence, with oil engineers for example, point to a reinterpretation of the 1931 article. To explain these facts, we reformulate Hotelling’s classic model of exhaustible resource extraction as a drilling problem: firms choose when to drill, but production from existing wells is constrained by reservoir pressure, which decays as oil is extracted. Following this analysis a cycling of oil prices is predicted with fluctuations of 0-1 S% per year. We must also remember that Hotelling's Rule is the same idea as that the stock market must on average rise at the discount rate. by the Hotelling rule, an equation proposed in 1931 that remains central to the economics of natural resources today. In fact, these two approaches to the price of oil are completely consistent. That's nothing at all to do with how things happen in reality: it's just how things behave in textbooks for beginners. It turns out that the ‘rule’, which he had devised as early as 1924 for abstract assets, was in no way intended to be applied to the concrete case of mineral and energy resources. The Hotelling rule may not be a good guide to the actual behavior of mineral prices over time for several reasons. From 1925 to 1930, Hotelling himself identified unavoidable geological constraints that … You can also provide a link from the web. ��r������2�B�Q�i%�� ���L�ۗ�!�g� [v�XDx�g����S��/�[���0鈭����@��"P$ ؾ� kG��������T:ry��X�bh��� This is also referred to as the principle of minimum differentiation as well as Hotelling's linear city model.The observation was made by Harold Hotelling (1895–1973) in the article "Stability in Competition" in Economic Journal in 1929. Hotelling's rule in his Ely Lecture presented to the 1973 conference of the American Eco-nomic Association (Solow, 1974, p 12). After all, we also think that the price of oil is determined by demand and supply in a market. The origins of the field of nonrenewable resource economics can be traced to Harold Hotelling's (1931) “The Economics of Exhaustible Resources”. In an article published on 11 May 2020 in the Canadian Journal of Economics, economists Roberto Ferreira da Cunha, of the Berkeley Research Group, and Antoine In that case, it is the \$10 part that should rise at the discount rate, which means the \$60 price will rise at a much lower rate. Uncertainty in demand and reserves may affect the expected change in the oil price. Click here to upload your image The economics of exhaustible resources is expressed through Hotelling’s rule. Brief introduction to the energy transition in Europe. rents follow the Hotelling rule have generally failed to lend support to the theory. Energy transition and environmental regulation. )�8�}td���R To explain these facts, we reformulate Hotelling’s (1931) classic model of exhaustible resource extraction as a drilling problem: firms choose when to drill, but production from existing wells is constrained by reservoir pressure, which decays as oil is extracted. We most often hear this concern voiced about oil. The price of oil is about \$60/barrel now. It's on average, and in any particular month, or even year, the stock market swings wildly because of unexpcted supply and demand changes. A general conclusion Hotelling's rule and all economic models derived from its perspective deal with the issue of how much of a non-renewable resource must be extracted today and how much must be saved for the future, depending on present and expected economic conditions. Eventually, the last barrel of the oil will either cost an enormous amount of money or will be worthless because of the rise in substitutes (solar, hydro, and wind power; electric cars). By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy, 2020 Stack Exchange, Inc. user contributions under cc by-sa, https://economics.stackexchange.com/questions/12341/how-helpful-is-hotellings-rule-in-determining-the-price-of-oil/12345#12345, https://economics.stackexchange.com/questions/12341/how-helpful-is-hotellings-rule-in-determining-the-price-of-oil/19102#19102. If the natural resource market is perfectly competitive, then the Hotelling rule implies that the market price minus marginal costs must grow at the rate of interest, and therefore that the natural resource price should be increasing over time if marginal costs are constant. The maximum rent is also known as Hotelling rent or scarcity rent and is the maximum rent that could be obtained while emptying the stock resource. 1 Meanwhile, a new micro- empirical energy economics literature focused on the oil and gas industry has The principal result of that paper is the now-famous Hotelling Rule: for a nonrenewable resource, net price (market price minus marginal cost) must rise at the rate of interest in a competitive market equilibrium. In that case, it is the \$10 part that should rise at the discount rate, which means the \$60 price will rise at a much lower rate. My guess is that about \$10/barrel is the value in the ground, though I might well be wrong. :�X\D����v�|��0���f�&pJ���K`��s��@���&���m�. From an Economics standpoint, How helpful is Hotelling's Rule in determining the price of oil? In fact, these two approaches to the price of oil are completely consistent. Obviously, if we keep using up a nonrenewable resource, we will eventually run out of it, which is why it is called exhaustible. In reference to this, Solow re ects that Hotelling's concept is not a 'rule' at all in the appropriate sense. Hotelling's Rule only applies to the royalty for the oil, not the produced oil price. Retail gasoline (Session 9) Mergers, collusion, Edgeworth cycles and sticky prices in retail gasoline markets. Hotelling's law is an observation in economics that in many markets it is rational for producers to make their products as similar as possible. This seems a little bit mysterious. Phelps's Golden Rule is and does. Given the discount rate, the actual price path still depends on the initial price Po , as can be seen from the diagram. After all, we also think that the price of oil is determined by demand and supply in a market. 2. Hotelling Meets Darcy: A New Model of Oil Extraction Charles F. Mason and Klaas van ’t Veld* March 4, 2013 Abstract For decades resource economists have relied on the seminal Hotelling paper to model extraction and price paths, despite overwhelming evidence of the empirical limitations of the approach. Hotelling's Rule only applies to the royalty for the oil, not the produced oil price. 281 0 obj <>stream To explain these facts, we reformulate Hotelling’s classic model of exhaustible resource extraction as a drilling problem: firms choose when to drill, but production from existing wells is constrained by reservoir pressure, which decays as oil is extracted. endstream endobj 255 0 obj <> endobj 256 0 obj <> endobj 257 0 obj <>stream Natural resource stocks held in situ are physical assets. The price of oil is about \$60/barrel now. endstream endobj ... For oil, greater extraction cost goes hand-in-hand with declining well pressure. 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