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Fundamental Economics of Depletable Energy Supply - page 15 / 30





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Resources for the Future

Krautkraemer and Toman

3.3 Capacity Investment and Capacity Constraints

The basic nonrenewable resource model does not capture the capital intensity of extractive industries. The development and extraction of fossil fuels is capital intensive, and the timing and size of investment in extractive capacity are functions of the cost of capital and the expected price path. Once the existence of capacity constraints is incorporated, the behavior of the energy resource price along an efficient path generally will depart from the kind of behavior implied by (5) (or its extension to incorporate new reserve additions). This problem too has been studied by a number of authors (Lasserre 1985, Powell and Oren 1989, Cairns and Lasserre 1991).

If extraction is expected to decrease over time, either because the present value price of the resource is declining or the extraction cost increases with depletion, the extractor would seek to reduce its capital input over time if it were able to do so. However, this is not possible if capital is nonmalleable (i.e., once invested in oil fields, it cannot easily be converted into rail car investments). The energy-producing firm takes this into account when the initial investment is made, and the initial capital investment is lower than it would have been if capital were malleable.

Once in place, this lower initial extractive capacity is likely to constrain the rate of extraction from the deposit, at least early in the extraction horizon. In addition, it may be relatively costly to increase extractive capacity, at least quickly. Firms may invest in advance of the need for some capacity in order to smooth out their investment costs over time, but they will also invest slowly in response to previously unanticipated price increases. Consequently, the short-run supply curve for an energy resource may be very inelastic and so variations in market demand (especially increases) may be mediated more by price changes than by quantity changes. The result is that short-term energy prices can be relatively volatile.

In the standard nonrenewable resource model, an increase (decrease) in the interest rate decreases (increases) the relative value of extraction in the future relative to current extraction and so tilts the depletion path toward the present and away from the future. However, if a large capital investment is necessary before extraction begins, an increase in the interest rate increases the cost of the capital investment. Thus, a higher interest rate reduces the incentive to use capital, and can lead to lower rather than greater initial extraction whether or not capital is


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