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Fundamental Economics of Depletable Energy Supply - page 16 / 30





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Resources for the Future

Krautkraemer and Toman


The effect of the higher interest rate on the capital investment outweighs the effect of the higher interest rate on user cost if the initial resource stock is relatively large (Farzin 1984). A lower interest rate increases conservation if the interest rate is low (when user cost is high and capital cost is low), but decreases conservation when the interest rate is high (user cost is low and capital cost is high). A higher (lower) interest rate also can increase the capital cost of a backstop technology, increasing the maximum or “choke” price for the depletable energy resource and resulting in less (more) rapid extraction.

4. Effects of Uncertainty

There is uncertainty regarding the future values of many important influences on the intertemporal supply of depletable energy resources: future price, future extraction cost, the costs and outcome of exploration and development activities, and the cost and timing of the availability of a backstop technology. The intertemporal extraction and resource development patterns and price path are affected by uncertainty in a variety of ways, depending on the source and nature of the uncertainty. From a financial perspective, the risk associated with holding reserves of a depletable energy resource can be mitigated by also owning other assets. The necessary return to holding the energy resource asset—including the rate of in situ appreciation plus the benefits of increased reserves in moderating costs can be less if the return is negatively correlated with the return to other assets in a portfolio, thereby reducing overall risk.

Even with modern developments in financial markets, like energy commodities futures that more tightly link energy and financial markets and provide added options for risk management, in practice it is not possible for energy producers to completely insure away fluctuations in net income. Moreover, firms will not be indifferent to risks even if their basic management posture is what economists call “risk neutral.” Work by Pindyck (1980) and others shows that these impacts depend on the curvature of incremental cost relationships, among other factors. For example, uncertainty about the growth of demand would shift extraction from the future to the present; if the degree of uncertainty increases with time, a limiting case would be the risk of expropriation, meaning no return from future production. Uncertainty about reserves could


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