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Fundamental Economics of Depletable Energy Supply - page 19 / 30

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Resources for the Future

Krautkraemer and Toman

theoretical tenets sketched above.

6.1 The ‘Hotelling Valuation Principle’ for Assessing Resource Scarcity

An illustration of the methods for testing the resource scarcity implications of the depletable energy supply model involves the relationship between average reserve value and current net price using cross-section data. Miller and Upton (1985a) argue that this relationship can be written as:

(7)

V0 S0

= α + ( P 0 C 0 ) .

H e r e V 0 d e n o t e s r e s e r v e v a l u e , S 0 i s t h e r e s o u r c e e n d o w m e n t , a n d 0 0 C P i s t h e p r i c e n e t

of extraction cost; the term α, which can be positive or negative, reflects influences like changing cost and price trends.

The model was found to be consistent with pooled, cross-section data from December 1979 to August 1981 for 39 oil and gas producing firms in the United States (Miller and Upton 1985a). A subsequent test of the Hotelling Valuation Principle using data from August 1981 to December 1983 produced a quite different result: in that analysis, an increase in the net price translated into an increase in average reserve value less than half as large (Miller and Upton 1985b).

An explanation for why the Hotelling Valuation Principle might overvalue reserves, at least in the case of oil and natural gas production, is that it affords producers greater flexibility for choosing output than they actually have. The extraction of petroleum over time is restricted by declining well pressure as the reservoir is depleted. If the rate of extraction declines at the rate a because of declining well pressure, the average reserve value is:

(8)

V0 S0

=

a a +r-g

(P0 C0 )

where g is the expected rate of change in net price (Adelman 1990, 1993).

This example and others in the literature provide strong empirical evidence that a simple

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