The U-Shaped Oil Price: A Theory and Some Evidence

Abstract

An empirical test for the theory of exhaustible resources requires an estimate of the extraction rent, that generally is not observable. This paper introduces a model of exploratory and developmental oil-well drilling, with geological constraints that cap the speed of pumping oil out of the ground. In contrast to the established view, as actuated by the Hotelling rule, that extraction rents rise more or less at the rate of discount, the extraction rent of this model rises or falls depending on whether or not new reserves can offset depletion effects in extraction. This extraction rent is empirically constructed for a state-level panel dataset on US oil exploitation and tests show that it rationalizes the data. In particular, estimating the model’s dynamic efficiency condition yields a point estimate for the discount rate of twenty percent, which is in line with reported industry rates. Moreover, it is observed that uncertain returns from drilling effort introduced precautionary behavior in the depletion of producing US oil reserves over the period 1955 to 2002.

Keywords: Oil, Geology, Price, Peak, U-shape

JEL Classification: C5, Q31, Q35, Q41