Economics of Exhaustible Resources

1. Economics of Exhaustible Resources www.uh.edu/energyinstitute UNIVERSITY of HOUSTON BAUER COLLEGE of BUSINESS ADMINISTRATION Econ 3385 – Economics of Energy S. Gürcan Gülen, Ph.D. ENERGY INSTITUTE

2. Exhaustible Resources • More than 90% of the world’s energy comes from fossil fuels – coal, oil and natural gas • About 98% if one counts uranium • These are “exhaustible” or “non-renewable” resources • Although this is correct geologically, economic considerations matter

3. Two Views • Julian Simon view: technological developments and human ingenuity will yield more resources • “Drowning in oil” The Economist, March 6th-12th 1999, pp. 23-25 • Colin Campbell, et al. use Hubbert curves to predict the end of oil • “The End of Cheap Oil” Scientific American, March 1998, pp. 78-83 (Campbell and Laherrere)

4. Geologic Life & Hubbert Curves

5. Hubbert curves • M. King Hubbert was a geologist with Shell Oil in the 1950s • He observed that • Flow of oil from any basin starts to fall when about half of the crude is gone. • Largest fields tend to be discovered sooner. • Aggregation of all “known” basins at the time led him to predict a peak level of production for the lower 48 U.S. in 1969

6. Hubbert curves • Campbell & Laherrere refer to the accuracy of this prediction, but: • Environmental regulations limit drilling in California, Florida, parts of the Rockies, etc. since the 1970s • When Hubbert made his prediction in the late 1950s, offshore was not a factor! • R/P ratio of 10 years has been the standard in the U.S.

7. Hubbert curves • Also, from the global perspective: • Why would oil companies drill in the U.S. while they can for cheaper somewhere else? • Like with the offshore, many areas of the world has been opening for exploration since Hubbert made his predictions! • Michael Lynch and others have been using above arguments against Campbell.

8. U.S. Crude Oil Replenishment(billion barrels)

9. U.S. Natural Gas Replenishment(trillion cubic feet)

10. Canadian Natural Gas Replenishment(trillion cubic feet)

11. World Crude Oil Replenishment(billion barrels)

12. World Natural Gas Replenishment(trillion cubic feet)

13. World Coal Replenishment(billion short tons)

14. Reserves to Production Ratios Source: www.bp.com/worldenergy/

15. Years of Current Consumption

16. Careful with R/P ratios • Production (~consumption) does not remain constant over time • If R = 100 and P remains the same at 10, R/P=10 • But if P grows 10% a year (P1=10, P2=11, P3=12.1, and so on), 7<R/P<8! • But, reserves does not remain constant either although changes in reserves are less well observed. • If R grows at 5% and P grows at 10%, R/P9 • If R grows at 10% and P grows at 5%, R/P15

17. Reserves v Resources Speculative Known Low cost High cost Another look: www.world-petroleum.org/mart1.htm

18. Geologic v Economic Life of Resources • Economic life < geologic life if • Cost of extraction in a particular field rises at a rate faster than the increase in price • In other words, resources in this field/basin are being depleted at a rate faster than the depletion of worldwide resources • Economic life depends on: • Technology • Fluctuations in price • Alternative investment opportunities

19. Life of Resources • Life of resources also depend on market structure • Is there a cartel deliberately restricting supply? TRRC, OPEC, etc. • Is competition extreme enough to damage total recoverability? Conservation in early days of the industry in the U.S. • And also on perception of the resource: • National or privately owned? Different discount rates! • The ultimate question: What is the optimal rate of extraction over time?

20. Time Value of Money

21. Time Value of Money • Present value (PV) of an amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

22. Present Value of a Series • Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

23. Net Present Value • Suppose a manager can purchase a stream of future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision is NPV < 0: Reject NPV > 0: Accept

24. NPV of Projects (10%) NPV(A) = 50/(1+0.1) + 50/(1+0.1)2 + 50/(1+0.1)3 + 50/(1+0.1)4 - 100 = 58.49 NPV(B) = 20/(1+0.1) + 40/(1+0.1)2 + 60/(1+0.1)3 + 80/(1+0.1)4 - 100 = 50.96 NPV(C) = 80/(1+0.1) + 70/(1+0.1)2 + 20/(1+0.1)3 + 20/(1+0.1)4 - 100 = 59.27 NPV(D) = 60/(1+0.1) + 40/(1+0.1)2 + 60/(1+0.1)3 + 40/(1+0.1)4 - 100 = 60.00 NPV(E) = 10/(1+0.1) + 20/(1+0.1)2 + 70/(1+0.1)3 + 110/(1+0.1)4 - 100 = 53.34

25. NPV of Projects (20%) NPV(A) = 50/(1+0.2) + 50/(1+0.2)2 + 50/(1+0.2)3 + 50/(1+0.2)4 - 100 = 29.44 NPV(B) = 20/(1+0.2) + 40/(1+0.2)2 + 60/(1+0.2)3 + 80/(1+0.2)4 - 100 = 17.75 NPV(C) = 80/(1+0.2) + 70/(1+0.2)2 + 20/(1+0.2)3 + 20/(1+0.2)4 - 100 = 36.50 NPV(D) = 60/(1+0.2) + 40/(1+0.2)2 + 60/(1+0.2)3 + 40/(1+0.2)4 - 100 = 31.79 NPV(E) = 10/(1+0.2) + 20/(1+0.2)2 + 70/(1+0.2)3 + 110/(1+0.2)4 - 100 = 15.78

26. Comparison

27. Theory of Optimum Extraction • Allocate the “fixed” resource over time to maximize its value • Socially optimal solution = perfect competition solution • Key issue: production of one unit today has an opportunity cost: the foregone value of producing that unit at a later date • So, instead of P=MC, we have P=MC+OC

28. Theory of Optimum Extraction Instead of competitive profit max rule of P=MC, we have P=MC+OC AB = user cost (Hotelling rent)

29. Theory of Optimum Extraction • The behavior of this rent over time is important: a barrel of oil not produced today will be worth something tomorrow. • What is, then, the profit maximizing resource extraction pattern? • Output will be decreasing over time as the price increases over time. • Hotelling rule: the rent will increase at the rate of interest (discount rate)

30. Theory of Optimum Extraction Price, Output Backstop technologies Price Output Time

31. Theory of Optimum Extraction