Presentation for Environmental Economics
Relationship between Hotelling’s Rule and fluctuation of oil prices
Xiangcheng Zhu(Matthew), Richard Barry Lovass
Outline of the presentation
1. Refresh on the theory – Hotelling’s rule
2. Observation in the real market
3. Difference in Theory and Observed Reality
- Importance of difference between long-term and short-term cycle
- Data is unavailable for net price (Marginal Cost)
4. Factors that could influence the marginal cost
3 Factors: Technological, Geopolitical, Financial
5. Summary and extensions
Matt
Introduction to Hotelling Rule
(Definition of Hotelling’s Rule)
Note: Net Price is marginal price, not the market price for the price of oil
Barry
Different phases of Hotelling’s rule (long-term)
(H&R textbook p506, chapter 17)
In stage I, we expect a decrease in price even as extraction rapidly increases
Matt 1
Observed Price of Crude Oil
The Price of oil, adjusting for inflation (2024 monetary terms), is depicted to the right .
Does this reflect our predictions from the previous slide?
This knowledge does not.
What are potential reasons for the disparity between theory and reality?
Barry
Info from US energy information administration
Barry
1998 Paper “Nonrenewable Resource” by Jeffrey Krautkraemer
A 1998 paper summarized the empirical tests of Hotelling’s rule and found these analyses:
(H&R p505)
Matt2 p505
Intuitions
-While P0 and P1 can be obtained through data which each organization and company releases, Marginal Cost is essentially secretive since no company or country is willing to give out this information due to competition.
-Next, we will discuss what factors could potentially affect the Marginal Cost. And then we can test how effective Hotelling Rule is empirically in the field of oil.
Barry
Observable short-term fluctuations — Maugeri paper on oil price(2009)
-Oil price was relatively high in the 1990s, while decreased drastically in the new century, however it starts to increase in 2008, and then steadily decrease.( A Boom and Bust cycle)
“After hovering around $18–$20 per barrel through most of the 1990s, oil prices collapsed to $10 in 1998 and 1999, before beginning a climb that led to a record-shattering $147 per barrel in New York on July 11, 2008. Then steadily decreased to $32 a barrel in 2008.”
-Factors affect which phase of the price cycle the oil price is in and which factors influences it
-Oil needs to be refined from crude oil(gasoline, Kerosene), which lead to demand for specific type of crude oil.
Matt 3
-Will discuss the price trend and quantity extracted during Office Hour
Response to Housing Crisis of 2008 – Decrease in Demand for Oil decreases Price
We are not facing eminent scarcity yet.
$147 per barrel = Short-Term speculation affects prices →
Can we say that Hotelling’s Rule does not hold in this example (price-marginal cost)?
Hotelling’s Rule considers the entirety of a resources lifespan, while the observable short-term fluctuations represent only a period of two years
Speculation of future events, such as the Recession of 2008, can lead to extreme volatility of market price of oil
The beliefs can cause an instant shift in demand, causing an immediate change in price
Graph from last slide
Barry
Will resources ever completely deplete?
Short Answer: Not for a long time! Researchers have argued in four different periods that oil production would slow because of limited available capacity; Oil production has never slowed
“Hubbert Curve” did not accurately reflect the oil production around the world, but perfectly represented oil production in the United States
Hubbert Curve = Oil production increase will peak, and then dwindle at the same amount after the peak once resources are extracted
When oil prices drop suddenly, extreme damages occur for future generations, as the investments meant to produce more will lengthen the process of demand exceeding supply and an inequitable distribution of oil resources throughout the world
Barry
Effect of Technological Innovations on Oil Prices
According to the simplest economic theory, advances in innovation will lead to a lower marginal cost of production, shifting out the potential supply and lowering price.
However, the effect of a new way of obtaining oil, known as fracking, can decrease the power of OPEC and the volatility of oil prices.
This volatility will help the theory of Hotelling’s rule become closer to the reality, as the net price will stay closer and can be evaluated throughout a longer period of time with more certainty.
“Based on a model in the paper, fracking reduces the long run volatility of oil prices and world production by 42% and 33%, respectively”
https://knowledge.wharton.upenn.edu/article/fracking-cushion-oil-price-shocks/
Barry
Geopolitical factors
(OPEC Countries Map)
Matt4
Effects of Ukraine War on oil price (black swan events)
-Energy price surged after the start of Ukraine War
-The price of crude oil increased 20%, it is substantially because there is already a drastic price increase due to COVID.
- Events like Ukraine War and COVID could dramatically influence marginal cost, which is usually unavailable to public, hence cause price fluctuations in the short-term mentioned in slide 5.
-These events are often unpredictable, and are called “black swan events”.
Matt
Financial Factors
-Maugeri(2009) states that financial speculation price estimation(futures, options is better than spot market price
-The financial market prediction can affect oil prices drastically
-News and information are also important because it can affect the confidence of the general public
Matt
Hartwick paper(1998) - The economics of natural resource use
-Where does the profit earned by extraction go matters a lot
-The paper illustrated how to reconcile with the future generations
-If the profit from extraction can go to investment to improve technology of extraction, it can have positive effects on future generations. However, if spent irresponsibly, it would hurt the future generations.
(H&R p132)
What would be the prescription by economic science for more efficient use of scarcity rent?
Matt(p521) -This graph corresponds with the conclusion of Maugeri’s 2009 article
-Oil price fluctuate in stages and there are different factors such as technological, financial and geopolitical
Summary
Empirical evidence shows that so far hotelling’s rule is inconsistent for oil prices
However, the reason is not that the rule is theoretically incorrect
Rather, new discoveries of oil have led to the absence of an imminent scarcity of oil.
Marginal cost is unavailable and there are many factors that could potentially influence it.
Unexpected(black swan) events such as wars, pandemics and natural disasters etc.
An extension that can be applied using the Magueri paper and Chapter 17 of the textbook can lead us to ask the question: Which stage of oil prices are we experiencing currently, aligned with Hotelling’s rule?
the Magueri paper remarks of a potential increase in oil prices soon, which would lead us to believe that the oil market is between stages II and III.
References
Hartwick, John. “Intergenerational Equity and the Investing of Rents from Exhaustible Resources.” American Economic Review, January 1, 1977. https://econpapers.repec.org/article/aeaaecrev/v_3a67_3ay_3a1977_3ai_3a5_3ap_3a972-74.htm.
Krautkraemer, Jeffrey A. “Nonrenewable Resource Scarcity.” Journal of Economic Literature, January 1, 1998. https://econpapers.repec.org/article/aeajeclit/v_3a36_3ay_3a1998_3ai_3a4_3ap_3a2065-2107.htm.
Maugeri, Leonardo. “Understanding Oil Price Behavior through an Analysis of a CR.” Review of Environmental Economics and Policy, January 1, 1970. https://ideas.repec.org/a/oup/renvpo/v3y2009i2p147-166.html.
Parameshwaren, Shankar. “How Fracking Could Cushion Oil Price Shocks.” Knowledge at Wharton, February 28, 2022. https://knowledge.wharton.upenn.edu/article/fracking-cushion-oil-price-shocks/.
Yagi, Michiyugi. “The Spillover Effects of Rising Energy Prices Following 2022 Russian Invasion of Ukraine.” Economic Analysis and Policy, December 27, 2022. https://www.sciencedirect.com/science/article/pii/S0313592622002338.
Thank you!