Oil and Gas Prices

Economics of Depletable Resources

Prof. PP. Capros
Prof
National Technical University of Athens

1
 The Coming Energy Wars
Oil prices could hit $200 a barrel in the next few
months. How the spike changes everything
NEWSWEEK June 9, 2008

Farmers in France protest rising prices

2
 Hotelling 1931 – Depletion Economics
How to decide about the time schedule of production from a depletable resource
Assume that total reserve is known, there is no extraction cost and no new discoveries
t is time t = 0,1,2,..., T (continous time, but T is unknown)
R(t ) is the volume of remaining reserves at time t (unknown)
q (t ) is production at time t (unknown)
dR (t ) •
It is obvious that = R(t ) = −q (t ) since Rt +1 − Rt = q(t)
dt
Assume that demand is price elastic (decreasing function of prices)
following a demand function qD (t ) = D[ p(t )] where p (t ) is the price
Obviously total reserve will be exhausted until horizon T (unknown), so
T

∫ q(t)dt = Ω the initial reserve

0

at the horizon t = T we assume that no production is possible, so

q (T ) = 0
3
 Perfect Market Competition
p Case
Under perfect competition the producer is a price taker from the market
and as he sets production quantity q(t), aggregate demand determines prices
But what function q(t) of time is optimal for the producer, if he knows
that the reserve is limited and known R?
The Hotelling (1931) conjecture is that since he is a price taker he will
be indifferent between any pair of prices such as
p (t = 0) and p (t ≠ 0) only if p (t ) = p (0) ⋅ eδ ⋅t
where δ is the discount rate he is using.
Remember that eδ ⋅t is the present value factor for continuous time, since
n⋅t
δ ⋅t ⎛ δ⎞
e = lim⎜1 + ⎟
n →∞
⎝ n⎠
δ in discrete time would correspond to δ of continuous time through (1 + δ ) = eδ

4
 Solve Perfect Competition case
Unknowns
q (t ) production time profile, p (0) initial price, T time horizon of depletion
Equations
q (t ) = D[ p (t )] ∀t = 1,..., T aggregate demand function
T

∫ q(t )dt = Ω
0
depletion of initial reserve

[ ]
q (T ) = D p (0) ⋅ eδ ⋅T = 0 terminal condition

This is a system for T + 2 equations and unknowns and can be solved

5
 Example of perfect competition case
p (t ) = p (0)eδt
q (t ) = D[ p (t )] = a − bp(t ) = a − bp (0)eδt
a −δT
q (T ) = a − bp(0)eδT = 0 ⇒ p ( 0) = e
b
(
Thus q (t ) = a 1 − eδ (t −T ) )
The exhaustion equation becomes

( )dt = aT − ( a 1 − e −δT )=Ω

T T
δ (t −T )
∫ q(t )dt = ∫ a 1 − e
0 0
δ
The last equation can be solved numerically for T.
It can be written as intersection of two curves :

aT −
(
a 1 − e −δT )=Ω ⇔ e −δT = 1 +
δ
Ω − δT
1
δ a
Knowing T we evaluate the rest from

p ( 0) =
a −δT
b
e and (
q (t ) = a 1 − eδ (t −T ) ) ∀t = 1,..., T T* T
6
 Monopolistic Production case
A monopoly can set prices p(t) and quantities q(t) provided that
they lie on the aggregate demand curve
q (t ) = D[ p(t )] ⇔ p (t ) = D −1 [q (t )]
so as to maximise the present value of total intertemporal profits
T
Max π = ∫ D −1 [q(t )]⋅ q (t ) ⋅ e −δ ⋅t dt
0

subject to constraints
d •
R (t ) = R = −q(t ) and R(t = 0) = Ω
dt
with unknowns q(t ) and T
Recall that the revenue is M = p(t ) ⋅ q(t ) = D −1 [q (t )]⋅ q(t )
and the marginal revenue is
∂M ∂D −1 [q (t )]
MR = = D [q(t )] +
−1
⋅ q(t )
∂q(t ) ∂q (t )
7
 Monopolistic case as optimal control
Suppose that time t is discrete (not continuous ), then the profit max problem is
T
M
Max π = ∑ D −1 [qt ]qt (1 + δ )−t
qt
0

st Rt +1 − Rt = − qt ∀t = 0,1,..., T − 1
R0 = Ω and RT = 0
Introduce a new unknown va riable λ t as dual of the constraint and the

{ }
T −1
langrangia n is ℑ = ∑ D −1 [qt ]⋅ qt ⋅ (1 + δ ) + λt +1 (Rt − Rt +1 − qt )
−t

First order conditions are set to zero and a system of equations is :

∂ℑ
=
∂
∂ q t ∂q t
( )
D −1 [qt ]qt (1 + δ ) − λt +1 = 0 ∀t = 0,1,..., T − 1
−t

∂ℑ
= λt +1 − λt = 0 ∀t = 1,,...,, T − 1
∂Rt
∂ℑ
= − λT = 0
∂RT
∂ℑ
8 = Rt − Rt +1 − qt = 0 ∀t = 0,1,..., T − 1
∂λt +1
 Monopolistic case as optimal control
Assume now that time t is continuous, then a generalisation of the Langrangian function
is the Hamiltonian and the maximum principle of Pontryagin. The maximum problem was :
T
Max π = ∫ D −1 [q (t )]⋅ q (t ) ⋅ e −δ ⋅t dt
0

subject to constraints
d •
R (t ) = R = −q (t ) and R (t = 0) = Ω
dt
The Hamiltonian is ℵ(t) = D −1 [q (t )]⋅ q (t ) ⋅ e −δ ⋅t − λ (t ) ⋅ q (t )
with λ (t ) the new unknown which is dual to the differential condition. First order conditions :
∂ℵ(t) ⎡ −1 ∂D −1 [q (t )] ⎤
= ⎢ D [q (t )] + q (t )⎥ ⋅ e −δ ⋅t − λ (t ) = 0 ⇒ MR(t ) = λ (t ) ⋅ eδ ⋅t
∂q(t)
() ⎣ ∂q (t ) ⎦
•
∂ℵ(t) d MR(t )
− = λ (t ) = 0 ⇒ λ (t ) constant ⇒ =δ
∂R(t) dt MR(t )
∂ℵ(t) d
= R(t ) = −q (t )
∂λ(t) dt
The monopoly produces so that marginal revenue increases in % equally to the discount rate

9
 Competitive case as optimal control
In case of competitio n the producer t akes the price p(t) = D −1 [q (t ) ] as given. Maximum profit is also :
T
Max π = ∫ D −1 [q (t ) ]⋅ q (t ) ⋅ e −δ ⋅t dt
0

subject to constraint s
d •
R (t ) = R = − q (t ) and R (t = 0 ) = Ω
dt
The Hamiltonia n is ℵ (t) = D −1 [q (t ) ]⋅ q (t ) ⋅ e −δ ⋅t − λ (t ) ⋅ q (t )
with λ (t ) the new unknown wh ich is dual to the differenti al condition. First order conditions :
∂ℵ (t)
= D −1 [q (t ) ]⋅ e −δ ⋅t − λ (t ) = 0 ⇒ D −1 [q (t ) ] = λ (t ) ⋅ e δ ⋅t
∂q(t)
∂ℵ (t) d
− = λ (t ) = 0 ⇒ λ (t ) constant = λ
∂R(t)
( ) dt
⇒ D −1 [q (0) ] = p (0) = λ p (t ) = λ ⋅ e δ ⋅t = p (0) ⋅ e δ ⋅t
•
δ ⋅t
Also MR = p (t ) = p (0) ⋅ e ⇒ MR = δ ⋅ p (0) ⋅ e δ ⋅t = δ ⋅ MR
•
MR
⇒ =δ
MR
∂ℵ (t) d
= R (t ) = − q (t )
∂λ (t) dt
10 The competitiv e producers sets production quantity schedule so as to keep present va lues of prices equal
 Example of Monopoly case
a 1
Demand function q (t ) = a − bp (t ) and the inverse function p (t ) = − q (t )
b b
a 1
Marginal Revenue is MR(t ) = − 2 q (t )
b b
Terminal condition ℵ(T ) = q (T ) = 0
a 1 a
but MR(T ) = − 2 q (T ) = and MR(t ) = λ (t ) ⋅ eδ ⋅t
b b b
a
so λ (T ) = MR(T ) ⋅ e −δ ⋅T = ⋅ e −δ ⋅T = λ (t ) since λ (t ) constant ∀t
b
a a
But MR(t ) = λ (t ) ⋅ eδ ⋅t = ⋅ e −δ ⋅T ⋅ eδ ⋅t = ⋅ eδ ⋅(t −T )
b b
a 1
b
a
b
( a
)
⇒ − 2 q (t ) = ⋅ eδ ⋅(t −T ) and by solving ⇒ q (t ) = 1 − eδ (t −T )
b 2

( ) ( )
T T
a a a
Terminal condition leads to : ∫ q (t )dt = ∫ 1 − eδ (t −T ) dt = T − 1 − eδT = Ω
0 0
2 2 2
11 which can be solved for T
 Comparison of the two cases
The equation solved for T was different in the two cases
1 − e −δT Ω
Competitive case : T −
δ a
= ( )
and q (t ) = a 1 − e −δ (t −T ) q

1 − e −δT Ω
Monopoly case : T −
δ
=2
a
a
2
(
and q (t ) = 1 − e −δ (t −T ) ) Competition
1 − e −δT
Since T − is increasing with T it follows that
δ
T of competitio
p n < T of monopoly
p y and that Monopoly
q (0) of competition > q (0) of monopoly
Prices are determined from demand function depending on q(t), so
prices of competition start lower than prices of monopoly
but after a certain quantity prices of competition increase more than t
the prices of monopoly.

The monopoly increases present value of profits by restricting production early on.

The competitive production path is the same from maximising social surplus and is
equivalent to the result of social planning (perfect regulation)
12
 Depletion with extraction costs
Assume that extraction costs are function of q
quantity
ypproduced
C (t ) = Φ (q (t ) ) e.g. Φ (q (t )) = c + dq 2 with marginal cost MC (q(t )) = 2dq(t )
and the quantity q corresponding to minimum average cost q * (t ) = c
d
Profit maximisation becomes

π = ∫ [D −1 [q (t )]q(t ) − C (q (t ))]e −δ ⋅t dt
T
Max
0
•
st R(t ) = −q(t ) R(0) = Ω R(T ) = 0
d
[MR(t ) − MC (t )]
For a monopoly this leads to dt = δ and [MR(t ) − MC (t )] = λ ⋅ eδt
[MR(t ) − MC (t )]
If extraction cost was an increasing function of cumulative production C (t ) = Θ( R(t ))
the optimality condition changes and it would be possible to leave some
quantity in the ground (never produce it).

13
 Consider Exploration and their Costs
Consider that exploration for new discoveries is possible but the exploratory effort
with cost of exploratio
p n C ( w(t ) increasingg with cumulative discoveries
Lets w(t ) the exploratory effort and X (t ) the cumulative discoveries
The differential equation relating roduction to reserves changes
• •
R(t ) = X (t ) − q(t )
•
X (t ) = g (w(t ), X (t ) )
And the maximisation problem becomes

π = ∫ [D −1 [q (t )]q (t ) − Θ[R(t )]q (t ) − C [w(t )]]e −δ ⋅t dt

T
Max
0

with R (0) = Ω and X (0) = 0

which is solved for q(t), w(t) and T.

14
 The peak oil discussion

Remaining reserves
Peak Peak
quantity Exploration Production

t
15 Peak time