© UHCBA Energy Institute 1 Economics of Exhaustible Resources UNIVERSITY of HOUSTON BAUER COLLEGE of BUSINESS ADMINISTRATION ENERGY INSTITUTE Econ 3385 – Economics of Energy S. Gürcan Gülen, Ph.D.

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

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

© UHCBA Energy Institute 4 Geologic Life & Hubbert Curves

© UHCBA Energy Institute 5 Hubbert curves M. King Hubbert was a geologist with Shell Oil in the 1950sM. King Hubbert was a geologist with Shell Oil in the 1950s He observed thatHe 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 1969Aggregation of all “known” basins at the time led him to predict a peak level of production for the lower 48 U.S. in 1969

© UHCBA Energy Institute 6 Hubbert curves Campbell & Laherrere refer to the accuracy of this prediction, but: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.

© UHCBA Energy Institute 7 Hubbert curves Also, from the global perspective: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.Michael Lynch and others have been using above arguments against Campbell.

© UHCBA Energy Institute 8 U.S. Crude Oil Replenishment (billion barrels)

© UHCBA Energy Institute 9 U.S. Natural Gas Replenishment (trillion cubic feet)

© UHCBA Energy Institute 10 Canadian Natural Gas Replenishment (trillion cubic feet)

© UHCBA Energy Institute 11 World Crude Oil Replenishment (billion barrels)

© UHCBA Energy Institute 12 World Natural Gas Replenishment (trillion cubic feet)

© UHCBA Energy Institute 13 World Coal Replenishment (billion short tons)

© UHCBA Energy Institute 14 Reserves to Production Ratios Source:

© UHCBA Energy Institute 15 Years of Current Consumption

© UHCBA Energy Institute 16 Careful with R/P ratios Production (~consumption) does not remain constant over timeProduction (~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 (P 1 =10, P 2 =11, P 3 =12.1, and so on), 7<R/P<8! But, reserves does not remain constant either although changes in reserves are less well observed.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

© UHCBA Energy Institute 17 Reserves v Resources Proved reserves Probable reserves: Exploration and Development activity can prove Possible reserves: Higher prices may prove Undiscovered resources Low cost High cost Known Speculative Another look:

© UHCBA Energy Institute 18 Geologic v Economic Life of Resources Economic life < geologic life ifEconomic 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:Economic life depends on: –Technology –Fluctuations in price –Alternative investment opportunities

© UHCBA Energy Institute 19 Life of Resources Life of resources also depend on market structureLife 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: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?The ultimate question: What is the optimal rate of extraction over time?

© UHCBA Energy Institute 20 Time Value of Money YearABCDE

© UHCBA Energy Institute 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”:Present value (PV) of an amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

© UHCBA Energy Institute 22 Present Value of a Series Present value of a stream of future amounts (FV t ) received at the end of each period for “n” periods:Present value of a stream of future amounts (FV t ) received at the end of each period for “n” periods:

© UHCBA Energy Institute 23 Net Present Value Suppose a manager can purchase a stream of future receipts (FV t ) by spending “C 0 ” dollars today. The NPV of such a decision isSuppose a manager can purchase a stream of future receipts (FV t ) by spending “C 0 ” dollars today. The NPV of such a decision is NPV < 0: Reject NPV > 0: Accept

© UHCBA Energy Institute 24 NPV of Projects (10%) NPV(A) = 50/(1+0.1) + 50/(1+0.1) /(1+0.1) /(1+0.1) = NPV(A) = 50/(1+0.1) + 50/(1+0.1) /(1+0.1) /(1+0.1) = NPV(B) = 20/(1+0.1) + 40/(1+0.1) /(1+0.1) /(1+0.1) = NPV(B) = 20/(1+0.1) + 40/(1+0.1) /(1+0.1) /(1+0.1) = NPV(C) = 80/(1+0.1) + 70/(1+0.1) /(1+0.1) /(1+0.1) = NPV(C) = 80/(1+0.1) + 70/(1+0.1) /(1+0.1) /(1+0.1) = NPV(D) = 60/(1+0.1) + 40/(1+0.1) /(1+0.1) /(1+0.1) = NPV(D) = 60/(1+0.1) + 40/(1+0.1) /(1+0.1) /(1+0.1) = NPV(E) = 10/(1+0.1) + 20/(1+0.1) /(1+0.1) /(1+0.1) = NPV(E) = 10/(1+0.1) + 20/(1+0.1) /(1+0.1) /(1+0.1) = 53.34

© UHCBA Energy Institute 25 NPV of Projects (20%) NPV(A) = 50/(1+0.2) + 50/(1+0.2) /(1+0.2) /(1+0.2) = NPV(A) = 50/(1+0.2) + 50/(1+0.2) /(1+0.2) /(1+0.2) = NPV(B) = 20/(1+0.2) + 40/(1+0.2) /(1+0.2) /(1+0.2) = NPV(B) = 20/(1+0.2) + 40/(1+0.2) /(1+0.2) /(1+0.2) = NPV(C) = 80/(1+0.2) + 70/(1+0.2) /(1+0.2) /(1+0.2) = NPV(C) = 80/(1+0.2) + 70/(1+0.2) /(1+0.2) /(1+0.2) = NPV(D) = 60/(1+0.2) + 40/(1+0.2) /(1+0.2) /(1+0.2) = NPV(D) = 60/(1+0.2) + 40/(1+0.2) /(1+0.2) /(1+0.2) = NPV(E) = 10/(1+0.2) + 20/(1+0.2) /(1+0.2) /(1+0.2) = NPV(E) = 10/(1+0.2) + 20/(1+0.2) /(1+0.2) /(1+0.2) = 15.78

© UHCBA Energy Institute 26 Comparison

© UHCBA Energy Institute 27 Theory of Optimum Extraction Allocate the “fixed” resource over time to maximize its valueAllocate the “fixed” resource over time to maximize its value Socially optimal solution = perfect competition solutionSocially 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 dateKey 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

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

© UHCBA Energy Institute 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.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?What is, then, the profit maximizing resource extraction pattern? Output will be decreasing over time as the price increases over time.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)Hotelling rule: the rent will increase at the rate of interest (discount rate)

© UHCBA Energy Institute 30 Theory of Optimum Extraction Time Price, Output Backstop technologies Price Output

© UHCBA Energy Institute 31 Theory of Optimum Extraction