Black gold as an asset
The relevant measure of an industry’s profitability is not the absolute level of its output price, or even of its price minus the average out-of-pocket cost of production (“net price”). The best measure is its rate of return to capital, relative to the rates of return on alternative assets. The government pondering nationalization is in the same position as a financial investor who is contemplating whether to buy more Google stock: To increase the value of his portfolio, he will shift his wealth to the asset with the highest rate of return. He will buy Google stock only if its rate of return exceeds that of the best alternative asset – another stock, perhaps, or a bond or even money. The current net price of the stock is neither here nor there. Similarly, a government should view natural resources as assets in the nation’s portfolio.
A former newspaper reporter in the United States, Harold Hotelling, explained this 80 years ago. (According to legend, Hotelling had to give up journalism for mathematical economics because he was a slow writer.) The opening of the article could have been written today: “Contemplation of the world’s disappearing supplies of minerals, forests, and other exhaustible assets has led to demand for regulation of their exploitation.”
As Hotelling sees it, the owner of an oil deposit may choose either to leave part of his wealth in the ground or to convert it to some other asset such as a security. Of the two options, he will choose the one with the higher return.
For simplicity, suppose that oil extraction incurs no out-of-pocket costs; the oil price is thus pure profit. The expected return to the oil in the ground is the expected increase in its price over time. If we anticipate that the price of an oil barrel will rise from $100 now to $108 next year, then our expected return is 8%. Suppose that the alternative asset is a savings account with an interest rate of 4%. Then the owner of oil should leave it in the ground, where it will earn the higher return. Extracting and selling the oil now, banking the money at 4% interest, is foolish. The investor could have realized eight cents on a dollar of wealth by waiting until next year to cash in on high oil prices, but instead he has chosen four cents. Whether the current spot net price of a barrel of oil happens to be $1 or $1 million should be of interest only to the newspapers.
The government should not treat oil as just another perishable commodity. Were we talking about apples, then relating the level of production directly to the current price would be appropriate. Apples harvested today will spoil next year; there is no opportunity cost of foregone future use to take into account. Only harvest costs matter. But oil is a durable asset. Forty gallons in the ground will not vanish next year, and they may well be worth more then than now. The current price should not determine the decision of when to extract, since the oil can be sold either now or later.
In our example, owners of oil deposits will leave oil in the ground for another year, since this will earn the higher return. The rate of extraction will fall. The current supply of crude on the spot market will decrease. This scarcity will force up the current price of crude until the expected return on the oil deposit falls to 4%. (This would occur when the current spot price rises to $103.85, given that the price next year will be $108.) At this point, there is no longer an incentive for owners of oil deposits to cancel more plans to extract the crude; the rate of return to holding oil in the ground equals that of the alternative asset. Consequently, we would expect oil prices to rise over time at the rate of interest.
All for the best
This allocation of crude oil to users over time is the most valuable available. Although we assumed away out-of-pocket extraction costs, a vital cost of extracting today still remains – the loss of that oil to future users. To take that opportunity cost into account, current users of oil should pay higher prices than they otherwise would. When oil producers compete for customers, they will bid down the current price of oil to the point that it just covers the costs of producing another barrel. In addition to the out-of-pocket expense of paying workers and buying derricks, we must add the profit foregone by selling another barrel of oil now rather than next year. That opportunity cost is the price that the oil would have fetched in 2012. But the price next year of another barrel of oil must equal its value to the buyer, since otherwise that price must change: Either the price would rise (because the value to a buyer of another barrel is greater than the price that he would pay, which would compel buyers to compete for the barrel by bidding up the price), or it would fall (because the barrel’s value falls below the price that the buyer must pay, generating excess supply). Consequently, the current price of oil equals the value foregone by consuming it now rather than later. If consumers today are willing to pay this price, then they must value another barrel at least as much as would future users. The resulting allocation of oil over time is efficient in the sense that it ensures that each barrel goes to the users who would value it the most.
The real world imposes complications galore. The global oil market is not perfectly competitive, thanks to the Organization of Petroleum-Exporting Countries, and so the OPEC cartel may set the spot price above the cost accruing to another barrel, without fearing that rivals will undercut it in price. Oil extraction may also incur environmental costs – costs that the spot market does not take into account, since neither the buyer nor the seller of oil has to pay them. Incorporating these details into the analysis does not change the tenet that the owner of oil should view it as just another asset.
The model predicts that the net price of oil (adjusted for inflation) should rise over time at the rate of interest. Adjusting for inflation, the global rate of return to physical capital may be roughly 2% to 4% over the very long run.
The interest rate also provides a measure of how rapidly resource prices should rise, remarked Hotelling. “…The rate of interest is set by a great variety of forces, chiefly independent of the particular commodity and industry in question, and is not greatly affected by variations in the output of the mine or oil well in question. It is likely, therefore, that in deciding questions of public policy relative to exhaustible resources, no large errors will be made by using the market rate of interest.” -– Leon Taylor, tayloralmaty@gmail.com
Good reading
Hotelling, Harold. The economics of exhaustible resources. Journal of Political Economy, April 1931.
Solow, Robert M. The economics of resources or the resources of economics. American Economic Review, May 1974. Reprinted in Robert and Nancy S. Dorfman, editors, Economics of the environment: Selected readings. Third edition. New York: W. W. Norton.
Parts of this post draw upon an article of mine published by the Caspian Digest in 2008.
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