As a follow up to my post on Hotelling's rule and oil prices, check out Econbrowser where James Hamilton explains the intertemporal allocation of exhaustible energy resources (i.e., "what's going on with oil prices?"):
Suppose you told me that, as a result of a careful examination of oil reservoirs, you were certain that annual oil production was just about to plummet, and would be 30% below its current level in two years. I realize that's a more extreme example than anybody is advocating, but perhaps you'll bear with me in examining its implications for a few minutes before turning to a more subtle scenario.
Let's see if we can first agree on how society ought to respond to these facts that you would be giving us. I would say that the first thing we should do is curtail current oil consumption drastically. Oil is going to be an incredibly valuable commodity in two more years, and we've got to stop wasting it now. By leaving more of the oil in the ground now, we could stretch out the time available to us for developing alternative sources from oil sands and coal and to make radical changes in our transportation systems. And we would need to start immediately making huge investments in those alternatives.
Now let's consider what would happen if the government doesn't make any policy response. Oil is going to become extremely valuable under this scenario in a very short period of time. Let's say for discussion we're talking about $200 a barrel two years hence. Then I would like to make the observation that, if the facts were indeed as we just conjectured, oil surely could not continue to sell for $60 a barrel today. Anybody who pumps a barrel out of a reservoir today to sell at $60 could make three times as much money if they just left it in the ground another two years before pumping it out. The same is true for anybody with above-ground storage facilities-- they're throwing away money, and lots of it, for every barrel they sell at $60 that they could have instead stored for two years and sold for $200. If oil producers did respond to these very strong incentives by holding back oil from today's market, the effect would be to drive today's price up. This profit-seeking wouldn't drive the price all the way up to $200, because you have significant interest, storage, and idle capacity expenses from trying to wait around a couple of years before getting your profit. An economist would expect the end result of this profit-seeking to be that the price today is lower than what it will be in two years by an amount that reflects these interest and other expenses, but certainly far less than the difference between $60 and $200 a barrel.
Yep.
