Implications of option values for natural resource economics

Although there is a large and well-developed literature on natural resource economics, the ability of this theory to describe actual market behavior remains an open question. This study attempts to provide empirical and theoretical elements that may help us to understand better the behavior of nonrenewable resource extraction. The study is divided in three chapters. Chapter 1 provides an overview of the work, identifying the key questions that arise in the theory of natural resource economics and the issues addressed in this study.; Chapter 2 analyzes the behavior of total factor productivity (TFP) in natural resource industries. This variable, which we interpret as real cost reduction (RCR), may be an important element of reconciliation between theory and data since RCR can modify the natural upward trend that, ceteris paribus, is expected for natural resource real market prices. Our results suggest that TFP improvements have varied in important ways across countries and between sectors. Similarly, they suggest that increases in RCR are reflected at least partly in lower consumer prices. Nevertheless, this negative relationship between RCR and market prices seems to be insufficient to explain empirical data. In particular, some sensitivity exercises about the behavior of shadow prices suggest that the returns implied by RCR adjusted prices would be too low to compensate an investor for holding the resource in the ground.; Chapter 3 develops a simple model of petroleum extraction that incorporates some “real option” aspects faced by oil producers. The model shows that even if net prices are growing at a rate lower than the rate of interest, a firm might find optimal not to extract today. This contrasts with traditional Hotelling models in which a firm would attempt to extract as fast as possible the resource in the ground if the rate of growth in prices is lower than the rate of interest. In the simplest world, Hotelling models state that the asset equilibrium condition is achieved when capital gains (price increases) are equal to the rate of interest. The introduction of options, however, changes this result. Specifically, the asset equilibrium condition contains an additional term that results from option values. This occurs because the possibility to postpone represents an additional source of value. In the simplest world, capital gains (price increases) plus the premium of the option to wait have to equal the rate of interest. Thus, option values might be an important element of reconciliation between theory and data.