Optimal Oil Production and the World Supply of Oil

Nikolay Aleksandrov, Lajos Gyurko and Raphael Espinoza

No 2012/294, IMF Working Papers from International Monetary Fund

Abstract: We study the optimal oil extraction strategy and the value of an oil field using a multiple real option approach. The numerical method is flexible enough to solve a model with several state variables, to discuss the effect of risk aversion, and to take into account uncertainty in the size of reserves. Optimal extraction in the baseline model is found to be volatile. If the oil producer is risk averse, production is more stable, but spare capacity is much higher than what is typically observed. We show that decisions are very sensitive to expectations on the equilibrium oil price using a mean reverting model of the oil price where the equilibrium price is also a random variable. Oil production was cut during the 2008–2009 crisis, and we find that the cut in production was larger for OPEC, for countries facing a lower discount rate, as predicted by the model, and for countries whose governments’ finances are less dependent on oil revenues. However, the net present value of a country’s oil reserves would be increased significantly (by 100 percent, in the most extreme case) if production was cut completely when prices fall below the country's threshold price. If several producers were to adopt such strategies, world oil prices would be higher but more stable.

Keywords: WP; equilibrium price; Oil production; Real Options; Capacity Expansion; Equilibrium Price of Oil; OPEC; oil price; extraction cost; threshold price; continuation value; price shock; investment cost; Oil prices; Oil; Asset prices; gas and mining taxes (search for similar items in EconPapers)
Pages: 31
Date: 2012-12-17
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