Hotelling Under Pressure

We show that crude oil production from existing wells in Texas does not respond to current or expected future oil prices, contradicting a basic prediction of Hotelling’s (1931) canonical model of exhaustible resource extraction. In contrast, the drilling of new wells exhibits a strong price response, as does the rental rate on drilling rigs. To explain these observations, we reformulate Hotelling’s model as a drilling problem, in which firms choose when to drill new wells, but flow from existing wells is limited by a capacity constraint that decays toward zero as reservoir pressure declines. This drilling problem implies a modified Hotelling rule for discounted revenue flows net of drilling costs. Our model rationalizes the empirical findings from Texas and can replicate several other well-known features of the oil industry: local production peaks, backwardated price expectations following unanticipated positive demand shocks, and expectations that prices will rise faster than the interest rate following large, unanticipated negative demand shocks. JEL classification numbers: Q3, Q4