Despite the
avalanche of reports and prognostications regarding the future of crude oil
prices, there is virtually no mention of the starting point on which all
scholarly research on the subject is based – the Hotelling theorem. Though the derivation can be daunting, the
conclusion of the Hotelling theorem is straightforward. The theorem states that, irrespective of the
current spot price, the price of crude oil should be expected to rise at the
rate of interest (adjusted for risk).
The intuition underlying the theorem is simple. If prices are not expected to rise at the
rate of interest, then owners of reserves should pump more oil and invest the
proceeds in financial assets. If prices are
expected to rise faster than the interest rate, then it is rational to slow
production and leave oil in the ground.

In
Hotelling equilibrium, the spot price is set so that as prices rise at the
interest rate reserves are drawn so as to maximize the present value of the
stream of oil profits. Over the last 18
months, of course, prices have not risen but headed straight down. So what has gone wrong? Is the Hotelling theorem overly theoretical nonsense? In defense of the theorem, note that
throughout the oil price collapse during the last 18 months the futures curve
has always been upward sloping just as the theorem predicts. However, rather than following the curve
upward, spot prices have been on a relentless decline from over $115 to under
$30.

The
Hotelling theorem points to three primary factors to potentially explain the
spot price collapse. The first is new
information about either the stock of reserves or the demand for oil by final
consumers. The problem with this first
factor is that during the last 18 months there has been little new news remotely
sufficient to explain a 75% price drop.
On the supply side the impact of fracking has been known for years and
there have been no large unanticipated discoveries. On the demand side, the usage of crude has
followed a predictable, slow upward trend despite the slowdown in China.

The
second factor is speculation. Oil is not
only a commodity, it is also a financial asset.
Like other financial assets, its price responds to speculation and
sentiment. Unfortunately, assessing the
impact of this factor is next to impossible because motives for investment are
not observable. Suffice it to say that a
change in speculative sentiment probably has played a role in the drop, but it
cannot explain the massive collapse.

Third,
the Hotelling theorem depends on the long-run rational behavior of reserve
owners to draw down their reserves so as maximize the present value of the future
profit stream. However, actual owners of
reserves seem to be responding to other forces such as maintaining the
political status quo, punishing competitors, undertaking strategic initiatives
and so forth. Given the relatively inelastic
demand for oil, and the rising marginal cost of adding storage, pushing more
oil into the spot market can have a dramatic impact on prices. Nonetheless, for whatever reason, reserve
owners keep pumping when they should be leaving oil in the ground. It is this third factor which the Hotelling
theorem suggests accounts for most of the dramatic price decline we have
witnessed. The theorem also suggests the
when bleeding will end. At some point,
the spot price will be so low that the anticipated rate of future appreciation
will be large enough to convince even the most skeptical reserve owners to
leave more oil in the ground. At that
point, the spot price will stop falling.

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