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The Effect of Uncertainty on Investment: Evidence from Texas Oil Drilling

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  • Ryan Kellogg

Abstract

This paper estimates the response of investment to changes in uncertainty using data on oil drilling in Texas and the expected volatility of the future price of oil. Using a dynamic model of firms' investment problem, I find that: (1) the response of drilling activity to changes in price volatility has a magnitude consistent with the optimal response prescribed by theory, (2) the cost of failing to respond to volatility shocks is economically significant, and (3) implied volatility data derived from futures options prices yields a better fit to firms' investment behavior than backward-looking volatility measures such as GARCH.

Suggested Citation

  • Ryan Kellogg, 2014. "The Effect of Uncertainty on Investment: Evidence from Texas Oil Drilling," American Economic Review, American Economic Association, vol. 104(6), pages 1698-1734, June.
  • Handle: RePEc:aea:aecrev:v:104:y:2014:i:6:p:1698-1734
    Note: DOI: 10.1257/aer.104.6.1698
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    References listed on IDEAS

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    1. R?diger Bachmann & Steffen Elstner & Eric R. Sims, 2013. "Uncertainty and Economic Activity: Evidence from Business Survey Data," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(2), pages 217-249, April.
    2. Nicholas Bloom & Max Floetotto & Nir Jaimovich & Itay Saporta-Eksten & Stephen J. Terry, 2012. "Really Uncertain Business Cycles," NBER Working Papers 18245, National Bureau of Economic Research, Inc.
    3. Rust, John, 1987. "Optimal Replacement of GMC Bus Engines: An Empirical Model of Harold Zurcher," Econometrica, Econometric Society, vol. 55(5), pages 999-1033, September.
    4. Ryan Kellogg, 2011. "Learning by Drilling: Interfirm Learning and Relationship Persistence in the Texas Oilpatch," The Quarterly Journal of Economics, Oxford University Press, vol. 126(4), pages 1961-2004.
    5. Hassler, John A. A., 1996. "Variations in risk and fluctuations in demand: A theoretical model," Journal of Economic Dynamics and Control, Elsevier, vol. 20(6-7), pages 1115-1143.
    6. John A. List & Michael S. Haigh, 2010. "Investment Under Uncertainty: Testing the Options Model with Professional Traders," The Review of Economics and Statistics, MIT Press, vol. 92(4), pages 974-984, November.
    7. Nick Bloom & Stephen Bond & John Van Reenen, 2007. "Uncertainty and Investment Dynamics," Review of Economic Studies, Oxford University Press, vol. 74(2), pages 391-415.
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    9. Michelle Alexopoulos & Jon Cohen, 2009. "Uncertain Times, uncertain measures," Working Papers tecipa-352, University of Toronto, Department of Economics.
    10. Wiggins, Steven N & Libecap, Gary D, 1985. "Oil Field Unitization: Contractual Failure in the Presence of Imperfect Information," American Economic Review, American Economic Association, vol. 75(3), pages 368-385, June.
    11. Leahy, John V & Whited, Toni M, 1996. "The Effect of Uncertainty on Investment: Some Stylized Facts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(1), pages 64-83, February.
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    13. Szakmary, Andrew & Ors, Evren & Kyoung Kim, Jin & Davidson, Wallace III, 2003. "The predictive power of implied volatility: Evidence from 35 futures markets," Journal of Banking & Finance, Elsevier, vol. 27(11), pages 2151-2175, November.
    14. Ser-Huang Poon & Clive W.J. Granger, 2003. "Forecasting Volatility in Financial Markets: A Review," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 478-539, June.
    15. Jesus Fernandez-Villaverde & Pablo Guerron-Quintana & Juan F. Rubio-Ramirez & Martin Uribe, 2011. "Risk Matters: The Real Effects of Volatility Shocks," American Economic Review, American Economic Association, vol. 101(6), pages 2530-2561, October.
    16. Lutz Kilian, 2009. "Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market," American Economic Review, American Economic Association, vol. 99(3), pages 1053-1069, June.
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    18. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
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    22. James L. Paddock & Daniel R. Siegel & James L. Smith, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, Oxford University Press, vol. 103(3), pages 479-508.
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    More about this item

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • L71 - Industrial Organization - - Industry Studies: Primary Products and Construction - - - Mining, Extraction, and Refining: Hydrocarbon Fuels
    • Q31 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Nonrenewable Resources and Conservation - - - Demand and Supply; Prices

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