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Optimal Oil Production and the World Supply of Oil

  • Nikolay Aleksandrov
  • Raphael Espinoza
  • Lajos Gyurko

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 2008-09 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 more 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 threshhold price. If several producers were to adopt such strategies, world oil prices would be higher but more stable.

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Paper provided by Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford in its series OxCarre Working Papers with number 092.

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Date of creation: 2012
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Handle: RePEc:oxf:oxcrwp:092
Contact details of provider: Postal: Manor Road, Oxford, OX1 3UQ
Web page: http://www.oxcarre.ox.ac.uk/
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  1. Rick Van der Ploeg & Tony Venables, 2011. "Harnessing windfall revenues: Optimal policies for resource-rich developing economies," Economics Series Working Papers 543, University of Oxford, Department of Economics.
  2. Lajos Gergely Gyurko & Ben Hambly & Jan Hendrik Witte, 2011. "Monte Carlo methods via a dual approach for some discrete time stochastic control problems," Papers 1112.4351, arXiv.org.
  3. N. Aleksandrov & B. Hambly, 2010. "A dual approach to multiple exercise option problems under constraints," Mathematical Methods of Operations Research, Springer, vol. 71(3), pages 503-533, June.
  4. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August.
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  7. N. Meinshausen & B. M. Hambly, 2004. "Monte Carlo Methods For The Valuation Of Multiple-Exercise Options," Mathematical Finance, Wiley Blackwell, vol. 14(4), pages 557-583.
  8. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
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  11. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
  12. repec:spr:compst:v:71:y:2010:i:3:p:503-533 is not listed on IDEAS
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  14. Alvarez, Luis H. R. & Keppo, Jussi, 2002. "The impact of delivery lags on irreversible investment under uncertainty," European Journal of Operational Research, Elsevier, vol. 136(1), pages 173-180, January.
  15. Samu Peura & Jussi Keppo, 2006. "Optimal Bank Capital with Costly Recapitalization," The Journal of Business, University of Chicago Press, vol. 79(4), pages 2163-2202, July.
  16. Nikolay Aleksandrov & Raphael Espinoza, 2011. "Optimal Oil Extraction as a multiple Real Option," OxCarre Working Papers 064, Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford.
  17. Octavio A. F. Tourinho., 1979. "The Option Value of Reserves of Natural Resources," Research Program in Finance Working Papers 94, University of California at Berkeley.
  18. René Carmona & Nizar Touzi, 2008. "Optimal Multiple Stopping And Valuation Of Swing Options," Mathematical Finance, Wiley Blackwell, vol. 18(2), pages 239-268.
  19. Christian Bender, 2011. "Dual pricing of multi-exercise options under volume constraints," Finance and Stochastics, Springer, vol. 15(1), pages 1-26, January.
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  22. Nagae, Takeshi & Akamatsu, Takashi, 2008. "A generalized complementarity approach to solving real option problems," Journal of Economic Dynamics and Control, Elsevier, vol. 32(6), pages 1754-1779, June.
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