Equilibrium Exhaustible Resource Price Dynamics

Authors

  • MURRAY CARLSON,

  • ZEIGHAM KHOKHER,

  • SHERIDAN TITMAN

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    • Sauder School of Business at the University of British Columbia, Richard Ivey School of Business at the University of Western Ontario, and McCombs School of Business at the University of Texas at Austin. We would like to thank an anonymous referee, Harjoat Bhamra, the editors, Ali Lazrak, Tan Wang, and seminar participants at the University of Texas, the Real Options Conference at Cambridge University, Texas A&M University, and the Western Finance Association Meetings in Park City for their comments. All errors are our sole responsibility.


ABSTRACT

We develop equilibrium models of exhaustible resource markets with endogenous extraction choices and prices. Our analysis demonstrates how adjustment costs can generate oil and gas forward price dynamics with two factors, consistent with the behavior these commodities exhibit in the Schwartz and Smith (2000) calibration. Our two-factor model predicts that stochastic volatility will arise in these markets as a natural consequence of production adjustments, however, and we provide supporting empirical evidence. Differences between endogenous price processes from our general equilibrium model and exogenous processes in earlier papers can generate significant differences in both financial and real option values.

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