Optimal oil production and the world supply of oil

Working paper

We study the optimal oil extraction strategy and the value of an oil eld using a multiple real option approach. The numerical method is exible 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 2008-2009 crisis, and we nd that the cut in production was larger for OPEC, for countries facing a lower discount rate, as predicted by the model, and for countries with government finances less dependent on oil revenues. However, the net present value of a country's oil reserves would be increased signicantly (by 100 percent, in the most extreme case) if production was cut completely when prices fall below the country's threshold price. If several producers were to adopt such strategies, world oil prices would be higher but more stable.

Authors: Aleksandrov, N; Espinoza, R; Gyurko, L

• Publication status: Published
• Publisher: University of Oxford
• Series: OxCarre Papers
• Publication date: 2012-08-07
• Paper number: 92
• Keywords: capacity expansion; real options; equilibrium price of oil; OPEC; oil production