Short-Term Contracting and Strategic Oil Reserves

Abstract

The effect of short-term contracting on resource extraction is studied, in a two-country model of international trade in oil. Countries' planners are assumed to be fully rational, with perfect information and perfect foresight. Contracts are assumed perfectly enforceable and complete, except that short-term contracts do not allow commitments to actions taken beyond the contract period. We show that short-term contracting limits countries' opportunities for intertemporal consumption-smoothing, reducing their collective tolerance for temporal variation in consumption. This tends to make them extract more slowly than in the efficient plan that results from long-term contracting. Contractual relationships often outlive the contracts that govern them. It is therefore common for a long-term relationship to be governed by a sequence of short-term contracts. When these contracts allow complete control of the organization of the relationship within each contract period, any outcome that can be achieved in a long-term contract, covering the entire life of the relationship, is also feasible with a sequence of short-term contracts. Short-term contracting can nevertheless have significant effects on resource allocation, because each contract must be voluntarily negotiated in the environment created by its predecessors. An allocation that is acceptable to both parties as a long-term contract might not be voluntarily negotiable as a sequence of short-term contracts. Because short-term contracting is so prevalent, it is worth asking what sorts of relationship can be organized efficiently only by long-term contract, and what kinds of distortion are caused by short-term contracting.' Two kinds of answers to these questions have been given in the literature. One important line of investigation considers the use of memory in contracts designed to control parties' incentives under asymmetric information. Baron and Besanko (1985), Rubinstein and Yaari (1983), Sanchez and Zapater (1985), Stiglitz and Weiss (1983), Tirole (1986), and Townsend (1982), among others, have shown how parties can use