The private and social value of information: Exploration for exhaustible resources

Abstract

In this paper, I develop a model where “exploration” yields information about the size and location of the stock of an exhaustible resource. This information is valuable in two ways. First, before production takes place, reserves must be located through exploration. The process of exploration changes “unproven reserves,” which cannot be produced, into “proven reserves,” which can. One value of exploration, then, is that it allows total production over time to expand (the expansion effect). Second, by exploring in an early time period, a producer gains information about the true stock size prior to making a decision about how fast to exploit reserves. With better information, the extraction rate chosen by the producer will yield higher expected returns from the stock (the timing effect). I show that the expansion effect is undervalued by a firm relative to a social planner. An increase in proven reserves increases production and lowers prices improving consumer welfare. The timing effect, however, can be over- or undervalued by a firm relative to a social planner. If the exploring firm makes up a relatively small portion of industry, and if consumers are not highly risk averse, then the firm will overvalue the timing effect. As a result, firms may not explore some tracts where it is efficient to do so. If, however, a firm finds it valuable to explore a tract, it may explore earlier in time than is optimal.