Why the Principle Over-Predicts Actual Values*

Abstract

Two articles previously published in this Journal (Watkins 1992 and Adelman 1993) reported that the valuation version of the Hotelling Principle over-predicts in-ground values of oil and gas reserves by a factor of approximately two. This paper shows these results are to be expected once it is understood that: (1) the Principle assumes individual operators have the effective freedom to schedule extraction rates so as to make net prices rise at the rate of discount, regardless of the course of gross (wellhead) prices; and (2) the long-prevailing system of regulating oil well spacing and extraction rates in the United States and Canada, designed to deal with the common pool problem, effectively denies operators that freedom. The discrepancy between actual in-ground values and those predicted by the Hotelling Principle suggests the benefits to be had by substituting compulsory reservoir unitization cum manager freedom for the current system of regulation.