The Hotelling Principle, backwardation of futures prices and the values of developed petroleum reserves - the production constraint hypothesis

We explore the practitioner-stylized facts that petroleum wells require large initial investments, have daily production capacities, and have small marginal costs for production rates meaningfully below these capacities. Long-run backwardation of futures prices is required to induce drilling new wells. In contrast to Miller and Upton (1985a,b) and Litztenberger and Rabinowitz (1995), production from developed reserves is essentially a corner solution at capacity regardless of baukwardation or price volatility. Economically interesting supply decisions take the form of investment in exploration and drilling. Empirical evidence strongly rejects the Miller and Upton hypothesis in favor of our more general model. (C) 2001 Elsevier Science B.V. All rights reserved.