Steven Dutch, Natural and Applied Sciences, Universityof Wisconsin - Green Bay
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Harold Hotelling was an economist at Stanford University. Not, as widely reported, a geologist. I am not sure how that misattribution got started unless it was because one of his most famous papers uses mineral resources as examples. One of Hotelling's most famous papers was "The Economics of Exhaustible Resources" in The Journal of Political Economy, April, 1931, vol. 2, no. 2., pp. 137-175. It seems to be emerging among libertarian economists as a prescription for laissez faire economics and maximum resource exploitation.
Not everyone is happy with that state of affairs. Francis de Winter, writing in Comments on the Work of Harold Hotelling onhttp://www.hubbertpeak.com/, perpetuates the misconception of Hotelling being a geologist, and writes:
The Harold Hotelling paper is often referenced because of its description of the "Free Market" mechanism by which our descendants are systematically deprived of any significant access to the finite natural resources which we currently have at our disposal. This mechanism works as follows.
If one "owns" an oil well, one has to decide whether to "produce" (i.e. extract) and sell the oil now or later. If one produces and sells the oil now, one can put the money in the bank, and it will grow because of the interest it will earn. If on the other hand one produces and sells the oil later, one has to discount the money one will get for the oil, because one is getting the money later, and not now. With either way of looking at this, there is only an incentive to produce and sell later (rather than now) if one has the certainty that the oil in the ground is appreciating as fast as the money in the bank (in annual percentage rate), or as fast as the annual discount rate used in the operation one runs. Many operations (companies, etc.) use an annual discount rate of 10% or even larger.
Consider an annual discount rate (or interest rate) of 10% and a 25 year-long generation. In 25 years, a compounded 10% annual interest rate will multiply an original investment by a factor of 10 (yes, ten), and an annual discount rate of 10% will decrease a later money receipt by a factor of 10. What does this mean? It means that an oil well owner using a discount rate of 10% has no incentive to leave any oil in the ground for our children 25 years from now unless there is a certainty of getting the children to pay 10 times as much for the oil as we are paying now, and our grandchildren 50 years from now would have to pay 100 times as much as we are paying now.
Things aren't quite as grim as de Winter suggests. For one thing, if you over-produce, you drive down prices and get less, not more. On the other hand, a producer doesn't have the liberty of leaving resources in the ground indefinitely. The resource will still be taxed, it will still cost money to be in business, and if the producer shuts down and then resumes production, he will incur startup costs. Not to mention that shareholders will not be happy at seeing their money lie fallow for an extended period. Finally, oil, once consumed, is gone, but copper or aluminum mined today should still be available in the future.
Also, in de Winter's scenario where interests remain at ten per cent for 25 years, the economy will evolve between one of two extremes. In the one case, the interest rate is purely inflationary. Yes, the resource 25 years from now will have to sell for ten times its present price, but that will be in dollars inflated by a factor of 10. In terms of, say, hours worked to buy a tank of gas, the cost will be the same. The other extreme is that the economy is experiencing real growth at a rate of 10 per cent. In that case, the resource 25 years from now will cost 10 times more, but the overall economy will be ten times as large.
From the standpoint of the consumer, the second scenario is far better. As anyone who remembers the golden age of Jimmy Carter knows, whatever corrections the economy applies for double digit inflation, they never make it all the way down to everyone, and consumers inevitably lose purchasing power. So do other institutions; it took my university fully 20 years to make up for the losses it suffered during the inflation of the 1970's. On the other hand, consumers won't see the full benefits of economic growth, either, but they will see some.
As for the observation "Many operations (companies, etc.) use an annual discount rate of 10% or even larger," that's just simple prudence. If you assume that next year's environment will be favorable, and don't leave a safety margin, you could be in serious trouble. Considering that oil companies are also often accused of restricting supply to keep prices high, there seems to be little danger of oil companies sucking oil out at the fastest possible rate just because they discount future oil at 10 per cent.
Finally, the wild swings in the economy make it virtually impossible to apply Hotelling's ideas to more than the immediate future. I can see a mine owner ramping up production when interest rates are high simply to avoid losing value by letting ore sit in the ground, and planning production based on current interest rates, during a period of relative economic stability. How long will that be? Five years? Ten, tops?
I checked into Hotelling's ideas thanks to a reader who took umbrage at the following heresy. I stated that although I considered myself a conservative, nevertheless:
"Conservatism" and "conserve" come from the same root. You don't unnecessarily squander limited resources you may need later. In fact you don't unnecessarily squander anything - period. You keep your debt limited to the minimum necessary. You pay your bills. If you get an unexpected windfall, you manage it carefully to stretch it out. You treat things in your care like they're your own.
So completely apart from global warming, fossil fuels are finite and will have a finite lifetime, and we have no practical substitute ready to replace them. Therefore we need to manage them carefully to maximize their lifetime.
There is nothing whatsoever in that passage calling for government action. The first paragraph is entirely about personal choices. The second paragraph does include the use of "we," but that could merely mean the sum total of good personal choices by individuals (in practice, of course, it won't because so many people make bad choices). In response I got this:
Are you familiar with Hotelling's analysis of the economics of depletable resources? It's a classic piece, about seventy years old. The implication is that, in a world of secure property rights, current prices for depletable resources take account of all future demands, as best they can be estimated. To the extent that describes the real world, there is no more reason why "we" need to manage depletable resources than why "we" need to manage agriculture in order to make sure people get fed--and quite a lot of evidence that management by "we," which I take to mean some sort of political mechanism, produces less desirable results than those produced by lots of individuals separately optimizing for themselves.
It is not a good idea to tell me to check the writings of some authority figure. I like to call peoples' bluffs.
Hotelling actually considered many different scenarios, including varying degrees of monopoly, the effect of past production on prices, discontinuities in production and demand, and so on. But for the simple case of a reasonably steady economy and free competition, he found that it made sense to produce resources if the price was rising more slowly than interest, because it paid to earn the profit now and invest it. On the other hand, if prices were rising faster than interest, it paid to delay production because the value of the resource in the future would be greater than one could gain from investment.
One of the blessings of the digital age is that it can be easy to access works, and even better, analyze them. Hotelling's paper is accessible through JSTOR, a service at many university libraries. It is easy to search the paper for specific phrases. It turns out that Hotelling never used the term "property rights," let alone "secure property rights." And a search of the word "future" showed that he never said anything remotely akin to "current prices for depletable resources take account of all future demands." On the other hand, Hotelling's introductory discussion gives ample insight into his political and economic frame of mind:
The government of the United States under the present administration has withdrawn oil lands from entry in order to conserve this asset, and has also taken steps toward prosecuting a group of California oil companies for conspiring to maintain unduly high prices, thus restricting production. Though these moves may at first sight appear contradictory in intent, they are really aimed at two distinct evils, a Scylla and Charybdis between which public policy must be steered (p. 138).
On the one hand, the government is taking oil lands out of production in the name of conservation, but at the same time prosecuting oil producers for artificially restricting production. Oh to live in an age when people understood what Scylla and Charybdis meant! (They were sea monsters in the Odyssey who guarded opposite sides of a strait and made it impossible to steer safely through.) I doubt if I could get that allusion into even an academic paper today. He's saying that public policy must try to avoid both wanton waste and crass profiteering. This doesn't exactly read like the work of a laissez-faire economist.
Suppose the [hypothetical] mine [a type example for depletable resources] is publicly owned. How should exploitation take place for the greatest general good, and how does a course having such an objective compare with that of the profit-seeking entrepreneur? What of the plight of laborers and of subsidiary industries when a mine is exhausted? How can the state, by regulation or taxation, induce the mine-owner to adopt a schedule of production more in harmony with the public good? (p. 139)
He doesn't seem to have a problem with public ownership of resources, factoring in externalities like layoffs and hardships to consumers, or using regulation or taxation as incentives for socially responsible behavior.
This conclusion does not, of course, supply any more justification for laissez faire with the exploitation of natural resources than with other pursuits. It shows that the true basis of the conservation movement is not in any tendency inherent in competition under these ideal conditions. However, there are in extractive industries discrepancies from our assumed conditions leading to particularly wasteful forms of exploitation which might well be regulated in the public interest. We have tacitly assumed all the conditions fully known. Great wastes arise from the suddenness and unexpectedness of mineral discoveries, leading to wild rushes, immensely wasteful socially, to get hold of valuable property. (p.143-144)
This rather complex passage needs to be taken apart sentence by sentence.
This conclusion does not, of course, supply any more justification for laissez faire with the exploitation of natural resources than with other pursuits.
Hotelling himself explicitly rejects the use of his results to justify laissez-faire economics.
It shows that the true basis of the conservation movement is not in any tendency inherent in competition under these ideal conditions.
Refer back to deWinter's rather alarmist take on Hotelling. If interest is 10 per cent per year, then in 25 years, prices will have inflated 10-fold. Say GDP is a trillion dollars and your mine produces $100 million per year, and prices rise in tandem with interest. Your mine produces 1/10,000 of total GDP. If the interest rate is solely inflationary, after 25 years, the GDP will be $10 trillion, but with the same purchasing power as today's $1 trillion. Your mine output will be $1 billion, still 1/10,000 of GDP. Now let's suppose the economy is really growing at 10 per cent per year. That sort of thing is a blast while it happens but it lulls people into thinking that it can go on indefinitely. Anyway, in 25 years, the GDP will be $10 trillion, and it will be ten times larger in real terms. Your mine will earn $1 billion, again in real terms, and still 1/10,000 of GDP. So Hotelling's result is actually pretty innocuous - if prices more or less keep pace with interest, a producer will pretty much maintain a constant share of GDP. It certainly doesn't imply, as deWinter claims, that Hotelling's analysis amounts to "loan sharking" future generations.
This is probably what Hotelling means by saying the real basis for conservation is not to be found in the actual terms of competition he outlines. Instead, conservation looks ahead to the implications of ultimate resource exhaustion. The public policy desirability of conserving resources for the future, versus exploiting them now, is not to be decided on the basis of Hotelling's math.
However, there are in extractive industries discrepancies from our assumed conditions leading to particularly wasteful forms of exploitation which might well be regulated in the public interest. We have tacitly assumed all the conditions fully known. Great wastes arise from the suddenness and unexpectedness of mineral discoveries, leading to wild rushes, immensely wasteful socially, to get hold of valuable property.
This passage makes it very clear that:
Of this character is the drilling of "offset wells" along each side of a property line over a newly discovered oil pool. Each owner must drill and get the precious oil quickly, for otherwise his neighbors will get it all. Consequently great forests of tall derricks rise overnight at a cost of $50,000 or more each; whereas a much smaller number and a slower exploitation would be more economic. Incidentally, great volumes of natural gas and oil are lost because the suddenness of development makes adequate storage impossible. (p. 144)
This passage is an interesting historical perspective. Oil isn't extracted this way much any more. Companies either buy the mineral rights to all property over an oil field and pay royalties to the owners or work out agreements for extraction rights. Far more wasteful than the inability to store oil and gas was the fact that excessively rapid drilling bled off the pressure that otherwise drove oil to the surface. Since oil weighs less than rock, the pressure on the oil at the bottom of an oil well is greater than the weight of the oil in the well. The pressure will force the oil to the surface. If you do things right, and allow water to percolate in to replace the oil, or maintain the pressure exerted by the natural gas in the well, you maximize the amount of oil you can get from the well. But we ruined a few oil fields before figuring this out.
The unexpectedness of mineral discoveries provides another reason than wastefulness for governmental control and for special taxation. Great profits of a thoroughly adventitious character arise in connection with mineral discoveries, and it is not good public policy to allow such profits to remain in private hands. Of course the prospector may be said to have earned his reward by effort and risk; but can this be said of the landowner who discovers the value of his subsoil purely by observing the results of his neighbors' mining and drilling? (p.144)
Hotelling explicitly endorses windfall profits taxes.
The market rate of interest [gamma] must be used by an entrepreneur in his calculations, but should it be used in determinations of q social value and optimum public policy? ...There is, however, an important difference between the two cases in that the rate of interest is set by a great variety of forces, chiefly independent of the particular commodity and industry in question, and is not greatly affected by variations in the output of the mine or oil well in question. It is likely, therefore, that in deciding questions of public policy relative to exhaustible resources, no large errors will be made by using the market rate of interest. (p. 144-45)
Basically, interest is as good an estimator as any of social value. After all, as Hotelling notes, interest depends on a broad variety of factors all across the economy and won't be especially affected if a gold or iron mine run out of ore.
If, that is, interest is not affected much by variations in output. Some metals are in shorter supply than others. Iron and aluminum are all but unlimited, and substitutes for many others are available. When copper becomes too expensive, use aluminum wire and switch to PVC pipe...
Which is made from oil. And variations in oil output do affect interest rates because energy is at the base of everything else. When it costs more to transport goods because the price of oil has gone up, the cost will go up. Prices will go up. Workers will demand higher wages to keep up. And with prices going up, the bank has to raise interest rates, because the money you pay back in the future won't buy as much. So energy is not a case where interest is "chiefly independent of the particular commodity and industry in question."
Of course, changes in this rate are to be anticipated, especially in considering the remote future. If we look ahead to a distant time when all the resources of the earth will be near exhaustion, and the human race reduced to complete poverty, we may expect very high interest rates indeed. But the exhaustion of one or a few types of resources will not bring about this condition. (p. 145)
We're not at this point yet or even close to it. If anything causes a global economic crash in the near future it will probably be overpopulation and lack of sufficient farmland. Recycling was in its infancy when Hotelling wrote his paper. Economic geologists used to talk about eventually extracting metals from common rock, but long before that becomes economically viable it will probably pay more to mine old landfills. A quarter of all copper ever mined was mined in the 1990's. Long before it pays to extract 100 parts per million copper from ordinary granite, it will pay to extract 500 or 1000 parts per million from the waste stream. So we probably won't reach a point where non-energy mineral resources will be an economic choke point.
And we will not run out of oil in the foreseeable future. What we will do, and in fact are likely feeling the first effects already, is to reach the point where demand for oil exceeds our ability to get it out of the ground. It only flows through the rocks just so fast, and, as I noted earlier, excessive production can ruin an oil field. And oil is an inelastic resource. When you have too much, all you can do is store it. When there's not enough, people bid for it because they have to have it - now.
They measure the social value of the mine in the sense concerned with the total production of goods, but not properly its utility or the happiness to which it leads, since this depends upon the distribution of wealth, and is greater if the products of the mine benefit chiefly the poor than if they become articles of luxury. A platinum mine is of greater general utility when platinum is used for electrical and chemical purposes than when it is pre-empted by the jewelry trade. However, we must leave questions of distribution of wealth to be dealt with otherwise, perhaps by graded income and inheritance taxes... (p. 145)
Money metals, of course, occasion very special cause for public concern. Not only does gold production tend to unstabilize prices; but if the uses in the arts can be neglected, the costs of discovery, extraction, and transportation from the mine are, from the social standpoint, wasted. (p. 145. Picture advocates of returning to gold coinage shrieking in rage here.)
Still a different reason for caution in deducing a laissez faire policy from the theoretical maximizing of V under "free" competition is that the actual conditions, even when competition exists, are likely to be far removed from the ideal state we have been postulating. (p. 145-46)
How does Hotelling's theory work in practice? Short answer: it doesn't.
Although Hotelling's theory has many followers, it has generally failed to hold up historically. ("Oil As An Asset: Hotelling's Theory On Price" by Robert Stammers, Investopedia)
The Hotelling rule forms the basis of theeconomic theory of non-renewable resources. It is simple, elegant, well-justified within general macroeconomic theory, and entirely worthless as a guide to past and future prices ... Oil has never been priced as a non-renewable resource. So where does that leave us? The oil price is not right. Changing Clive Maund's "penny stock" analogy, oil is priced as if it were soybeans, a renewable crop, or iron, for which reserves are vast and therefore not a concern. ("The price is not right" by Dave Cohen, Energy Bulletin, December 17, 2008)
Now, as a physical scientist, I don't see anything the least bit surprising here. The world is full of elegant, rigorous theories that just plain don't work in practice. They don't work for a wide variety of reasons. In one celebrated case, astronomer (and economist) Simon Newcomb showed that heavier than air flight was physically impossible. The lift created by wings would increase as the square of their dimensions, but their mass would increase as the cube. Therefore, mass would increase faster than lift and make it impossible for a large object to fly. It's mathematically impeccable. And utterly wrong, as the Wright Brothers demonstrated just a few weeks later. When your flying object is made of some solid material, and you scale it up by a factor of 10, lift will increase by 100 and mass by 1000. If the material is, say, muscle, scaling will set a limit on the size of the flying object. You can beat the scaling issue a little with hollow bones and long wings in proportion to body size, but basically the mass-area principle limits the size of birds.
It does not limit the size of airplanes because airplanes are mostly hollow. The mass of an airplane increases more slowly than the cube of its size. A small jet, the Gulfsteam G150, has a wingspan of 17 meters and an empty weight of 6849 kg. A Boeing 747 has a wingspan of 57.6 meters, almost 3.4 times larger. Its mass, following Newcomb's thinking, should be 266,408 kg. The actual empty weight of a 747 is only 178,000 kg. So Newcomb's analysis was mathematically flawless, and useless in practice.
Are imperfect theories useful at all? All the time. They can be useful for heuristic (teaching) purposes, and they can be useful to compare theory with reality so we can try to understand why the theory differs from actual observation. And, if they're the only game in town, they can at least help us anticipate what is likely to happen. For example, hurricane path predictions, even 24 hours out, are extremely uncertain, but if there's a hurricane in the center of the Gulf of Mexico, it's very useful to know whether it's headed for Houston, New Orleans, or Tampa. Granted, a hurricane headed for Houston could make a U-turn and head for Tampa, but the odds are against it. Hotelling's theory is about on that level.
Cohen nails the reasons why Hotelling's analysis doesn't work for oil even worse than it doesn't work for anything else: "Oil has never been priced as a non-renewable resource...oil is priced as if it were soybeans, a renewable crop, or iron, for which reserves are vast and therefore not a concern." People in denial about peak oil generally adopt one of two approaches: they either assume we will always manage to find more (the soybean model) or there is so much that we will never run out (like iron).
lgyl
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