Oil is an incredibly important commodity, and investors are continually looking for methods to forecast the future price of this nonrenewable resources. In 1931, Harold Hotelling wrote a paper titled "The Economics of Exhaustible Resources" that suggests that the deposits of exhaustible resources should be viewed as an asset, just like any other income-producing investment. He wrote that because nonrenewable resources must compete with other assets there, is a systematic way to forecast their future prices.

As the world's supply of oil diminishes, supporters of the theory suggest that there is increasing rationale in evaluating Hotelling's insights into future oil prices. In this article we will explore Hotelling's theory and its criticisms to see if there is anything investors today can use when they try to predict oil prices. (For background reading on the "non" part of this nonrenewable resource, see Peak Oil: Problems And Possibilities.)

The TheoryDespite the large implications of Hotelling's theory, the hypothesis is relatively simple. It proposes that, assuming that markets are efficient and that the owners of nonrenewable resources are motivated by profit, they will only produce a limited supply of their product if it will yield more than bonds or interest-bearing instruments. Although short-term market volatility is still a function of short-term supply and demand forces, according to Hotelling, long-term prices should increase year after year at the prevailing interest rate. If oil prices, taking into consideration the cost of production and storage, didn't rise at the prevailing interest rate, there would be no restrictions on supply. If owners believed that future oil prices were not going to keep up with interest rates, then they would be better off selling as much as possible for cash and then purchasing bonds.

Conversely, if the expectations were that prices would increase faster than the prevailing rate, they would be better off keeping the oil in the ground. But because oil continues to be produced and there is no evidence of massive inventories of oil, the assumption should be that oil prices will increase at the prevailing interest rate. This theory should hold for all exhaustible resources and lead to a situation where increasing prices lead to the gradual reduction in demand and production levels until there is no supply and the resource is completely consumed. (To learn more, read What Is Market Efficiency?)

Considering the amount of published support for this theory, it is surprising that the empirical evidence and historic oil prices do not support the model. Oil has been produced since the mid-1800s, and since then, prices have been stable for most of that time (with an exception to a period in the late 1970s and early 1980s). It wasn't until 2000 that oil prices began increasing more than the rate of interest and the gradual and predictable price path described by Hotelling.

Another curious situation that contradicts the model is the price movement of oil futures. Dynamics in the oil futures markets have led to periods where future prices were below spot prices. This event, known as strong backwardation, suggests that expected future prices in real terms were falling and were not growing by the prevailing rate. When discussing future prices, one also has to consider that they include a risk component and the expectation of the volatility of spot prices. Although those opposing the theory provide too many reasons for why the model fails to discuss them all, there are some that are noteworthy and provide some insight into the model's failure and others that may support why it may hold in the future. (To discover what moves oil and why, read What Determines Oil Prices? and Become An Oil And Gas Futures Detective.)

In the next section we will examine some of the common criticisms and problems with Hotelling's theory.

CriticismsAlthough Hotelling's theory has many followers, it has generally failed to hold up historically. Opponents of the theory have multiple reasons for dismissing its precepts, suggesting that the impact of alternative energy sources and other energy-related market factors cause the model to fail. Using oil as an example, one can look at both supporting and contrarian positions to decide whether this theorem is viable for predicting the value of future nonrenewable commodities.

  • Production Costs - One fact that the opposition uses to contradict the model is that it does not take into consideration the changes in production costs due to the cost of extraction, technological change or market view on supply limitations. The theory assumes that the marginal cost of production increases irrespective of the stock being produced ,which means it does not take into consideration the cumulative effect of oil already produced. Oil producers have suggested that the cost of production, specifically extraction costs, increases as wells are drilled deeper to reach ever-diminishing supply.
  • Levels of Quality - Another disregarded fact is that oil, as well as other resources, varies in quality. Real-world experience suggests that less expensive grades are produced first, once again leading to increasing extraction costs with the reduction of stock supply. In both cases, the cost and future price of the resource would not follow a gradual and predictable path.
  • Technological Advances - A trend that is not taken into consideration is the rate of technological change and its effect on production costs and price. It also doesn't take into consideration the advent of new renewable energy sources, their cost of production and prices, and their effect on nonrenewable resources. Innovation and technological progress should improve the extraction capacity of producers and decrease extraction costs and prices over time. Technological progress in the production of solar, wind and other substitutes for oil will also affect prices if they significantly reduce demand or provide these resources profitably and competitively with petroleum products.

Another theory suggests that future oil prices can be calculated as a function of the production costs of substitutes. Take solar energy for example: If we assume that a barrel of oil is equal to 5.8 million BTUs of energy (equivalent to 1,700 kilowatt hours of electricity) and solar power can be produced at some price between 30 cents and 50 cents per kilowatt hour (kWh), then buyers of energy could replace oil with solar power at a barrel equivalent price of between $510 and $850 (1,700 x 0.3 and 1,700 x 0.5). The idea here is that oil prices will continue to rise until the price of oil and other substitutes hit price equilibrium, at which point the supply of oil will be exhausted and users will switch to the alternate energy source. This hypothesis also assumes rising prices, but it does not necessarily expect them to be gradual or predictable.

One explanation for the criticisms and problems with Hotelling's theory is that it is only since the beginning of this century that the market has viewed oil as an exhaustible resource. For the period where oil prices remained stable, new sources of oil were being discovered as fast as it was being consumed. The market reacted as if that trend would continue - as if there wasn't a limited supply of oil. The rapid increase in price witnessed since 2000 may not infer a price "bubble" but a price effect due to transition as the market changed its view of oil from renewable to nonrenewable.

In concert with this transition have been the highly publicized scientific estimates of when the oil reserves will run out. Even with the advances in locating and estimating supply, there is still significant disagreement in scientific circles of when this doomsday event will occur. Supporters of the Hotelling theory would advocate that as prices adjust to the transition and increases in concerns about the scarcity of oil, prices will begin to increase at the prevailing interest rate and follow the path predicted. (Find out how to invest and protect your investments in this slippery sector in Peak Oil: What To Do When The Wells Run Dry.)

ImplicationsIt is clear that oil reserves should be considered an asset and that their value and the decision to extract them must consider competitive investments. Whether they will increase at the prevailing interest rate is yet to be seen. There is, however, an indication that as the market continues to concern itself with the scarcity of oil, the Hotelling theory may provide investors with insight into future oil prices. Regardless of what camp one is in, the theory is worth additional review and worth being part of a set of analytical models as the market continues to search for the definitive forecast of future oil prices.

Before jumping into this hot sector, check out Oil And Gas Industry Primer.