After posting this question, I realized that there was quite a bit of controversy surrounding the use of Hotelling's Rule to estimate the price of oil. Participants on this site seemed to be evenly split on the issue.

From an Economics standpoint, How helpful is Hotelling's Rule in determining the price of oil?

From my analysis, it doesn't make sense that the price of oil should depend on Hotelling's rule instead of the traditional supply and demand models.

For example, when fracking was "new," its use was limited, making the impact on the oil industry negligible. Because the amount of oil produced was small, supply (for the most part) remained constant; businesses would also be incentivized to raise prices to market levels, increasing their profit margins.
However, as fracking became more widely used, the oil entering the market increased, affecting the price of oil (and, originally, causing concern for OPEC).
Years from now, when the Middle East is out of oil, companies will shift to drilling less accessible and more expensive oil, increasing the prices of oil for the consumer. Eventually, the last barrel of the oil will either cost an enormous amount of money or will be worthless because of the rise in substitutes (solar, hydro, and wind power; electric cars).

Thoughts or other analysis?


2 Answers 2


It would be easy enough to subject the question to simple quantitative analysis - get the time-series of historical oil prices and away we go.

Or, we can take a quick qualitative approach and get the same answer:

The Rule just sets out what the most economically efficient path would be. That's nothing at all to do with how things happen in reality: it's just how things behave in textbooks for beginners. For example, it relies on an assumption of perfect foreknowledge; whereas, in the real world, we have previously-unanticipated innovation that radically changes both industry's cost structures, and the amount of known reserves - as your fracking example illustrates.


Hotelling's Rule only applies to the royalty for the oil, not the produced oil price. The price of oil is about \$60/barrel now. How much of that is royalty, and how much is extraction cost? My guess is that about \$10/barrel is the value in the ground, though I might well be wrong. In that case, it is the \$10 part that should rise at the discount rate, which means the \$60 price will rise at a much lower rate.

We must also remember that Hotelling's Rule is the same idea as that the stock market must on average rise at the discount rate. It's on average, and in any particular month, or even year, the stock market swings wildly because of unexpcted supply and demand changes.


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