Modeling Peak Oil and the Geological Constraints on Oil Production

Abstract

Geological constraints are considered in the context of a Hotelling type extraction-exploration model for an exhaustible resource. It is shown that such constraints, in combination with initially small reserves and strictly convex exploration costs, can coherently explain bellshaped peaks in natural resource extraction, and hence U-shapes in prices. As production increases, marginal profits (marginal revenues less marginal extraction cost) are observed to decline, while as production decreases, marginal profits rise at a positive rate that is not necessarily the rate of discount. A numerical application of the model to the world oil market shows that geological constraints have the potential to substantially increase the future oil price. While some non-OPEC producers are found to increase production in response to higher oil prices induced by the geological constraints, most producers’ production declines, leading to a lower peak level for global oil production.

Keywords: Peak oil, Hotelling rule, Exploration, Reserve development, Accelerated depletion

JEL Classification: Q30, Q47, C61, C7