This post was written by HEC-Montréal professor Simon van Norden
With changes to environmental review processes, I get the feeling that the Harper government is keen to speed up development of the Oilsands. That’s not particularly odd. Oil prices tripled and Canada is sitting on the second largest reserves in the world; the Canadian dollar now rises and falls with the price of oil. Development of this resource has the potential to have an important effect on Canadian GDP for many years.
So let me try to argue that speeding up resource production in response could be a very bad idea. Let me try to argue that we should think hard about doing exactly the opposite, even if it lowers GDP growth, because delay may make us wealthier.
Just to be clear, I’m going to ignore any possible arguments about environmental impacts, native land claims or social issues. I’ll ignore market failures and labour shortages, transport bottlenecks, etc. for now (I’ll come back to that at the end) so I can focus narrowly on the economics of resource extraction in a simple world with perfect markets. I’ll use the Oilsands as an example, but the argument applies generally to non-renewable resources: oil, gas, mining, forestry (in Canada, we don’t farm trees – we mine them) and forget about hydro power and agriculture for today. I also want to focus on resource extraction: exploration that adds to our known stock of reserves seems like good thing, as do new technologies that make extraction more efficient.
For argument’s sake, suppose we have a pipe in the ground that spews oil and we have a valve that controls the flow rate. (If you prefer, you can suppose we have gold bars buried in our basement that we can dig up as wanted.) The more we open the valve, the more oil we produce, the more we increase real GDP. Is opening that valve wide a good idea? Could it be a very bad idea?
I think it depends on our wealth. In this case our wealth depends on the profit stream that our well can produce. Because we’ve got a non-renewable resource, opening the valve wider means we’re producing more barrels of oil today, but fewer in future. It seems to me that we really want to be asking the question “Would we prefer to pump oil today or tomorrow?”
The advantage of producing oil now is that we can earn interest (i) on the revenue it generates. However, it also means that we get today’s price of oil for our barrel instead of tomorrow’s. If that oil price is expected to grow at rate g (g<>0), then delaying production by one period costs us roughly i-g. The higher the interest rate, the more delaying our oil revenues is costly. The higher the expected growth rate of oil prices, the better it is to wait and pump our oil in the future to get a higher price for it. So the key question should be, is i<>g?
At this point, many economists invoke Hoteling’s Rule. Harold Hoteling argued back in the 1930s that non-renewable resources should be produced at the rate where their expected price increase g equals the rate of interest i. That makes a lot of sense if you’re looking at the world market and you want to understand how the market should clear. That’s not the question I’m asking. I’m assuming that Canada is small relative to world markets; we take the market price as given. (Probably a bad assumption for natural gas, better for oil and good for gold.) For that matter, I think it’s probably a bad idea to assume that all countries face the same i and g; interest rates have not moved similarly across major economies in recent years, and expected changes in real exchange rates mean that g isn’t necessarily the same. So, as I said above, I think the key question should be, is i<>g?
I’m not sure what the answer to that question is. Consider oil: if I’m looking long-term, the govt.’s 2010 survey of long-term oil-price forecasts showed the average outlook was for just over 1% growth, with more bullish forecasts going up to 2.3% and bearish ones around -1.2% (all in real terms.) Meanwhile, the Bank of Canada tells me that the yield on long-term government real-return bonds is about 0.5%. On that basis, some could argue that we should shut the value for now. I’m not sure that’s right because I think the right interest rate should be higher than that. Our long-run forecasts of oil prices are very uncertain, so I think we need to add a risk-premium to that govt. bond yield.
And that’s where I think the debate the needs to be. How bullish are we about the long-term prospects for oil (or gold, etc.) prices? How uncertain are we? What kind of premium should we be using to adjust for that risk? The more bullish you are on oil for the long-term, the more likely that you should want to delay production. The more uncertain or risk-averse you are, the more you should want to produce immediately. That same logic applies to gold mines, forestry developments and any other non-renewable resource.
Has anyone heard this debate? Me neither. I don’t think we’ve had to think seriously about this trade-off for a long time because it seemed pretty clear that i>g. But both seem to have shifted in recent years. Most have raised their estimates of g as demand pressures from industrializing BRICs made themselves felt. Just after this took place, the financial crisis caused a profound shift in real interest rates, dropping rates in favoured countries (including Canada) to new lows. The result, as I think I’m made clear, is that there can be doubt was to whether we should favour current production or prefer to “save” our resources for a better day.
Now, to make my argument simple, I’ve ignored some real-world factors that may complicate things. Perhaps most importantly, I’ve assumed that anything we don’t produce today we can produce tomorrow; the implicit trade-off is 1-for-1. If it isn’t, that skews our decision. If we think current production is less efficient than future production (due to supply bottlenecks or expected technology improvements), that makes delaying or smoothing production more attractive. If we instead expect that the resource will decay if we wait (think of trees killed by pine beetles), we may prefer to produce now. I’ve also ignored demand elasticity by assuming that g isn’t affected by our production choices. Where it is (Alberta heavy oil might be this year’s poster child for this problem), that gives an additional incentive to shift production over time to avoid glutting the market.
At this point, someone is bound to argue that a competitive and free market will take into account all these factors and guide us to the wealth-maximizing solution. I can think of three factors that might prevent that.
- If investors are overly concerned with short-term corporate performance rather than long-term wealth creation, managers will respond with too much production in the short-term.
- If the supply bottlenecks or demand elasticity factors I mentioned above are important, they operate at the industry level. Perfectly competitive firms will ignore such factors as beyond their control, causing too much production in the short-term.
- Our politicians understand that we don’t vote on the basis of wealth creation; we’re more easily swayed by GDP growth and employment growth. I think Alberta politicians who are bullish on oil long-term and would therefore advocate a “go-slow” approach to the resource sector would be buried at the polls. I think much the same would happen in pretty much any democracy I can think of. That gives politicians a strong incentive to encourage short-term expansion rather than long-term wealth creation. Usually that’s not a big difference; non-renewable resources may be an exception.
This post was written by HEC-Montréal professor Simon van Norden