Hotelling Under Injected Pressure : An empirical study on the price responsiveness of waterflooding in US oil production

Abstract

Harold Hotelling's (1931) canonical model of exhaustible resource extraction, featuring resource-owners that maximize profits by trading off extraction today versus extraction in the future, is widely cited in the literature. However, the mapping of Hotelling's logic to empirical work in the energy literature has been a limited success. To bridge this gap, Anderson, Kellogg & Salant (2018) aim to show that a Hotelling model for oil production and drilling can generate empirical predictions consistent with market observables. They find well-level oil production (the intensive margin) in Texas to be unresponsive to the oil price, while drilling activity (the extensive margin) responds strongly. Hence, they reformulate Hotelling's model as a drilling problem where resource-owners choose when to drill, but the oil flow is restricted by reservoir pressure. Our thesis aims to contribute to the literature by showing that resource-owners in fact do manipulate oil production on the intensive margin by injecting water to increase reservoir pressure. We first graphically analyze how oil production and the drilling of new wells respond to crude oil prices in the US between 2000 and 2020. We find that production declines monotonically over time for a stock of existing wells and that firms respond to increasing crude oil prices by drilling new production- and water injection wells. These findings are in line with current literature. However, we also find that the oil production curves for wells that have injection wells nearby do not decline monotonically. We then proceed to develop an expression for the marginal cost of water injection and a function for optimal water injection volumes. Using this function, we estimate a fixed-effect linear regression model and find that water injection volume responds to oil prices, adding to the current economic literature. Our findings indicate that firms leverage their ability to manipulate oil production on the intensive margin by injecting water in response to oil prices. The evidence contradicts a central assumption made in the model proposed by Anderson, Kellogg & Salant (2018).