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Introduction to Petro Economics:

Industry Structure
Geographical Setup of India
Theory of Exhaustible Resources
Hotellings Principle
Peak oil theory
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The search for oil in the country began way back in

1866 when Mr Goodenough of Mckillop Steward
company drilled a well near Jaypore in upper Assam
and struck oil. However, he could not commercially
exploit this discovery.
In 1899, the Assam Railway and Trading Company
(ARTC) which had obtained exploration rights in the
same area, struck oil at Digboi making the beginning
of oil production in India.
Subsequently, the Assam oil company (a wholly
owned company of ARTC) sold its rights to the
Burmah Oil Company. But the exploration and
production activities confined to the North East until
the middle of the 20th century.
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Exploration

for oil in the upper Assam shelf

was recommenced after the Second World War
and large-size oilfields were discovered at
Nahorkatiya and Moran in 1953 and 1956,
respectively.

At

the same time, the Government sought advice,

aid and collaboration from a number of foreign experts.

Technical

assistance was also obtained during

this period for carrying out aero-magnetic
surveys over Rajasthan, Punjab, UP and Bihar
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In August, 1956, ONGC was set

up and assigned the

task of planning, promoting and implementing
programmes for exploration and exploitation of
petroleum resources in the country.

In 1959, Burmah Oil Company and the Government of

India formed a joint sector company Oil India Ltd. It
became a wholly owned public sector enterprise in
1981.

Indian Refineries Ltd. and Indian Oil Company were

set up in 1958 and 1959 to take up refining of oil and
marketing of petroleum products respectively. These
were later merged to form Indian Oil Company (IOC)
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Two Major Activities:

Exploration & Production of crude oil

& gas Upstream

Refining, Distribution & marketing Downstream

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Oil Companies are grouped into:

Exploration & Production ONGC, OIL, companies
in JV with NOCs. ONGC & OIL conduct exploration
activities across the country and in the territorial waters

Refining plus marketing - IOC, BPCL, HPCL

have their own refineries and also market petroleum
products
Pure refining - Kochi Ref. Ltd., CPCL both
subsidiaries of IOC do not have any marketing rights &
their products are marketed by marketing companies
Pure marketing IBP now a subsidiary of IOC
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The upstream oil and gas sector is characterized

by high commercial risks, upfront financing
exposure
and commitments necessitating high
premium
on
stable relationships
with
Government and partners. In the context of
domestic upstream sector, some other typical
constraints are:

Stagnant production level

Rapidly rising oil import bill
Increasing maturity of production acreage
Large unexplored/less explored terrain
Requirements of large investments
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The government has decided at present to provide

more openings for the private sector in exploration.
Two critical inputs - technology and finance can be
provided by the private sector.
Oil production from old and depleting fields may
be sustained over longer periods by applying suitable
enhanced oil recovery techniques
Large investments need to be made to commence
production on a large scale.
Production levels from existing wells cannot be
increased beyond a certain point.
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According to one estimate about US$60 billion will

be required in exploration, drilling and development
activities over the next 10 years.

The Indian acreages have the capacity of absorbing

this order of investment and the government is
encouraging private sector participation with attractive
fiscal and contract terms in the exploration and
production sectors.

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With

the acceleration of exploration activity in

India, increased opportunities are available to
foreign and domestic companies in the area of
oilfields goods and services.

The existing facilities will be grossly inadequate to

meet many times higher demand, in future.

Opportunities are available to foreign companies

to form joint ventures with domestic companies to
provide oil field equipment and services to the
national oil companies as well as to private
companies operating in India.
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The sedimentary basins of India, on land and offshore,

have an area extant of about 1.79 million sq.km. So far, 26
basins have been recognized and they have been divided into
four categories based on their degree of prospectivity.

In the deep-waters the sedimentary area has been estimated to

be about 1.35 million sq. km. The total thus works out to 3.14
million sq. km. of which about 32% is totally unexplored.

Based on the surveys, in unexplored/ poorly explored areas

of the country especially Deep waters off west coast, east
coast and in the Andaman Sea, blocks were carved out and
offered under various rounds of NELP for exploration of oil
and gas. As a result, unexplored areas have been reduced
from 50% to 32%.
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Classification of Sedimentary Basins:

Category I - these are proved petroliferous with
commercial production. 6 basins fall under this
category.

Category II - these are geographical forms with

known occurrences of hydrocarbons but from
which no commercial production has yet been
obtained. 6 basins fall under this category.

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Classification of Sedimentary Basins:

Category III - these are those in which significant
shows of hydrocarbons have not yet been found but
are found to be of highly perspective. 2 basins fall
under this category.

Category IV these are those in which analogy with

similar hydrocarbon producing basins in the world,
are considered to be the perspective. 12 basins fall
under this category.
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Renewable
replaceable naturally

OR

by human activity
Examples of renewable resources include
trees and other plants, animal
populations, groundwater, etc.

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Non-Renewable Resources
are those that are not replaceable OR

replaced so slowly by natural/artificial

processes that for all practical purposes not
available again within any reasonable time
frame

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Economists add another dimension to this

distinction between renewable and nonrenewable resources

For an economist non-renewable resources

not only have a fixed stock, they are also in
limited supply relative to the demand for
them
Thus, old growth trees with life span as much
as 1000 years while renewable, may be
classified as non-renewable due to their
relatively slow growth
to maturity
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Similarly, coal would be considered nonrenewable by some, but most resource

economists consider it renewable due to the
vast remaining stock

According to some estimates at current rates of

consumption of 1 billion tons, it is estimated to
last 3000 years.
From an economic perspective there is no
immediate coal scarcity simply due to its fixed
stock - as if it were renewable.
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The central question in non-renewable resource

economics is:
Given consumer demand and the initial
stock of the resource, how much should be
harvested in each period, so as to maximize
profits?

Hotelling Principle
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Assume

no extraction costs and

focus on the price

per unit P - of the resource in the market

that the real (inflation adjusted) risk free

interest rate on investments in the economy is
R per cent per year
Thus, one can either extract the resource now or
hold on to & extract in the future
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NOTE:

Any amount of the resource extracted today will not

be available in the future

And any resource left untouched today may fetch a

higher price in the market in the future

These are the two fundamental factors

influencing my extraction decision

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If I extract the resource today I can invest the

proceeds and earn R per cent year

However, if I expect the price of the resource

to rise faster than R per cent per year, then it
would make sense to hold on to the resource
What I would do is forgo the interest earned on the
proceeds but earn a higher total income by selling the
resource at a higher price per unit
The opposite argument would hold if the resource
price was expected to rise slower than R per cent
per year
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In a competitive market each resource owner

would be faced with the same options & would
follow the same logic
Result:
The result is that in this market the quantity
extracted will be such that resource price will
rise at exactly R per cent per year

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If it were to rise slower, resource owners

would begin to sell off current stocks & the
current market price would fall

If the resource price were to increase at a rate

faster than R per cent per year, all owners of
the resource would hold on to their stock

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An implication of the continuously rising price

is that the quantity extracted would be
continuously falling until such time as the
resource is exhausted

As the price rises the demand for the

resource is slowly choked off

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Eventually, the price would be so high that

the demand would be eliminated altogether
This is precisely when the resource stock
would also be completely exhausted
Price of a non-renewable resource in a
competitive market would rise at the
interest rate
That the production trajectory would
be monotonically declining till the resource
is exhausted - Harold Hotelling
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Thus, under competitive market conditions,

the price of oil should be expected to rise at
a rate R, the rate of interest
H. Hotelling is widely acknowledged to be the founder
of the theory of exhaustible resources .He based his
work (1931) on the groundwork of L C Gray (1914)
For close to 4 decades his work almost went
unnoticed.
This theory was rediscovered in the 1970s and made
famous by a seminal article by R M Solow
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Hotellings Law states that:

If production costs are negligible, the
price of an exhaustible resource increases
at a rate equal to the real rate of interest (or
discount rate)

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If the price of the resource were stable or increasing in

anticipation at a rate less than discount rate: It would be
in the producers interests to produce as fast as possible
If it were growing at a higher rate: Producers would hold
back from producing as this would increase the
discounted value of future receipts

The only price behaviour which produces

market equilibrium is that which gives a stable
value for the present value of future receipts

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So what happened to the world crude oil market, if

we try to see through the perspective of Hotelling?

Logically the prices of non-renewable

resources should be rising at a constant
rate & we would be approaching depletion
In general however oil prices after 1973 have
been volatile but not increasing
In fact from the period 1949 to 1973, they have
been highly smooth and have seen a stable
decline
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So then whats happening?

To better understand the peak oil theory, it is
important to look at the concept of Oil

depletion rate
Depletion & rate of depletion and decline & rate
of decline have separate & precise meaning

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Depletion of a reservoir refers to the

decrease in the amount of oil contained in
the reservoir

Decline of a reservoir refers to the decrease

in the rate of oil production in the reservoir

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Depletion & production decline are

strongly influenced by advances in
technology
Development & deployment of technology
has allowed oil to be produced from areas
that were previously uneconomic

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This has:
increased the amount of oil that can be
economically recovered from existing fields

led to an increase in resources and can help

offset decline
To examine the impact of decline on
production & investment, a distinction is made
between the observed decline rate and the
natural or cashless decline rate
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Cashless decline rate is the decline in

production that would be observed in the
absence of additional investment to sustain
production
Examples: additional drilling and enhanced
secondary & tertiary recovery techniques

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The discussion on the oils depletion rate and/or the

peak oil theory always follows a period of high oil
prices
Oils worldwide depletion rate has attained an
importance that extends well beyond the confines of
the oil companies E&P departments
Although it seems straightforward, depletion as a
concept is not easy to pin down. The very use of
the word depletion implies that oil resources are
being run down & that one day they will dwindle
into insignificance.
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Oil resources may well become insignificant in the

years to come

But it is not certain whether this will be due to

their physical exhaustion
or to the world moving away from oil
and towards another source of energy

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Peak oil has its foundations in the work by

Dr M. King Hubbert and, more recently, by oil
industry veterans, C.J. Campbell and J.H.
Laherrre
The focus of the depletionists is on the
production peak which, it is reasoned, can be
predicted from the discovery peak
The depletionists estimate that the rate of
discoveries are declining & hence that a
dramatic decline in oil production may be just
around the corner
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The mainstream response to concerns of oil

depletion is that oil has been running out ever
since the beginning of the oil industry 150 years
ago

Reserves have grown, rather than shrunk,

over the recent decade
Interestingly the major International agencies
do not share the depletionists concern

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History of failed projections:

Year

Prediction

Source

1914

A decade

1920

20 billion remaining

1922

US has only 20 years

US Bureau of
Mines
US Geological
Survey
USGS

1926

4.5 billion

US FOCB

1932

10 billion

US FOCB
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History of failed projections:

1944

20 billion

Petroleum Administrator for

War

1950

100 billion

American Petroleum Institute

1951

13 years
left

Interior Dept US

1977

Next
decade

Jimmy carter

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