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ECN 125 Energy Markets Spring Quarter 2015 Problem Set 1 Due April 21 Professor Rapson Your problem set is due either to Jim's mailbox in the...
Problem 1You own a small pipeline that transports crude oil from Canada to the US. Yours is one of many such pipelines (which we’ll label “S”, for small) operating in this competitive market, each of whose cost is $3/bbl (barrel). There are two other ways to export crude oil from Canada’s tar sands as well. The cheapest way is via a large pipeline (“XL”), whose cost is $1/barrel, and the most expensive way is by rail (“R”), with a cost of $4/barrel. Total capacity of XL, S, and R are 10, 40, and 30 MMbbl/day (millions of barrels per day), respectively. Assume that the market is perfectly competitive, and that there is no entry or exit.US demand for Canadian oil is perfectly inelastic at 35 MMbbl/day in the winter, and 55 MMbbl/day in the summer.1.1: On an annual basis, do you expect your pipeline to be profitable? Explain.1.2: Suppose the marginal cost of all S-type pipelines (including yours) increases to $3.25/bbl, and the cost of R increases to $4.50. In the short-run, are these changes likely to raise your annual profits, lower your profits, or have no effect on your profits?1.3: The XL pipeline encounters political resistance, and is forced to shut down for one month. Would this affect your profits more if the outage occurred in the winter, when demand tends to be fairly low, or in the summer when demand is higher?1.4: Now suppose that you run an oil refinery in the US, and your only option is to buy oil from one of these Canadian exporters. Your refinery demands the same amount of oil on all days of the year, but the overall market is the same as in parts 1-3 above. If the marginal cost of the XL pipeline increases (if, say, environmentalists successfully lobby for a tax on XL oil), would that harm you more if it occurred in the winter or during the summer?Problem 2Consider the optimal extraction problem associated with an exhaustible resource, such as oil or natural gas.2.1: Discuss the main results of the Hotelling model outlined in class. Under what assumptions does this model hold?12.2: Suppose marginal cost of extraction is 6, the market price in period 1 is 10, the price in period 2 is 12, and the interest rate is 20%. Is the rate of extraction equal to, higher, or lower than the optimal rate? Show your work and explain the intuition behind your answer.2.3 The figure below plots oil and natural gas prices over the past 40 years, or so. The Figure also plots oil and natural gas “futures” prices, that is the prices of oil and natural gas sold at some future date. (The royal blue curved and dotted lines that begin in around 2012 are the futures prices.) So, for example, if I buy a 2020 futures contract for a barrel of oil, I am entitled to take delivery of that barrel of oil in 2020.Discuss whether these future prices are consistent with the Hotelling model described in class. If so, why? If not, what might explain the inconsistency? Note: specific calculations are not required.Figure 1: Oil and gas spot market and futures prices
