The Effect of Uncertainty on Investment: Evidence from Texas Oil Drilling

Abstract

This paper estimates the response of investment to changes in uncertainty using data on oil drilling in Texas and the expected volatility of the future price of oil. Using a dynamic model of firms' investment problem, I find that: (i) the response of drilling activity to changes in price volatility has a magnitude consistent with the optimal response prescribed by theory, (ii) the cost of failing to respond to volatility shocks is economically significant, and (iii) implied volatility data derived from futures options prices yields a better fit to firms' investment behavior than backward-looking volatility measures such as GARCH. (JEL C58, D92, G13, G31, L71, Q31)

Assessing the Energy-Efficiency Gap

“…Option value-the net benefit of delaying an investment even when the investment's net present value is positive-is a general feature of dynamic-optimization problems with uncertainty, irreversible investment, and timing flexibility (Dixit and Pindyck 1994;Kellogg 2014). Consumers and firms commonly face decision problems of this type when investing in energy-consuming durable goods with little or no resale value.…”

A General Approach to Recovering Market Expectations from Futures Prices with an Application to Crude Oil

“…For example, there is a long tradition of using oil futures prices as proxies for energy price expectations in empirical models of the purchases of energy-intensive durables, in models of the effect of uncertainty on investment decisions, and in models of the impact of regulatory policies such as automotive fuel standards and gasoline taxes (e.g., Busse,Knittel and 4 Zettelmeyer 2013; Kellogg 2014;Allcott and Wozny 2014).…”

Oil volatility risk and expected stock returns

“…Acharya, Lochstoer and Ramadorai (2013) study the interaction of volatility with producers'hedging demand and futures risk premium in the oil and gas markets. Kellogg (2014) studies how uncertainty of the economic environment, measured by implied volatility from oil futures options, a¤ects …rms'investment decision. Other recent related work includes Baker and Routledge (2012) and Ready (2013).…”