Aggressive Oil Extraction and Precautionary Saving: Coping with Volatility

The effects of stochastic future oil prices on optimal oil extraction paths and optimal tax, spending and government debt policies are analyzed when demand for oil is linear and preferences quadratic. Without prudence, optimal oil extraction is governed by the Hotelling rule and optimal budgetary policies by the tax smoothing principle. With prudence, the government depletes oil reserves more aggressively and engages in precautionary saving financed by postponing spending and bringing taxes forward, especially if it has substantial monopoly power on the oil market, gives high priority to the public spending target and is very prudent, and future oil demand has high variance. If the oil market is fairly competitive, prudent governments deliberately under-estimate oil reserves and under-predict future oil prices. This leads to less aggressive oil depletion and less government saving. However, if the government attaches high priority to raising public spending to its bliss level, prudence implies a tendency to over-predict future oil prices and reserves which induces more aggressive oil depletion and more government saving. Uncertain economic prospects induce precautionary saving and more aggressive oil extraction.