Petroleum Economics: Issues and Strategies of Oil and Natural Gas Production.

by ROGNVALDUR HANNESSON. (Westport, CT: Quorum Books, 1998), 163 pages. ISBN 1-56720-220-9.

This is a short book of high quality. Rognvaldur Hannesson prepared it from a course in petroleum economics he has given for several years at the Norwegian School of Economics and Business Administration. Chapter

1 reviews the vital role of oil in industrial countries. Hannesson rightly states "Oil in modern society is like blood in the human body. Without it modern society as we know it would cease to exist." Chapter 2 discusses world markets for oil, natural gas, and coal. Here Hannesson analyses substitution among fossil fuels induced by changes in their relative prices. He reviews world trade in oil and gas, and the heavy dependence of the United States, Western Europe, and Pacific Asia on imported oil. Of course the Middle East is the largest oil exporting region, followed by Africa and the Former Soviet Union. The international market for natural gas is much smaller than that for oil, and Hannesson explains why. He also reviews the geographic distribution of oil and gas reserves and production. In 1996, the Middle Eastern countries held 65% of the world's oil reserves, North America (including Mexico) 8.3%, South and Central America, 7.6%, and Western Europe a scant 2.0%.

Chapter 3 focuses on natural gas. Hannesson clearly spells out the costs of transporting natural gas by pipeline and in liquified form over varying distances. Average and marginal costs increase linearly with increasing distance.

How do unit costs vary with different volumes shipped a given distance? Most of the cost of transporting gas by pipeline is fixed capital cost. In the United States, for example, fixed costs of acquiring land and laying the pipeline account for more than 90% of total transportation costs. The consequence is straightforward: Declining average fixed cost combines with decreasing average variable cost of larger volumes to create a natural monopoly in gas transmission. These cost conditions create an opportunity for transmission companies to charge their customers a two-part tariff: The first fee is the customers' payment to use the pipeline (an access fee); the second is payment for shipping costs.

As a regulated monopoly, a pipeline company sold a "bundle" of services to its customers: transportation, storage, and the gas itself. However, as gas markets have become deregulated in the United States and United Kingdom, pipeline companies were required to unbundle these services to make clear what costs are due to transportation, storage, and the gas itself. Hannesson discusses in clear English and then in simple linear models how unbundling has been achieved and how it works.

Chapter 4 is devoted to oil production. Here Hannesson sets forth the physical principles that cause a given reservoir's oil production rate to decline. He includes a lucid explanation of general hyperbolic decline curves, and their special cases: harmonic and exponential decline. He briefly touches on the effects of rock permeability, oil viscosity, and declining reservoir pressure on the oil production rate. Hannesson also analyses the common property problem when oil in a given reservoir can be produced from wells located on different people's land. If land ownership above an oil reservoir is fragmented, each landowner has an incentive to drill fast and produce hard. This practice of "stealing your neighbors' oil before he steals yours" is wasteful, because it prevents maximum recovery of oil originally in place.

Chapter 5 discusses Hotelling's model of production and price for an exhaustible resource, but with far gentler math than in Hotelling's original work. Hannesson rigorously derives the familiar Hotelling rule (with no new discoveries): the price of the exhaustible resource will rise over time according to the real rate of interest. He then carefully explains the reasons why this elegant theoretical result is seldom found in real world markets.

Chapter 6 centers on ways used by governments to tax oil (gas) production: license fees whose values can be determined by competitive bidding; royalties; and taxes on private firms' profits from production. His case study of Norwegian petroleum taxes is a model of clear writing. Chapter 7 is a crystal clear essay on proper management of a petroleum fund designed to benefit a region's inhabitants. Proper management boils down to creating inter-generational equity. Oil and gas produced today cannot be produced in the future. So how can the rents obtained from producing these depletable resources today be invested in physical capital and education that will benefit future generations as well as today's? Hannesson explains how, using as an example the Alaska Permanent Fund.

Rognvaldur Hannesson has written a first-class book for economics and business students. He covers a wide range of important topics. His writing is admirably succinct. And because of succinctness, the book is short. The next time I teach an energy economics course, Hannesson's Petroleum Economics will be the main text.

John R. Moroney Texas A&M University