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

Despite widespread acceptance and application of real options theory in the economic literature, little empirical work has attempted to assess the extent to which firm behavior accords with the theory’s prescriptions. In particular, it is not well-known whether, or by how much, firms actually delay irreversible investments following an increase in the uncertainty of their economic environment. In this paper, I estimate firms’ responsiveness to changes in uncertainty by combining detailed data on the drilling of oil wells in Texas with expectations of future oil price volatility that I derive from the NYMEX futures options market. Using a dynamic model of the firms’ investment problem, I find that oil production companies significantly reduce the number of wells they drill following an increase in expected price volatility. Moreover, the magnitude of the effect is consistent with the optimal response prescribed by theory. ___________________________ Department of Economics, University of Michigan, and NBER. [email protected]. I am grateful for financial support from the OpenLink Fund at the Coleman Fung Risk Management Center. I thank Maximilian Auffhammer, Ruediger Bachmann, Bob Barsky, Severin Borenstein, Lutz Kilian, Kai-Uwe Kühn, Jeffrey Perloff, Matthew Shapiro, and Catherine Wolfram for helpful comments, as well as seminar and conference participants at Duke, the International IO Conference, Ohio State, Tulane (Energy Institute), UC Berkeley (Haas), the UC Energy Institute Summer Camp, and the UM IO lunch. I thank Reid Dorsey-Palmateer, Tay Feder, and Haili Pang for excellent research assistance.