REXAMINING THE HOTELLING VALUATION PRINCIPLE: Empirical Evidence from Canadian Oil and Gas Royalty Trusts

The Hotelling Valuation Principle (HVP) implies that the in situ value of a unit of a non-renewable resource is equal to current price less the cost of extraction. The required assumptions for this principle are strongly violated in the oil and gas industry, but despite this, results from previous research are mixed, with studies based on market data supporting the principle, and those based on basin-aggregate data rejecting the principle. To address problems with the data choice in previous studies, we test the HVP using market data on Canadian oil and gas royalty trusts. Unlike previous studies using market data for conventional oil and gas compa-nies, our results tend to reject the HVP and we generally find market value to be significantly less than that predicted by the principle. The re-duced value is explained by a significantly negative response to a real op-tion to expand (proxied by a call option on oil and gas prices). These findings are consistent with the argument that in the period of rising oil prices that we consider, (2000–06), the net extraction price is high rela-tive to its expected future growth, but production constraints prevent firms from fully exploiting the high price