Economic rent is excess income earned from a resource over the amount that is required to maintain the production and use of the resource.
Economic rent is thus very relevant in oil markets and specifically details the extra income—positive spread—earned from oil extraction and sales over operational costs and investments.
Private price taking firms that produce oil earn rent because oil is a fundamentally valuable and scare resource with low-elasticity demand and [comparatively] high barriers to entry.
Rent is measured as the difference between marginal cost and marginal revenue, as firms will produce up to the point of marginal cost equaling marginal revenue, with price equaling marginal cost + rent and MC = MR detailing this point of marginal cost equaling price (rent = 0).
A reference list of these critical equations and points is available at the end of this article.
The value of rent significantly rises over time, while rent itself must theoretically decline over time (over a long time) since oil is a nonrenewable. Short-term, factors like technology, discovery, market demand and prices, and resource depletion affect the movement of rent.
Meanwhile, as time goes on, prices should get higher and production should fall each year, again given that oil is a nonrenewable resource.
Assuming that individual firms maximize the net present value of rent, production changes the fastest in an economy whereas demand for oil is insensitive to price.
Generally, lower elasticity means that firms have a greater ability to move price without a corresponding drop-off in demand, and thus basic optimization problems allude to a net gain from increasing prices in a low-to-no elasticity environment.
However, thus far we have assumed a competitive environment.
For monopolists, rent and profit as a whole generally reflects opportunity cost as well as marginal cost, since firms can set prices above marginal cost. Monopolists will as a rule produce less than competitive markets because they’re purely seeking profit (+ rent) as opposed to other factors like maintaining competitiveness and market share. This is reflected in a residual, concave down demand curve.
Thus, in a competitive market, prices will go down over time and production will increase over time, while in a monopolist-governed market, prices will stay relatively high as per constrained production inflating demand.
Competitive markets generate greater social welfare because they simply allocate resources better than monopolists; at scale, proper resource allocation is the difference between lower costs, higher rent for productive producers and individuals, greater supply and availability, and other factors that increase social welfare.
Here’s a quick rundown of the rent-related concepts we’ve covered:
Produce until MC = MR if price is a given (price taker).
Price = MC + rent.
Value of rent rises over time because of stock constraint.
Price = MC + rent.
Rent today = present value of rent tomorrow.
Total stocks = extraction today + extraction tomorrow.
Firms control rent by choosing how much to produce; they increase rent by producing less, maximized at the MC = AC curve.
Rent increases over time, price changes, production decreases.
Thanks for reading!
To learn more, consider reading about PADD Districts, the Why WTI and Brent are Crude Oils, and Why There are Price Differences Among Crude Oils, and my Oil & Gas Terms Guide.
