DRILL BABY DRILL? THE EFFECT OF UNCERTAINTY ON INVESTMENT

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 firms’ investment problem, I find that oil production companies significantly reduce the number of wells they drill following an increase in expected price volatility, and preliminary results further suggest that the magnitude of the effect is consistent with the optimal response prescribed by theory.