ABSTRACT We develop equilibrium models of exhaustible resource markets with endogenous extraction choices and prices. Our analysis demonstrates how adjustment costs can generate oil and gas forward price dynamics with two factors, consistent with the behavior these commodities exhibit in the Schwartz and Smith (2000) calibration. Our two‐factor model predicts that stochastic volatility will arise in these markets as a natural consequence of production adjustments, however, and we provide supporting empirical evidence. Differences between endogenous price processes from our general equilibrium model and exogenous processes in earlier papers can generate significant differences in both financial and real option values.

We study the distinct impacts of own and rival actions on risk and return when firms strategically compete in the product market. Contrary to simple intuition, a competitor’s options to adjust capacity reduce own-firm risk. For example, if a rival possesses a growth option, an increase in industry demand directly enhances profits but also encourages value-reducing competitor expansion. The rival option thus acts as a natural hedge. Within the industry, we obtain endogenous differences in expected returns. In a leader-follower equilibrium, own-firm and competitor risks and required returns move together through contractions and oppositely during expansions, providing testable new predictions.