To hedge or not to hedge

Navigating through the hedging maze

Larry Hickey, FRM, Sapient Global Markets, London

There are several theoretical reasons why oil and gas producers might want to hedge. All that's missing is hard evidence that it works: that hedging actually adds value.

Hedging, by definition, reduces the risk of a portfolio. So extreme outcomes are less likely, which among other things, might help risk-averse managers sleep better at night. But does it add value to the firm?

A subtle point has to be made. The intent of a hedge is to reduce risk, not make speculative profits. We're not asking if hedging is a profitable trading strategy. Individual hedges may be winners or losers, like red or black bets on a roulette wheel. We're asking a more basic question. Does hedging, through any of several mechanisms, make the firm itself more valuable? Should we be playing roulette at all?

Thou shalt not worship false idols

The hedge dogma is well entrenched. Many companies hedge. A 2009 hedging study of 38 small to mid-sized independent crude oil and natural gas producers found 41% regularly hedge their production and only 29% never hedge. This is in line with a 2005 study of 119 oil and gas producers between 1998 and 2001 which found that 45% of oil producers and 54% of gas producers hedged.

In terms of exposures, 33% of oil and 41% of gas production was hedged. In both cases, medians were lower than these averages. So the bigger players were hedging more. The same is true of the global airline industry which hedged 50% on average of its fuel needs in 2008. There must be a reason.

In a perfect market, hedging would neither create nor destroy value. Investors could hedge themselves for free. So they would be unwilling to pay a premium for the firm to do the same thing. But perfect markets don't exist. The real world features a range of frictions that might provide a value maximizing rationale for hedging.

Taxes

Such as taxes. If making two in one year and zero the next generates less after-tax income than making one each year, the firm is incentivized to reduce net income volatility. Graham and Rogers looked into this proposition in a 2001 study and rejected it. Carter, Rogers, and Simkins reached the same conclusion in 2003. A meta-study in 2003 looked at 15 studies and only two showed a significant relationship between taxes and hedging.

Leverage

Lower earnings volatility also enables the firm to use greater leverage. Graham and Rogers found that hedging firms were able to increase their debt ratio by 3% leading to a 1.1% increase in firm value. But the validity of these results was called into question by other researchers in 2003. What is beyond dispute is that there is a significant relationship between hedging and leverage. Put simply, highly leveraged firms hedge more, perhaps in response to restrictive loan covenants. But this doesn't prove that hedging actually adds value through leverage.

Bankruptcy

Hedging reduces distress costs. Distress costs are the extra costs incurred by a bankruptcy or even the threat of a bankruptcy. The hedged firm is less likely to enter bankruptcy and incur these costs. If true, smaller firms, which are more likely to experience distress, should be expected to hedge more. But that's not the case. We've already seen that large firms hedge more, perhaps reflecting the high fixed cost of a risk management program.

Rigs and rights on sale for a song

Hedging may help relieve the problem of underinvestment. In a boom and bust business cycle, investment opportunities may be negatively correlated with cash flow. In other words, everyone is broke when the fire sale happens. But the hedged firm will be in a position to buy distressed assets.

This was famously the case with Southwest Airlines which hedged up 95% of their fuel exposure up to 2009 and was able to continue profiting and growing when fuel prices were rising in the 2000s. A 2003 study of the airline industry estimated the hedging premium at a 12% to 16% increase in firm value and attributed it to this issue.

Mike Corley, a long-time energy and risk management consultant and president of Houston-based Mercatus Energy Advisors, recounts the story of a family-owned, Oklahoma-based oil and gas producer that hedged conservatively. "The company would sell 70% of PDP forward for the front year, 40% for the second, and 20% for the third. When gas prices collapsed two years ago, with MidCon wellhead under $3, the company approached owners of adjoining leases offering a modest premium to the market. That premium was possible because they were hedged at $8 in a sub-$3 market." This anecdote perfectly demonstrates the concept. But anecdotes are not empirical evidence, and there is no published study which supports this claim for oil and gas producers.

On balance, there is no compelling evidence to support the proposition that hedging adds value to oil and gas producers specifically. Over the years, a number of studies have looked at the question of whether hedging adds value to the firm. The results are mixed. A sampling have been stripped of their nuance and presented below. Note that the three studies that focused on oil and gas producers are all in the nay column. (See accompanying table.)

One consistent observation is that the big guys hedge more than the little guys. "They're called wildcatters for a reason," quips Corley. "Traditionally, smaller operators tend to hedge less."

Hedging even affects those who don't hedge. The non-hedging producers face increased market volatility. Hedging effectively disconnects some participants from the market price. So there are fewer remaining participants to match supply to demand and greater price swings are required. It's like trying to steer a ship with a smaller rudder.

Commenting on this "producers-on-autopilot" phenomenon, Ed Burns, a seasoned commodities broker with Energyshop.com, notes that "Hedging leads to over-production when prices fall. Many gas producers are hedged at $6 or $7 from three years ago. So they continue to happily produce into a $3 market."

If we can't find a compelling rationale for hedging using the value maximizing model, perhaps we should take a closer look at the folks making hedging decisions.

"Understand the incentives that apply to senior management and you will understand the resulting hedging decisions," notes Corley, whose company produced the 2009 hedging study of small to mid-sized independent crude oil and natural gas producers that found 85% to 100% of hedging decisions are made by company managers. The 15% range depends on whether the board and/or hedge committee is independent of management.

Personal utility maximization for managers

Managers have a highly concentrated exposure to their firms. It's an exposure that is different from that of owners. While owners can quite easily diversify their holdings, managers can't. By virtue of working for one firm, managers are generally unable to work for others. So much of their wealth is tied to the fortunes of one company. This can breed risk-averse behavior, such as hedging. Theoretically, if hedging is being undertaken due to managerial risk aversion, it should have no effect on the value of the firm.

Incentives

Consider the extreme case of company manager, Mr. Flat. Flat receives a salary but no bonus or stock options. Flat does not like any risk and hedges everything. As he has no upside participation, he can only lose with volatility. At another company, Ms. Long is paid in stock options. Long loves risk. She hedges nothing and in fact would do a Texas hedge if they let her. Her personal wealth is positively correlated with volatility.

And this is exactly the dynamic we see. Rogers (2002) showed that firms whose managers are incentivized to take risk hedge less. Chen, Jin, and Wen (2008) show that hedging is negatively correlated with management option holdings. In short, incentives matter.

Interestingly, stock and options do not have the same impact on managers' behavior. Tufano (1996) found that managers who hold stocks hedge more and those who hold options hedge less. This makes sense because stock comes with both an up and downside. But options only have the upside. So volatility is the option-holder's friend.

To hedge or not to hedge

So what is the owner of an oil or gas producing company to do? As is usually the case, we're forced to make a decision with imperfect information. Like the issue of an optimal debt to equity ratio, the value of hedging remains an open question. Academics have developed a number of plausible rationales for why hedging might add value to oil and gas producing firms. But none have withstood contact with the buzzsaw of real-world markets.

Allow me a digression about a man and an ox. Francis Galton, a half cousin of Charles Darwin, visited a livestock fair in 1906 and happened upon an intriguing contest. An ox was on display and the villagers were invited to guess the animal's weight after it was slaughtered and dressed. Almost 800 submitted guesses and no one nailed the exact answer of 1,198 lbs. But the average of the guesses was pretty close: 1,197 lbs. The average was closer than the estimates of most villagers and closer than any of the estimates made by experts.

Maybe we can look to Galton's ox for one data point. You are not alone in trying to solve the hedging problem. Like the villagers at the fair, all of your competitors are trying to answer the same question. There is likely to be solid information in their average answer – the industry norms which were quoted earlier. At the same time, we know there is a systematic bias in the numbers. The presence of managerial risk aversion means that the average is likely to be too high. So if your hedge ratio is above the average of similarly leveraged firms, you should probably reduce it.

Between the average hedge ratio and zero, the answer is less clear cut. We've cited three studies focused on oil and gas firms which conclude that hedging does not add value. We are also aware of a bias that can at least partially explain the observed levels of hedging. Whatever your firm's hedge ratio, there is no evidence that you should raise it and some evidence you should reduce it.

How to steer your hedge ratio

Chen, Jin, and Wen (2008) show that executive compensation policy is like a dial that can be used to align the interests of owners and managers. To reduce hedging, reduce management's ratio of salary to total compensation. Put simply, issue more options to managers, preferably out-of-the-money options. In-the-money options can look an awful lot like stock.

After strutting and fretting my hour upon this stage, I will dither no longer. Alas, anon, my dear Ophelia….Not to hedge.

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