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Review of Quantitative Finance and Accounting
Published in: Review of Quantitative Finance and Accounting 1/2020

22-01-2019 | Original Research

On the Market Timing of Hedging: Evidence from U.S. Oil and Gas Producers

Authors: Liu Hong, Yongjia Li, Kangzhen Xie, Claire J. Yan

Published in: Review of Quantitative Finance and Accounting | Issue 1/2020

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Abstract

Using a hand-collected data, we provide evidence of extensive use of commodity derivative in hedging among U.S. oil and gas producers. We find large variations in hedging intensity and hedging profits while on average they generate significant positive profits. The profits relate positively to the intensity of hedging. We further decompose the hedge ratio into two components: the pure hedging component and the market timing component. We find that the hedging profits relate strongly and positively to the market timing component. We also identify a group of firms that can consistently generate profits from their hedging activities. Among firms who actively change their hedging positions, the winners tend to be larger firms. The hedging outcome does not increase equity beta while the pure hedging component tends to decrease equity beta. The positive profits are exclusive for the commodity derivative transactions of the oil and gas producers, while they do not profit from their interest rate or foreign exchange derivative transactions.
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Appendix
Available only for authorised users
Footnotes
1
The literature has proposed several channels for hedging to affect shareholder value including reducing cost of financial distress (e.g., Stulz 1984), tax saving (e.g., Smith and Stulz 1985; Graham and Smith 1999), alleviating under-investment (e.g., Froot et al. 1993), product market competition (e.g., Zhu 2011), and changing information environment (e.g., Lin et al. 2017). Smith (2008) provides a survey on corporate risk management. However, the empirical evidence is mixed; see a review paper by Aretz and Bartram (2010). Bodnar et al. (2016) use survey data and find that managerial risk aversion plays a role in the decision to hedge.
 
2
Since the literature also uses terms such as “selective hedging” and “speculation” for market timing hedging, we use these terms interchangeably in our paper.
 
3
Although the effective date for FASB 161 is the fiscal year beginning after Nov 15, 2008, most firms in our sample also reported the profits from the use of derivatives in 2007.
 
4
We do not claim that all firms use non-hedge accounting for market timing activities, as Demarzo and Duffie (1995) suggest that the choice of hedge accounting may also be affected by information asymmetry and career concerns. Lin and Lin (2012) show a non-linear relationship between hedging decision and information asymmetry. On the other hand, hedge accounting may cause mismatch of accounting period between the underlying transaction and the corresponding hedging transaction. A firm may not choose hedge accounting due to the earning-smoothing preference (e.g., Zorzi and Friedl 2014; Frestad 2018). The association between the use of non-hedge accounting and market timing activities is an empirical question, on which we provide some evidence.
 
5
For example, a firm lists its outstanding derivatives contracts that would be in effect from January 2010 in the 2009s annual report. These derivatives positions are actually scheduled to hedge the oil and gas production in fiscal year 2010 and forward and hence are used to calculate the portfolio delta in 2010. The portfolio delta is then scaled by the production in 2010. Chen et al. (2003) utilize a theoretical approach to derive the optimal futures hedge ratio. We empirically study the actual hedge ratio of oil and gas producers by examining the actual hedging activities conducted by these firms. Besides, our hedge ratio calculation considers all types of derivatives including non-linear derivatives while Chen et al. (2003) only consider the futures contract. Chen et al. (2003) show that the effectiveness of a hedge increases with the hedge horizon. We leave this topic to future exploration.
 
6
The tables are not reported in the paper to save space and are available upon request.
 
7
Out of the 397 observations, several firms only report “net of tax gains or losses.” We address the tax issue by calculating the firm-year’s corporate income tax rate and adding back the taxes to its gains and losses.
 
8
These numbers are not obtained by multiplying the mean and median of total profit in Panel A of Table 2 by the mean of asset in Panel B due to the normalization.
 
9
We use cash ratio instead of liquidity because we find cash has stronger effect.
 
10
Some recent papers studying this industry include Bakke et al. (2016), Kumar and Rabinovitch (2013), Manchiraju et al. (2013), Mnasri et al. (2013) and Ranasinghe et al. (2013).
 
11
If, however, the derivative position is classified as a fair value hedge, profits will be recognized in earnings when the profits occur. Since fair value hedges are typically applied to commodity inventories and are rare in the energy industry, we find that almost all hedges in our sample are cash flow hedges.
 
12
The results of this test and other related tests using Relative Notional Production are all similar to the results using Relative Delta Production.
 
13
Abadie et al. (2017) shed some insights on this issue. They conclude that “if there is no heterogeneity in the treatment effects, one need not adjust standard errors for clustering once fixed effects are included”. Hence, our use of two-way clustering is on the conservative side.
 
14
We also run the tests with non-hedging firms and our results are similar. We do not report the results because our main tests focus on the relationship between derivative profits and hedge ratio. Adding the non-hedging firms simply adds zeros to both sides of equation since zero hedge ratio immediately implies zero profit. Hence, we think it is inappropriate to add them in our sample.
 
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Metadata
Title
On the Market Timing of Hedging: Evidence from U.S. Oil and Gas Producers
Authors
Liu Hong
Yongjia Li
Kangzhen Xie
Claire J. Yan
Publication date
22-01-2019
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting / Issue 1/2020
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-019-00790-y

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