Financial distress around introduction of hedging in the oil and gas industry.
Iqbal, Zahid
I. INTRODUCTION
The shareholder wealth maximization hypothesis of hedging suggests
that hedging can increase firm value by reducing expected taxes (Mayers
and Smith, 1982; Smith and Stulz, 1985), by reducing underinvestment
problem in the presence of costly external financing (Froot et al.,
1993), and by reducing expected cost of financial distress (Mayers and
Smith, 1982; Smith and Stulz, 1985). (1) To empirically test these
arguments, prior studies examine several determinants of hedging with
mixed results. For example, Gezcy et al. (1997) show that firms that
have high financial leverage are more likely to use derivatives to avoid
costs of financial distress. Tufano (1996) and Mian (1996), on the other
hand, find little support for the financial distress argument. One issue
not examined in prior studies is the behavior of these determinants
around the time derivative instruments are first introduced. It is quite
possible that the firm implemented hedging in response to high leverage
and that leverage subsequently decreased as part of the firm's
overall hedging policy. Hence, the difference in leverage may not be as
pronounced between the hedge and nonhedge firms after hedging is
adopted.
This study fills the gap in the risk management literature by
examining the hedging indicators around the time financial derivatives
are first introduced by a firm. (2) Specifically, we examine the
determinants of financial distress around the introduction of derivative
instruments in the oil and gas industry. According to Mayers and Smith
(1982) and Smith and Stulz (1985), hedging reduces the probability that
a firm encounters financial distress. Prior empirical studies identify
several indicators that can reduce these expected costs, and hence have
an impact on hedging decision. Some of the key financial distress
indicators are the firm's financial leverage (Nance et al., 1993;
Gezcy et al., 1997; Haushalter, 2000) and short-term liquidity (Gezcy et
al., 1997; Haushalter, 2000).
Our study focuses on the oil and gas industry which is subject to
significant price risk as observed in prior studies (Scholtens and Wang,
2008; Mohanty and Nanda, 2011; Gogineni, 2010). This industry has been
experiencing extreme price volatility ever since the oil embargo in
1973. Although Haushalter (2000) examines hedging data for the oil and
gas firms, it is not known whether the hedge firms are financially
distressed around the introduction of derivative instruments.
Our results suggest that the hedge firms have higher debt than the
nonhedge firms in the years immediately before derivative instruments
are first used. There is no evidence of high leverage in the three years
following the introduction of hedging. We also find evidence that the
dividend payouts and the number of firms paying dividends are higher in
the year and immediately after hedging is first introduced.
The rest of the paper is organized as follows. The next section
provides background information, followed by descriptions of the sample
in section III and the empirical results in section IV. Concluding
remarks are given in section V.
II. BACKGROUND
A. Oil Price Risk
Prior studies show that volatility in oil and gas prices impacts
earnings and stock returns in the oil and gas sector. Gogineni (2010)
shows that the oil and gas industry is sensitive to unexpected movements
in oil prices and Scholtens and Wang (2008) find that oil stock returns
are positively correlated with crude oil prices. According to Mohanty
and Nandha (2011), oil price risk exposures of the U.S. oil and gas
companies are generally positive and significant.
To hedge price risk, many oil and gas companies implement risk
management strategies as evidenced in prior empirical studies
(Haushalter, 2000; Jin and Jorion, 2006). In his sample of 100 firms,
Haushalter (2000) finds that 43 firms hedged in 1992, 49 hedged in 1993,
and 57 hedged in 1994. Also, these firms hedged 32.2 percent of
production in 1992, 29.6 percent in 1993, and 28.4 percent in 1994. In
Jin and Jorion's (2006) study, hedging of oil and gas price risk
occurred during 106 out of 330 firm-years.
B. Financial Distress and Hedging
Prior studies identify specific benefits that induce firms to
hedge. One of the benefits is reduction of expected costs of financial
distress. Mayers and Smith (1982) and Smith and Stulz (1985) indicate
that a reduction in the variability of cash flows and firm value reduces
the expected costs of financial distress. Some of the expected costs
arise from deterioration of long-term relationships with suppliers and
customers during periods of financial distress. As a consequence, firms
with high leverage and low liquidity should have greater incentives to
hedge their risks.
C. Financial Leverage
Nance et al. (1993) state that the magnitude of the reduction of
expected costs is a positive function of the probability that financial
distress will occur which is directly related to the amount of financial
leverage. Hedging and financial leverage are related because both affect
the probability of financial distress. Hence, the higher the level of
debt, the greater the need to hedge firm's risk. Empirical study by
Dolde (1995) reports a positive and significant relationship between the
use of hedging instruments and financial leverage. Haushalter (2000)
examines hedging activities of the oil and gas producers and finds that
debt ratio is positively related to the percentage of production hedged.
Using a sample of New Zealand firms, Berkman and Bradbury (1996) observe
that hedging activities increase with debt ratio. These results are
interpreted as evidence that high expected costs of financial distress
cause firms to use more derivatives. Mian (1996) and Tufano (1996), on
the other hand, find no evidence of any relationship between hedging and
expected costs of financial distress. Mian's (1996) findings show
no difference in book-value of debt to market-value of firm between the
hedgers and the nonhedgers. Using book-value of debt to market-value of
firm as a proxy for financial distress, Tufano (1996) also finds a weak
support for the financial distress argument.
D. Short-Term Liquidity
Nance et al. (1993) argue that firms can reduce the expected costs
of financial distress by maintaining a high level of short-term
liquidity. More liquid assets or low dividend-payout ratios help assure
bondholders that funds will be available to pay fixed claims.
Froot et al. (1993) contend that short-term liquidity ensure that
the firm has more internal funds that reduces the need for costly
investment and financing alternatives in the face of variable cash
flows. Hence, hedging is less valuable when the firm has more short-term
liquid assets. Gezcy et al. (1997) find that the users of currency
derivatives have lower quick ratio values than that of the nonusers.
Their logistic regression results indicate a significantly low
probability of using currency derivatives for firms with high quick
ratio. Haushalter's (2000) study shows that the hedgers in the oil
and gas industry have higher dividends when compared to the nonhedgers.
E. Empirical Predictions
Based on the above discussions, we propose the following empirical
predictions in our study. Hedge firms are likely to have higher leverage
than nonhedge firms when they first introduce derivatives. Also, since
low short-term liquidity increases the expected costs of financial
distress, hedge firms are likely to have lower short-term liquidity than
nonhedge firms around the time derivatives are first introduced.
III. SAMPLE
This study examines financial distress around the introduction of
derivative instruments in the oil and gas industry. To accomplish our
research goal, an initial sample of 482 firms is obtained from the
Compustat Research Insight database of which 310 firms are in the crude
petroleum and natural gas production and exploration business (SIC
1311). The remaining firms belong to drilling, oil field services,
refining, and other oil and gas related businesses. From the initial
sample, we identify hedge firms by searching sections 1A and 7A of the
SEC Edgar 10-K and DEF-14 filings for information related to hedging
during 1994-2010. (3) Hedging is defined as the use of futures, options,
swaps, and fixed price contracts for non-trading purposes. Here are some
excerpts on hedging provided in the 10-K reports: "Anadarko uses
derivative commodity instruments to hedge the Company's exposure to
changes in the market price of natural gas and crude oil and to provide
methods to fix the price for natural gas independently of the physical
purchase or sale". "Berry Petroleum has periodically entered
into bracketed zero cost collar hedge contracts on a portion of its
crude oil production with California refiners to protect the
Company's revenues from potential price declines".
Of the 482 firms, 107 reported use of derivative instruments for
commodity hedging purposes in their SEC filings. We use two methods to
identify the year when derivative is first used for hedging. The first
method requires that hedging be reported at least one year after the
first SEC filing. (4) For example, if the first filing for a firm was
1996, and use of derivatives was first reported in 1998, we classify
1998 as the introduction year for the firm. We identified introduction
years for 18 firms using this method. For the remaining 89 firms, we
search the financial statements on the Compustat Research Insight
database to determine financial data on hedging prior to the first SEC
filing. Examples of hedging or derivative data are, "hedging",
"gains/losses on commodity derivatives", "derivative
instruments", "derivative assets", "derivative
liabilities", "fair value of derivatives", etc. We
identified data on hedging for 31 firms using this second method. Thus,
our final samples consist of 49 hedgers with an introduction year.
For comparison purposes, we pair each hedge firm with a firm from
the nonhedge sample by the 4-digit SIC code and by total assets in the
introduction year. A breakdown of the samples by 4-digit SIC code and
total assets in Table 1 shows that, of the 49 hedge firms, 40 belong to
the crude petroleum and natural industry (SIC 1311). The mean asset size
of the hedge sample is $2.87 billion while that of the non-hedge sample
is $3.43 billion. The mean asset size of the crude petroleum and natural
gas firms (SIC 1311) for both the hedge and nonhedge samples is around
half a billion dollars.
IV. EMPIRICAL FINDINGS
To gain an understanding of when the oil and gas firms first
introduced hedging, we provide a breakdown of the hedge sample in
relation to the movements of the price of crude oil. We collect monthly
West Texas Intermediate (WTI) prices from January 1994 to December 2010
from the Haver Analytics database. For oil price, we utilize adjusted
real oil price that is similar to the measure used by Davis and
Haltiwanger (2001). The real oil price is computed as the nominal WTI
price divided by producer price index for all commodities. Davis and
Haltiwanger (2001) argue that a change in real oil price can be a
reversal of a previous change which may not represent unexpected shocks
in the oil market. To address this, they propose adjusting the real oil
price, computed as the log of real WTI price divided by weighted average
of real WTI prices in prior sixty months (five years), with weights
summing to one and declining linearly to zero. This adjusted measure
produces significant change in oil price relative to the average price
over the past five years.
Figure 1 shows that 35 of the 49 hedging introductions in the oil
and gas industry (roughly 71 percent) occurred during a 9-year period
from 2000 to 2008. There are about 4 introductions per year. The
remaining 14 introductions occurred during 8 years in 1994-1999 and
2009-2010. In relation to the direction of oil price changes, 28
introductions occurred during the years when real WTI price declined,
and the remaining 21 introduction occurred during the years when real
WTI price rose. These data suggest that more firms introduced hedging
during falling oil prices. One possible reason is that, since most of
our sample firms belong to the oil and gas extraction industry (SIC
1311), hedging is more valuable for these firms during periods of
falling oil prices when revenue declines than during periods of rising
oil prices when revenue remains steady.
[FIGURE 1 OMITTED]
Table 2 presents data on financial leverage for the hedge and
nonhedge firms. Three measures of leverage are used. We use coverage
ratio following Nance et al. (1993) and Gezcy et al. (1997), long-term
debt ratio following Gezcy et al. (1997) and Haushalter (2000), and
total debt ratio following Nance et al. (1993). Mian (1996), and Tufano
(1996). Coverage ratio is computed as earnings before interest and taxes
to interest expenses. Long-term debt ratio is computed as the book-value
of long-term debt to firm size (defined as market value of equity plus
book-value of total debt and book-value of preferred stock). Total debt
ratio is book-value of all debt to firm size. Based on the empirical
predictions on leverage discussed earlier, we predict lower coverage
ratio, higher long-term debt ratio, and higher total debt ratio for the
hedge firms than for the nonhedge firms.
Panel A of Table 2 presents mean and median values of coverage
ratio from year -3 to year 3, with year 0 being the year of
introduction. The results in Panel A show that there is no difference in
coverage ratio between the hedgers and the nonhedgers in any of the
years from year -3 to year 3, except for the mean value in year 0. The
overall findings on coverage ratio are, therefore, not adequate to
conclude that the hedgers have higher leverage any time before or after
the derivative instruments are introduced.
Panel B of Table 2 presents the results on long-term debt ratio.
The results show that the hedge firms have higher long-term debt than
the nonhedge firms primarily in the three years prior to the
introduction year. The mean or median values of long-term debt for the
hedgers are significantly higher than that of the nonhedgers in years
-3, -2, and -1. For example, the hedger's mean value is roughly
41.54 percent while the nonhedger's mean value is roughly 23.33
percent in year -1. The results clearly show that the hedgers are highly
leveraged prior to the introduction year. In contrast, the data show
that the mean or median values of the long-term debt ratio of the
hedgers in the introduction year and three subsequent years are no
different from that of the nonhedgers. Overall, our findings of higher
long-term debt prior to introduction support the argument that hedging
occurs due to financial distress in prior period. Following the
introduction, it appears that the long-term debt decreases to a normal
level and becomes no different from the debt level of the nonhedgers.
Panel C of Table 2 provides mean and median values of total debt
ratio. The results are similar to that of long-term debt ratio. We find
that the hedgers are more leveraged than the nonhedgers prior to
introduction. In year -3, both mean and median values of the hedgers are
significantly higher than that of the nonhedgers.
Overall the results in Table 2 suggest that oil and gas firms
introduce derivatives in response to higher debt levels. The findings
that there is no difference in financial leverage between hedgers and
nonhedgers after introduction are consistent with that of Tufano (1996)
and Mian (1996), but inconsistent with Gezcy et al. (1997) and
Haushalter (2000).
Table 3 provides results on short-term liquidity. Following Gezcy
et al. (1997) and Haushalter (2000), we use quick ratio and dividend
payout ratio to measure short-term liquidity. Quick ratio is computed as
cash and short-term investments divided by current liabilities and
dividend payout ratio is computed as dividends divided by net income. We
predict that the hedgers have a lower quick ratio and a higher dividend
payout than the nonhedgers.
The data in Panel A of Table 3 show that the mean values of the
quick ratio for the hedgers are lower than that of the nonhedgers in
years -1, year 0, and year 1. Additionally, there is no difference in
median quick ratio between the hedgers and the nonhedgers.
Panel B of Table 3 provides the mean and median values of dividend
payouts. Although the majority of the oil and gas firms did not pay
dividends around introduction, out results show that the hedgers have
higher dividend payouts than the nonhedgers primarily in the year of
introduction and in subsequent years. For example, mean payout is 47.11
percent for the hedgers and only 5.48 percent for the nonhedgers in year
0. To provide a meaningful analysis of the dividend data, we examine the
percentage of dividend paying firms. The results in Panel C show that
the percentage of hedge firms paying dividends is significantly higher
than the nonhedge firms in year 1, year 2, and year 3.
Our results in Table 3 are generally consistent with those in prior
empirical studies (Gezcy et al., 1997; Haushalter, 2000) that hedgers
have higher dividends. The payouts and number of firms paying dividends
are higher primarily in and after the introduction year.
V. CONCLUSIONS
The purpose of this study is to examine the financial distress
indicators around the time oil and gas firms introduce derivative
instruments. We examine leverage and short-term liquidity from three
years before to three years after the introduction of derivative
instruments during the period, 1994 - 2010. The findings of our study
will provide further evidence whether hedging is motivated by financial
distress, specifically in the oil and gas industry.
Our data indicate that the hedgers have higher debt than the
nonhedgers in the years immediately before derivatives are used. The
level of debt decreases for the hedge firms and is no different from
that of the nonhedge firms beginning year 0. We also find that
short-term liquidity is lower for the hedge firms as compared to the
nonhedge firms. The dividend payout and the number of firms paying
dividends increase in the year of introduction and in subsequent years.
The findings of our study are consistent with prior findings that
the hedgers in the oil and gas industry experience financial distress.
The debt ratio indicator is more pronounced before the introduction of
derivative instruments and dividend payout indicator is more pronounced
in the year of introduction and in subsequent years.
Zahid Iqbal
Department of Accounting and Finance, Jesse H. Jones School of
Business Texas Southern University, Houston, TX 77004
[email protected]
ENDNOTES
(1.) Another hypothesis is based on the agency theory that focuses
on managerial incentive to manage risk (e.g., Stulz, 1984).
(2.) We recognize that a risk management program is more
comprehensive than the use of derivative instruments for hedging.
(3.) The earliest year of the SEC filings reported on Edgar is
1994. For many firms, the first filings are available on SEC Edgar after
1994.
(4.) For firms whose derivative activities are reported in the
first year of filing, we could not determine if hedging is introduced in
the filing year or in a prior year.
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Table 1
This table provides a breakdown of the samples
Sample N
Initial Sample 158
Deletions:
Not on SEC Edgars (1994-2010) 14
Introduction of hedging could not be determined 58
Final Sample 49
Final Sample - by 4-digit Hedge Firms
Industry and Asset Size
Assets (in
millions
of dollars)
N Mean
Crude Petroleum and Natural Gas (SIC 1311) 40 490.42
Drilling Oil and Gas Wells (SIC 1381) 1 698.64
Oil and Gas Field Services (SIC 1389) 3 5,492.92
Petroleum Refining (SIC 2911) 2 47,000.00
Special Industry Machinery (SIC 3559) 1 133.92
Petroleum Bulk Stations (SIC 5171) 1 2,210.01
Engineering Services (SIC 8711) 1 671.98
Total 49 2,872.60
Final Sample - by 4-digit Nonhedge Firms
Industry and Asset Size
Assets (in
millions
of dollars)
N Mean
Crude Petroleum and Natural Gas (SIC 1311) 40 501.04
Drilling Oil and Gas Wells (SIC 1381) 1 837.24
Oil and Gas Field Services (SIC 1389) 3 9,002.80
Petroleum Refining (SIC 2911) 2 58,000.00
Special Industry Machinery (SIC 3559) 1 136.10
Petroleum Bulk Stations (SIC 5171) 1 1,859.47
Engineering Services (SIC 8711) 1 360.49
Total 49 3,426.23
Table 2
This table reports the leverage ratios for the hedge and
nonhedge oil and gas firms. Year 0 is the year of
introduction of hedging
Nonhedge Firms Hedge Firms
Year N Mean Median N Mean Median
Panel A: Interest Coverage
-3 27 4.03 1.47 21 14.63 4.63
-2 35 16.76 3.26 25 18.09 3.25
-1 37 30.88 2.89 29 2.77 4.85
0 39 11.95 2.89 39 1.05 (a) 2.15
1 41 5.01 2.27 43 13.35 2.60
2 41 1.85 2.01 44 2.66 1.43
3 41 4.71 2.70 46 8.72 3.62
Panel B: Long-Term Debt to MV of Assets (%)
-3 31 22.25 10.05 13 51.51 (c) 59.58 (c)
-2 36 24.69 15.56 16 43.53 (b) 25.64 (a)
-1 35 23.33 10.72 22 41.54 (b) 27.18 (a)
0 38 27.69 20.88 28 32.80 19.14
1 43 27.25 22.07 33 35.14 24.39
2 44 29.05 24.55 38 30.73 22.53
3 44 29.68 24.53 39 33.06 24.46
Panel C: Total Debt to MV of Assets (%)
-3 31 32.77 22.55 18 57.02 (b) 64.60 (b)
-2 36 33.86 24.45 30 56.65 (b) 64.40 (b)
-1 38 39.11 19.80 36 54.06 61.30 (a)
0 39 33.41 21.80 44 40.48 24.70
1 43 32.77 23.85 44 35.64 24.00
2 44 34.57 25.45 47 33.17 23.80
3 44 33.83 25.45 48 35.19 26.45
(a) Significantly different from the mean or median of
the nonhedge firms at the 0.10 level.
(b) Significantly different from the mean or median of
the nonhedge firms at the 0.05 level.
(c) Significantly different from the mean or median of
the nonhedge firms at the 0.01 level.
Table 3
This table reports the short-term liquidity ratios for the hedge
and nonhedge oil and gas firms. Year 0 is the year of introduction
for the hedge firms and the year of the first major decline in
oil price for the nonhedge firms
Nonhedge Firms Hedge Firms
Year N Mean Median N Mean Median
Panel A: Quick Ratio (1)
-3 36 3.62 1.12 23 1.00 0.89
-2 39 5.05 1.28 29 1.45 1.02
-1 43 2.51 1.21 33 1.52 (a) 1.17
0 43 2.36 1.06 43 1.40 (a) 1.02
1 45 1.74 0.91 46 1.20 (b) 1.04
2 45 1.65 0.96 47 1.06 0.94
3 45 1.28 0.84 48 0.98 0.86
Panel B: Dividend Payout (%)
-3 33 4.21 0.00 23 9.14 0.00
-2 36 3.92 0.00 27 5.52 0.00
-1 38 3.69 0.00 34 12.92 (a) 0.00
0 37 5.48 0.00 41 47.11 (a) 0.00 (a)
1 38 2.35 0.00 40 23.49 (b) 0.00 (a)
2 37 1.85 0.00 41 31.28 0.00 (a)
3 36 17.01 0.00 42 61.62 0.00 (b)
Panel C: Number and Percentage of Firms Paying Dividends
Number Percentage Number Percentage
-3 33 4 12.12 23 6 26.09
-2 36 5 13.90 27 5 18.52
-1 38 5 13.16 34 9 26.47
0 37 7 18.92 41 12 29.27
1 38 5 13.16 40 11 27.50 *
2 37 4 10.81 41 10 24.29 *
3 36 4 11.11 42 13 30.95 *
(a) Significantly different from the mean or median of
the nonhedge firms at the 0.10 level.
(b) Significantly different from the mean or median of
the nonhedge firms at the 0.05 level.
* Pearson Chi-Square significant at the 0.10 level.
