The corporate use of derivatives to hedge energy price risk

Despite a number of studies testing the theories to explain corporate hedging with derivatives, the lack of detailed data on firms' compensation has limited the specification and power of tests and consequently leaves the hedging question largely unresolved. Using recently available, detailed data on firms' use of derivatives to hedge energy price risk and a sample well-suited for academic research, the oil and gas exploration and production (E&P) industry, this study improves the specification and power of tests on corporate hedging. In particular, this research creates a measure of the extent a firm hedges that is likely to be more precise than proxies used by most other research. In addition, while most research uses proxies of the convexity or risk-taking incentive effect of options held by managers that are noisy, this paper employs a more precise convexity-based measure based on the Black-Scholes (1973) model.; This paper makes four main contributions. First, results provide little support for the shareholder wealth maximization theories to explain corporate hedging with derivatives. In a test of whether there is a relation between firm value and hedging with energy price derivatives, this study fails to find a statistically, significant relation between hedging and firm value. This finding contradicts the Allayannis and Weston (2001) study, which finds firms that hedge with currency derivatives tend to have higher firm values. Second, this paper documents some support for the theory that hedging is value-increasing because it provides liquidity. Third, this study is one of the first to document a negative, relation between hedging and convexity or risk-taking incentive effect of options held by managers. This result is consistent with the managerial private utility maximization or risk-aversion theory. Finally, because of the unique nature of the oil and gas E&P industry, this paper creates a measure of the riskiness of a firm's yearly investments that is likely to be more precise than proxies used in prior studies. Results document a statistically significant, positive relation between the riskiness of investments projects and the risk-taking incentive effects of stock options held by managers.