Work-in-Process: Please do not Cite or Share without permission

This paper explores how the strategies that companies use to hedge the volatility in input costs influence their output pricing (pass-through) behaviour and competitive interactions in the output market. In industries with large dependence on inputs with volatile prices, companies often engage in risk management practices such as natural hedging (vertical integration, alliances) or financial hedging (future contracts, derivatives). When competitors within the industry use different risk management practices, the result is volatile heterogeneity among competitors in terms of accounting costs of inputs and resources. We explore how such heterogeneity is transferred to competitive interactions in the output market, in the context of fuel hedging in the U.S. airline industry. Although textbook economics suggests that firms should deploy resources based on opportunity costs, not historical (accounting) costs, we observe some correlation between hedging windfalls and aggressive pricing. Interestingly, we observe asymmetric treatment in situations of hedging losses, where firms tend to write off the losses rather than recovering them in their price. We also find that the aggressive effect of hedging is more prevalent for firms with growth opportunities, and less prevalent for firms with dominant market positions. The results are consistent with the view that hedging allows firms to invest in growth opportunities when they would otherwise be limited by financial constraints, but also suggests that asymmetric hedging in the market can contribute to the intensity of rivalry. Work-in-Process: Please do not Cite or Share without permission 3 Strategic Impact of Input Hedging on Output Markets: Do Hedging Windfalls Make Firms More Aggressive? According to the “resource based view” (RBV), strategy involves a process of acquisition of resources and development of capabilities, and their deployment to serve opportunities in output markets (Rumelt, 1984; Dierickx and Cool, 1989; Makadok, 2001). Theoretical development in the RBV emphasizes the importance of factor markets as markets where companies acquire the resources necessary for the implementation of strategy (Barney, 1986). However, in contexts of environmental uncertainty, the value of resources obtained in factor markets may change from the time that the company acquired the resources under uncertainty (ex-ante) to the time when those resources are to be deployed (ex-post). Such difference between the exante acquisition costs of resources and their ex-post value in use represents “entrepreneurial rents” (Rumelt, 1987). For instance, a pharmaceutical company may acquire control of a biotech compound development undergoing clinical trials. The ex-ante value of the compound will reflect the uncertainty about development. However, after the development process, the ex-post value of the compound will be either greater (if successful) or lower (if not) than the ex-ante value. In another example, Mittal Steel’s strategy of consolidation of the steel industry led the company to invest in substantial mining capacity for iron ore (a critical input in steel production). The acquisition price of the mining capacity reflected ex-ante market expectations, and Mittal stood to gain (or lose) if market evolution led to higher (or lower) market prices for iron ore. This difference between ex-ante and ex-post value of resources in factor markets underlies Barney’s famous dictum that, in the absence of imperfections in factor markets, firms can obtain above average returns by buying Work-in-Process: Please do not Cite or Share without permission 4 resources only if they are lucky or have superior expectations (Rumelt, 1984; Barney, 1986). One area that has received little theoretical and empirical elaboration is the economic deployment of resources. Indeed, even for companies that successfully acquire resources in factor markets, there remain some choices about their effective deployment in supporting alternative strategies. In particular, when resources are fungible and rivalrous in use (i.e., their deployment in one activity limits their deployment in other activities), such resources may be allocated among alternative internal or external uses (Penrose, 1959; Levinthal and Wu, 2010). Such alternative deployments constitute the opportunity cost of the resource. For example, the pharmaceutical company that successfully develop the patent for a biotech compound may decide to sell the patent, license the manufacturing rights to other companies, or produce the drug internally. Similar, if the value of iron ore appreciates, Mittal may choose to sell its iron ore mines, sell iron ore in the spot market, use the iron ore internally for steel production, or keep the iron ore in the ground for future use. Prescriptive research in the RBV emphasizes that, regardless of the acquisition (or historical) costs (AC) of resources, resources should be allocated to activities that will generate returns above the opportunity cost (or economic cost) of resources, where the opportunity costs (OC) represent the value generated in alternative uses (Cool, Almeida Costa and Dierickx, 2001; Lippman and Rumelt, 2003; Levinthal and Wu, 2010). Indeed, an important step in economic analysis of strategy is the evaluation of OC in order to measure the economic profit created in different activities (Besanko et al, 2013). Cool, Almeida Costa and Dierickx (2001) warned that accounting profits generated in the resource acquisition stage (difference between AC – representing exante valuations – and OC – representing ex-post valuation) may create a “hidden cross-subsidization” that biases resource deployment decisions towards less effective Work-in-Process: Please do not Cite or Share without permission 5 uses. Such deployment may imply a reduction of economic profits, even if accounting profits remain positive. Our paper seeks to explore the connection between resource acquisition accounting outcomes (profits or losses) and resource deployment decisions. To the best of our knowledge, this is a topic that has been discussed in the theoretical RBV literature (mainly in a prescriptive term) but has not been explored empirically. Therefore, this is an important step to advance factor market theory into more practical (and empirically testable) applications. We do so by leveraging the unique context of hedging. Hedging (whether done through financial instruments or real investments) is one important risk management tool to mitigate the fluctuations in economic and financial variables that have destabilizing effects on firm strategies and performance, and ensure that a firm has the cash available to make value-enhancing investments (Froot, Scharfstein & Stein, 1994). Natural hedging (such as Mittal’s acquisition of iron ore mining capacity) and financial hedging (buying derivatives and futures) involve making ex-ante acquisitions of volatile resources. As a consequence, hedging creates systematic differences between resource acquisition and opportunity costs (the latter being linked to spot prices or current market prices) that create accounting profits and losses, and cash flow variations. Interestingly, these hedging policies also create competitive heterogeneity among rivals, since these rivals may have different acquisition costs for resources with equivalent spot prices and opportunity costs. Our study exploits the systematic differences in acquisition costs of otherwise homogenous (commodity) inputs created by hedging policies, and questions whether those differences affect resource deployment decisions, and particularly whether the accounting windfalls generated by hedging increase competitive aggressiveness in pursuing market position in the output market. Empirically, we study question in the Work-in-Process: Please do not Cite or Share without permission 6 context of fuel hedging in the U.S. airline industry. We examine whether deviations between fuel acquisition costs (based on ex-ante hedging decisions) and opportunity costs (based on the ex-post spot prices) influence the pricing behavior of U.S. airlines in different city-pair markets. While there have been other studies in finance and risk management on the effects of hedging, these studies typically examine either the heterogeneity among firms in hedging policies (why some firms hedge and others do not), or the impact of hedging policies on firm value (Treanor, Simkins, Rogers and Carter, 2014; Carter, Rogers, and Simkins, 2006), this is the first study to our knowledge to link hedging policies in input markets with competitive behaviors in output markets. Therefore, the paper contributes to both the finance and risk management literature on hedging, by examining in greater detail the behavioral consequences of hedging, and to competitive strategy and the resource-based view, by examining how heterogeneity in resource acquisition costs end up affecting competitive behaviors in the output market. ANTECEDENTS AND CONSEQUENCES OF HEDGING Despite the popularity of hedging in business practice, there is substantial debate about its merits. The objective of hedging is to reduce the firm’s exposure to the volatility of a critical input (fuel, raw materials, currencies) by making investments that would offset the potential loses from the volatility of that input. One approach to hedging involves natural hedges, or investment on physical or business assets that could offset the negative impact of volatility for the main business. For example, backward integration may provide such benefits, as in the previous example of Mittal Steel’s integration into iron ore mining. For example, in April 2012, Delta Work-in-Process: Please do not Cite or Share without permission 7 Air Lines announced the purchase of an oil refinery operation in Pennsylvania for about $150 million (Bloomberg, 04/30/2012). The logic of these investments is that these investments would offset the risk of