Financial Distress around Introduction of Hedging in the Oil and Gas Industry

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. …