Hedging policy in oil sector: empirical analysis

Another factor that influences the proportion of production hedged is average costs of sale. The baseline coefficient of influence of average costs on proportion of production hedged to 0.9%. Although the variable is significant in terms of statistical inference, the coefficient is very small from economic point of view. If costs increase by USD 1, the companies tend to increase the proportion of production hedged on average 0.9%. The variable is significant on 5% level.There is no significant different of the coefficient (the slope) between oil, natural gas and gas liquids companies and companies that undertake / do not undertake the strategic hedge.

Regarding control variables, the only significant variable (p-value=0) is revenue, but the coefficient is too small to consider it as economically meaningful.

Net debt/EBITDA coefficient that is used as a proxy for debt burden is not significant at any reasonable significance level. That means that the variation in the debt burden does not explain the difference in hedging behavior.

The coefficient for capital expenditures is not significant at any reasonable significance level as well. That means that companies in the sample do not link their hedging decisions to their investment programs.

Regression results show that spread between the forward and historical average price and average costs influence hedging decisions, but they are not the major factors. They can be seen as the factors that explain the fluctuations of the proportion of production hedged around some target level. The target level is determined by factors that are not included in our model. We suppose that factors consist of some non-observable characteristics as shareholders' and managers' attitude towards risk and satisfaction on the previous hedging activities.

Robustness

To check the stability of our main findings we build several models (fixed effect model, random effect model) on our sample. The models showed the same significant variables with similar coefficients.

To ensure that the identified dependencies are not occasional we tested the modelson different parts of the sample. The results of such regressions are in line with the finding presented in this paper. Thus, multiple testing on the reconstructed sample attests the stability of empirical findings.

3. Potential Explanation of Main Results

Opportunity to hedge the price at historically attractive level hasan impact on proportion of production hedged, but does not explain the significant variation

Our empirical research shows that companies do pay attention to existing market opportunities. Butprice spread explains only a part of variation of proportion of production hedged.Such results can be explained by existence of a hedging policy that doesn't significantly depend on hedging levels.The existence of similar individual effects representing the hedging policy was also outlined by Stulz (2003).In presence of such a policy the company can marginally increase the proportion of production hedged if hedging levels are historically high or marginally decrease the proportion of production hedged if the hedging levels are historically low.

Existence of target proportion hedged also coincides with the logic of using hedging as a tool for cash flow stabilization without any speculation motive. Such risk management policy was also outlined by Haushalter (2000) andCampello et al. (2011). Under speculation motive we understand the incentive to hedge higher volumes if their price can be fixed at higher levels and to hedge lower volumes if the company expects that it will be able to sell commodity with higher profit at market price. Our research shows that such speculation motive exists, but it is not the main factors that determine the hedging policy.

Relatively low speculation motive can be explained by adherence to general hedging policy established by shareholders and by covenants placed by debtholders. Adherence to general corporate hedging policy/

Shareholders of the companies can have different attitudes towards risk. Variation of attitude towards risk can explain different hedging policies. Companies with risk-loving shareholders can agree not to hedge a selling price of its production at all. On the contrary, risk-averse shareholders can potentially oblige managers to hedge sale of certain proportion of production.

Risk-averse managers are expected to follow the shareholders preferences and can potentially try to minimize their own decisions that can lead to the result that does not correspond to shareholders view (Stalz, 1984; Turfano, 1996; Haushalter, 2000).

If shareholders are willing to bear the market risks the managers are supposed to follow these patterns. In such environment the negative payoff on hedging derivatives can be perceived as a result of poor managerial decision that caused additional costs. Moreover, such profit limitation is not in line with shareholders' preferences. Thus, managers in such companies can potentially try to avoid hedging even at attractive market levels.

Companies with risk-loving shareholders can represent the firms in the sample that do not apply the hedge or hedge small proportion of their production. Such companies can keep the hedging levels low even if the price levels are attractive. The reason of such behavior is the risk of bad perception of profit limitation by risk-loving shareholders.

Getting positive payoff on hedging can potentially bring benefits for both managers and shareholders, but benefits at this situation potentially do not cover the disadvantages of limitation the profit described above. Selling at a lower price [if hedge was not executed] is not beneficial for the company, but such result is in line with risk-loving shareholders preferences.

Table V. Results of decision to hedge / not to hedge in the company with risk loving shareholders

Table V reflect the analysis that demonstrates that in case of risk-loving shareholders it is more beneficial for managers just to share these views and not no hedge (above general hedging policy level). This table is in line with Richard H. Thaler approach, according to which people is more afraid of losses then are concerned about getting additional benefits As described by R. Taler in his book “New Behavioral Economics” (2017) people are more afraid of potential losses then are willing to get potential rewards.

If shareholders are risk-averse, managers are expected to undertake hedging depending on the degree of acceptance the risk. Shareholders of such company would rather agree to have a guaranteed amount of profit than bare the risk of price decrease.Thus, managers in such companies can potentially try to undertake hedging even at not attractive market levels.

Such phenomenon can explain the behavior of companies that hedge a high proportion of their proportion.

Table VI reflects the payoff for risk-averse managers and risk-averse shareholders in different states of the world.

Table VI. Results of decision to hedge / not to hedge in the company with risk-averse shareholders

Thus, companies have an incentive to minimize the deviations from general corporate hedging policy even if market offers attractive hedging levels. That can be the reason why the reaction to the price spread increase on proportion of production hedged is moderate.

Similar covenants with respect to hedging for different debt/EBITDA levels

Another factor that can potentially lead to limitedinfluence of market levels toproportion of production hedged is debt covenants. Although we revealed that net debt/EBITDA factor is not significant in explaining the proportion of production hedged, we cannot claim that attracting financing in does not influence a company's hedging behavior. Moreover, existing literature outlines that the effect of the debt on the proportion hedged does exists (Warner, 1977; Mayers and Smith, 1990; Bessembinder, 1991).

But it can be the case that attracting the debt that is sizable for a company implies covenant establishment which is not significantly influenced by further increase of net debt to EBITDA. Thus, it is possible that debt in general makes the company hedge certain level of its production, but there is no clear dependency between net debt/EBITDA level and proportion of production hedged (a net debt/EBITDA threshold above which the effect of the debt burden does not significantly influence the hedging behavior as the covenants are already established).

Average costs of sales per unit produced have only marginal impact on proportion of production hedged

Our empirical research shows that cost factor is possibly taken into consideration while making the decision on proportion of production hedged, but the effect of these factors is only marginal.

Such results can also be explained by stable hedging policy that doesn't depend on costs. In presence of such a policy the company can marginally increase the proportion of production hedged if costs of the company are high (to ensure getting reasonable margin) or marginally decrease the proportion of production hedged if the costs of the company are low.

The moderate effect of costs on the proportion of production hedged can be possibly explained by the features of decision-making process. If the risk managers that undertake the hedging activities mainly work on the revenue side, they can possible pay insufficient attention to the costs side. In this case the costs can be just neglected. Costs side can be significant in the determination of proportion of production hedged only if the hedging decisions are undertaken by the managers who consider both revenue and costs side and care about the margins.

Determinants of general corporate hedging policy

In the explanation above we refer to the general corporate hedging policy that can be potentially influenced by shareholders' attitude toward risk. That is the non-observed variable that is individual to each company.

As was described above, in presence of certain shareholders' attitude towards risk risk-averse managers can try to follow this attitude. They try to avoid the situations when the payoff on the derivative is not in line with the preferences of shareholders (limitation of profit in case of risk-loving shareholders and bearing the risk of commodity price drop in case of risk-averse shareholders). Thus, in case with risk-loving shareholders propensity to hedge can be low while in case of risk-averse shareholders propensity to hedge can be high.

The question is how we can explain the variation of proportion of production hedged by the same companies across time. Why do one company hedges a different proportion of production in different periods?

Firstly, the factors we analyze do have an influence. As shown in our empirical research, widening of a price spread by USD 1 on average leads to 2.2% / 6.48 / 0.17% increase of proportion of production hedged by oil /natural gas/gas liquids companies respectively.

Secondly, shareholders can correct their views towards hedging policy after realization of the payoff on the hedges executed in the past. In our case that is:

· increase of the proportion of production hedged if previous hedging contracts brought profit to the company and

· decrease of proportion of production hedged if previous hedging contracts brought loss to the company.

This is the analog of “learning-by-doing model”, but here it is not about getting the knowledge and improving the companies' practices, but about behavioral patterns when the company negatively perceives some scenario.

Thus, our model meaningfully explains part of variation of proportion of production hedged, but it lacks an important factor that determines the companies' target hedging proportion. There is some target hedging level that is not completely explained by price spread and average cost of sale. Companies do increase the proportion of production hedged in response to price spread increase, but these factors explain the fluctuations around the target hedging level. We expect the shareholders' attitude towards risk to be the important variable that is missed in the model. Identifying the variable that can be used as a proxy for shareholders' attitude towards risk can potentially improve the model.

Further investigations of target hedging level and its determinants is an important area for future research.

Conclusion

In this paper we examined thefactors that motivate companies to undertake hedging activities. The main factors analyzed are spread between forward commodity price and historical average price and average costs of sales per one unit produced.

As was discussed in the sample section, the proportion of production hedged has variance both from the time perspective [one company hedge a different proportion of production in different periods] and among companies [different companies hedge different proportion of production in one period].

The empirical analysis showed that variance in time can be partially explained by the spread between market hedging levels and historical prices. Wider spread means that forward level is higher than historical prices and companies can potentially get a positive payoff on hedging instruments. Our analysis showed that companies tend to increase proportion of production hedged if spread between forward and historical average price widens.

Concerning variance among the companies during one period, we suggested that such phenomenon can be explained by the costs that companies bear. If a company has low average costs of sales per unit produced it will get the reasonable margin even if commodity price drops for a certain amount. But if average costs of sales are high, the company has a risk of getting zero or even negative margin in case of commodity price decline. We expected companies with higher costs to hedge a higher proportion of production in order to ensure getting the reasonable margin. But empirical analysis showed that costs of the companies can explain a small part of existing variance. The costs variable is statistically significant, but the magnitude of its influence is small.

Although the price spread and average costs of sales are significant, they do not explain the significant part of variance of proportion of production hedged. Our analysis proposes that companies have individual characteristics that significantly affect their hedging behavior. Thus, we can suppose that such individual characteristics determine target hedging level, and the factors analyzed explain the fluctuations around such a level. We suppose that such individual companies' characteristics can account for different attitude towards risk.

Thus, we expect companies to increase the proportion of production hedged in response to price spread increase, but we do not consider this factors as variables that determine the target hedging level. We consider the shareholders' attitude towards risk can be an important variable in justification the hedging policy.

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