From the September/October 2012 issue of Treasury & Risk magazine

Derivatives: Not Just Hedges

Researchers find that 62% of derivatives used by oil and gas companies do not qualify for hedge accounting.

For decades now, companies have been hedging, especially those that are in the commodities business or depend heavily on commodities. But until recently, it was hard for outsiders to understand how companies used contracts. But in 2008, the Financial Accounting Standards Board’s Rule 161 required public companies to classify derivatives in their filings as either hedging vehicles or non-hedge derivatives. A team of academic accountants recently examined the filings of 87 oil and gas companies and found a remarkable amount of their hedging was actually economic, or speculative, in nature. According to their paper, “More than six out of every ten firms studied actually use the instruments for purposes other than managing risks.”

Swaminathan Sridharan, one of the study's authors and a professor of accounting at Northwestern University’s Kellogg School, was surprised by the finding. “Some 62% of hedges in the oil and gas industry don’t qualify for hedge accounting.

“A true hedge should help to reduce earnings and cash flow volatility, but the hedges that are not really true hedges actually increase volatility,” Sridharan adds.

“We found that firms that do a lot of non-economic hedging seem to be trying to manage their earnings, for example, so that they can meet analysts’ projections,” he says. Among just those companies whose derivatives were not structured as hedges, derivatives produced gains equal to 92.7% of their earnings excluding such gains. “They are almost doubling their earnings through the use of their derivatives,” Sridharan says.

The market performance of the companies suggests such practices don’t fool investors. “We find the market penalizes those companies that use non-hedge-designated derivatives,” Sridharan says.

At least one accounting expert questions the study’s conclusions. “I suspect there is some speculative use of derivatives going on here, but I think the reason for most of the non-hedge accounting is that companies simply get sick of trying to comply with Rule 161,” says Ira Kawaller, principal at Kawaller & Co.

While FASB’s goal of preventing companies from using hedging to hide real gains and losses was laudable, the regulator ended up making compliance “too onerous,” he says.

Lars Lochstoer, a finance professor at Columbia Business School who has also been examining derivative use by the energy industry, says he’s surprised at the extent of non-hedging use, but adds, “When I talk with people in the oil industry, they think they have better knowledge of the market and want to take advantage of it, so it’s not surprising that they are trading on that information advantage.”

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