Derivatives: Not Just for Hedging

Researchers find 62% of derivatives used by oil and gas companies don’t qualify for hedge accounting.

oil rig and derrickFor decades now, companies, especially those that are in the commodities business or depend heavily on commodities, have been hedging. Until recently, it was hard for investors and analysts 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 public 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 the companies’ 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.”

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

Ira Kawaller of Kawaller & Co.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 of Kawaller & Co. and former vice president of the New York office of the Chicago Mercantile Exchange.

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