A Review of the Literature on Commodity Risk Management for Nonfinancial Firms

Transcription

1 A Review of the Literature on Commodity Risk Management for Nonfinancial Firms Presentation by: Betty J. Simkins, Ph.D. Williams Companies Chair & Professor of Finance Department Head of Finance Oklahoma State University Co-authors: David Carter, Daniel Rogers and Stephen Treanor Betty Simkins, PhD

2 Thank you for inviting me here to speak! Colombia is amazing!

3 Outline Motivation Theories of Corporate Risk Management and Questions Explored Methodologies Findings for Commodity Hedging with a Focus on Energy Conclusions and Suggestions for Future Research

4 Motivation 4

5 Disparity in Commodity User Views - 1 If we don t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk. - Quote by Scott Topping, then VP Finance at Southwest Airlines, 2003

6 Disparity in Commodity User Views - 2 Hedging is a rigged game that enriches Wall Street. -- Quote by Scott Kirby, then President of American Airlines Group quoted in March 20, 2016 Wall Street Journal article

7 Past Media Views on Using Derivatives in Risk Management

8 Simple Illustration on What Hedging is About

9 Commodity Prices can be Very Volatile

10 What is Different about Commodity Risk Management? Many managers have an opinion about future commodity prices, which influences how they approach hedging. Managers of non-financial firms are far less likely to have a view about future interest and exchange rates. Therefore, a review that specifically focuses on commodity risk management is very valuable.

11 Oil price trend beginning in fall 2014 October 18,

12 Theories of Corporate Risk Management (ie, why firms should hedge) 12

13 Corporate Risk Management Corporate risk management theory extends the Modigliani and Miller (1958) perfect capital market framework by introducing market imperfections that imply risk management can alter firm value. Corporate finance research seeks an improved understanding of why firms hedge. Hedging = Simple risk mitigation technique Commodity prices are not predictable We extend to examining commodity risk management.

14 Theories of Corporate Risk Management Theories of corporate hedging suggest hedging adds value. See Table 1 of paper for summary. Minimize financial distress/underinvestment costs (Smith and Stulz, 1985, Bessembinder, 1991, Froot, Scharfstein, and Stein, 1993). Tax savings implications (Smith and Stulz (1985), and Leland (1998). Managerial Incentives (Smith and Stulz, 1985, DeMarzo and Duffie, 1991, Breeden and Viswanathan, 1998). Reduce cost of equity (Gay, Lin, and Smith, 2011) Collateral and risk management (Rampini, Sufi, and Viswanathan, 2014). Risk management is a positive function of corporate net worth.

15 Questions the Research has Explored Question 1: Is commodity risk reflected in share price behavior? Question 2: Is the use of commodity risk management tools (derivatives) associated with reduced risk? Question 3: Is there a relationship between the use of commodity risk management and the value of the firm? Question 4: Are there other factors that impact a firm s decision to manage commodity price risk? Industries studied for commodity hedging: airlines, gold mining firms, oil & gas firms, and energy utilities (one study). More research needed.

16

17 Methodologies 17

18 Common Methodologies Used Question 1: Is commodity risk reflected in share price behavior? R i,t = α i + β i R m,t + γ b R b,t +ε i,t Question 2: Is the use of commodity risk management tools (derivatives) associated with reduced risk? γ b,i = α 0 + α 1 (Hedge i ) + α 2 (Size i ) + Ʃ j α j,i x Control variable j,i + ε j,y Note: Absolute value not necessary, depending on rationale.

19 Common Methodologies Used (continued) Question 3: Is there a relationship between the use of commodity risk management and the value of the firm? Log(Tobin s Q i,y ) = α + β 1 *Hedge i,y + β 2-n (Control Variables i,y ) + e i,y Question 4: Many methods

20 Findings for Commodity Hedging with a Focus on Energy 20

21 Findings Question 1: Is commodity risk reflected in share price behavior? Positive support including energy commodity exposure. Question 2: Is the use of commodity risk management tools (derivatives) associated with reduced risk? Positive support. Question 3: Is there a relationship between the use of commodity risk management and the value of the firm? Positive support for users of energy commodities such as airlines. Mixed support for producers of commodities. Question 4: Are there other factors that impact a firm s decision to manage commodity price risk? Yes, managerial overconfidence, corporate governance, compensation, enterprise risk management, among others.

22 Findings Question 1 Question 1: Is commodity risk reflected in share price behavior? Positive support including energy commodity exposure.

23 Findings Question 2 Question 2: Is the use of commodity risk management tools (derivatives) associated with reduced risk? Positive support.

24 Findings Question 3 Is corporate hedging valuable (Question 3)? This has been a contentious issue among finance researchers since the publication of Allayannis and Weston (2001) who concluded that foreign currency hedging warranted an approximate five percent premium to firm value, on average, relative to those firms that did not hedge their currency risk. Question 3: Is there a relationship between the use of commodity risk management and the value of the firm? Positive support for users of energy commodities such as airlines. Mixed support for producers of commodities.

25 Findings Question 3 Carter, Rogers, and Simkins (2006) analyzed the determinants of jet fuel hedging by airlines. They find that more leverage and weaker credit ratings are associated with less fuel hedging across airline companies. A striking difference emerges in findings between studies. Results may not generalize when researchers study different industries. The difference may be driven by differences between the producer (output) versus user (input) perspective of commodity risk management. This points is crucial in my opinion.

26 Example of question 3 evidence It is IMPORTANT for studies to distinguish between hedging an input or output Input hedging Carter, Rogers, and Simkins (2006). Sample consists of US airlines (homogeneous risk exposures and one hedging strategy). Jet fuel is an important and highly variable cost component for airlines. Illustrate that airline investment environment is consistent with Froot, Scharfstein and Stein (1993) assumptions. Investment opportunities negatively correlated with jet fuel costs. Significant financial distress costs in airline industry. Hedging premium as high as 16%

27 Question 3 More Comments Academic Hedging and Exposure Guay (1999) Finds an increase in a firm s exposure an impetus for creating a new hedging program. Selective Hedging Adam and Fernando (2006) Finds evidence that gold mining firms that actively adjust their hedging experience no additional cash flows from such activities. Hedging Premium Several studies find a hedging premium for hedgers compared to non-hedgers.

28 Findings Question 4 Question 4: Are there other factors that impact a firm s decision to manage commodity price risk? Yes, managerial overconfidence, corporate governance, compensation, enterprise risk management, among others.

29 Eight Most Influential Papers (Table 6)

30 Some Hedging Lessons Learned from Our Research on Airlines Airlines have limited ability to increase prices in response to cost increases (in short-term) Hedgers are valued more highly by the stock market Hedgers are financially stronger companies Source of the higher value = hedgers better ability to invest consistently over time Operational hedging has more effect on airlines compared to financial hedging Stable hedging policy > Selective hedging policy

31 Conclusions and Suggestions for Future Research 31

32 Suggestions for Future Research More research needed on hedging input price risk. Do managers hedge more when the firm s exposure to commodity price is high? Does hedging more when exposure is high add value to the firm? Do shareholders value a consistent hedging policy more? What about value of hedging in other industries? Managerial overconfidence and hedging? Cost and benefits to risk management? Corporate culture

33 Conclusion Prior research has found positive support for questions 1 and 2. Commodity price risk can affect the returns on stocks and that commodity hedging can reduce this exposure. For question 3, whether commodity risk management adds value, the results are mixed. Strong evidence is found that commodity risk management adds value for firms hedging input price risk, particularly energy risk. For output price risk, the results are mixed. I believe that more research is needed in the area of commodity risk management.

34 Conclusion From a practitioner perspective, research needs to help businesses make decisions about whether or not to hedge, and if the answer is to hedge, how much. Therefore, hedging research may benefit from more field-based case studies in which researchers are closely engaged with corporate hedging policy by an individual company. The key issue here is that there is not prescriptive hedging policy that will fit all businesses.

35 As Charles Darwin noted over 150 years ago, in a world where mutability is the only permanent feature of the landscape, It s not the strongest of the species that survive, nor the most intelligent, but those that are the most responsive to change. Hedging helps nonfinancial firms adapt to commodity risk and change! Betty Simkins, PhD

36 Journal of Commodity Markets

37

38 Questions? 38