Derivatives: Not just for hedging

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

For 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.”

Swaminathan Sridharan, one of the study’s authors and a professor of accounting at Northwestern University’s Kellogg School, was surprised at 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 add. “You have to ask, why would a firm do that?

“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. The data showed that among those companies whose derivatives were not structured as hedges, derivatives produced gains equal to 92.7% of earnings excluding such gains. “They are almost doubling their earnings through the use of their derivatives,” Sridharan says.

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