Who is managing risk in oil and gas companies?

Author:Wang, Xuequn
Position:Report
 
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1. INTRODUCTION

Who is the person in charge of the risk management program? The CEO or the whole management team? This is the question I want to answer in this paper. Theoretical models often assume that a single manager runs the firm in order to simplify model derivation, and empirical studies often depict CEO as the manager. However, in the real world, managers may work as a team and share the decision-making authority. Stulz (1984) and Smith and Stulz (1985) argue that managers' incentive plays an important role in corporate hedging decisions. Companies whose managers own less equity ownership and receive more option-based compensation tend to hedge more. Based on the managerial incentive hypothesis, and if CEOs have exclusive control over risk management program, their equity ownership and stock option holdings should be significantly correlated with hedging activities. Alternatively, if risk management policies result from a decision of the whole management team, the extent of hedging should be related to the stock and option holdings of non-CEO officers and directors. Tufano (1996) examines hedging activities of gold producers and shows that the equity ownership of officers and directors as a group is more closely related to the level of hedging, which implies that managers work as a team to manage risk. In this paper, I also separate CEOs' equity ownership and option holdings from the holdings of non-CEO officers and directors. By examining the correlation between corporate hedging activities and the equity and option holdings of the two management groups, this paper can provide more evidence and gain an insight into corporate decision making structure.

2. DATA AND VARIABLES

2.1. Data

This paper adopts a database collected from U.S. oil and gas industry. I search in Compustat during a sample period of 2001--2002 for independent active oil and gas producers with a primary SIC code of 1311, which indicates the industry of Crude Petroleum and Natural Gas Extraction. Oil and gas producers face the same risk exposure to the fluctuation of oil and gas prices, and they have a wide range of financial instruments, including forward agreements, futures contracts, options and swaps, to achieve their hedging goals. Therefore, this industry has embraced hedging practices and provides an interesting sample for studying hedging at the corporate level.

2.2. Variables

2.2.1. Dependent Variable

The dependent variable is the level of hedging, and is defined as the fraction of the company's total annual oil and gas production that is hedged against price fluctuations.

2.2.2. Independent Variables Managerial Compensation Variables

Table 1 below provides a summary of the compensation variables and expected signs of correlation coefficients.

According to Stulz (1984) and Smith and Stulz (1985), managers typically have a significant amount of their wealth tied up in the firm they manage. Risk averse managers prefer to reduce their risk arising from under-diversification at the corporate level if they find that the cost of hedging on their own account is higher than the cost of hedging at the corporate level. Therefore, managerial...

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