Choices Among Alternative Risk Management Strategies: Evidence from the Natural Gas Industry

Preprint
Publisher Website
Google Scholar
Abstract
This paper examines the substitutability and complementarity of a variety of risk management strategies that firms can use to reduce price risk exposure. Time-series analysis over a period of significant regulatory changes indicates that natural gas companies increased diversification and started using derivatives as price risk increased following price deregulation and the regulated unbundling of sale and transmission activities. The use of derivatives is a substitute both for holding internal cash and for storing gas underground. The latter two activities are complements. In choosing between derivatives and storage or cash holdings, less profitable and more financially distressed firms are more likely to manage risk using derivatives. Accounting earnings management strategies, however, are not complements to activities that have a "real" effect on cash flow volatilityand diversification is not related to financial hedging activities. Market-based estimates of wellhead gas price sensitivities are negative prior to deregulation and become significantly positive following price deregulation. The change in exposure is consistent with the changing role of pipelines from buyers of gas for transport to only transporters of gas resulting from deregulation. Cross-sectional variation in price sensitivities is related to firms' use of combinations of operational (non-accounting) and financial hedging activities. Firms that pursue these activities have smaller and less variable risk-adjusted wellhead gas return exposures than firms that do not, especially post-deregulation.