Market risk, hedging & shareholder value

Strategic risk management is among the most powerful ways for companies to upgrade their competitive edge, boost profitability and enhance shareholder value. This is especially true for commodity-related industries where exposure to volatile prices of commodities, foreign currencies or interest rates represents some of the main sources of risk. However, such a business should not seek to eliminate the price risk as this would also eliminate one of the strongest drivers of profitability and value creation.

Without adequate risk-management programs, companies may inadvertently take on levels of risk that leave them vulnerable to the next risk-management disaster, or, alternatively, they may pursue recklessly conservative strategies, forgoing attractive opportunities that their competitors can take. Either approach will surely be penalized by investors.

Kevin Buehler and Gunnar Pritsch, “Running With Risk,” McKinsey & Co.

The proper role of market risk management

While it is natural to adopt a defensive posture toward risk and seek to minimize or eliminate it, it is far more important to recognize the enormous up-side potential in effective management of uncertainty and risk. After all, taking and managing risk is what firms must do to generate value.

As such, managing risk must enable a firm to take risks in a controlled and purposeful fashion, accept occasional losses and communicate such losses to its stakeholders openly and transparently, without losing stakeholder confidence in the validity of the firm’s strategic goals or the management’s capability to achieve them.

Specifically with respect to commodity prices (or foreign exchange, or interest rate) risk, this entails keeping favorable exposure to significant price trends while (1) limiting the losses from adverse fluctuations and (2) eliminating the possibility of financial distress through rogue trader actions. Achieving this in a cost effective way requires a high-quality decision making process at the heart of the hedging process.

“Yes, but we do not wish to speculate…”

This is what managers often tell us regarding market exposure. But, a strategy that bars all exposure to market prices is dangerously shortsighted. First, this approach destroys value that could otherwise be reaped from favorable market trends. Second, it assumes a fixed competitive environment – a flawed notion in the world of crumbling barriers to competition and eroding profit margins.

Market exposure and shareholder value

…many energy companies were reporting five day VaR of about $30 million to $40 million, ridiculously small compared to the hundreds of millions of dollars of profits (and the billions of dollars of market capitalization) that shareholders have since lost.

Claude Genereux et al., The special challenge of measuring industrial company risk, McKinsey & Co., Sep. 2003

Exposure to market trends is not incidental to value creation – on the contrary, it is critical. Recently, McKinsey published an extensive analysis of 100 of the largest US corporations’ performance and found that 90% of firms that were able to achieve strong growth (faster than GDP) during the 1993–2003 business cycle were concentrated in only four industries – the ones that enjoyed favorable market trends over the period. In other words, favorable market trends were the key driver of value creation for 90% of out-performing companies. The study’s authors observed that, “What’s striking for large growth-minded corporations is just how crucial it is to have this kind of favorable wind at their backs when they try to achieve strong growth.”

Warren Buffett expressed the same thing when he said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Our own case study of North American independent oil and gas producers provides some concrete evidence for this.

Case study: independent oil & gas producers

The oil market provided us the opportunity to study the extent to which favorable exposure to price trends can impact a firm’s profitability and shareholder value. We examined the hedging practices of nine independent oil & gas producers[1] among which one firm, Kerr McGee (KMG), stood out as a particularly aggressive hedger.

In 2003, KMG management decided to hedge 70% of their 2004 crude oil production, fixing the company’s selling price at $27.69 for their North American production and at $25.99 for their North Sea production. The other eight firms hedged on average only 25% of their 2004 production.

Kerr McGee's management decided in 2003 to hedge 70% of their 2004 oil price production. In effect, they set up a price cap $13.72 below the average 2004 market price.

As the oil price continued to rise, the 2004 average reached $41.41 in New York and $38 in London. By limiting their exposure to such a favorable price trend, KMG missed the opportunity to earn $13.72 in extra revenues per barrel. With 52 million barrels of crude oil production, KMG’s hedging deprived the company of $500 million in unrealized profits for 2004.

The $500 million lost to hedging paled compared to the effect on the firm’s market capitalization.

Rising oil price generates shareholder value for oil & gas firms: Kerr McGee (KMG) share price compared to an index of other independent oil & gas producers. The eight firms comprising the oil & gas index hedged on average only 25% of their production. Through greater exposure to the oil price trend, they generated an annualized average return to shareholders of 63.3% for the period, while KMG, hedging 70% of its exposure generated “only” 44.6%.

While shares of independent oil & gas companies appreciated on average 250% over the observed period, KMG shares underperformed by 20%. Had KMG performed in line with the industry average, its market capitalization would have reached $17.3 billion, well above its actual $13.8 billion market cap (at $85.64 per share in mid-August 2005) at the time this study was concluded. In other words, management’s hedging decision effectively helped destroy a full $3.5 billion in KMG shareholder value.

The value effect of poorly managed market exposure: shares of independent oil & gas producers rose by 250% from Oct 2003 to mid-Aug. 2005. By hedging 70% of their exposure, Kerr McGee failed to capitalize on the rising oil price trend, trailing its industry in terms of shareholder returns by 20%. This directly contributed to a loss of $3.5 billion in shareholder value.

This case illustrates the extent to which inappropriate hedging practices that bar exposure to favorable market trends can destroy shareholder value. Of course, a company’s share price is determined by a variety of factors. In this case however, oil price rise had such magnitude, it’s safe to assume that it had largely determined Kerr McGee’s underperformance. This underscores the point that hedging should not be hindered by a slow and rigid decision making process. Rather, it should be based on a flexible method, enabling the firm to respond quickly to changing market conditions.

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[1] Our case study included: Anadarko Petroleum, Apache Corporation, Burlington Resources, Canadian Natural Resources, Devon Energy, Encana, Kerr McGee, Talisman Energy and Unocal.

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