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 Boards 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 studys authors and a professor of accounting at Northwestern Universitys Kellogg School, was surprised at the finding. Some 62% of hedges in the oil and gas industry dont 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.

The researchers say the market performance of the companies studied suggests such practices dont fool investors. We find the market penalizes those companies that use non-hedge-designated derivatives, Sridharan says.

At least one accounting expert questions the studys conclusions. I suspect there is some speculative use of derivatives going on here, but I think the reason for most of the non-hedge accounting is that companies simply get sick of trying to comply with Rule 161, says Ira Kawaller, principal of Kawaller & Co. and former vice president of the New York office of the Chicago Mercantile Exchange.

While FASBs goal of preventing companies from using hedging to hide real gains and losses was laudable, the regulator ended up making compliance with the rule too onerous, says Kawaller, pictured at right.

Lars Lochstoer, a finance professor at Columbia Business School who has also been examining derivative use by the energy industry, says hes surprised at the extent of non-hedging use, but adds, When I talk with people in the oil industry, they think they have better knowledge of the market and want to take advantage of it, so its not surprising that they are trading on that information advantage.

Sridharan says the study did not analyze the specific purposes of the non-hedge derivatives. But his team plans to expand its research to look at a sample of 1,500 companies that will include businesses in a number of industries besides oil and gas that are also heavily reliant on commodity markets.