Hedging, vertical integration and firm value: Evidence from the oil and gas industry

Abstract Oil companies are accustomed to using a financial hedging strategy to manage commodity risk. Intuitively, independent oil and gas companies employ hedging on a much broader and deeper scale than integrated oil and gas companies. Does physical hedging of vertical integration cause this phenomenon? Do hedging and vertical integration have an impact on a company’s risk exposure, and finally do they add firm value? We divided 35 oil and gas corporations on the New York Stock Exchange from 1998 to 2012, into two groups according to their business nature. Then separate them into independent and integrated oil and gas companies before comparing their practice of hedging. By constructing hedge ratio, vertical integration index, industry revised Q statistics and models, we study whether hedging and vertical integration would reduce risk exposure and affect firm value. We find that vertical integration can reduce a company’s risk exposure and the effectiveness of hedging against price risk of oil and gas. For integrated corporations, hedging cannot diminish risk, while for independent companies, it can. We also discover that neither vertical integration nor hedging adds firm value.