“In the Oil and Gas Industry We Have the Data – That’s Empirical Gold”
Marcellus gas, North Dakota oil, fracking, and horizontal drilling are energy industry buzzwords that have made news headlines for nearly a decade. The terms became synonymous with a modern gold rush, as oil and gas producers made big investments in unconventional energy production and earned correspondingly large fortunes. For some, these fortunes slipped away as energy prices tumbled in recent years.
The big risk that accompanied a booming energy industry always seemed pretty clear. Energy market prices could swoon as quickly as they’d soared if the supply of energy resources outpaced demand. Companies built on mountains of debt might find themselves buried under those mountains.
Extra Risk for Canadian, Pennsylvania Energy Producers
New research from Kleinman Center visiting scholar Jerome Taillard looks at a related source of risk that has gone largely under the radar, namely the inability of energy producers in certain regions to adequately hedge against future energy price swings. In places like Alberta, Pennsylvania, and Texas, this limits the oil and gas industry’s ability to rebound from downturns, develop rich energy basins, and weather future market uncertainties.
Taillard is an Associate Professor of finance at Babson College who earned his Ph.D. from The Ohio State University in 2010, and completed earlier graduate work in his native Switzerland. His most recent research on hedging strategies could provide insights to policymakers looking to boost energy development, resulting in both positive and negative implications for the environment, Taillard admits.
Research Partnership Has Roots in Classroom
Taillard’s LinkedIn page notes that his Ph.D. is in “Finance, General,” and as Taillard himself says, ‘I’d never had a particular interest in oil and gas.”
He was drawn to the energy industry, and later to the subject of financial hedging strategies that energy companies use to help manage business risk, once he’d started teaching at Boston College. He befriended a graduate student who’d come from the energy field, and who passed his interest in energy to Taillard. The student, Erik Gilje, is now Assistant Professor of Finance at Wharton, and a partner with Taillard on energy finance research.
Luckily for the two, the fossil fuel industry turned out to be perfect for testing many of their hypotheses. Unlike other markets, say for running shoes or laundry detergent, sales volumes and hedging strategies in the oil and gas industry are on public record, making it easy to draw connections between product sales, investment decisions, and market conditions.
“In the oil and gas industry we have the data,” Taillard says. “That’s empirical gold. We don’t have the same transparency with Nike or Procter and Gamble.”
Taillard will go into the details of his hedging research in an upcoming policy digest to be published on this website. As a brief preview, he found that oil and gas companies operating in the hottest new energy basins in Canada weren’t able to benefit from financial hedging tools to the same degree as their American counterparts.
The result is that, at any given time, Canadian oil producers face greater price risk than their peers, making it more likely that investors and banks would shy away, and making it more difficult for Canadian businesses to grow. The problem, at its root, is due to the fact that Canadian producers have to buy energy futures (contracts that lock in the future price of the oil they produce) that are priced at the U.S.’ WTI benchmark price, even though they sell their oil in Canada. The difference between American and Canadian energy prices results in more risk for the Canadian producers, and more financial distress for the most highly leveraged of them.
Policy Options to Level the Playing Field
At the same time, relatively new energy regions like North Dakota, as well as the aforementioned Marcellus in Pennsylvania, are short on pipelines to get their oil and gas to market. The result is a dual market, similar to that faced in Canada, for Marcellus producers who buy financial hedges priced on a national natural gas market, yet sell their gas locally at prices that can be half the national rate. When Marcellus natural gas producers get less money for the gas they produce, less tax revenue finds its way to local government, catching the attention of communities and politicians.
Taillard says that policies that simplify the process for permitting and building pipelines would make it easier for oil and gas to get to market (and would also transport oil more safely than rail cars, an environmental plus, though gas production would increase). Equally important would be loosening Dodd-Frank laws —making it easier for banks to tailor financial hedging tools to regional energy companies.
Professor Taillard’s research on hedging is forthcoming in the Review of Financial Studies. His related policy brief will hit the Kleinman Center website this summer.