Survey of Energy Finance on the Corporate World

Abstract

This literature review surveys some of the main topics regarding energy finance in the field of empirical corporate finance. The basic goal is to conduct literature surveys on some of the major studies in the field that focus on energy finance. The primary focus is on corporate governance, capital structure, risk management, and hedging in relation to energy finance. This review will study the effect of accounting differences in corporate finance, initial public offerings, and mergers and acquisitions. This is done by summarising some of the existing literature in these areas with regard to energy finance in order to synthesize this research and examine the impact on corporate financial decision making.

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International Journal of Energy Economics and Policy | Vol 7 • Issue 6 • 2017 153
International Journal of Energy Economics and
Policy
ISSN: 2146-4553
available at http: www.econjournals.com
International Journal of Energy Economics and Policy, 2017, 7(6), 153-158.
Survey of Energy Finance on the Corporate World
Saud Althaqeb*
Kuwait University, Kuwait. *E-mail: salthaqeb@gmail.com
ABSTRACT
This literature review surveys some of the main topics regarding energy nance in the eld of empirical corporate nance. The basic goal is to conduct
literature surveys on some of the major studies in the eld that focus on energy nance. The primary focus is on corporate governance, capital structure,
risk management, and hedging in relation to energy nance. This review will study the effect of accounting differences in corporate nance, initial
public offerings, and mergers and acquisitions. This is done by summarising some of the existing literature in these areas with regard to energy nance
in order to synthesize this research and examine the impact on corporate nancial decision making.
Keywords: Energy Finance, Corporate, Corporate Governance, Capital Structure, Risk Management Initial Public Offering and Mergers and
Acquisitions
JEL Classications: F30, F39
1. INTRODUCTION
Energy rms occupy central positions in many economies. Oil
and gas rms face many issues that are similar to those faced
by rms in other industries, but the impact may be different
because of the dynamics of the industry. Energy nance is a very
dynamic eld that is growing exponentially by various means.
Along with this growth, the eld is also changing rapidly. The
changes in the dynamics of this eld are derived from a recent
renaissance along with technological advancement, specialization,
and new regulations. All of these factors guide and attract many
researchers to explore and study the eld of energy nance. This
also provides some explanation for many unanswered questions.
Therefore, exploring this eld is an essential tool to enhance
our understanding of the dynamics of nancial markets and can
provide a clearer picture of the relationship between the market
players. This literature review surveys some of the main topics in
light of the theoretical and conceptual ndings from other articles
relating to energy nance.
My primary focus is on energy nance and how can it affect
corporate nancial decision making. This will be accomplished
by reviewing some of the major work done in ve areas of oil and
gas rms: Corporate governance; capital structure; accounting
policies; initial public offerings (IPOs), mergers, and acquisitions;
and risk management and hedging. I consider the theoretical and
empirical evidence behind these phenomena before analysing the
effect of the new regulations and reforms.
The paper is organized as follows. The next section will show
how corporate governance can inuence rms’ decisions in the
energy sector. Section III will discuss capital structure theories in
relation to the oil and gas sector. Section IV will study the effect of
accounting differences in energy nance. Section V will investigate
the IPOs, mergers, and acquisitions in this industry; and Section
VI will review some of risk management and hedging in the eld.
Each section will be analysed in turn before presenting concluding
remarks, and a summary of the literature will be examined in the
concluding section.
2. CORPORATE GOVERNANCE
Corporate governance has a major inuence on the valuation of
companies, especially rms in the oil and gas sector. The literature
in general questions the impact of corporate governance on the
eld of energy nance and how it effects the corporate decisions
in this industry. Black et al. (2006) compared the valuation of the
Russia-based Gazprom, the largest oil and gas company in the
world, on the basis of proven reserves against those of western oil
rms, They found that western rms were valued about 18 times

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International Journal of Energy Economics and Policy | Vol 7 • Issue 6 • 2017
154
that of Gazprom if the amount of proven reserves is used as a
valuation measure. The same study stated that Russian price
controls and political risk had negative impacts on the valuation
of Gazprom, but the major factors for the discount in value was
the relative lack of rm-level governance. With poor protection
of shareholder rights, rm-level governance is a major issue in
Russia. The problem becomes more acute when the rm is large,
works in a strategic sector, and the government has a majority
stake.
This issue is especially pronounced for areas of ownership
structure, which are of greater importance for managers. One
of the main aspects of corporate governance is the ownership
structure (Dayanandan and Donker, 2011). Wolf (2009) analysed
a dataset of oil and gas companies covering both privately and
publicly owned rms from 1987 to 2006 and found that private
ownership encouraged better performance and greater efciency
than state ownership of oil and gas companies. This is expected
since private owners are more interested in monitoring the actions
of management so as to protect their wealth. In the case of publicly
owned energy rms, the strategic goals may not be focused mainly
on prots. The government may control the amount it pays to the
state-owned rm so as to improve the public-sector budget. This is
also likely to be one of the main reasons behind the lower valuation
of Gazprom as compared to private oil and gas companies.
Another nding in this area is that independent directors is
integral to good corporate governance. Though Enron had
many ‘independent’ directors on its board, many of them had
relationships with Enron and its management team, which clouded
their consciences (Downes and Russ, 2005). Directors were
collecting fees from Enron for services rendered, and some were
even on retainer for legal and consulting services, which may
have diminished their ability to question management’s activities
(Downes and Russ, 2005). This indicates that the independence of
directors should be followed in fact as well as in spirit for effective
corporate governance.
Another important aspect is corporate social responsibility. Frynas
(2005) states that the oil and gas sector has been among the
leading industries in improving corporate social responsibility. Oil
companies have initiated, funded, and implemented community
development Schemes A detailed analysis of measures adopted
by multinational oil companies, however, shows that they may
be inappropriate for addressing social problems in developing
countries and may divert attention from broader political,
economic, and social solutions for such problems (Frynas, 2005).
This suggests that the corporate social responsibility practices
adopted by some companies in the energy sector are designed more
to achieve social acceptance rather than genuinely attempting to
help local communities.
Corporate governance is important for rms in the oil and gas
sector because of its impact on valuation. The literature provides
signicant information that valuation of rms in the oil and gas
sector is linked to their ownership structure; that is, rms with
higher state ownership have lower valuation. At the same time,
there is evidence from the literature that the industry has taken a
leading position in corporate social responsibility, but the efforts
seem to be focused more on presenting a good corporate image
rather than genuine attempting to solve local problems.
3. CAPITAL STRUCTURE
There are two main capital structure theories: Trade-off and
pecking order. In trade-off theory, rms choose a capital structure
by weighing the benets and costs of additional debt. The benets
of debt include tax deductibility of interest and a reduction in
the free cash ow problem, whereas negative effects include the
expected nancial distress costs and the costs arising from agency
conict between shareholders and bondholders (Ovtchinnikov,
2010). The pecking order theory suggests that a rm uses internally
generated cash before raising external nance for expansion
(Chen, 2004).
The capital structure of a rm is linked to its investment decisions.
The amount of prots generated by large oil and gas companies
is high. However, the amount of cash required for investment
is also high. Boyer and Filion (2007) state that oil and gas
companies are very capital intensive since they need enormous
capital to purchase, develop, and operate properties. The rms
also must spend large amounts on normal business activities and
on equipment maintenance costs, particularly for oil sands and
offshore activities. In addition to that, oil and gas companies invest
in renewing and nding reserves to meet their growth and cash
ow objectives (Boyer and Filion, 2007). The high amount of
capital required for capital projects, exploration, and maintenance
has consequences for the rms’ nancial structures in the sense
that external nancing is unavoidable. The problem is more acute
in the case of small rms. Weljermars (2011) analysed cash ows
of oil and gas companies from 2004 to 2008 and found that the
operational income of smaller oil and gas companies is commonly
insufcient to fund new capital expenditures. This implies that
small oil and gas companies are more reliant on external debt for
nancing their growth. The use of debt by energy sector companies
indicates that interest rate variations represent an important risk
factor.
As discussed above, the high reliance by energy rms on external
capital implies that they are under more scrutiny by shareholders,
lenders, and analysts. International oil and gas companies are
under increasing pressure to maintain strict capital discipline
(Osmundsen et al., 2007). One of the main reasons found in the
literature behind this is that risky investments by energy companies
are typically funded by internal accruals (Osmundsen et al., 2007).
This is expected because of the high asymmetry of information
between management and external providers of nance in the
case of risky investments such as exploration. One of the negative
impacts of higher capital discipline is that oil and gas companies
may have to reduce their willingness to invest in exploration for
future reserves and production growth (Osmundsen et al., 2007).
The high risk of capital investments by oil and gas companies
suggest that credit rating agencies may have an important role in
determining the capital structure of rms in the industry. Credit
ratings are useful when investors feel that they do not have

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International Journal of Energy Economics and Policy | Vol 7 • Issue 6 • 2017 155
adequate skills to assess the nancial position of a company/
investment. Given the level of complexity involved in exploration
and development of oil and gas elds, investors are likely to rely
on credit ratings to form an economic opinion about a company.
Weljermars (2011) states that credit ratings profoundly affect the
structural gearing of oil companies. The ascent of oil companies
from small-cap to mid-cap and nally large-cap is commonly
supported by incremental improvements in their credit ratings
(Weljermars, 2011). Thus, smaller companies with lower credit
ratings nd it difcult to raise external debt and/or have to pay a
higher interest rate. This suggests that larger oil and gas companies
are better placed to assume debt on their balance sheets.
The main observation from the literature review of capital structure
regarding oil and gas companies is that they need external loans
because of high investments in exploration, capital expenditures,
and maintenance. This section as a whole demonstrates that smaller
rms are more dependent on loans to nance their operations. As
a result, a high amount of debt results in greater public scrutiny by
investors and analysts. This is supported to some extent by the fact
that credit ratings of rms also inuence their leverage structures.
4. ACCOUNTING DIFFERENCES
Accounting policies are very important in understanding oil
and gas companies and guides many researchers to explore this
eld. This section analyses the effect of accounting differences
in energy nance. Evidence shows that analysts and companies
place exaggerated weight on accounting protability (Osmundsen
et al., 2007). This can be explained by the fact that some analysts
may be using multiples based on accounting prots for valuing
and comparing rms. Since price-to-earnings is one of the most
commonly used valuation multiples, companies will focus on
accounting prots to attract investors.
One of the major accounting differences in energy nance is that
companies in the oil and gas sector could choose between ‘full
costing’ and ‘successful efforts’ accounting approaches. The full-
costing method allows all costs incurred from exploration activities
to be capitalised and subsequently amortised according to the
unit-of-production depreciation method. The successful-efforts
approach allows only costs incurred from successful exploration
activities to be capitalised and subsequently amortised according to
the unit-of-production depreciation method (Misund et al., 2008).
Hence, Deakin (1979) states that the use of full-cost accounting,
through the deferral of costs associated with unsuccessful projects,
tends to show higher and smoother earnings for companies that are
expanding their exploration activities. Given the weight placed by
managements on earnings, oil and gas sector rms are expected
to prefer the use of full-cost accounting. Smooth earnings through
the use of full-cost accounting will result in a higher valuations.
The preference for full-cost accounting in the oil and gas sector
was observed in July 1977 when the U.S. Financial Accounting
Standards Board proposed the adoption of a uniform nancial
accounting rule based on the successful-efforts concept (Deakin,
1979). A number of oil and gas rms appealed that they should be
allowed to use the full-costing system because of their inherent
characteristics. Currently, both methods are used in the energy
nance industry. Most of the large rms use full-cost accounting,
whereas most small rms use successful-cost accounting.
Statement of Financial Accounting Standard No. 19 requires oil
and gas companies to disclose supplementary data about their
assets as a result of the perceived inadequacy of historical cost
accounting for purposes of evaluating oil and gas assets (Harris
and Ohlson, 1987). This requirement ensures transparency and
equal opportunities for all market players. One of the most
useful accounting measures for valuing oil and gas assets is book
value, and this has been supported by empirical results (Harris
and Ohlson, 1987). When book value is compared with other
approaches, it is found that book values are in fact no less important
than the present-value measure (Harris and Ohlson, 1987). The
Harris and Ohlson (1987) study shows that book value is a better
measure for valuation than future net cash ows, direct prot
margin, or quantity of proved reserves. These measures did not
result in statistical signicance when the regression included book
and present values. Therefore, book value appears to be the best
valuation measure for this industry.
The book value of assets of oil and gas companies includes reserves
of oil. Future cash ows are inuenced by the quantity and quality
of their reserves. Therefore, the demand from shareholders and
lenders for accounting disclosure about reserves could be expected
to increase with leverage (Craswell and Taylor, 1992).
The accounting policy used by a particular company is also
inuenced by managements’ desire to avoid accounting methods
that lead to probable violations of borrowing covenants expressed
in terms of accounting numbers (Craswell and Taylor, 1992). This
is expected because avoiding bankruptcy is one of the main tasks of
a management team, especially after what happened in Enron case.
IPOS, MERGERS, AND ACQUISITIONS
The high amount of capital investment required by oil and gas
companies implies that they need to raise external capital from
both debt and equity. In this section, I investigate IPOs, mergers,
and acquisitions in the energy nance industry. Ritter (1991)
found that the mean age of issuing rm was smallest for oil and
gas companies as compared to rms in other sectors. He found
that the median age of oil rms going public was just two years,
which is small considering the time it takes for a business to
establish itself. This can be explained because of the need to spend
a high amount of capital on exploration and infrastructure before
any production can begin. In terms of post-IPO performance, the
results are strongly inuenced by the measurement period. Initial
post-IPO returns of rms in the oil and gas sector was best among
a number of sectors. The three-year post-IPO performance was
worst in his study. Ritter mentioned that the period of the study
included the phase when oil prices declined substantially, or what
is referred to as the oil crash of 1973. The uctuation in earnings
for oil and gas companies because of oil prices plays a major role
in post-IPO performance.
This argument is supported to a certain extent by Dunning and
Lundan (2008), who stated that the main corporate motive for

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mergers and acquisitions is to increase market share/resources,
acquisition of strategic assets, technology-seeking, and gains in
efciency. One of the reasons for mergers and acquisitions is the
achievement of resources. Large oil and gas companies nd it
difcult to maintain their return and reserve replacement ratio,
mainly because of the difculty in nding and developing new
elds (Weljermars, 2011). Moreover, the overall arguments are
in line with the broadly accepted theory that many of the mergers
and acquisitions in the oil and gas industry from 1998 to 2001
were driven by the desire by rms to increase their earnings by
benetting from synergies between rms (Searle, 2010).
At the same time, there is evidence from the literature that
the technology or knowledge-seeking motive for mergers
and acquisitions is important when acquirers want access to
technology/knowledge that can be readily used for their own
growth (Chung and Alcácer, 2002). In order to stimulate growth
in their earnings and meet shareholder expectations, large energy
rms have acquired several smaller companies that excel at
biofuels, unconventional gas production, and/or oil sands, and
that commonly have poor cash ow but attractive technology and
expertise (Weljermars, 2011). Acquisition of these rms gives
large rms ready access to technology that they can exploit for
their own growth. The acquisition allows large rms to make a
positive impact on cash ows in the medium term instead of in
the long term when investing in exploration on their own. Given
the pressure from markets and analysts to deliver earnings growth,
acquisition of smaller companies is a strategic investment by large
rms. Also, the higher difculty faced by smaller rms in raising
external nance suggests that they are prone to become merger
and/or acquisition targets.
Nevertheless, the failure of mergers and acquisitions to achieve
signicant positive returns for shareholders of acquiring rms
is well documented, and there is little consensus on whether
expectations at the time of mergers and acquisitions are actually
realised in the longer term (Danzon et al., 2007). Investors
support this view by showing signicant differences in the
returns of target and acquirer rms at the time of merger and
acquisition announcements. The shareholders of target rms
earn substantial returns at the time of announcement, but
shareholders of the acquiring rm typically face negative or
slightly positive returns (Fuller et al., 2002). In an analysis
of value changes in the nine major oil industry mergers from
1998 to 2001, Searle (2010) found that shareholders of target
rms gained returns about six times higher than shareholders
of the acquirers. This supports the general empirical evidence
in mergers and acquisitions that target rms’ shareholders earn
substantial returns, whereas gains of shareholders of acquirers
are either small or negative at the time of the announcement of
the transaction.
One feature of mergers and acquisitions is that they tend to occur in
clusters or waves, and that within a wave mergers and acquisitions
are typically limited by industry (Andrade et al., 2001). The high
value of mergers and acquisitions in the late 1990s suggests the
application of the wave or cluster theory. The cluster tendency is
inuenced by share prices. Many rms use their overvalued shares
during stock market booms to undertake mergers and acquisitions
by exchanging their shares for assets of other companies (Schleifer
and Vishy, 2003). This approach protects shareholders of the
acquiring rm if share prices drop substantially in the future.
The high share prices of companies from 1998 to 2001 supports
the use of ‘overvalued’ shares for mergers and acquisitions by oil
and gas companies.
The main observations from this survey of mergers and
acquisitions are that companies engage in such activities because
of their desire to increase reserves for future earnings, as well
as to gain access to technology that can increase revenues from
non-oil and gas energy sources. Target rm shareholders were
found to gain substantially more from merger and acquisitions.
Also, mergers and acquisitions follow a cluster trend and many
are nanced by the equity of the acquiring rm.
RISK MANAGEMENT AND HEDGING
In this section, I review research on the risk management perspective
of the energy nance industry, including hedging in oil and gas
companies. Risk can be dened as “randomness of uncertainty of
future outcomes that can be expressed numerically by a distribution
of outcomes” (Dobler, 2008, p. 187). Beretta and Bozzolan (2004,
p. 269) dene risk disclosure as the ‘communication of information
concerning rms’ strategies, characteristics, operations, and other
external factors that have the potential to affect expected results’.
The Deepwater Horizon oil spill in the Gulf of Mexico shows the
magnitude of risks faced by energy rms (Spence, 2011). Oil and
gas companies face a number of risks: Environmental, health and
safety, liability, and reputational (Spence, 2011). Environmental
risk is high as companies go into difcult terrains in their search
for new reserves of energy. The Deepwater Horizon oil spill
shows the environmental and technical challenges of oil and gas
exploration. The high amount of nes paid by BP because of the
spill illustrates the importance of risk management in the oil and
gas sector.
The main product of oil companies is oil, and therefore it is
expected that changes in oil prices are a signicant determinant
of returns in the sector. Mohanty and Nandha (2011) analysed the
oil price risk exposure of the U.S. oil and gas sector and found a
positive and signicant result. Given the greater capital structure
scrutiny by analysts, it is expected that the hedging practices of oil
and gas rms may be linked to their capital structures. Haushalter
(2000) studied the hedging policies of oil and gas producers
between 1992 and 1994 and found that the extent of hedging was
related to nancing costs; that is, companies with higher gearing
manage price risk more extensively. This is expected because
rms have to meet leverage covenants in terms of earnings-to-
interest ratios as well as cash ows to loan repayments. In other
words, without hedging, a rm is exposed to greater risk from
changes in oil prices, which can increase its chances of bankruptcy
and nancing costs. In terms of determining whether to hedge,
Haushalter (2000) found that the likelihood for hedging is greater
for rms with more total assets. This can be explained by the
assumption that large rms are able to achieve better economics
of scale and thus lower their costs of hedging.

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An analysis of the hedging practices of energy rms is important
because of the extent of dependence of their prots on oil prices.
Demand for oil is comparatively inelastic, and oil prices have
asymmetric and nonlinear effects on real activity (Hooker, 2002).
Oil price increases are followed by severe economic dislocations,
which suggests that there is a link between oil price shocks and
recession (Kilian, 2008). Substantial changes in oil prices can have
a major impact on the prots of energy companies, and therefore
one can expect that rms may use some hedging to improve the
predictability of their cash ows. At the same time, investors can be
argued to take positions with oil producers to gain from exposure
to oil prices. Therefore oil rms may not necessarily benet from
hedging oil price risk (Jin and Jorion, 2006). In their study, Jin
and Jorion (2006) demonstrate that theories of hedging based on
market imperfections imply that hedging should increase the rm’s
market value. They analysed the hedging activities of 119 U.S.
oil and gas producers from 1998 to 2001 and found that hedging
reduces the rm’s stock price sensitivity to oil and gas prices.
The usefulness of hedging is also viewed from the perspective
of industries where oil is a major input cost. Oil is a substantial
percentage of total operating costs in the airline industry. Carter
et al. (2006) studied the fuel hedging activity of 28 U.S. airlines
during the period of 1992–2003 to see whether fuel hedging
added value to the airlines. They found that jet fuel hedging is
positively related to airline rm values. On analysing the factors
that result in higher valuations of airlines using oil price hedging
instruments, they found that the higher the proportion of future
fuel requirements hedged, the larger the valuation premium. They
explained their ndings by the fact that higher hedging of fuel
requirements results in greater clarity of cash ows in the future,
which can be used by the rm to take advantage of investment
opportunities that arise when fuel prices are high and airline
operating cash ows are down.
The main conclusion from this section, the review of risk
management perspective, is that oil and gas companies face many
risks: Environmental, health and safety, oil price, and interest
rate risks. Oil and gas rms engage in hedging to improve their
predictability of cash ows. The extent of hedging is positively
linked to gearing. Firms where oil is a major cost also engage in
oil price risk hedging.
7. CONCLUSION
Energy is one of the main drivers of any economy. Improving
our understanding of the dynamics of energy nance markets can
provide a clearer picture of the whole economy and the relationships
between market players. This literature review surveys some of
the main topics in light of the theoretical and conceptual ndings
from other articles relating to energy nance. Energy nance is
a very dynamic eld that is growing and changing exponentially
by different means. The changes in the dynamics of this eld
are derived by the recent renaissance along with technological
advancements. Literature in ve areas – corporate governance;
capital structure; accounting policies; IPOs, and mergers, and
acquisitions; and risk management and hedging – was reviewed
with specic attention on oil and gas rms.
Corporate governance is important for rms in the oil and gas
sector for many reasons. For example, Russia is a major producer
of oil and gas but its corporate governance structure is poor. The
evidence indicates that state ownership of oil and gas rms has a
negative inuence on corporate governance. Also, independence
of directors will have more effect if it is followed in spirit. In
addition, oil and gas companies have initiated many community
development actions, but they are designed more to achieve social
acceptance rather than being genuine attempts.
The main observation from this literature review of the capital
structure of oil and gas companies is that they rely on external
nance due to high capital expenditures. With rms under more
public scrutiny, capital expenditures on exploration may be
curtailed to improve rms’ nancial position. This argument
is supported to a certain extent by the idea that high amounts
of capital expenditures and information asymmetry between
managers and shareholders implies that credit rating agencies have
an important role in determining the capital structure of these rms.
At the same time, there is evidence from the literature that
understanding accounting policies is very important for oil and
gas companies to have a better understanding of their nancial
situations. The full-costing system can be used to smooth earnings
and thereby achieve higher market valuations, but it does not reect
the true value of assets of an oil rm. Oil and gas rms are required
to disclose additional data to help investors make better economic
decisions. The evidence indicates that the new regulations have
signicantly improved the understanding of accounting in the
energy nance industry. Moreover, this has been done to ensure
transparency and equal opportunities for all market players.
This study as a whole demonstrates that high capital expenditures
also have an impact on the time taken by energy companies to
le for IPOs. Furthermore, the overall arguments are in line with
ndings that the median age at the time of IPO for oil and gas rms
was lowest among different sectors. Also, energy rms undertake
mergers and acquisitions to increase their revenue, reduce costs,
and gain access to technologies that can help them grow in the
non-oil energy sources sector. As is the case in other industries,
the gains of shareholders of target rms were many times that of
acquiring rms’ shareholders.
The nal important factor to consider as a driver of energy nance
is risk management and hedging. Oil and gas companies face many
risks: Environmental, health and safety, oil price, and interest
rate risks. Also, the evidence indicates that risk management is
important in energy rms since changes in oil prices can have a
substantial impact on their earnings and ability to manage capital
expenditure. Companies with higher gearing make more use of
hedging to minimize their risk. Nevertheless, a number of nancial
instruments are used by rms to hedge against changes in oil prices.
These issues are unresolved by the current literature and thus
need to be investigated in future research. The overall analysis of
the research covered in this literature review shows how energy
nance is a very dynamic eld that is growing and changing
quickly. The changes in the dynamics of this eld are derived

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mainly by the recent renaissance. All of this attracts researchers
to explore this eld and provides some explanation for some
unanswered questions.
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