In December, 1993, Metallgescellschaft AG revealed publicly that its "Energy Group" was responsible for losses of approximately $1.5 billion, due mainly to cash-flow problems resulting from large oil forward contracts it had written. In a lucid discussion of this infamous derivatives debacle, Digenan, Felson, Kelly and Wiemart explore the trading strategies employed by the conglomerate, how proper supervision could have averted disaster and how similar financial crises may be avoided in the future.

Background

Metallgesellschaft AG, or MG, is a German conglomerate, owned largely by Deutsche Bank AG, the Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait Investment Authority. MG, a traditional metal company, has evolved in the last four years into a provider of risk management services. They have several subsidiaries in its "Energy Group", with MG Refining and Marketing Inc. (MGRW) in charge of refining and marketing petroleum products in the U.S.[1] In December, 1993, it was revealed publicly that the "Energy Group" was responsible for losses of approximately $1.5 billion. MGRM's expanded venture into the derivatives world began in 1991 with the hiring of Mr. Arthur Benson from Louis Dreyfus Energy. It was Benson's strategy that eventually contributed to the massive cash flow crisis that MG experienced.

The Deals:

MGRM committed to sell, at prices fixed in 1992, certain amounts of petroleum every month for up to 10 years. These contracts initially proved to be very successful since it guaranteed a price over the current spot. In some cases the profit margin was around $5 per barrel. By September of 1993, MGRM had sold forward contracts amounting to the equivalent of 160 million barrels. What was so unique about these deals was that the vast majority of these contracts contained an "option" clause which enabled the counterparties to terminate the contracts early if the front-month New York Mercantile Exchange (NYMEX) futures contract was greater than the fixed price at which MGRM was selling the oil product. If the buyer exercised this option, MGRM would be required to pay in cash one-half of the difference between the futures price and the fixed prices times the total volume remaining to be delivered on the contract. This option would be attractive to a customer if they were in financial distress or simply no longer needed the oil. The sellback option was not always an option, because MGRM sometimes amended its contracts to terminate automatically if the front-month futures price rose above a specified "exit price".[2]

The MGRM Strategy:

MGRM provided their customers with a method that enabled the customer to shift or eliminate some of their oil price risk. The petroleum market is an environment plagued with large fluctuations in the price of oil related products. MGRM believed their financial resources gave them the ability to wholesale and manage risk transference in the most efficient manner. In fact, MGRM's promotional literature boasts about this efficiency at risk management as a key objective to continued growth in acquiring additional business. MGRM's hedge strategy to manage spot price risk was to use the front-end month futures contracts on the NYMEX. MGRM employed a "stack" hedging strategy. It placed the entire hedge in shortdated delivery months, rather than spreading this amount over many, longer-dated, delivery months because the call options mentioned above were tied to the front month futures contract at the NYMEX. Studies have demonstrated the effectiveness of using stacked hedging. MGRM's strategy was sound from an economic standpoint. The futures contracts MGRM used to hedge were the unleaded gasoline and the No. 2 heating oil. MGRM also held an amount of West Texas Intermediate sweet crude contracts. MGRM went long in the futures and entered into OTC energy swap agreements to receive floating and pay fixed energy prices. According to the NYMEX, MGRM held the futures position equivalent of 55 million barrels of gasoline and heating oil. By deduction, their swap positions may have accounted for as much as 110 million barrels to completely hedge their forward contracts.[3] The swap positions introduced credit risk for MGRM.

What Went Wrong:

The assumption of economies of scale was mistaken. MGRM attributed to such a great percentage of the total open interest on the NYMEX that liquidation of their position was problematic. Without adequate funding in case of immediate margin calls, this seemingly sound strategy becomes reckless. MGRM's forward supply contracts left them in a vulnerable position to rising oil prices. Therefore, MGRM decided to hedge away the risk of rising prices as described. However, it was the decline in the price of oil that ultimately led MGRM to financial distress. Another problem MGRM encountered was the timing of cash flows required to maintain the hedge. Over the entire life of the hedge, these cash flows would have balanced out. MG's problem was a lack of necessary funds needed to maintain their position. Given the fact that this risk management strategy played a key role in acquiring business pursuant to their corporate objectives, management should have obtained an understanding of the strategy. Did MG's Supervisory Board really know what was going on?

Analysis of MGRM's Methods:

MG's losses in the futures and swaps markets have raised questions about whether MG was really hedging or speculating. When news of MG's losses began to leak to the public, it was rumored that they had speculated, betting that oil prices would rise. If they were hedging, as initially reported in the press, they would be indifferent to a change in prices. MGRM was not indifferent to the direction of oil price movements because they were engaged in an indirect hedge of their forward positions. The enormous losses they incurred did not result from naked futures positions in which MGRM gambled that the price of oil would rise. The position was more complex than that. MGRM's futures and swaps positions were hedges of the medium-term fixed-rate oil products they had sold forward. The hedge scenarios were as follows: If oil prices drop, the hedge loses money and the fixed-rate position increases in value. If oil prices rise, the hedge gains offset the fixed-rate position losses. A hedge is supposed to transfer market risk, not increase it. If this were a hedge, as we have proposed, we must answer the question: how did MG lose over $1 billion? MGRM's hedge adequately transferred its market risk. When oil prices dropped, they lost money on their hedge positions but the value of their forward contracts increased. MGRM exposed themselves to funding risk by entering into these positions. In that sense, they were speculating. They were speculating by entering into medium-term fixedrate forward positions totaling approximately 160 million barrels of oil. The sheer size of this position created an enormous amount of risk. According to an MG spokesperson, this position was the equivalent of 85 days worth of the entire off output of Kuwait. If oil prices were to drop, MGRM would lose money on their hedge positions and would receive margin calls on their futures positions. Although gains in the forward contract positions would offset the hedge losses, a negative cash flow would occur in the short run because no cash would be received for the gain in the value of the forward contracts until the oil was sold. Although no economic loss would occur because of their hedge strategy, the size of their position created a funding crisis.

From Backwardation to Contango:

Another issue compounding MG's crisis is the shift of the oil market from normal backwardation to contango. In the oil futures market, the spot price is normally greater than the futures price. When this occurs, the market is said to be in backwardation. When, however, the market shifts and futures prices are greater than the spot price, the market is said to be in contango. Since MGRM was long futures, the contango market created rollover losses that were unrecoverable. MGRM entered into "stacked" futures positions in the front month contracts and then rolled its position forward at the expiration of each contract. In the contango market, the spot decreased more than the futures prices. As long as the market stayed in contango, MGRM continued to lose on the rollover. It would not be accurate, however, to say that Benson's gamble on a market in normal backwardation created MGRM's dire cash flow crisis. The contango market compounded MGRM's problem but their real problem was created by their inability to handle the cash flow problems created by the drop in oil prices in conjunction with the huge volume of futures contracts they entered into. The rollover risk that the oil market might go into contango should have been factored into the price of the call options within MGRM's forward fixed-rate contracts. The contango market simply meant the market was at full carry. The contango market did not make their hedge a bad hedge. It simply compounded their cash flow crunch. It has been widely reported in the press that the contango market was the key to MGRM's downfall. We agree that the contango market played a role in the crisis. We disagree that it was the key element. If the market had stayed in normal backwardation, as Benson expected it would, MGRM would actually have picked up a gain on the rollover of their hedge positions. In the particular case of crude oil, the backwardation can be considered the market's judgment that OPEC's cartel pricing was unsustainable over the long run and prices would some day collapse. As OPEC managers became deadlocked on reaching production quotas in late 1993, the spot price tumbled in accordance with the expectations reflected in the inverted market and oil markets moved from backwardation to a strong carry[4]. MGRM's rollover gains turned into rollover losses. The rollover loss that resulted from the contango market was the only real economic loss suffered by MGRM. By this, we mean that the rollover loss was unrecoverable and was not offset by another position.

U.S. vs. German Accounting Methodologies:

German accounting standards also compounded MG's problems. Lower of Cost or Market (LCM) accounting is required in Germany. In the U. S., MGRM met the requirements of a hedge and received hedge accounting. Therefore, in the U.S., MGRM actually showed a profit. Their hedge losses were deferred because they offset the gains of their forward fixed-rate positions. Using LCM, however, MG was required to book their current losses without recognizing the gains on their fixed-rate forward positions until they were realized. Since German accounting standards did not allow for the netting of positions, MG's income statement was a disaster. As such, their credit rating came under scrutiny and the financial community speculated on the demise of MG. This drastically changed the market arena for MGRM. Their swap counterparties required additional capital to maintain their swap positions and the NYMEX imposed supermargin requirements on MGRM more than doubling their performance bond requirement. If hedge accounting had been acceptable in Germany, MGRM's positions may not have alarmed the marketplace and they might have been able to reduce their positions in the OTC market without getting their eyeballs pulled out.

 

1.Background Questions
1)Why did Metallgeselschaft AG’s US subsidiary, MG Refining and Marketing Inc. (MRGM), want to offer a price guarantee on purchase contracts for its customers?
2)What were the basic features of the hedging strategy?

2. Metallgesellschaft and Financial Markets
3) Explain the difference between a hedger, speculator and arbitrageur.
4) Was Metallgesellschaft AG really hedging or speculating in the financial markets?

3. Hedging Mechanics
5)What is a hedge constructed with a ‘stack’ of short-dated contracts? What is a hedge constructed with a ‘strip’ of futures contracts?
6) How do ‘stack’ and ‘strip’ compare as far as funding or cash flow risk is concerned?