Metallgesellschaft AG: A Case Study in Managing Risk

The Company

Metallgesellschaft AG (MG) is a German company owned by institutional investors including Deutsche Bank AG, Dresdner Bank AG, Allianz, Daimler-Benz, and the Kuwait Investment Authority. MG, traditionally a metal company, has evolved over the last several years into a provider of risk management services similar to Enron. At the end of 1992, MG had 251 subsidiaries with activities ranging over trade, engineering, and financial services. MGs main trading vehicle is its Energy Group which has several subsidiaries including MG Refining and Marketing Inc. (MGRM) in charge of refining and marketing petroleum products in the US. In December of 1993, it was revealed that the Energy Group was responsible for losses of approximately $1.5 billion. These losses stemmed from cash-flow problems associated with large oil forward contracts it had written.

The Team

In December 1991 hired Arthur Benson and his management team to lead its marketing effort. Arthur Benson previously worked at Louis Dreyfuss Energy Corporation and had extensive experience in trading energy derivatives contracts. Bensons key strategy was to offer long-term fixed price contracts. These contracts were for as long as five and in some cases, ten years on gasoline, heating oil, and diesel fuel purchased from MGRM. The team was extremely successful that by September of 1993, MGRM had sold forward the equivalent of over 150 million barrels of petroleum products.

The Contracts

MGRM had two main programs. The first was a firm-fixed program under which a customer agree to fixed monthly deliveries at a fixed price. The second was a firm-flexible contract which specified a fixed price and total volume but gave the customer the option to set the delivery schedule prior to the maturity of the original contrast. In total, there were firm-fixed contracts that totaled 102 million barrels and firm-flexible contracts worth about 48 million barrels. Most of these contracts were put in place during the summer of 1993, when energy prices were historically low.

The firm-fixed program was relatively straightforward as it set the price for delivery on the maturity date. The firm-flexible program allows for 20 percent of its total contract size to be terminated with 45 days notice if the front month NYMEX futures contract was greater than the fixed price specified in the contract. Under these cancelable provisions, the customer was permitted to receive one-half the difference between the current short-end NYMEX futures contract and the contracted delivery price multiplied by the remaining quantity of scheduled deliveries if market prices surged above the set fixed price in the contracts. MGRM Sometimes amended its contracts to terminate automatically if the front-month futures price rose above a specified exit price.

The Hedge

During the summer of 1993, the market was significantly in contango. This implies that the forward prices that customers locked into were much higher than the prevailing spot prices at the time of the contract. Given MGRMs sizable exposure to this activity, there is a need to hedge its inherent risk owing to its portfolio. The given long duration of its contracts proved a challenge to the companys traders and it overall hedging strategy. Liquidity in long-dated futures contracts have always proven to be a challenge resulting in less than efficient execution and sub-optimal pricing.

This situation led MGRM to use short-dated futures contracts to hedge its long-term delivery commitments against spot oil price increases by purchasing a stack of short-dated futures equivalent to its remaining delivery obligations. A significant portion of MGRMs futures position owing to its hedges were on the New York Mercantile Exchange (NYMEX) in the most liquid contracts of between one and three months to maturity based on New York harbor regular unleaded gasoline, New York harbor No. 2 heating oil, and West Texas Intermediate (WTI) grade light, sweet crude oil.

Stack Hedging

The mechanics of a stacked hedging strategy are as follows. On the first delivery date, MGRM buys in the spot market for delivery, offsets all its maturing futures contracts, and re-establishes a long position in the new front-month (i.e., one month) futures contract, this time with its long futures positions reduced by the amount delivered on its flow contracts. On the next settlement date, MGRM again decreases the size of its futures position by the amount delivered and rolls the rest forward to the next maturing one-month futures contract. And so on, month by month.

A Profitable Proposition

In addition to stack hedging being a tenable strategy, the market at the time was in contango. This means that the futures price is higher than the current spot price. This means that by hedging with shorter-dated futures contracts, MGRM was assured that the cost of hedging its contracts with its customers was lower than the price it expects to receive once the contracts are up. As long as the market stays in contango, MGRM can keep rolling over its futures positions at lower prices and accrue profits with its maturing contract obligation.

Contango vs Normal Backwardation

In the oil futures market, the spot price is normally greater than the futures price. This has less to do with market expectations and more with how futures prices are calculated in this commodity. The futures price is calculated as follows:

F_{t, t+1} = S_t [1 + b_{t, t+1}], where b_{t, t+1} = r + z d

r_{t, t+1} = interest cost of physical storage

z_{t, t+1} = physical cost of storage

d_{t, t+1} = convenience yield of having physical inventories on hand

In oil markets, the convenience yield often exceeds the cost of physical storage plus the interest cost of storage. Normal backwardation (S > F) usually occurs when the current demand for oil is high relative to current supply. High demand necessitates that firms have oil on hand to avoid inventory stock-outs. Normal backwardation rewards firms for lending their inventory to the current spot market.

Normally, the oil market is in normal backwardation which implies that when MGRM rolls over its hedge, it is able to take a long position at a lower price and book some gains in the process. As long as the market stays in normal backwardation, MGRM keeps making money on the rollover.

The Fall in Oil Prices

In 1993, oil and oil product prices fell precipitously after OPEC failed to reach agreements on its product quotas. As oil prices fell, MGRM gained on its short forward positions with its customers. At the same time, MGRM suffered losses on its long futures positions on its hedges.

Under a perfect hedge scenario, this should not have mattered as the losses on the long futures position (hedge) should have been offset by the gains on the long forward positions.

By September of 1993, MGRM had sold forward contracts equivalent to 150 million barrels of petroleum products. This was equal to 85 days worth of the entire oil output of Kuwait. By December of 1993, Metallgesellschaft AG announced that its Energy Group was responsible for losses of approximately $1.5 billion resulting from large oil forward contracts it has written.

Questions

• Identify the risks that MGRM faced when putting in place its forward contracts with its customers.
• Did MGRM face a different set of risks with its firm-fixed program compared to its firm-flexible contracts?
• What are the basic mismatches between the forward contracts and MGRMs hedge using futures contracts?
• Was the stack hedging program a sound strategy? What are the risks inherent in this strategy?
• How did the shift in the market from normal backwardation to contango affect MGRM and its positions?
• How did this shift affect the convenience yield?
• What type of funding risk did MGRM face due to its stack hedging strategy?
• How do you think the creditors will react to the shifting fortunes of MG?
• What could MGRM have done to mitigate its increasing losses?
• How does the size of MGRMs position create additional risks?