METALLGESELLSCHAFT : HEDGING GONE AWRY

Presented By : Suvendu Kumar Bishoyi JKPS/PGDM/09/50

OVERVIEW OF THE CASE ««

Metallgesellschaft was a German based oil Refining & Marketing Company. MG sold 5-year and 10-year fixed-price oil supply contracts to customers at 6to 8 cents above market prices. MG then purchased short-term energy futures to hedge the long-term commitments ² a "stack" hedging strategy It hedged its exposure with long positions in short dated futures contract that were rolling forward .

As the oil prices crashed, leading to billion dollars of margin call to be met in cash. The Company was faced with temporary funds crunch.

The member of MG who devised the strategy argued that: 

if oil prices dropped, the hedge would lose money while the fixed-rate position increases in value; 

if oil prices rose, the hedge gains would offset the losses on the fixed-rate position.

MG management and bankers , disagreeing with the strategy, decided to close out the positions to curtail further losses. Thus, the company cashed in its positions at a loss totaling over $1.33 billion.

WHAT WENT WRONG ?
Cash

flow mismatch ² liquidity

risks 

Futures contracts are marked-to-market. A steep fall in oil spot price creates an immediate and large cash requirement to meet margin calls.

The corresponding gains on the short forward positions would not translate into cash inflows until some date in the future.

The problem is that when oil prices drop, the gains from the sale of the oil are realized over the long-term, but the losses on the hedges will be realized immediately as margin calls come in. This creates a negative cash flow, leading to a funding crisis .

FROM BACKWARDATION TO CONTANGO (BASIS RISKS)

A futures market is said to be in backwardation if futures prices are below spot prices.

It is said to be contango if futures prices are above spot prices.

In a typical commodity market, the futures will be above spot, i.e., the market will be in contango.

In some commodity markets (especially oil) futures prices have remained below spot for long periods of time.

MG rolled over futures positions at the end of each month 

Closing out the existing long futures position by taking a short futures position in the expiring contract. 

Taking a long futures position in the new nearby (next month·s) contract

This is effectively selling at the current spot price and buying at the current futures price. 



In backwardation, rollover creates cash inflows. However, in contango, rollover creates cash outflows

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