METALLGESELLSCHAFT'

S HEDGING DEBACLE
GROUP 7

S H R E YA S O O D ARPIT MALIK ABHISHEK JAIN

A N S H U L TA N D O N A R U N I K A S A N G WA N VA R U N PAT E L
 METALLGESELLSCHA
FT CORPORATION Premise behind forwards

(MG) To supply oil at fixed price to independent retailers who often faced
severe liquidity crisis and squeezes on margin when oil prices rose

• Subsidiary of Metallgesellschaft A.G., a German conglomerate with 15 major

subsidiaries

• Trading Subsidiary - MG Refining and Marketing (MGRM)

- Established? very large energy derivatives positions

- To hedge? its price exposure on its forward supply contracts Premise behind futures

- Amount hedged? 160 million barrels To arbitrage between the spot oil market and the long-term contract
market.
- Counter-parties? Retail gasoline suppliers, large manufacturing firms, and some
government entities
CONTRACT PROGRAMS

• Customer would agree to a fixed

• Customers were given extensive rights
monthly delivery of oil products at a set
to set the delivery schedule for up to • Agreed to make deliveries at a price that
price.
20% of its needs in any year, besides the would assure the independent operator a
fixed price commitments. fixed margin relative to retail price
• 102 million barrels of oil products
offered by its geographical competitors.
were obligated under this program by
• 52 million barrels were contracted
September 1993
under this program • The contracts could be extended
annually for a defined period at
MGRM’s discretion.

• By September 1993, a total of 54 million

barrels were committed

FIRM FIXED CONTRACTS FIRM FLEXIBLE CONTRACTS

GUARANTEED MARGIN CONTRACTS
CONTRACT PROGRAMS
• 154 million barrels of obligations for periods up to 10 years constituted MGRM’s designated short position in oil

• Contracts came with cash-out option if the energy price were to rise above the contractually fixed prices

• Fixed delivery prices were set 3 to 5 dollars higher than the spot price

• Cash-out provision

Buyer could choose to sell the remainder of its forward obligations back to MGRM for a cash payment of one-half the difference between the prevailing near
month futures price and the contractually fixed supply price times the total volume remaining on the contract.

• MGRM opted for early exercise sell-back options instead of negotiated unwinding. These options take effect when the front-month futures rises above the
fixed delivery price in the flow contract
 EXPOSURE

Risk?
MGRM’s fixed price forward delivery contracts exposed to the risk of rising energy prices

Solution?
MGRM hedged this price risk with energy futures contracts of between one to three months to maturity at NYMEX and OTC swaps.

Premise?
Hedging strategy was to protect profit margins in its forward delivery contracts by insulating them from increases in prices. Gains would be substantial from its
derivative positions if energy prices rise.

1993 CRISIS

WHAT HAPPENED RESULT

• Later part of 1993, energy prices fell sharply ($19 a barrel in June 93
to $15 a barrel in Dec. 93)
• Resulted in unrealized losses and margin calls on derivative positions in
excess of $900 million
• Board responded to mounting margin calls by –
1. replacing MG’s top management
2. liquidating MGRM’s derivative positions and forward supply contracts
which ended MG’s involvement in the oil market

• Futures market went into a contango price relationship for almost • Suffered derivative related loss of $1.3 billion by the end of 1993.
entire year in 1993 increasing cost each time it rolled its derivatives
• A massive $1.9 billion rescue operation by 150 German and international
banks kept MG from going into bankruptcy
 HEDGING STRATEGY

STACK AND ROLL

• MGRM opened a long position in futures staked in the near month contract
• Each month MGRM would roll the stack over into the next near month contract, gradually decreasing the size of the position
• Under this plan the total long position in the stack would always match the short position remaining due under the supply contracts
• MGRM’s total derivative’s position was almost equal to its forward commitments, a barrel for barrel hedge or with hedge ratio of 1:1

RISKS ASSOCIATED

1) ROLLOVER RISK

A stack hedge refers to a futures position being “stacked” or concentrated in a particular delivery month (or months) rather than being spread over many delivery
months.

The stack and roll strategy can be profitable when markets are in “backwardation” that is, when spot prices are higher than
futures prices. But when markets are in “contango” that is, when futures prices are higher than spot prices, the strategy will result in losses

2) FUNDING RISK

Because of the marked-to-market conventions that applied to its short-dated derivative’s position

3) CREDIT RISK

It is exposed to credit risk because of its forward delivery counter-parties might default on their long-dated obligations to purchase oil at fixed prices.
 QUESTION 1

Why did the MG’s Supervisory Board end its forward delivery program and liquidate its derivative positions in response to large unrealized
losses in derivatives position when, in fact, its forward delivery contracts were in the money?

• Incurred a huge losses on futures which were settled at end of month while compensating gain on forward contract was supposed to happen over 10 years

• Current losses on futures demanded huge cash outflows which led to the inability to respond to margin calls and squaring off positions

• One more problem was the hedging ration of 1:1 as the one barrel of oil at present-day or a month after is simply not equal to the present value of the same
barrel oil contracted to be delivered 10 years from now

• Also, they could not enter into a forward contract of the same duration to hedge their forward supply contract due to low credit rating and small market of such
contracts.

Contract was no longer risk-adjusted and board could not think of any better way to recover the lost amount, the MG’s Supervisory Board had to end this
program
 QUESTION 2

Did the Board panic in the face of huge margin calls?

• Yes
• Board saw mounting losses due to the margin calls which exceeded $900 million
• Took a hard step to replace the management and close all its position in futures and forwards because of their inability to hedge the risk forward supply contract.
 QUESTION 3

Could it be that the Board did not understand the full implications of the hedging strategy and panicked in the face huge margin calls?

• Foundation for taking such big action might have aroused from inability of MG to raise funds to respond to margin calls.

• If the board did not exploit opportunity of raising the funds from banks in the form of loans because of less understanding about the stack and roll hedging
strategy, then they really missed out on an exceptional opportunity of earning in the long term as current losses would have translated into future gains, with
only counterparty risk on the forward supply contract.

• In case of margin losses, the same banks came to the rescue and bailed out MG when it was about to go bankrupt.
 QUESTION 4

Did MG have funding problems?

• MG had lower credit rating which forced them into entering a mismatched duration future contract

• Since, they hedged their long forward supply position through near term futures and swaps with short-duration derivative positions, they had to show the value
of the derivatives at a prevailing price (marked to market) which was quite low during low crude oil prices

• During unfavorable times i.e. low crude oil prices and contango condition, MTM did not accurately represent the true value of MG’s assets and harmed the
company’s ability to raise funds against it

• Short-duration derivative positions put pressure on the company when oil prices fell because of huge margin calls on the contract stack
 QUESTION 5

Some critics say that MG’s stack and roll strategy was flawed because it exposed it to rollover risk, funding risk, and credit risk. Is this the
reason for liquidating the derivatives position ?

• Only the rollover and funding risk caused the liquidation of derivatives

• MG incapable of raising enough cash for responding to their huge margin calls and fall in prices (MTM pricing) of assets at hand
• Lower crude prices for prolonged periods and huge contract stacks put even more pressure on the company’s books as it had to use its cash and credit
lines for squaring off short-term positions

• Credit risk was managed to an extent through the contract program of providing not more than 20% needs and cash-out option

• It was rather a true asset as it could have as the collateral for getting funds.
 QUESTION 6

Why did management choose a hedge with a mismatched maturity structure? Why did management run such a large stack?

• Company had to reluctantly choose a hedge with mismatched maturity structure because

• Less Number of players offering long term forward contracts

• MG’s credit rating was low for these companies to be exposed to it
• There were liquidity issues in long-term forward contracts

• The company’s Stack and Roll Strategy entailed the company to maintain the hedging ratio around 1

• The company provided forward-supply contracts to its customers for a duration of 10 years whereas its price risk was hedged using energy futures
contracts of 1-3 months duration to maturity at NYMEX and OTC swaps

• Large Stack maintained as deemed fit by MG’s strategy

• The stack and roll strategy can be profitable when markets are in “backwardation,” that is, when spot prices are higher than futures prices
• But when markets are in “contango,” that is, when futures prices are higher than spot prices, the strategy will result in losses.
THANK YOU