EBF 301
Global Finance for the Earth, Energy, and Materials Industries

Case Study 3: Metallgesellschaft (MG)


MG was a huge, German industrial conglomerate that decided to open an energy trading office in the US in the early 90s.

The original plan was threefold:

  • sell refined products in the forward, physical market;
  • invest in refining capacity to produce the products;
  • hedge the forward sales through financial derivatives.

When the strategy was first implemented in 1992, current physical prices were lower than the futures prices. So, the sales contracts were set at those higher future prices. And it meant that purchasing the "near" month futures contracts would be profitable. So, MG developed a strategy whereby they would cover the long-term, fixed-price sales by buying contracts in these few, near months. As each month "rolled off," they would merely buy contracts in the next month. It was their intent to continue this process until the physical product sales contracts expired in 10 years. This strategy worked as long as the futures market was "backwardated," whereby each successive month is lower than the prior one (Lesson 3).

One of the major flaws in this approach, however, was the volume of contracts being traded since they were "loading up" on closer month contracts. Add to that, the fact that they would not get paid for the product sales for years out, and you begin to have a cash flow problem where margin calls are concerned. Their position in the fall of 1993 was estimated to be between 160 and 180 million barrels, stretched out over the following 10 years.

In 1993, prices fell as the market received a "bearish" signal from OPEC on production quotas. This lowered futures prices and reversed the market from "backwardated" to "contango," whereby each successive month's price is higher than the prior one (Lesson 3). Faced with this position, MG management was changed, and the new team was directed to close all positions. This resulted in losses on the futures purchases totaling almost $1.5 billion USD. They had to seek bailout funds from one of their banks, and in return, had to sell off several divisions. Today, the German industrial giant no longer exists, having been bought out by a competitor.

Please watch the following video (6:20).

Metallgesellschaft case on hedging disasters
Click here for the transcript.

DAVID HARPER: Hi. This David Harper at Bionic Turtle with a very brief overview, just selected highlights for one of the key case studies for the FRM candidate. This concerns the German company that goes by this name (Metallgesellschaft) that I will abbreviate to MG so as to not mispronounce the proper German name for the company.

And the case is about the very public disaster experienced by the company in the early 1990s. It starts with the initial positions in which MG offered fixed-price, long-term contracts to deliver or supply heating oil and gasoline to its customers, independent wholesalers, and retailers. So, these initial positions were short positions in long-term forward contracts with maturities of 5 to 10 years.

How did the company hedge its exposure? It did this with what is called or by employing a stack and roll strategy, or a stack and roll hedge. And so, in this hypothetical example, each barrel might represent 10,000 barrels of oil.

Let's say at the beginning of the year in January, the company enters into short-term futures contracts-- long positions. So, that is to purchase 120,000 barrels of oil.

And then, we go forward only a single month-- let's just say, from January to February. And right before expiration on those long positions in futures contracts, MG, the company, closes those out and enters into a new stack, a new set of short-term futures contracts where it takes a long position.

And so, in this way, the company could go, say, month-to-month with this stack and roll. That is to say, buy it, go long a short-term stack, close that out, enter into another short-term stack, and keep doing that month-to-month. And so, you can see the short position in these long-term forwards is hedged to a degree but not perfectly by these long positions in short-term futures.

So, notice that if oil prices or oil spot prices are increasing gently, then these short positions are losing money on the forwards. However, they are hedged by the profits that are made on the long positions in these futures contracts.

And so, generally, the strategy had relied on the continuation of backwardation in the marketplace-- that is to say, where the forward price is lower than the spot price or where long-term forward prices are less than near-term forward prices. As long as backwardation persisted, this hedge is generally effective.

However, the market shifted to contango. Contango is when the forward price is greater than the spot price or the long-term forward is greater than the near-term forward. And now this was the company's undoing.

Because what happens if we focus here at the start of the curve-- this is the spot price. The spot price here is dropping rapidly relative to the forward price. And these long positions in short-term futures contract are being rolled over with losses.

And in this case, the long-term forwards are hedged by short-term futures. So, there is a timing and maturity mismatch, which exposes the very significant basis risk at play.

But also, just as significantly, notice the short positions in long-term are forwards. But the hedges are with futures. And under the German accounting rules that existed, at least at the time, these futures were being marked to market on a daily basis.

So, these hedge instruments were losing as they were rolling over into the lower spot prices. The losses, owing to the fact they are futures, were being marked to market and recorded as losses immediately.

However, the forward contracts, owing to the fact they are forwards are not futures, had to await settlement for their gains to be realized. So, their losses here, in theory were, to some extent, being offset by the forward contracts. After all, there was something of a hedge in either direction.

However, only the futures were marked to market. And so, only the losses were realized. So, this triggered reported losses and margin calls and a loss in faith by the counter-parties. So, even accounting here exacerbated the basis risk in the first place.

And so, we have a number of minor risks here. But my vote for the big three would be, first of all, basis risk. As I've said before, basis risk always attaches to a hedge instrument on another underlying, simply because they aren't the same asset. And in this case, they're clearly different, given the fact we had long-term forwards and short-term futures. So, there was significant basis risk to the strategy.

Second, liquidity risk was obviously very significant given the fact that losses would be realized on the futures contract immediately. But the offsetting gains would have to await long-term settlement. And finally, operational risk refers to the fact that the accounting standards themselves played a role in the problem.

This is David Harper of the Bionic Turtle. Thanks for your time.

Credit: Bionic Turtle