LESSONS LEARNT FROM
METALLGESELLSCHAFT FINANCE ESSAY
Published: November 27, 2015
Sells long-dated oil forwards hedged by "stacking and rolling" oil futures. Unable to
meet margin calls, Metallgesellschaft has to be rescued by a consortium of banks after
losing $ 1.6 billion.
Background
Metallgesellschaft AG, or MG is German conglomerate, owned largely by DaimlerBenz, Deutsche Bank AG, Kuwait Investment Authority, Dresdner Bank AG and Allianz.
MG is traditional metal company has evolved into a provider of risk management services.
They in charge of refining and marketing petroleum products in the US with MG Refining
and Marketing Inc.(MGRM). Began 1991, MGRM's expanded venture into derivatives with
hiring of Arthur Benson from Louis Dreyfus Energy. It was Benson's strategy that
eventually contributed to massive cash-flow crisis that MG experienced.
At prices fixed in 1992, MGRM sell certain amounts of petroleum every month for up
to 10 years. Since it guaranteed a price over the current spot price, these contracts had
successful in the beginning. By September of 1993, MGRM had sold forward contract
amounting of 160 million barrels. These deals is unique because these contract contained
an 'option' clause which enabled the counterparties to terminate the contract early if the
front month New York Mercantile Exchange (NYMEX) futures contract was greater than
the fixed price at which MGRM was sell the oil product. MGRM would be required to pay
in cash one-half of the difference between the future price and the fixed price times the
total volume remaining to be delivered on the contract if the buyer exercised this option.
It will attract the customers who in financial distress or no longer needed oil.
Actually, MGRM provided their clients with a method that enabled them to eliminate
the oil price risk since the petroleum market is an environment plagued with large
fluctuation in price. To manage spot price risk, MGRM's hedge strategy was to use the
front-end month futures contracts on NYMEX. It used a 'stack' hedging strategy which is
it placed the entire hedge in short-dated delivery months rather than spreading over
longer-dated delivery months, because the call options were tied to the front-month
futures contract at the NYMEX. MGRM used to hedge unleaded gasoline and number 2
heating oil with futures contract. MGRM went to long in the futures and entered into OTC
energy swap agreement to receive floating and pay fixed energy prices.
However, the assumption of economies of scale was mistaken. MGRM expect to hedge
away the risk of rising oil prices. But, it was the decline in the price of oil lead to financial
distress. Another problem was the timing of cash-flows required to maintain the hedge.
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 only result from naked future positions in which MGRM speculated that
the price oil would increase but it would also of future and swap positions were hedged
of the medium term fixed rate oil products they had sold forward. A hedge is supposed
to transfer market risk, not increase it since the hedge scenarios were as follow, if oil
prices decline, the hedge losses money and the fixed rate position increases in value but
if oil prices rise, the hedge gains offset the fixed rate positions losses.
As long as the spot prices for oil and gas remain relatively stable or increase over the
one-month holding period of the stack hedge contracts and the market is in
backwardation, then a profit is earned using this strategy. However, if the spot price
drops significantly, then losses will be incurred. In the event the spot price drops to less
than the futures prices, the market is said to be Contango. Entering a long-position stack
hedge in a Contango market can generate a profit only if a spot and futures prices diverge
or if spot prices increase while the basis spread does not decrease by an equal amount
as if the futures prices increase. The roll over risk that 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 aftermath
The Metallgesellschaft AG (MG)'s fiscal year ended on Sept. 30, 1993, and it gradually
became evident that the parent company would have to disclose the extent of the US
affiliate's paper losses emerging from its massive swaps positions. In early December
1993, press reports began to circulate. Trading of MG's stock was suspended in Frankfurt
on Jan. 6, 1994. MG issued an announcement to its shareholders in early January that
losses were "nearly $1 billion." MGRM's supervisory board had decided in December 1993
to end the forward-sales program and appointed a new management team to unwind its
positions.
The MG affair give three primary messages to petroleum industry, which are involving
the relationship between hedging and speculating, corporate governance and commodity
market dynamics. On the message of hedging and speculating, MG Refining and
Marketing (MGRM) designed an innovative program aimed at rapid expansion in a mature
but evolving business- the marketing of petroleum products. Regarding the issue of
corporate governance, the extent of MGRM's activities in financial energy markets
appears to have caught its parent by surprise. On the aspect of market dynamics, MGRM's
open interest in the oil financial markets, both exchange traded and over the counter
became extremely large.
In early 1994, MG AG's management terminated the MGRM program. Since it is
terminated, the affair inspired Christopher Culp and Merton H. Miller to publish a valuable
collection of analytical essays that concentrate almost entirely on the issues of hedging
versus speculation and corporate governance. They defended MGRM, based on the view
that the "stack and roll" strategy could have worked but it required very considerable
financing on the part of its parent company. Mello and Parsons jumped into the debate
with a paper that defined the MG rolling stack strategy as speculation in the spring of
1995. The characterization of MGRM's program as hedging or speculation becomes the
major points of controversy in the post-mortems of the MGRM derivatives program. In
the summer of 1995, MG settled a complaint lodged against it by the Commodities Futures
Trading Commission to escape admission of guilt and brought to light the basic story of
the transactions whereby MG attempted to become a major player in the US oil market.
Lessons learned
From this study, we noted that Metallgesellschaft did not involve fraud. Rather, their
stack and roll hedge exposed them to basis risk. They also exist a shift to Contango that
created losses on roll return where the roll return profits are on backwardation and the
losses are on Contango. Then, the accounting standard required recognition of futures
losses but not forward gains.
From this, we can learned that the short-term hedge against long-term contacts
require liquidity. The uncertainty of roll returns was taking into consideration and also we
can learn that liquidity consideration may favor other than minimum variance hedge. The
Stack-and roll involves buying a stack (bundle) of short-term futures/forwards contract
with the aim of hedging a long- term exposure. Each stalk is "rolled over" just before
expiration by selling existing contract while buying another stack of contracts for more
distant delivery date. Metallgesellschaft used short-dated contract because the future
markets for most commodities have relatively little liquidity beyond the first few contract
dates. The gains or losses on each side of the forward and futures transactions should
have offset each other.
The strategy was inefficient for two reasons. The first factor was the market shifted
to Contango make the futures price is greater than the spot price. Then, the second factor
was German accounting methods required Metallgesellschaft to show futures losses (i.e.,
from hedge) but could not recognize unrealized gains from the forward. These reported
losses triggered margin calls and a panic, which led to credit rating downgrades.
One of the fundamental problems argued by many is Barings management’s
decision to allow Leeson to execute both the trades, and settle the accounts.
Huge (and Quick) Market Movements Might be Orchestrated by Institutions
The next time you see a huge discount in any asset, do not be too sure that it is a
buying opportunity.
Regardless how much the discount is, be sure that you know the company of the
stock very well, if not extremely well before buying.