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 – 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 – 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