In short, MGRM’s hedging policy was that its short-position in long-term forward contracts is hedged by long positions in short-term futures contracts that are rolled over. However, there was only a hedge to a certain extend (imperfect hedge). Even though there was a matching amount, there was a mismatching maturity. This introduced basis risk.
What went wrong?
If the oil price increases the short position (forwards) is losing money. However, this loss is offset by the gain in the long position (futures). The problem however, was that this strategy relied on the continuation of backwardation. The steadily decline of spot oil prices with a changing relationship between near-future markets and spot prices resulted into losses when MGRM rolled over its stack of near-term futures. Another problem was the timing of the cash-flows (Laurent. 76).
Normally, the spot price is greater than the futures price ( in oil futures market. This relationship is called backwardation. However, when the market shifts to contango, which is what happened in the 1990’s, this means that the spot price is smaller than the futures price ( . This relationship had a drastically high impact on MGRM’s hedging policy.
As a result, the short-term futures contracts are being rolled over with losses. If MGRM was hedging, it should have been indifferent to a change in price movements. However, this was clearly not the case. Due to the fact that oil markets tend to be in backwardation, MGRM based its hedging policy on this assumption. However, at that time, the market shifted to contango, Due to this, MGRM incurred massive losses when the spot price declined in excess of the backwardation discount.
Nevertheless, it would be inaccurate to say that MGRM entered financial distress just because of an unexpected market change.
There was also the timing and maturity mismatch. Futures were traded market to market so the losses were realized and recorded on a daily basis while forwards had to await settlement for gains to be realized. MGRM had a cash-flow problem. It experienced violent short-term losses while gains were slowly realized at maturity. When oil prices dropped, MGRM lost money on their hedge positions and receive margin calls on their futures. Although gains in the forward position may have been able to offset these losses, a negative cash flow occurred, because there was no cash that would have been received before the oil in the forward contract was delivered at maturity. This created a funding crisis. Moreover, these losses could technically be hedged by the long position the company held, by regulations of the German Accounting Law at this time, these gains could only be officially realized at their maturity dates. In turn, MGRM had to show huge losses on its balance sheets.
Another point worth mentioning is the hedge ratio. MGRM entered a “one-for-one” or “barrel-for-barrel” hedge. Here, MGRM hedged by hedging its entire amount of its longer dated short position forwards by entering the same amount of near-term long position futures. However, hedging is not about the complete elimination of price risk. It is more about minimizing the variance of the firm’s value. Due to the maturity mismatch a lower hedge ratio would have been necessary. The one-for-one hedge ratio was overkill and increased the firm’s exposure to price risk. Even worse, it increased the volatility of MGRM’s cash flows which increased its liquidity problem, which exposed MGRM to funding risk.
How Traders Were Disciplined
The company president of Refining and Marketing, Arthur Benson, who was hired specifically to perform a clever hedging strategy for MGRM and was therefore claimed to be responsible for these huge losses, was dismissed after almost running the company into bankruptcy. He was blamed for having “significantly damaged the company through reckless trading” The gains that he assumed the company would be gaining with the hedging strategy was said to be a complete speculation on his part, thus he and his team assumed that the oil prices will perform in a specific way because of historical evidence. “Metallgesellschaft has said it had no choice but to pull the plug on an operation that had become unauthorized speculation.” The company also dismissed Benson’s group of traders all members of MG’s board of directors were fired in December 1993 and Arthur Benson was fired in February 1994.
Did the institution Go Bankrupt?
There is no exact data available to the public as to how much money was lost each month that the future’s contracts were rolled over, but according to Charupat and Deaves, “the cumulative return from holding long 12 consecutive near-month crude oil, heating oil and gasoline futures contracts starting in December was -52%, -35% and – 58% respectively” (Charupat and Deaves 20). Taking into account that MGRM had an enormous hedging position of over 160 million barrels of oil, the losses it incurred were tremendous, “totaling nearly $1.3 billion” (Jacque 76).
MGRM incurred so many losses in one year that it was on the verge of bankruptcy. As a result, it was forced by MG Supervisory Board to terminate the hedging operation and was required to close its futures positions and to liquidate its forward contracts to supply oil.
However, it was saved in the end by a “massive $1.9 billion rescue package mounted by as many as 150 German and international banks.” (Jacque 73)
Lesson Learned
In the aftermath of the losses of MGRM there were several measures suggested to prevent similar situations from occurring again.
Firstly, MGRM should have been aware of the fact that history will not necessarily repeat itself in the future. MGRM took large bets in the futures market in the belief that the market is going to stay in backwardation. Consequently, it suffered big losses as the market went to contango.
Secondly, MGRM had a poor risk management and therefore it missed to take the worst case scenarios into account. This could have been done by using stress testing and multiple scenario analysis. Stress testing “emphasizes one non-controllable variable”, whereas multiple scenario analysis “emphasizes on two or more key non-controllable variables” (Laurent 95). Both are useful tools in order to control the company’s overall risk exposure and to predict what can happen in the worst case scenario. It was grossly negligent of MGRM not to undertake these steps. Especially, when you consider that the notional value of the hedge was more than $3 billion, twice as much as the equity value of MG. (Laurent, 94)
Thirdly, MG and MGRM were facing a problem of bad corporate governance, because MG’s board of directors and MGRM’s supervisory board failed to do their job. Both did not fully understand the ramifications of the hedging strategy. Consequently, they were unable to intervene until the outcome was apparent and huge losses were unavoidably. Therefore, they can be blamed as well for not doing their job. Thus, their job was to set clear strategic objectives and risk tolerance guidelines for the corporation.
Moreover, economists, especially Nobel laureate Merton H. Miller, suggested that MG had closed out the short term long positions in the future contracts too soon. As a result, it forwent cash inflows as the oil prices increased. (Krapels 4).
In conclusion, a key element to implement in order to avoid such losses in the future would be a better supervision of the supervisory board over the management. The supervisory board has to understand the use of the derivative instruments and to evaluate the benefits and the risks. Otherwise, it allows the management to take too much risk and to depart from its actual hedging strategy to speculation and big losses might occur.
After the management was fired, they still claimed that they were not responsible for the losses. At least, the new management assured its shareholders to consider more carefully the downside risks of future strategies and to implement additional measures to monitor and supervise the traders.
At this time, other companies, such as Orange County in 1994 or Barings in 1995, faced huge losses by using derivatives as well. Consequently, a new role of corporate risk management emerged and many large institutions introduced new measures such as stress testing, multiple scenario analysis and value at risk metrics in order to manage the overall risk exposure of the company more accurately.
But how realistic is it that such measures will be implemented in the future?
Implementing risk measures should be an essential task in any large corporation, but taking them serious and interpreting them in a right way is far more difficult, because often the management is tempted to do otherwise. On the one hand, as long as the trader is making profit the management is likely not to look too closely at what the trader is actually doing, trusting his/her skills. On the other hand, if losses do occur, not only will the trader be blamed for misusing derivatives, but also the upper management will be held responsible as well. Thus, it is important for the management not to increase the amount of risk a trader is allowed to take even if he/she shows a good record, and for it to fully understand the strategy being undertaken.
The disaster of MG should remind the corporate industry to understand their positions in the financial markets and understand the consequences of market movements on their financial positions. It should not be seen as a warning sign to managers to stay away from derivatives. These can be very beneficial to transfer market risk. MG failed, however, to estimate the funding risk in their positions.
According to the G30 Derivatives study, MG’s near financial ruin could have been avoided so answering the question we raised in the introduction; it would be false to say that MG was just an unlucky hedger that was caught by adverse and abnormal oil price movements. It was a speculator with a naïve hedging strategy.
Bibliography
Jacque, Laurent L. Global Derivatives Debacles: From Theory to Malpractice. World Scientific Publishing Co. , 2010. eBook.
Krapels, Ed. "Re-examining the Metallgesellschaft affair and its implication for oil traders." Oil&Gas Journal. (2001): 4. Web. 14 Dec. 2011.
Miller, M. H., and C. L. Culp. "Metallgesellschaft amd the economics of synthetic storage." Journal of Applied Corporate Finance. (1995): 62-76. Web. 14 Dec. 2011.
Edwards, Franklin. "Derivatives Can be Hazardous to Your Health: The Case of Metallgesellschaft." Diss. University of Columbia, 1995. Print.
Charupat, Narat and Deaves, Richard (2004) "Backwardation in Energy Future Markets: Metallgesellschaft Revisited," Energy Studies Review: Vol. 12: Iss. 1, Article 2.
Digenan , John, Dan Felson, et al, and First . Metallgesellschaft AG: A Case Study. 2004. Web. 14 Dec. 2011. <http://www.stuart.iit.edu/interview/fmtrev3.htm>.
Avsen, James, and Laurent Jaque. "When a Hedge is a Gamble: An Empirical Investigation (1993-2002) of Metallgesellschaft's High Stake Debacle." The Financier . Vol 11/12. 2004-2005. Print.
To be “short oil” means having committed to making a future oil delivery.
MGRM’s success would still depend on both parties holding their side of the bargain.
This strategy is called “month-to-month stack and roll”
Basis risk: the risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other.
This can be explained by a “convenience yield” that participants in the oil market attach to holding the product.
This relationship can be explained by the “cost of carry” (e.g. storage cost)
This is simply due to the fact that the present value of gains/losses on a 10 year forward contract are considerably smaller than the present value of a 30-60 day futures contract.
Various estimates put the optimal hedge ratio between 0.50 and 0.75 for a 10-year monthly annuity of oil (Laurent, 2010 pp. 92)
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