Risk Management Case Study: Metallgesellschaft AG (MGRM)

Background of the case

This German conglomerate is owned largely by some very big banks in Germany like Deutsche Bank, Dresdner Bank to name a few as well as the Kuwait Investment Authority. The Energy group subsidiary of this conglomerate (MG Refining and Marketing (MGRM – hereinafter referred to as the firm) which deals with petroleum products reported a loss of round-about $1.5 billion in December 1993.

The Firm had exposure to short forward positions of certain amounts of petroleum every month over 10 years. These positions were slated to make profits since the forward price was at a premium over spot. These deals had an “option” clause involving the NYMEX futures contract on oil. The Options clause entailed that if the front-month NYMEX futures price exceeded the forward price the counterparties could terminate the contracts early. On exercise The Firm would be required to pay in cash one-half of the difference between the futures price and the fixed price times the total volume to be delivered of the contract. This would be attractive to the customer if they were in financial distress and simply no longer in need for oil.

Given the fluctuations in the oil market prices, The Firm employed a “stack and roll” hedge strategy using long NYMEX futures contracts. The delivery months used were short-dated along the lines of the call options used. The Firm went long in futures and entered into OTC energy swap agreement to receive floating and pay fixed. The futures positions accounted for 55 million barrels and the swap positions accounted for 110 million barrels and these positions introduced credit risk for The Firm.

Causes of the losses

The hedge was created with a view that the market would be in backwardation (where spot prices are higher that futures prices) which is normally the case. However, the market shifted to contango (where futures prices are higher than the spot prices) greatly increasing the cost of the hedge. The gain due to the short positions was more than offset by a loss due to the futures positions.

This caused the following problems:

1. The contribution due to the size of the The Firm’s total open interest was a considerably larger percentage of the total and liquidating these positions would be very difficult. There was also a danger of not having adequate funding in case of immediate margin calls.