Metallgesellschaft

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MGRM was a U.S. subsidiary of Metallgesellschaft AG, an industrial conglomerate based in Frankfurt, Germany. In 1993, MGRM entered into long-term, fixed-price contracts to deliver oil products (primarily gasoline and heating oil) to end-user customers. Because MGRM could not change its prices after these contracts were signed, it was exposed to the risk of rising energy prices. Lacking a liquid market for appropriate long-term futures contracts would allow it to hedge its price risk, MGRM implemented a dynamic hedging strategy that used short-dated energy futures contracts.

 

This strategy required that the hedging instruments (i.e., the futures contracts) be "rolled forward" each month as they expired. The derivative position was adjusted monthly to reflect the changing amount of oustanding contracts to be hedged in order to preserve a one-to-one hedge. "Such a strategy is neither inherently unprofitable nor fatally flawed, provided top management understands the program and the long-term funding commitments necessary to make it work," according to Culp and Miller.The type of dynamic hedging strategy implemented by MGRM is known as a rolling hedge, and it can be profitable when assets for immediate delivery are priced higher (i.e., the spot price) than assets for future delivery (i.e., the futures price).

 

This type of pricing curve situation is known as backwardation. When the firm rolls the hedge position in a market characterized by backwardation, the contract that is about to expire is sold at a price that is higher than that of the replacement longer-delivery contract and thus there is a resulting rollover profit. However, this type of strategy can result in losses when the opposite price relationship exists (a situation known as contango). MGRM therefore was exposed to curve risk (i.e., the risk of shifts in the price curve between backwardation and contango).

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Additionally, the firm was exposed to basis risk resulting from deviations between short-term prices and long-term prices. Spot oil prices fell significantly in 1993, from nearly USD 20 a barrel mid-year to less than USD 15 a barrel by year-end. This led to USD 1.3 billion in margin calls on MGRM's long futures positions that had to be met in cash. While MGRM had unrealized economic gains on its original short forward contracts, it had a (temporary) substantial negative cashflow. The problem was exacerbated when the oil price curve changed shape, moving from backwardation to contango. MGRM's parent company, which had been told the position was hedged and therefore did not expect a negative cashflow, ordered the hedges liquidated in December 1993. This resulted in large paper losses being turned into large realized losses.