Derivatives Can Be Hazardous to Your Health: The Case of Metallgesellschaft FraNkUN R. Enwarns FRAriuan R, EDwane i the Aor F. Buns profesor im dhe Graduate School of Business 2¢ Columbia University, and ite Ing scholar at the American, Emtepaive hice it Wainy ‘on, DC Late 1993 and early 1994, MG Refining and Marketing, Inc. (MGRM), the American affli~ ate of Germany's fourteenth largest industrial firm, Metallgesellschaft AG (MG), reported staggering losses of about $1.3 billion on positions in energy futures and swaps (see Protzman [1994] and Eckhardt and Knipp (1994]}. Subsequent to these losses, MG spent another $1 billion buying its way ‘out of contracts it had made with Castle Energy.’ Only 4 massive $1.9 billion rescue operation by 150 German and international banks kept MG from going into bankruptcy, an event that would undoubtedly have had far-reaching consequences for MG's creditors, suppliers, and some 58,000 of ies employees (see Miller (1994)). Had MG defaulted ‘on its enormous derivatives positions and other debt obligations, major international banks and perhaps ‘even the clearing association of a major farures ‘exchange could have sustained substantia loses, the ramifications of which we will never know. ‘What went wrong at MG, and what can we learn fom the MG experience about the pitfalls of| ‘sing derivatives? How could large, sophisticated, worldwide enerey conglomerate like MC have been 0 inept as to incur derivatives-related losses that all bbut destroyed the firm? Clearly, derivatives can be hazardous to a firm’ health. WAS MGRM HEDGING OR SPECULATING? Initial prece reports of MGRM’s losses suggested that MGRM incurred these losses as a 8 Darevarrves CaN BE HAZARDOUS TO YOUR HEALTE Tit CASE cP METALLGSELLSCHAFT ‘Son 1995result of massive speculative positions in energy Bacures and over-the-counter (OTC) energy # During the latter half of 1993, MGRM purportedly established long energy futures and swap positions equivalent 10 neatly 160 million barrels of oil, post- tions that would benefic handsomely if energy prices rose. Instead, energy prices (crude oi, heating oil, and gasoline) fell sharply during the latter part of 1993, causing MGRM to incur huge unrealized losses and margin calls on its derivatives positions. Subsequent press reports, however, sugzest that MGRM was not speculating but was in fact using derivatives 10 reduce the exposure it had to rising energy prices. In particult, MGRM was said to be engaged in a complex hedging operation using both futures and swap contracts as a hedge against a lage volume of fixed-price, forward supply contracts for gasoline and heating oil that it had written for customers MGRMS forward supply contracts commit- ted it to supplying at fixed prices some 160 million barrels of energy products over the next ten years to end-users of gasoline and heating oil. The fixed supply prices were agreed to when the contracts were entered into, and were typically $3 x $5 a barrel higher than the prevailing spot prices at the ime the concracts were negotiated (this was MGRM% profit margin or markup). Most of these contracts were negotiated during the summer of 1993, when energy prices were falling and end-users saw an attractive opportunity co lock in low energy prices for che focare, MGRM’ counterparties in these forward contracts consisted of retail gssoline suppliers, large ‘manufacturing firms, and even government entities Although many of che endousers were eal firme some were substantial: Chrysler Corporation, Brown= ing-Fernis Industries Corporation, and Comear Indus ‘ies, which has annual diesel fuel use of some 60 million gallons a year (sce “New Shadows.” 1994) These forward supply contracts exposed MGRM to rising eneray prices. If energy prices were to rise in the future, MGRM could find itelf in the unprofitable postion of heving to supply energy prod Luce to its Customers at prices below prevailing spot prices. If prices rose high enough, MGRMS profit margin could be eroded, and it could even have ended up with substantial loses for years to come. Thus, MGRM reportedly sought to hedge is price risk with long futures and OTC saps ‘ot co have hedged this risk would have pur MGRM (and therefore MG) in the position of Sieve 1995 making a substantial bet that energy prices either ‘would fill of at least not rite in the Future, a bet too large for MG to have prudently made. MGRM'S HEDGING STRATEGY MGRM sought to hedge the risk of rising energy prices by acquiring long energy fatures posi- tions on the New York Mercantile Exchange (NYMEX) and by entering into OTC energy swap agreements to receive floating and pay fixed energy prices (see Taylor and Bacon [1994)). MGRMS swap counterparties were large OTC swap dealers such as major banks. During the latter part of 1993, MGRM held long furures positions on the NYMEX ‘equivalent of 55 million barrels of gasoline and heat- ing oil (55,000 futures contract), and had swap posi tions amounting to some 100 to 110 million barrels, substantial poriciont by any mescure (ee Taylor and Sullivan [1994)). Thus, MGRM was hedging its forward supply contracts on a one-to-one basis with energy derivatives. ‘An important aspect of MGRM’s hedging strategy is chat its derivatives positions were concen- trated (or stacked”) in short-dated futures and swaps that had to be rolled forward continuously to main- tain the hedge.? In general, MGRMS futures and swap positions were in contracts with maturities of at most a few months fiom the current date, so that it had to roll these contracts forward periodically (perhaps even monthly) to maintain its hedge against the forward supply wontza.s, This short-dated stack hedging strategy clear- ly exposed MGRM to the basis risk associated with its having co roll its furures and swap positions Forveird through rime MGR M apparently believed this risk to be acceptable Indeed, MGRM believed that a short-dated stack hedging strategy was the most attractive hedg~ ing strategy for ewo reasons (see Benson v. MG (1994). Fist, because its forward delivery contracts included an “early liguidation”” option for end-users af energy prices were co rise, MGRM believed that the actual duration of itt forward supply contracts ‘would likely be far shorter than the periods stated in ‘he contracts jee Falloon (1994). If end-users were to exercise their options, presumably because the options had value to chem, MGRM would have (© make substancal up-front, lump sum payments £0 chem at the time of exercise, These lump sum payments would be based on changes in spot (or neat-month) energy prices. Dasovarves Quasrenty 9Specifically, they would be based on the difference between the prevailing near-month {atures price at the ume of exercise and the conteac- tually fixed supply price times the quantity t0 be supplied over the term of the contract, MGRM believed that 2 stack hedge, which would increase in value substantially as spor and near-term energy prices rose, could be relied on to provide the needed funds for MGRM to meet these potential carly- payment obligations Second, MGRM saw the necessity of having to roll its positions forward constantly as a benefit and not as a rik, MGRM believed ie could extn a positive returns by rolling its positions forward, More specifically, its rolling-forward strategy was designed to take advantage of a common characteristic of nergy futures markets: backwardation le backwardation markets, oil for immediate delivery (neaeby-oil) gets > higher pries than does deferred-delivery oil, such as thtee-month oil. Thus, a sttategy of purchasing deferred-delivery contracts and continually rolling these postions forward yields profit (or “roll gains”) MGRM strategy, therefore, sought to exploit the backwardation that 1s common in energy farures markets, Its implicit assumption was that enerzy futures markets would continue being in backwarda- tion much of che ume, and that the roll gains it made when markets were in backwardation would ‘more than offiet any rol loses that it incurred when markets were in contango." While itis clear that under certain conditions 4 shore-dated stack hedging strategy such as MGRM. Used can be an effective way to hedge long-dated forward commitments, there are sill risks associated with it} Fits, as with any hedging strategy, there is, “operational” risk. Hedge postions must be correct ly implemenced and managed (and in particular che “hedge tatio™ muse be correct) for the hedge to reduce price exposure effectively Second, there is “basis risk” associated with I hedging strategies. MGRM's hedging strategy exposed it to “intertemporal basis risk” because it requited MGRM to roll its derivatives positions vonstantly forward through time.” Under cera conditions, rolling positions forward can result in substantial losses. Third. MGRM was potentially subject to a fionding risk” because its derivatives positions were subject to mark-to-matker valuation and to varia~ tion margin payments, while its forward supply ccongracts were not. Under some circumstances, this 10. Dekivarves CaN Be Hazanocus 0 YOUR HEAL Th Cast oF MeTALLCELASCArT marking-to-market asymmetry could result in MGRM needing sizable amounts of funding to cee margin calls Fourth, MGRM$ forward supply contracts exposed it o “ctedit risk” MGRM‘ ability to profie on its forward supply contracts depended on its customers honoring theit contractual obligations to purchase oil for many years into the future. Finally, MGRM was subject to “reporting risks." As we shall see, the application of inappropri- ate accounting and disclosure conventions to MGRMS hedging acuvities resulted in misleading financial statements that threatened to undermine public confidence in the firm.7 WHAT WENT WRONG? MGRMS problems surfaced in late 1993 when energy spot prices tumbled (instead of rising, as MGRM had both expected and feared). As a result, MGRM experienced large unrealized losses on its stacked long futures and swap positions and incurred huge margin calls" Adhering to German accounting and disclosure principles, MG disclosed these unrealized loses publicly, sending shock waves through the financial community Tn addition, because of an unusual forward Pricing curve in energy fuiures suutkers during 1993, MGRM sustained substantial “rolling losses” when it rolled its large stacked futures positions forward ‘through time. In 1993, energy fatures markets were in contange for almost the entire year, causing MGRM to incur losses each time it rolled its deriva- tives postions forward If, instead, energy prices had risen rather than fallen, there would have been no problem. MGRM. would have had unrealized gains on its derivatives positions and positive margin Oows (or cash indlows) In addition, when prices are rising, energy markets are often in backwardation, rather than contango, so that MGRM may not have had roliover losses, The fact that MGRM also would have had uncealized loses on its forward delivery obligations would not hhave mattered, No one would have cared. Duc eneigy prices did fll, om around $19 = barrel of crude oil in June of 1993 to less than $15 2 barrel in December 1993, forcing MGRM to come up with enormous amounts of money to fund margin calls and rollover losses so that its hedge posi- tions could be maintained. In response to these reversals, MG's supervisory board brought in new management, which quickly made the decision co Seren 1995