THE COLLAPSE OF METALLGESELLSCHAFT: UNHEDGEABLE RISKS, PooR HEDGING STRATEGY, OR JUST BaD LUCK? FRANKLIN R. EDWARDS MICHAEL S. CANTER, INTRODUCTION In late 1993 and early 1994 MG Corporation, the U.S. subsidiary of Germany's 14th largest industrial firm Metallgesellschaft A.G. (MG), reported staggering losses on its positions In energy futures and swaps." Only a massive $1.9 billion rescue operation by 150 German and inter- national banks kept MG from going into bankruptcy, an event whi Earlier versions of some parts of this article were presented at conferences on “Coping with Financial Fragility: A Global Perspective” in Maastricht, The Netherlands, September 7 and 9 [Diy andthe lmpiestons of Denvatives Tor Hegulation, atthe London School of economies, December 2, 1994, The aithors wish to thank participants at these conferences for thee comment. ‘The authors also found eary discussions with Silverio Fores and Suresh Sundaresan helpful, IMGs losses, which may ultimately exceed the 51.5 billion that it reported, represented. about haf of is total capital of DM3.672 bilion as of September 30, 1994. See Protaman (1994) and Ecltharde and Koipp (1994), = Franklin R. Edwards is the Arthur F. Burns Professor of Economics and Finance at the Graduate School of Business, Columbia University = Michael S. Canter is a PhD candidate in Economics and Finance at the Graduate School of Business, Columbia University “Te Joumal of Fes Make, Yl 1, No, 9, 811-264 (1098) 121008 by dotin Wey & Sone ne coe cara raraasa1-s4Edwards and Canter undoubtedly would have had far-reaching consequences for MG's ered- itors, suppliers, and some 58,000 of its employees. (Miller, 1994). During 1993 MG's U.S. oil trading subsidiary, MG Refining and Marketing (MGRM), established very large derivatives positions in energy futures and swaps (equivalent to about 160 million barrels of oil), from which it would profit handsomely if energy prices were to vise, However, iustead uf sisi, energy prices (Gude vil, heatiang vil, ad gasoline) fell sharply during the latter part of 1993, causing MGRM to incur unrealized losses and margin calls on these derivatives positions in excess of $900 million (Hanley, 1994). Initial press reports indicated that MG's predicament was the result of massive speculation in energy futures and off-exchange (OTC) energy swaps by MGRM. Some members of MG's Supervisory Board also characterized MGRM's oil trading activities as “... a game of roulette.” And when MC's Supervisory Board installed new management at MGRM near the end of 1993, the new management team declared that “... speculative oil deals ... had plunged Metallgesellschaft into the crisis.” See Benson supplemental memorandum (1994). Not all press reports, however, have held to this view. Some have suggested that MGRMs derivatives activities were, in fact, part of @ complex oil marketing and hedging strategy. In particular, MGRM reportedly was using its derivatives positions to hedge price exposure on forward-supply contracts that committed it to supplying approximately 160 million barrels of gasoline and heating oil to end-users over the next ten years at fixed prices. The fixed supply prices in these contracts, negotiated at the time that the contracts were established, were typically three to five dollars a barrel higher than prevailing spot prices when the contracts were negotiated. (These were MGRM’s profit margins or mark-ups).* See atfidavit ot Benson (1994). The forward delivery contracts also contained a cash-out option for MGRM's counterparties. If energy prices were to rise above the contractually fixed price, MGRM’s counterparties could choose to sell the remainder of its forward obligations back to MGRM for a cash payment of one half the difference betwoon the provai ig near month futures price and the contractually fixed supply price times the total volume remaining on the contract.? 2MGRM's markups were the same repardles of the length ofthe contracts. Critics have argued that higher markups should have been used fo longer-term contracts, perhaps because of increasing credit eink. Soe Special Audit Report (1995), In some contracts MGRM also could exercise ths option if prices rose above a specified exit price. See affidavit of Benson (1994),Most of the forward delivery contracts were negotiated during the summer of 1993, when energy prices were low and falling. Energy end- users apparently saw an attractive opportunity to lock-in low energy Prices far the future, and MGRM apparently saw an equally attractive opportunity to develop long-term profitable customer relationships that would help its long-run strategy of developing a fully-integrated oil business in the United States. See affidavit of Benson (1994). MGRM's counterparties in these forward contracts were retail gasoline suppliers, large manufacturing firms, and some government entities. Although many of the end-users were small, some were substantial firms: Chrysler Corporation, Browning-Ferris Industries Corporation, and Comcar In- Austries (which has annial diesel fel nse af some 60 million gallons a year). See Handelsblatt (1994). In 1989, as part of its efforts to develop a fully integrated oil business ins dhe United States, MGRM als acquied 4 49% interest in Castle Energy, a U.S. oil exploration company, which it then helped to become an oil refiner. To assure a supply of energy products in the future, MGRM agreed to purchase Castle’s entire output of refined products (estimated to be about 126,000 barrels a day) at guaranteed margins for up to ten vears into the future (Power. 1994). In addition. MGRM set about to develop an infrastructure to support the storage and transportation of various oil products. See affidavit of Benson (1994). MGRM's fixed price forward delivery contracts exposed it to the risk of rising energy prices. If energy prices were to rise in the future, it could find itself in the unprofitable position of having to supply energy products to customers at prices below prevailing spot prices. More importantly, if prices rose high enough and remained high, the profit margins in the contracts would be eroded and MGRM could end up taking substantial losses for years to come. MGRM hedged this price risk with energy futures and OTC swaps.> Not to have hedged would have put MCRM (and therefore MC) in the position of making a substantial bet that energy prices would either fall or at least not rise in the future. Had MGRM been able to hedge its price risk successfully, 1t stood to make substantial profits. By locking- in an average contractual markup of $4 a barrel on its forward energy sales over ten years, it would have earned profits of approximately $640 million. “Akermatvely, i has been contended that MGRM entered into these contracts in order ta hook, unrealized profits against the futures losses it had atthe time. For a description of MGRM's business and hedging activites, se affidvit of Benson (1994).