The Case of Metallgesellschaft

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Metallgesellschaft (1991)
Commodity and engineering conglomerate 14th largest industrial firm in Germany 58,000 employees Business segments
- Trading services - Financial services - Engineering services

Major shareholders
- Kuwait Investment Authority - Deutsche Bank (also major creditor!)

US subsidary
- MGRM, an oil trading company
Slide 6-2

Delivery Contracts
Starting in 1991, MGRM entered into price/delivery guarantees for gasoline, heating oil, and diesel fuel.
Length of contracts: up to 10 years Customers
- Retail gasoline suppliers - Manufacturing firms - Government agencies

By 1993, MGRM had committed itself to deliver over 150 million barrels of petroleum products at fixed prices (~20% of open interest in futures market).

Slide 6-3

MGRMs Risk Exposures

By entering into price/delivery guarantees MGRM exposed itself to the following exposures.
- Price risk - Credit risk - Delivery risk

How should MGRM hedge these exposures?

Slide 6-4

Hedging Alternatives (Price Risk)

Physical storage
- No comparative advantage, high cash requirement

Static hedge (strip hedge)

- Liquidity of long-term contracts, MGs credit rating, accounting treatment

Dynamic hedge (stack hedge)

- Cash flow mismatch, basis risk, accounting treatment

Slide 6-5

Heating Oil - US$/Barrel

28

26

24

22

20

18

16 Jan-93 Mar-93 May-93 Jul-93 Sep-93 Nov-93 Jan-94 Mar-94 May-94 Jul-94 Sep-94 Nov-94

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Time Line of Events

Fall 1993: Oil prices fell by 25% (to about $20/barrel). Market moved into contango. Implications for MGRM?
- Book losses on long futures positions (margin calls) - Instead of roll over gains MGRM faces roll over losses. - But delivery contracts are very valuable now.

Sept 1993: MG reports an accounting loss of US$300 million ($60 million profit under GAAP!) Liquidity crisis
- Mounting margin calls - Accounting loss - The case of Klckner, 1988

What should be done?

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Time Line of Events

Instead of tapping into existing credit lines, MG approached Deutsche Bank for new overdraft facilities. After a short-lived recovery in October, oil price drops to $18/barrel. Dec 1993: Board of directors fires CEO and liquidates the hedging portfolio.
- Implication for MGRMs risk exposure?

1. Jan 1994: MG reports a net loss of US$1.3 billion. Jan 1994: MG offered to terminate delivery contracts without close-out payment to MGRM. 15. Jan 1994: MGs creditors inject US$1.9 billion to cover MGs losses.
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METALLGESELLSCHAFT AG
Share Price in Euros
40

Strong rise in oil prices between Dec. and Feb.

30

20

Decline in oil prices

10 Jan-93 Apr-93 Jul-93 Oct-93 Jan-94 Apr-94 Jul-94 Oct-94

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What went wrong?

MGRM was overhedged. Cash flow mismatch - liquidity crisis
- Futures contracts are marked-to-market - Delivery contracts are not marked-to-market

Accounting treatment
- No hedge accounting under German accounting rules!

Outsiders, as well as the board of directors, were not familiar with hedging strategy.
- Rumors that MG took a huge bet that went bad - Did the board overreact? - Personal conflicts between CEO and chairman of board of directors

Basis risk (minor)

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Lessons for Risk Management

A long-term exposure can be hedged with short-term instruments.
- Basis risk - Backwardation: long stack generates positive cash flows, short stack generates negative cash flows

Tailing a futures hedge is important if the maturity of the hedge is long. Provide for sufficient liquidity to meet margin calls. Manage funding risk ex ante. Accounting regulations are important. Ensure creditors, supervisors, etc. understand the purpose of the hedging strategy, especially if the hedging program is inseparable from your business strategy.
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