Metallgessellschaft (MG)

MG was a huge, German industrial conglomerate that decided to open an energy trading
office in the US in the early 90s.

The original plan was threefold:

 sell refined products in the forward, physical market for as long as 10 years –
long term, fixed price sales contracts;
 invest in refining capacity to produce the products;
 hedge the forward sales through financial derivatives.
When the strategy was first implemented in 1992, current physical prices were lower than
the futures prices. So, the sales contracts were set at those higher future prices. The
Treasurer of MG, a young, bright German, who was new to the company, decided to use
crude oil futures on the New York Mercantile Exchange (NYMEX), to manage the price risk
arising out of these long term sales contracts (what is the risk?) He did not believe that
the Board, made up largely of older, traditional German businessmen, would be
interested in, or even fully understand the nuances of this hedging strategy. He told
them that the price risk on the forward sales would at all times be hedged in the financial
derivatives market and neither provided, nor was asked about the details.

To hedge this exposure on a fully matched basis, MG needed to buy a “strip” of futures
contracts covering the same period as that of the physical sales. However, most of the
liquidity was in the futures contracts for near-term delivery, say, in the next 1-3 month (see
today’s volume stats, not very different in 1990s in relative terms)

Contracts
MONTH LAST CHG OPEN HIGH LOW SETTLEMENT DATE VOLUME OPEN INT

Crude Oil Oct 2023 91.42 0.65 91.20 91.59 90.86 90.77 09/15 5,384 139,744

Front Month 91.42 0.65 91.20 91.59 90.86 90.77 09/15 5,384 139,744

Crude Oil Nov 2023 90.60 0.58 90.41 90.75 90.05 90.02 09/15 20,040 299,467

Crude Oil Dec 2023 89.46 0.49 89.31 89.59 88.96 88.97 09/15 9,801 248,515

Crude Oil Jan 2024 88.34 0.42 88.21 88.46 87.89 87.92 09/15 4,715 127,364

Crude Oil Feb 2024 87.21 0.36 87.05 87.33 86.80 86.85 09/15 2,910 69,756

Crude Oil Mar 2024 86.17 0.32 85.80 86.30 85.80 85.85 09/15 1,820 82,146

Crude Oil Apr 2024 85.24 0.31 84.99 85.36 84.99 84.93 09/15 453 45,716

Crude Oil May 2024 84.37 0.28 84.23 84.50 84.10 84.09 09/15 523 33,733

Crude Oil Jun 2024 83.60 0.30 83.45 83.70 83.27 83.30 09/15 2,221 153,353

Crude Oil Jul 2024 82.81 0.28 82.91 82.92 82.80 82.53 09/15 341 30,278
Crude Oil Aug 2024 82.09 0.27 82.09 82.19 81.84 81.82 09/15 126 26,392

Crude Oil Sep 2024 81.42 0.27 81.77 81.42 81.42 81.15 09/15 418 48,495

Crude Oil Oct 2024 80.66 0.14 80.33 80.79 80.30 80.52 09/15 92

Hence, MG developed a strategy whereby they would cover the long-term, fixed-price sales
by buying contracts in these few, near months. As each month approached maturity or
actually "rolled off," they would merely sell/settle the front month and buy contracts for
delivery in the next month. It was their intent to continue this process until the physical
product sales contracts expired in 10 years.

One of the major flaws in this approach, however, was the volume of contracts being traded
since they were "loading up" on closer month contracts. Every month, the market quickly
figured out that MG would be coming in to sell their near month contract and buy the next
month – what do you think markets would do once they figure this out ?Their position
in the fall of 1993 was estimated to be between 160 and 180 million barrels, a material
position in NYMEX.

In 1993, prices fell as the market digested signals from OPEC on increasing production
quotas. Faced with this position, what was the situation that MG faced ? Were the long
term forward sales profitable ? How about the hedge ? What would have happened to
MG’s cashflow?

This resulted in losses on the futures purchases totalling almost $1.5 billion USD, resulting in
a large margin call. Is this an economic loss ? The Treasurer tried to explain the margin call
to the Board and argued that they were not economic losses. The Board was not convinced
and directed the team to close all the futures positions (after sacking the Treasurer). They
had to seek bailout funds from one of their banks, and in return, had to sell off several
divisions. What is the risk that MG is now running ? Oil prices then went back up. What
do you think happened to MG?

What are the lessons from this derivatives hedging disaster ? Who was “right” ? What
would you have done differently, if you had been the Treasurer of this company?