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Specialist Masters Programme

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(Surname, first name) 5. Siddhant Dalmia
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3. Mahika Panchmatia GROUP NUMBER:
MSc in: Corporate Finance

Module Code: SMM250

Module Title: Corporate Risk Management

Lecturer: Junli Zhao Submission Date: 12th February 2023

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Group 1 SMM250 12/02/2023

Coursework Corporate Risk Management

MSc Corporate Finance

1. The Marketing Program and its impact on MGRM price risk exposure
With the aim of transforming its energy activities and establishing itself as a fully integrated
oil business in the US, MGRM implemented a marketing plan that involved three different
types of forward supply contracts. This strategy proved successful in boosting MGRM's
visibility, as it resulted in the sale of 160 million barrels worth of forward supply contracts.
However, it also significantly increased the company's exposure to energy price risk. The
following section of this paper will further examine the risks associated with the forward supply
contracts MGRM sold.
The first type of forward-supply contract that MGRM offered its clients was a “firm-fixed”
program. The outlines of the agreement concerned a fixed monthly delivery of oil products to
a fixed price. The agreement would enable MGRM to hedge itself against possible negative
price developments in the underlying asset. By going short in forwards, like in the case of
MGRM, their payoff profile at time of delivery would be the difference between the forward
price (𝐾) and the spot price ( 𝑆! ) at time of delivery.
𝑃𝑎𝑦𝑜𝑓𝑓 𝑠ℎ𝑜𝑟𝑡 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛 = 𝐾 − 𝑆!
The second type was a “firm-flexible” contract, which also involved a fixed price but instead
of a monthly volume, it specified a total volume that were to be delivered over the life of the
contract. The contract would give the customer the extensive right to the delivery schedule,
promising delivery of up to 20% of total contract volume with 45 days’ notice. The payoff
profile would however be equal to that of the firm-fixed contract, providing a gain for MGRM
if the spot price upon delivery is lower than the forward.
The third and final contract in the program were “guaranteed margin” contracts. Here MGRM
would sell at predetermined discounts relative to the retail price offered by the competitors in
the geographical area.
With regards to the three different types, only the two that include a fixed price would increase
MGRM’s exposure to price risk, while the third would not. Price risk in a forward contract
refers to the risk associated with the possibility of the market moving in the opposite direction
relative to your initial position. As MGRM are short in futures, an increase in energy prices
above the fixed price specified in the contract, would result in a loss for MGRM. Assuming
that upon delivery, MGRM would purchase in the spot market and sell to its counterparty. Then
in the case of the guaranteed margin contract there would not be any price risk since the only
loss they would incur is the margin that they owe to the independent operator. Therefore, the
following discussion of MGRM’s exposure to energy price risk will focus on type one and two.
When assessing the probability of the market price exceeding the forward, it is of interest to
further analyse the historical price fluctuations in the energy market for the three major types
of commodities that MGRM sold; Heating Oil, Gasoline and Crude Oil.

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Group 1 SMM250 12/02/2023

Figure 1 Price fluctua.ons in oil commodi.es

During the observation window it was Unleaded Gasoline that experienced the greatest
fluctuation, exhibiting a monthly volatility1 of 5.34%. Heating Oil followed closely, exhibiting
a volatility of 4.45%, while Crude Oil displayed the least at 3.80%. The forward contracts that
MGRM sold would typically include a premium of $3 to $5 on the prevailing price. With the
volatility of for example gasoline amounting to somewhere between $1 and $2 dollars per
month, its assumed highly plausible that within for example a year, the price could move above
the forward price, thus increasing the price risk. Furthermore, another very important factor
concerning the volatility in the energy market, is its sensitivity towards exogenous factors such
as political and economic events. An example of this relationship is the reorganization of OPEC
in the early 1970s. The event led to a restriction in supply, which combined with increased
demand, raised the prices in the oil market considerably. Then in 1993, prices fell dramatically
due to OPEC’s decision to not reduce production. These two incidents illustrate the high price
sensitivity that oil prices extinguish, and as the forward contracts has terms extending up to 10
years, the likelihood of such events occurring is great.
Moreover, under the firm-flexible contract, MGRM has a contractual right to deliver 20% of
the total volume of the contract with a 45-day notice period, which is a crucial factor in
managing the company's exposure to price risk. This right empowers the holders of the firm-
flexible contract to decide the timing of oil delivery, giving them the flexibility to either defer
or accelerate purchases. Consequently, this would mean that a large fraction of MGRM’s
counterparties, could increase their purchases in periods when prices were higher than the
forward price and decrease their purchases during periods characterized by low prices.
2. MGRM’s Rolling-hedge Strategy
Recognizing the price risk posed by the forward contracts, MGRM aimed to assure its
customers that it would be able to fulfil its obligations in the coming years. To achieve this, the
company determined that a one-to-one hedge was necessary. To implement this strategy, they
entered into long positions in futures contracts for gasoline, heating oil, and crude oil. However,
when the market faced a major downturn in 1993, MGRM suffered substantial losses on its
futures positions. The subsequent section of this paper will examine MGRM's rolling hedge
strategy, evaluating the gains and losses that occurred from September 1993 to December 1993.

1Volatility refers to the commodities standard error, measured on the percentage change in price each month during January 1992 to
September 1993

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The rolling-hedge strategy that MGRM implemented constitutes selling maturing contracts and
simultaneously buying new short-dated contracts. This process would be repeated until the
delivery date arrives. At that point, the commodity will be as mentioned in section 1, acquired
in the spot market in accordance with the forward contract for delivery. This technique proves
to be profitable if the energy markets are in a state known as “Backwardation”, meaning, that
the current spot prices are higher than the future prices, and short-dated futures prices exceed
longer-dated futures prices. The risk that MGRM was exposing itself to in its futures position,
was that energy prices could go into the opposite direction where the current spot price of the
underlying asset is lower than its futures price. This phenomenon is known as “Contango”,
which is what led to losses for MGRM.
Assuming that rollovers are done on the last trading day of the expiring contract, the futures
price would according to the principle of convergence, move towards the spot price at maturity.
The settlement price paid to offset MGRM’s entire future position would be equal to the spot
price. The total profit from both its futures position, can therefore be formulated as follows:
!
$ 𝑇𝑜𝑡𝑎𝑙 𝑅𝑜𝑙𝑙𝑜𝑣𝑒𝑟 𝐺𝑎𝑖𝑛/𝐿𝑜𝑠𝑠 (𝑡) = = [𝑆" − 𝐹" ]
"$%
Where ST is the spot price at time t, and Ft is the futures price for delivery at time t. Each term
in this summation is the gain or loss per month from the rollover carried out by MGRM.
Furthermore, if each rollover gain in times of backwardation is higher than the losses incurred
in contango, the cumulative rollover gains can still be obtained even if backwardation and
contango occur equally frequent (Charupat, Deaves, 2003). The gains and losses that MGRM
incurred during the period are summarized in panel A below.
Panel A
Estimated gains and losses from MGRM’s long position in futures. The assumed contract liability of MGRM included 50
million barrels of heating oil, 50 million barrels of unleaded gasoline, and 50 million barrels of crude oil. At end of each
month and for each commodity, MGRM delivers 5 million barrels to its customers. Spot prices assumed at end of month.

Profit and losses MGRM Futures Position (in millions)

Commodity Heating Oil Unleaded Gasoline Crude Oil Gain/Loss per month
September-93 $ 3.36 $ -105.21 $ -24.00 $ -125.85
October-93 $ 25.33 $ 20.22 $ 29.25 $ 74.80
November-93 $ -72.91 $ -106.85 $ -62.80 $ -242.56
December-93 $ -112.16 $ -115.10 $ -78.40 $ -305.66
Total $ -156.39 $ -306.94 $ -135.95 $ -599.27

Estimation from panel A shows that MGRM’s rolling hedge strategy resulted in substantial
losses during the period from September 1993 to December 1993. The greatest losses came
from the investments in unleaded gasoline futures, which accounted for approximately 50% of
MGRM’s cumulative losses during the 4-month period. As OPEC did not cut their production,
the prices of heating oil, gasoline and crude oil fell -17%, -22% and -17% respectively, turning
the energy market from being in a state of backwardation to a state of contango.
3. Reflections around the collapse of MGRM
The rollover strategy employed by MGRM proved to be a disaster, pushing the company to the
brink of bankruptcy. When oil prices fell, MGRM incurred huge losses on its hedge positions.
Though gains from its forward contract positions would offset some of these losses, a negative

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Group 1 SMM250 12/02/2023

cash flow effect would occur in the short term as no funds would be received for the increase
in the value of the forward contracts until the oil was sold. Furthermore, MGRM's hedging
policy required stability in the market for an extended period, which is not always a given. The
short-term outcome could be unpredictable, as evidenced by MGRM's experience in 1993. The
following section of the paper aims to elaborate further on the viability of MGRM's short-term
hedging strategy and why it went wrong.
3.1 MGRM’s cash flow issues
An important factor that contributed to MGRM's crisis was the shift in the oil market from
normal backwardation to contango in light of OPEC's decision. As the spot prices decreased
more than the futures prices each month, MGRM’s experienced continued rollover losses.
However, it would not be entirely accurate to say that the shift was the sole cause of MGRM's
downfall. The contango market only exacerbated the problem, but the true issue was MGRM's
inability to manage its cash flow requirements.

When the prices of the underlying assets fell, MGRM would first require funds to finance the
rollover losses. However, more importantly, MGRM would also be required to meet its margin
requirements. Unlike forwards that are only settled at date upon delivery, futures are marked-
to-market, meaning that at the end of each trading day, the margin account associated with
MGRM’s position would be adjusted to reflect the gains and losses. Therefore, as the value of
the futures fell considerably, MGRM would have to provide funds to satisfy its maintenance
margins, which later became MGRM’s main cash flow issue. As highlighted in the case,
MGRM did not have unlimited cash at its disposal, resulting in the company facing liquidity
issues. Though MGRM obtained a substantial back-up credit line from Deutsche Bank and
Dresdner Bank, it was not enough as NYMEX decided to raise MGRM’s margin requirements.
However, given that the drop in price would also increase the value of the forward contracts, it
is questioned why MGRM couldn’t satisfy its cash flow needs by borrowing additional funds
using their forwards as collateral. There could be two reasons as to why this was not possible.
Firstly, the gains on the forward delivery contracts may not have been sufficient to offset the
loss from the futures, forcing MGRM to increase its general debt obligations. This is assumed
to have been unappealing to creditors if the company was already heavily in debt. Secondly,
MGRM's forward delivery contracts were perhaps not transparent enough for creditors.
Creditors might have struggled to evaluate the credit risk associated with the counterparties
linked to each of MGRM's forward delivery contracts.
3.2 Limitations of the One-to-One Hedging Approach
In hindsight, there were also some caveats related to MGRM’s hedging strategy. The use of a
one-to-one hedging strategy aimed to protect against changes in energy prices but is likely to
have failed producing equal and offsetting changes in the value of the forward contracts and
futures. The first reason being that MGRM assumed a perfect relationship between forward
and spot oil prices, which is not the case. Oil prices are highly influenced by political and
economic events. In a paper published by French (1986) it is argued that an immediate increase
in the demand for a commodity, both the current spot price and the expected spot price will
increase. However, the change in the spot price will be of greater magnitude compared to that
of the expected price (French, 1986). A shock to the price today will not create an equally large

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Group 1 SMM250 12/02/2023

change to forward prices 5 to 10 years from now, such as in the case of MGRM. Secondly,
MGRM’s strategy did not consider the gap between the expected cash flows from the forward
contracts and the futures. As the cash flows from the forward contracts would be expected at a
later stage, the offsetting gains from changes in the current spot price would result in a
subsequently smaller change in NPV value compared to that of the loss from its futures
positions. This mismatch in timing highlights the need for a more comprehensive hedge
strategy that accounts for expected cash flows from both the forward delivery contracts and the
hedge positions.
Furthermore, an additional negative cash flow effect could come from the early cash-out
options in MGRM's forward delivery contracts. If customers exercised these options MGRM
would be required to pay its counterparty one-half the difference between the contractually
fixed supply price times the remaining volume in the contract. In addition, if there had been
any rollover losses, MGRM would not be able offset these with future rollover gains.
3.3 German accounting Standards
Though the liquidity problem that MGRM faced was of great concern, it was the application
of German accounting conventions to MGRM's activities that constituted the final blow. Under
German accounting standards, it was required that the firm recognizes the unrealized losses on
its derivatives positions in futures and swaps. However, it was not allowed to recognize any
unrealized gains it may have had on its forward contracts. Assets and liabilities had to be
reported at the lower of cost and market. As a result, when energy prices fell in 1993, MGRM
could only report its substantial derivatives-related losses, and not its potential offsetting gains.
Consequently, this led to the perception that MGRM was engaging in speculative derivatives
trading as well as NYMEX imposing additional margin requirements on their futures position,
which as discussed earlier further aggravated their liquidity problem.
In contrast, accounting standards in the U.S. address this problem by imposing different
disclosure requirements on companies that are engaged in hedging activities. Under U.S.
hedge-deferral accounting standards, unrealized gains or losses on cash flow hedge instruments
are recognized in the same period in which the hedged item affects the company’s earnings
(Deloitte, 2023). Therefore, if MGRM would have followed U.S. accounting principles instead
of German, it could have deferred the reporting of its unrealized losses on the futures until it
could recognize its gains on the forward contracts. Alternatively, U.S. accounting standards
also allow companies to use a mark-to-market approach (PWC, 2021). This would have
enabled MGRM to immediately recognize the gains and losses on both its forward contracts
and its derivatives positions, painting a better picture of the company’s financial situation.
3.4 Final remarks
In conclusion, there was not a single contributing factor that led to the collapse of MGMR.
Instead, it is thought to be the combined product of several, including the change from
backwardation to contango, MGRM’s funding issue and the use of German accounting
standards. Nevertheless, the rollover strategy employed by MGRM was fundamentally flawed
due to the size of its derivatives positions. Had they not established such a large position in
hedge instruments, the funding risk would have dropped significantly, increasing the likelihood
of MGRM surviving in periods of which the market was in a contango.

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Group 1 SMM250 12/02/2023

References
Charupat, N., Deaves, R. (2003). Backwarda(on in Energy Futures Markets: Metallgesellscha9
Revisited. Energy Studies Review, 12(1), p. 1-26.

DeloiHe. (2023). What you should know about hedge accoun(ng. Retrieved from DeloiHe:
hHps://www2.deloiHe.com/us/en/pages/audit/arMcles/derivaMves-hedge.html

French, K. R. (1986). Detec(ng Spot Price Forecasts In Futures Prices. The University of Chicago Press.

Hull, J. (2021). Op(ons, Futures, and Other Deriva(ves. Pearson EducaMon, Limited.

IESE - InternaMonal Graduate School of Management. (2023). Case Study: Metallgesellscha9 Refining
& Marke(ng.

PWC. (2021). Deriva(ves and hedging.