Study on the Financial Strategies Used by Metallgesellschaft Finance Essay

Check out more papers on Business Law Financial Markets Investment

Metallgesellschaft MG is the 14th largest industrial company in the Germany. It has started working in December 1991. Its executive chairman was Heinz Schimmelbusch. About 58000 employees were working in this company. It was a large company, involved in a wide range of activities, like mining, engineering, commodity market and financial services. Major shareholders in this company were Deutsche Bank AG, the Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait Investment Authority MG, a traditional metal company. Its customers were mainly retail gasoline suppliers, manufacturing firms and government agencies. MGRM expand its business by transforming into the derivative world in 1991. They hire a special person for this work whose name was Mr. Arthur Benson from Louis Dreyfus Energy. It was Benson's strategy that eventually contributed to the massive cash flow crisis that MG experienced.

MGRM dealings

MGRM promised to his customers that he will provide certain amount of petroleum at a fixed price every month. This contract starts from 1992 and was valid up to 10 years. At first this contract was going well because oil prices were moving upward than the committed price. The profit margin was even raised up to $5 per barrel. Approximately 160 million barrels were supplied by MGRM by September 1993. This mechanism was about to raise the oil prices.

Hedging strategy by MGRM

MGRM hedged its spot price risk exposure by using exchange traded future contracts via "stack and roll" hedging strategy. In this strategy, the firm takes long position in future contract to cover its entire risk exposure. In the "stack" part, MGRM placed the entire hedge in short dated delivery months. He managed to use front-end month futures contracts on the NYMEX. MGRM's strategy was sound from an economic standpoint. At the end of each month, the company closes out its position, and opens new long positions to cover its remaining exposure. (This is the "roll "part.). MGRM had a large amount of Texas Intermediate sweet crude contracts. In the "roll" part, MGRM made long future contracts and entered into OTC energy swap agreements to receive floating and pay fixed energy prices. NYMEX reported that during this time, MGRM hold about 55 million barrels of gasoline and heating oil.

What can stack and roll strategy do?

Theoretically, a stack-and-roll strategy should provide a good hedge for an exposure like MGRM's. If oil prices rise, there would be a loss on the forward contracts, but a gain on the long futures positions. If oil prices fall, there would be losses on the long futures positions, but these would be offset by the increased economic value of the forward commitments.

Loss occurrence

The company was running well, but at last in December 1993, oil prices were reducing constantly. Reduction in prices was almost 25%. The spot and near term oil future prices were so much increased over the long term forward prices that it upset the " roll" strategy and brought losses to the firm. Instead of tapping into existing credit lines, MG approached Deutsche Bank for new overdraft facilities. In December 1993 Board of directors liquidates the hedging portfolio. After that on 1st January 1994 the company reported that he has incurred a net loss of US $1.3 billion. MG offered to terminate delivery contracts without close-out payment to MGRM. On 15th January 1994, metallgesellschaft creditors inject US$1.9 billion to cover MG's losses.

Risks faced by MGRM

There were four specific risks that MGRM's strategy entailed which are discussed below, The size of the positions involved: Positions limits made it impossible to completely hedge MGRM's total commitments of 160 million barrels using only futures contracts. MGRM had long futures positions of 55 million barrels on NYMEX. It also entered into OTC swaps arrangements to hedge the remaining exposures. These large positions also made it impossible for the company to maintain anonymity in trading. A steep fall in oil prices: Every $1 fall in oil prices would lead to a $55 million cash outflow on the futures margin accounts alone. A steep oil price fall would thus create an immediate and large cash requirement to meet margin calls. The corresponding gains on the short forward positions would not translate into cash inflows until some date in the future. Thus, although the economic value of the position is unaffected (it remains hedged), a severe short-term cash flow requirement is created. Unfortunately for MGRM, this scenario came true: oil prices plummeted in late 1993. This led to a cash requirement of around $900 million to meet margin calls (on the futures positions) and extra collateral (on the OTC positions). A change in the oil market from backwardation to contango: A futures market is said to be in backwardation if futures prices are below spot prices. It is said to be contango if futures prices are above spot prices. In a typical commodity market with a positive cost-of-carry, the futures will be above spot, i.e., the market will be in contango. However, in some commodity markets (especially oil) futures prices have remained below spot for long periods of time. This phenomenon is commonly attributed to the presence of a large "convenience yield "from holding the spot commodity. MGRM rolled over futures positions at the end of each month (stack-and-roll strategy): Closing out the existing long futures position by taking a short futures position in the expiring contract. Taking a long futures position in the new nearby (next month's) contract. Unfortunately for MGRM, in late 1993, the oil market went into contango. As a consequence, by end-1993, MGRM was incurring a cash outflow of up $30 million each month on rollover costs alone. Basis risk from the futures/forward mismatch: A final technical issue that may have hurt MGRM is basis risk. MGRM was hedging long-term forwards with short-term futures. Since these two prices may not move in lockstep, there is basis risk in hedging. In the presence of basis risk, theory shows that it is not, in general, optimal to use a hedge ratio of unity (i.e., to hedge exposure one-for-one).However, MGRM does appear to have used a hedge ratio of unity which may have further degraded the quality of the hedge, adding to losses.

Criticism to MGRM hedging program.

MGRM hedging program was criticized on the following grounds, According to Edward and canter, MGRM was over hedged, because short-term oil futures prices tend to be much more volatile than prices on long-term forward contracts. Furthermore they said that there was Cash flow mismatch, because of much variability in short term cash flows. MGRM could have minimized the variance of its cash ows by buying short-term futures contracts for 61 million barrels of oil to hedge a 160 million barrel long-term exposure. According to Mello and Parsons, MGRM's stack-and-roll strategy as a misguided speculative attempt to profit from the backwardation; as this strategy has hedge reverses the order of cause and effect.

Concluding remarks

Profit and losses are a part of business activity. These type of losses are mostly occurring in our daily financial markets. Using of derivatives and hedging should be used in a very wise way. Its usage must be according to the prevailing market. Using of derivatives was not only a cause of MGRM losses. If we can hear the growing nature of a business by using derivatives, we can also continue to hear about the losses. The main thing which differs is the usage. In this case study, we can give a reminder to the corporate sector especially in oil dealing markets, that they should know their position in a fluctuating market, because MGRM was not looking at this side. Ensure creditors, supervisors, etc. understands the purpose of the hedging strategy, especially if the hedging program is inseparable from your business strategy. The swaps and futures markets provided MGRM with an opportunity to transfer their market risk. They successfully did this. They failed, however, to accurately estimate the funding risk of their hedge position. By following the recommendations of the G30 Derivatives study, MG's near financial ruin could have been avoided.

Did you like this example?

Cite this page

Study On The Financial Strategies Used By Metallgesellschaft Finance Essay. (2017, Jun 26). Retrieved October 14, 2024 , from
https://studydriver.com/study-on-the-financial-strategies-used-by-metallgesellschaft-finance-essay/

Save time with Studydriver!

Get in touch with our top writers for a non-plagiarized essays written to satisfy your needs

Get custom essay

Stuck on ideas? Struggling with a concept?

A professional writer will make a clear, mistake-free paper for you!

Get help with your assignment
Leave your email and we will send a sample to you.
Stop wasting your time searching for samples!
You can find a skilled professional who can write any paper for you.
Get unique paper

Hi!
I'm Amy :)

I can help you save hours on your homework. Let's start by finding a writer.

Find Writer