Metallgesellschaft

In 1991, Metallgesellschaft Refining and Marketing (MGRM), an American subsidiary of

Metallgesellschaft (MG), an international trading, engineering, and chemicals conglomerate,
implemented a marketing strategy designed to insulate customers from price volatility in the
petroleum markets for a fee.

MGRM offered customers contracts to buy fixed amounts of heating oil and gasoline at a fixed price
over a 5- or 10-year period. The fixed price was set at a $3 to $5 per barrel premium over the
average futures price of contracts expiring over the next 12 months. Customers were given the
option to exit the contract if the spot price rose above the fixed price in the contract, in which case
MGRM would pay the customer half of the difference between the futures price and contract price.
A customer might exercise this option if she did not need the product or if she were experiencing
financial difficulties. In later contracts, the customer could receive the entire difference in exchange
for a higher fixed contract price.

The customer contracts effectively gave MGRM a short position in long-term forward contracts.
MGRM hedged this exposure with long positions in near-term futures using a stack-and-roll hedging
strategy. In this strategy, the firm buys a bundle of futures contracts with the same expiry date,
known as a stack. Just prior to delivery, the firm liquidates the stack and buys another stack of
contracts with longer expirations, known as a roll. The level of uncertainty in the cost of this strategy
should have prompted MGRM to use a valuation reserve since they were currently basing roll costs
on historical data rather than potential future costs.

MGRM used short-term futures to hedge because alternatives in the forward market were
unavailable and long-term futures contracts were highly illiquid. As it was, MGRM’s open interest in
unleaded gasoline contracts was 55 million barrels in the fall of 1993, compared to average trading
volume of 15 to 30 million barrels per day. In December of 1993, MGRM cashed out its positions and
reported losses of approximately $1.5 billion.

Although some market observers cite the maturity mismatch between MGRM’s short position in
long-term fixed-rate contracts with customers and its long position in near-term futures contracts,
many economists believe this hedging strategy is fundamentally sound. Over the life of a properly
constructed hedge, the cash flows from the forward and futures contracts would balance out,
provided the hedging firm could withstand interim cash flow requirements from marked to market
losses, margin calls, credit risks, and liquidity risks associated with adverse market movements. The
fundamental issue for MGRM was a cash flow problem that constrained the company’s ability to ride
out the hedge. This cash flow problem had several causes and severe consequences, which are
discussed next.

Gains and losses on forward contracts are realized at the agreement’s expiration, whereas futures
contracts are marked to market such that the gains and losses are realized on a daily basis. In
MGRM’s case, gains and losses on its customer contracts were realized if and when the customers
took delivery, which would occur over a 5- to 10-year period.

During 1993, oil prices dropped from a high of about $21 per barrel to about $14 per barrel,
resulting in losses of $900 million on MGRM’s long positions, which were realized immediately as the
futures contracts were marked to market. The offsetting gains on their customer contracts, however,
would not be realized for years to come, which created potential short-term cash outflows, and
resulted in funding liquidity risk. Declining oil prices also created margin calls that exacerbated the
cash flow problem. Due to these losses, MG ordered MGRM to close out of its customer contracts.
This forced the firm to unwind its positions at very unfavorable terms.

According to German accounting rules, MGRM was required to report losses associated with its
futures hedges, but was not permitted to show associated gains from its customer contracts, which
the futures were meant to hedge. The magnitude of the losses caused its credit rating to drop,
increasing its perceived credit risk and restricting the company’s access to credit. The losses also
created a crisis of confidence with its counterparties, which began to suspect the firm was
speculating rather than hedging and, therefore, demanded collateral to secure contract
performance. These same concerns induced the New York Mercantile Exchange to increase the
firm’s margin requirements. It is interesting to note that these consequences, which aggravated an
already mounting cash flow problem, did not stem from a fundamental flaw in MGRM’s hedging
program. They occurred due to overly conservative financial reporting requirements that failed to
recognize the relationship between hedging losses and offsetting gains on the underlying positions
that motivated the hedge in the first place.

The cash outflows might have been tolerable and possibly balanced out by cash inflows over the life
of the hedge were it not for the sheer size of MGRM’s position, which would have taken ten days to
liquidate. To liquidate without affecting market prices would have taken from 20 to 55 days. As a
result, the company lacked liquidity to unwind its positions, if necessary, without significant market
impact, and was therefore subject to trading liquidity risk. To make matters worse, MGRM was
carrying a heavy debt load and had little equity to withstand losses and cash flow problems on
positions of this size