Metallgeshellschaft Ag

MetallGeshellschaft AG is the fourteenth largest German corporation specializing in metals and oils; a conglomerate with 15 major subsidiaries. MG Refining and Marketing (MGRM) was a trading subsidiary in the "Energy Group", in charge of refining and marketing products in the US, with over 65% of stock owned by institutional investors including banks. In the early 1994 Metallgesellshaft AG, was on the verge of bankruptcy. The trading strategy of the company had led to an outstanding loss of 1 billion USD.

1. Situation:

In 1992, Metallgesellschaft Refining and Marketing (MGRM) tried to set up a strategy meant to be highly profitable: the company planned to sell determined amounts of petroleum products every month for ten years, at fixed prices (that were higher than the current market price). MGRM then purchased short-term energy futures to hedge the long-term commitments - a "stack" hedging strategy.

This strategy failed because it didn't take into consideration one problem: when oil prices drop, the benefits from the sale of oil are realised in the long-term, but the losses from the energy futures will be realised immediately. Thus, when oil prices dropped, the company faced a cash flow crisis

More precisely, Metallgesellshaft AG (MG) owned 51 %ЁOf MGRM Metallgesellshaft Refining and Marketing, MGRM in the late 1991 offered 5 to 10 years heating oil and gasoline fixed price contracts to its clients. This offer was 210 basis point over the market price with maturity up to one year. Those contracts had therefore known good craze from the investors. Following the settlement of those contracts MGRM was committed to deliver 20 millions barrels in October 1992 and 210 millions barrels in December 1993. MGRM tried to hedge their long term exposure to customer using a long position in short-term futures and forwards.

2. Hedging strategy

The futures trades were apparently a hedge for the firm's oil delivery contracts. The main problem was the mismatch in maturities between the company's delivery contract exposure to oil price risk and the company's portfolio of futures. Although the contract exposure was to long-term oil prices, it hedged with short- dated futures in order to capture profits from perceived mispricings in that market. When that gamble did not pay off, it undermined the entire company. Understanding the mistakes made by Metallgesellschaft is critical if other firms are to avoid a similar fate without forsaking the significant benefits available from a correctly planned hedging strategy.

3. Why the strategy failed

The main factor is that oil prices decreased abruptly in 1993.They had not expected such a trend. They went long on future contracts, due to this trend they have realized huge call margins on their contract. At the end they sold the oil barrels to their customers but they received less money than they spent for the margin calls The spread between what they spent and what they earned was a loss of 1,26 Billion USD. They entered a huge liquidity crisis which became public. The crisis was accentuated by many factors: the OTC -counterparties did not renew expired contracts, NYMEX increased initial margin of the contracts, Suppliers demanded pre-payment and banks did not provide fresh liquidity.

4. Additional Factors to be considered

At the time, different subsidiaries of MG AG were adopting different accounting method-ologies which led to a discrepancy in the financial statement for the company. In Germany, Lower of Cost or Market (LCM) accounting is required, which required to book current losses without recognizing the gains of the fixed-rate forward position until they are realized.