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Case Study 1
METALLGESELLSCHAFT REFINING AND MARKETING, INC
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Name Student ID
Jashvina Anbarasan 170034472
Sasiporn Eamdeengamlert 170004650
Zi Wang 140047705
Haonan Zou 140041653
MSc Banking & International Finance 2017 – 2018
SMM104 Risk Management
12 March 2018
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Contents
Part 1: What were MGRM’s main market risks from the fixed-price contracts signed with
customers, and what was the strategy for managing those risk? ………………………………… 1
Part 2: Why did it all go wrong? What type of risk triggered the collapse?………………….. 2
Part 3: Do you think the board of the parent company protected shareholder value
by what they did? If so, why? If not, what would you have done differently
as the board?………………………………………………………………………………………………………… 3
Part 4: Do you think the rolling hedge should have worked?……………………………………… 3
Part 5: Describe in one paragraph what went wrong. ……………………………………………….. 4
Part 6: Given Size of MGRM’s Fixed price contracts, and assuming an annual volatility
of crude price of 30% and an oil price of $20 a barrel, estimate how much collateral or
margin might be needed by MGRM over a year………………………………………………………. 4
Part 7: Using data from Exhibits 1 to 5, what would the company profits be if it had to
deliver 12 million barrels of crude oil, 42 million gallons of gasoline, and 42 million
gallons of heating oil each month in 1992……………………………………………………………….. 5
Part 8: How profitable if the counterparty decides to exercise the opt-out clause in June
1992 ………………………………………………………………………………………………………………….. 6
Appendices ………………………………………………………………………………………………………… 7
References ………………………………………………………………………………………………………… 10
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1
Metallgesellscahft AG (MG), founded in 1881, is a large German conglomerate with
over 251 subsidiaries representing interests in metals, mining, engineering, trade and financial
services activities. Only about 35% of MG shares were freely traded as the remaining 65%
were held by large institutional investors such as Deutsche Bank, Allianz and Daimler-Benz
(IESE, 1997). MG’s U.S. oil trading subsidiary was MG Refining & Marketing, Inc. (MGRM)
and they recruited Arthur Benson in December 1991 who had a key strategy to offer long-term
fixed price contracts. MGRM entered into long-term contracts to supply a large amount of
refined energy products such as gasoline and heating oil to its customers. MGRM started
marketing long-term firm price guarantees to customers in 1992 and these contracts were for 5
and 10 years which were generally at prices from $3 to $5 over the prevailing spot rate at the
signing time.
MGRM had two fixed-priced programs (Conroy, 1998). The first was a “firm–fixed”
program whereby customers agree to fixed monthly deliveries at fixed prices. The second,
“firm–flexible” contract specified a fixed price and total volume, but customers have the
flexibility to set the delivery schedule. Both these contracts had been proved to be a success by
September 1993 as MGRM had sold forward the equivalent of almost 150 million barrels of
gasoline and heating oil. Most of these contracts were negotiated at the time when energy prices
were historically low. The advantage for MGRM offering these contracts is being able to
develop long-term relationships in the oil business in the United States as they attracted a wide
array of customers: retail gasoline suppliers, large manufacturing firms and governmental
agencies. Both these programs had “cash–out option” clauses providing the customers with an
embedded liquidity option whereby the buyer could terminate the contract if the spot prices
rose above the fixed prices. This provided customers with some relief and avoid default risk.
Part 1: What were MGRM’s main market risks from the fixed-price contracts signed
with customers, and what was the strategy for managing those risks?
MGRM’s fixed price forward delivery contracts primarily exposed the business to
market risks which is the “risks relating to movements in market variables” (Hull, 2015). In
the oil sector, the market risk refers to the risk of rising energy prices and for MGRM this risk
is significant due to the size of the supply contracts. MGRM therefore decided to hedge but not
in a straightforward way. The firm hedged this price risk with energy futures contracts of
between one to three months to maturity at New York Mercantile Exchange (NYMEX) and
over-the-counter (OTC) swaps – a “stack-and-roll” hedging strategy (IESE, 1997). Under this
strategy, MGRM opened a long position in futures staked in the near month contract and would
then roll the stake each month into the next near month contract, hence gradually decreasing
the size of the position and providing the company liquidity. This plan was to constantly match
the total long position in the stack with the remaining short position due under the supply
contract. MGRM went long in futures and entered into OTC energy swap agreement to receive
floating energy prices while making fixed payment.
At the time MGRM entered the market with the hedging strategy, the market structure
was in backwardation – whereby spot prices were higher than future prices. In this market
construct, the company would make profit margin on their forward contracts hedged by their
long futures contracts therefore effectiveness of the strategy depended on the continuation of
backwardation in the market place. The U.S. managers had the idea that backwardation would
come to their benefits as Culp and Miller (1995) quoted “At any given point in time, certain
parts of the commodity market may be overvalued or undervalued relative to that commodity’s
own forward price curve, to other commodities or to other markets…That, in turn, provides
attractive opportunities from an arbitrage standpoint”.
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However, MG’s theory that backwardation is the “status quo” of oil market does not
apply because the price changes in the energy sector are driven by exogeneous factors. These
factors refer to the likelihood of “erratic” behaviour by the Organisation of Petroleum
Exporting Countries (OPEC) and the unpredictability of speculators’ behaviour in the oil
market (Krapels, 2001). The backwardation was due to the market judgment that OPEC’s cartel
pricing was unsustainable over the long run but in the late 1993 the OPEC managers failed in
reaching production quotas resulting in the drop of spot prices. The argument against relying
on crude price backwardation is also strongly influenced by the speculators’ net positions since
speculators have become more and more important in setting short-term prices (Krapel, 2001).
Therefore, in this case the speculators are strongly net short hence contributing to strong
prompt supply for crude resulting in drop of oil prices.
The movement in the price of the commodities is also caused by seasonality changes
influencing the supply and demand of the heating oil and gasoline. Gasoline demand is
influenced by summer driving conditions, fuel efficiency regulations and winter heating oil
needs. Gasoline supply, on the other hand is influenced by storage capacity, cost of crude oil
imports, refiner’s production ratios and government regulations (IESE, 1997). These
exogenous circumstances are the reason the market flipped into contango resulting in future
prices higher than spot prices.
Part 2: Why did it all go wrong? What type of risk triggered the collapse?
This hedging strategy worked as long as the market was in backwardation,
unfortunately, in September 1993, the futures markets for crude oil shifted to contango. The
reason why MGRM ran into trouble was due to how it decided to hedge the long-term price
exposure so when the market experienced contango, the company incurred significant losses
each time MGRM rolled over their future contracts. MGRM’s mark–to-market losses in its long