Outline
Financial crisis is a common phenomenon in today’s society and organizations. Various strategies, frameworks, theories and policies have been developing to contain and manage financial crisis.This paper will have a closer look at financial crisis of the Metallgesellschaft AG (MG).In this case analysis, the paper will cover the following issues;
- Brief details of what happened to Metallgesellschaft AG (MG) and why
- The potential risks did MGRM face as a result of its forward contracts and its use of derivatives -whether MGRM hedging or speculating
- the barriers of entry to the oil industry
Company Description
Metallgesellschaft AG (MG) is a metal company that was formed by a conglomeration of various organizations situated in Germany such as Deutsche Bank, Dresdner Bank Kuwait Investment Authority among others, which was founded as a traditional metal company that was later transformed into a risk management service provider.
The company has various branches with MG Refining and Marketing Inc. (MGRM) dealing with the production and selling of refined petroleum products in America. (Culp, and Miller, pp. 62-76).
Case Analysis
In the year 1993 the MGRM faced a major financial crisis whereby reports indicate that the company lost more than a billion US dollars. This was as a result of its venturing into derivative strategies in 1991 which was introduced by Mr. Arthur Benson hired from Louis Dreyfus Energy Company. The company indulged into various financial transactions such as selling its gasoline and heating oils at fixed prices from 1992 over a period of ten years. Though in the beginning it looked attractive, it wasn’t a good option, since some of the contracts had an option that allowed customers to dissolve the agreement if they speculated that future contracts with (NYMEX) New York Mercantile Exchange would be more than the fixed price for MGRM products. This speculation by the MGRM regarding the link between distant and near prices backfired for a while causing a tremendous decline in its cash flows. (Culp, and Miller, pp. 62-76).
Potential risks of MGRM
MGRM was faced with some risks in its efforts to run its business. Firstly, they devised a way in which their customers would avoid or transfer the risk on the price of oil since the markets for petroleum products is constantly faced with changes in prices. They have a belief that their resources in finance gives them a higher standing sell in large volumes and also in managing the transfer of risks in the best possible manner. This involved the use of hedge strategy to check on near risks on prices. (Jorion).
Also it entails shortening the months of delivery and this was very important to the from an economic point of view company. Secondly, they also faced the basis risk which involved money circulation timing needed to retain the hedge, and there had to be a balance between the two across the lifespan of the hedge. There was also a problem in the location of oil products since they were situated far from where they were to be traded. (Edwards, pp. 189-210) Thirdly, MGRM encountered the funding risk whereby they had insufficient funds that could enable them retain the same standing. Since this strategy in managing risks is very vital in successfully achieving the main goals of the company the players in the company need to have perfect knowledge about it. MGRM also faced the rollover risk. This was as a result of MG’s move from backwardation to contango in its oil market. Naturally in the oil markets prices in the future are less than those in the present. This is called backwardation. If there is a move in the market and the current price is less than the future price it’s known as contango. Suppose this oil markets faced a long contango period then the rollover losses would be very high. This would mean they had to purchase at a very high price but disseminate them at a relatively low one. Assumptions are, if hedging period had gone for a longer period, say more than a year, then MGRM could have faced huge losses. (Edwards, pp. 189-210).
Lastly MGRM’s credit risk was as result of creditors’ reluctancy to fund the firm due to its long periods of hedging and falling energy prices. This meant that the gap between current and future fixed prices would be comparatively very large. The size and also the timing of MGM’s rollover trades had an impact on the above risks in that the ten year period that the futures were spread was too long since the oil market is frequently faced with swings and hence anything is possible. The timing of the rollover was not right. Had Benson devised this option some months a bit early they would have worked well for the company, though still had MG waited a bit longer before terminating them, then still they would have offset their losses?
Speculating or Hedging
MG contracted with it’s counterparts to sell it’s petroleum products at fixed prices for a period of 10 years. Conversely, consumers could opt to withdraw the contract just incase the spot cash was more than the future prices. The company was hedging its state by lengthening its futures near month and having to spread them across the months i.e. the stack and roll strategy. This hedging strategy could have been successful only if prices rose which could have translated into customers craving for more. MG hedged in heating oil and gasoline. This led to it’ going into contract with over the counter energy swap to acquire cash flow to be able to counter the fixed prices. This forced MGRM to hedge out the escalating oil prices. (Mello and Parsons, pp. 106-200) MG was speculating when they did enter into the fixed rate pricing average state of about 160 million oil barrels. This size was in itself so large posing a great risk to the company. Could the prices of oil drop drastically, then MG would have to experience enormous losses. MG’s use of financial instruments in one way or another contributed to its problems. In Germany LCM accounting is preferred which is different with the U.S accounting system. This meant that as MG made profits in the U.S it was at the same time making losses in Germany. The MG’s counterparts had to acquire extra funds to retain their swap status since NYMEX had put a prerequisite margin on MG. (Kyle, pp. 13-35).
Corporate Strategy
The use of short term futures contracts while the distribution agreements was long run in nature posed a problem to MG in that it had to, after a short period, replace them. Furthermore, the petroleum products were in afar place different from where exchange was to take place. This led to the basis risk. An advantage of using derivatives is that NPV (net present value) of a firm can be discounted on its revenues making them more than their operating costs. Hedging proves to be more cost effective in compensating sudden fall in prices or increased costs. Hence use of derivatives could not be avoided. (Mello and Parsons, pp. 106-200).
Communication Breakdown
MG had very poor communication with the Supervisory Board regarding the MGRM’s strategy. Its not clear cut what mad the Supervisory Board of MG to terminate MGRM’s futures contracts but it seems it based on argument that MGRM’s strategy was not the best i.e. being highly exposed to the credit and rollover risks could bring about the necessary benefits it expected. It’s still possible that MGRM did not understand MG’s goals and that’s why it came up with its on corporate strategy to run its affairs and due to this lack of understanding later led to its termination. (Jorion).
Termination of MGRM
It wasn’t necessary for MG’s Supervisory Board to terminate MGRM’s holdings since from December 1993 to August 1994 the prices of crude oil rose from $13.91 to $19.42 and that of heating oil from $18.51 to $20.94, then for gasoline was from $16.88 to $24.54 for each barrel. This implies had MGRM stayed a bit longer then they would have offset those losses but apparently this was not the case. Though, suppose the prices could have continued to decline instead of increasing then automatically MGRM infact it would have incurred more losses than what it had so far. This makes it however difficult to conclude whether the MG’s timing was to terminate MGRM was proper or not. (Mello and Parsons, pp. 106-200).
Conclusion
MG’s failure should not be laid on its use of derivatives but rather on the luck of understanding between the two parties especially on the corporate strategy that MGRM was using in conducting its affairs. Still MG’s Supervisory Board would have given MGRM some chance to see if they would have succeeded or not.
References
- Culp, C, and M. Miller, Hedging a flow of commodity deliveries with futures: lessons from Metallgesellschaft Journal of Applied Corporate Finance, 1994, Pp. 62-76
- Edwards, F and M. Canter, The collapse of Metallgesellschaft: unhedgeable risks, poor hedging strategy or just bad luck, Journal of Future Markets, 1995 Pp. 15, 211-64.
- Edwards, F. Hedge funds and the collapse of Long-Term Capital Management, Journal of Economic Perspectives, 1999 Pp 13, 189-210
- Jorion, P. Risk management lessons from Long-Term Capital Management. 1999.
- Kyle, A. Continuous auctions and insider trading, Econometrica, 1985 Pp 53, 13-35.
- Mello, A. and J. Parsons, the maturity structure of a hedge matters: lessons from the Metallgesellschaft debacle”, Journal of Applied Corporate Finance, (1995) Pp106-200. Pirrong, C., “Metallgesellschaft: a prudent hedger ruined, or a wildcatter on NYMEX, Journal of Futures Markets, 1997, Pp. 17, 543-578.