MG, now part of GEA Group Aktiengesellschaft, was a large German industrial conglomerate, owned mainly by the Dresdner Bank AG, Deutsche Bank AG, Daimler-Benz, Allianz, and the Kuwait Investment Authority. The company was engaged in a diversity of activities, such as mining, engineering, trade and financial services. A traditional metal company had developed into a provider of risk management services. The company had several subsidiaries in its "Energy Group," with MG Refining and Marketing Inc. (MGRW) in charge of refining and marketing petroleum products in the U.S. (Culp & Miller, 1994).
In December 1993, it was publically revealed that the "Energy Group" was responsible for huge losses of about $1.5 billion. It all started with the hiring of Mr. Arthur Benson from Louis Dreyfus Energy in 1991. He was responsible for MGRM's increased venture into the derivatives world began and later his strategy contributed to the huge cash flow crisis that MG experienced. Infact in December 1993, the company reported large derivatives-related losses at its U.S. oil subsidiary, MG Refining and Marketing (MGRM). These huge losses were later estimated at $1.5 billion, the biggest derivatives-related losses ever reported by any firm at the time. This event pushed MG, then Germany's fourteenth largest industrial corporation, to the verge of insolvency. Heinz Schimmelbusch, the firm's executive chairman and several other senior managers were dismissed. MG's board of supervisors were forced to settle a $1.9 billion rescue package with the firm's 120 creditor banks (Roth 1994). After the failure of the Klöckner in the oil business MG is the second largest German company that experienced large losses from oil derivatives trading.
MG's management board blamed the firm's problems on the negligent operational control of senior management, stating that the speculative oil deals had forced MG into the crisis. Some observer echoed the interpretation of events, but subsequent studies report that the MGRM's use of energy derivatives was an essential part of the combined marketing and hedging program under which the firm offered customers long-term price guarantees on the deliveries of petroleum products such as gasoline and heating oil. Reports that MG's losses were attributable to a hedging program have raised a host of new questions. Many analysts and observers are still confused by how the firm could lose over $1.5 billion through hedging.
The Metallgesellschaft disaster has sparked a dynamic debate on the weakness of the firm's hedging strategy and the lessons to be learned from the incident. Moreover, the huge derivatives loss suffered by Metallgesellschaft is an example of what can happen because of misleading accounting principles (German accounting principles) or misuse of derivatives. The Supervisory Board of the Metallgesellschaft, examining large unrealised losses on the firm's hedging positions (i.e. energy futures and swap contracts), and evidently not recognising the offsetting unrealised gains on the firm's physical-delivery contracts, controlled the general liquidation of the firm's hedging positions, realising substantial losses. Therefore, whatever accounting and disclosure practices are adopted should consider derivatives and hedged positions symmetrically. Market value accounting applied exclusively to derivatives will mislead and will likely discourage firms from using derivatives to manage risk.
MGRM Oil Business
In 1991, MGRM began to market the long term OTC oil contracts to its customers. These contracts obligated MGRM to sell a variety of refined oil products at a determined price every month for five or ten years. The contract price was determined by the current future prices of the following 12 month plus a margin of between 5 and 10 cent per gallon (equivalent to 2.1 or 4.2 $ per barrel). There were two programs that changed their attached cancellation rights (blow out option) as well as delivery timing options (Special Accountants Report 1995). Under the so called firm fixed program that accounted for about 2/3 of the business, the customer had the right to withdraw the contract when the front month future price exceeded the contract price. In that case the firm was entitled to a payment of about 50% of the price difference times the amount of outstanding deliveries. During autumn of 1993, 50% of the contracts were renegotiated such that exercise would be generated automatically when the front month future price reached a certain level. The other program was the firm flexible contracts that allowed the customers to choose the time of delivery of the fundamental product as long as deliveries did not exceed about 20% of its annual oil purchases. The firm flexible contracts also allowed early termination when the second month futures price exceeded the contract price. In this case the customer was entitled to a payment of the price difference times the remaining amount. In order to compensate MGRM for the bigger flexibility of the customer the contract price was determined by the maximum futures price of the following 12 months plus a higher margin.
The risk management strategy of MGRM identified that the firm may not engage in speculative trading and therefore may not hold any outright long or short position. Since there were insufficient availability of long term hedge contracts in the market, MGRM decided to use the short term futures and OTC swaps in order to hedge its exposure. By rolling these transactions forward at maturity, MGRM created a so called stacked hedge. The amount of outstanding futures in barrels was at any time equivalent to the amount of outstanding deliveries. An irregularity of MGRMs hedging program was that oil traders were free to choose either gasoline, heating oil or crude oil futures as the appropriate hedge contract. According to the special auditors report, the actual hedge ratio exceeded 1:1 during autumn 1993 because MGRM initiated its hedging program at the time the contract offer was made. However, according to the Special Accountants Report (1995) contracts with a volume of US$7.8 Million were not confirmed by the customers and therefore created a temporary hedge ratio exceeding 1:1.
In 1993, the volume of the MGRMs oil business increased tremendously. The long term delivery programs started from a volume of about 43 Million at the beginning of the year and more than tripled until September 1993, which remained at that level until the end of the year when the liquidation of the portfolio started.
MGRM Marketing Program
In 1992, MGRM began to implement an aggressive marketing program in which it provided long-term price guarantees on the deliveries of gasoline, heating oil, and diesel fuels for up to five or ten years. This marketing program included some novel contracts, two of which are relevant to this study. The first marketing program was the "firm-fixed" program where the customer agreed to the fixed monthly deliveries at fixed prices. The second, identified as the "firm-flexible" contract, specified a fixed price and total volume of the future deliveries but provide the customer some flexibility to set the delivery schedule. Under the second program or firm-flexible, the customer could demand 20 percent of its contracted volume for any one year with 45 days of notice. By September 1993, MGRM had committed to sell forward the equivalent of over 150 million barrels of oil for delivery at fixed prices, with most contracts for terms of ten years.
Both types of the contracts included options for early termination. These cash-out provisions allowed the customers to call for the cash settlement on full volume of outstanding deliveries if the market prices for oil rose above the contracted price. The firm-fixed contract allowed the customer to receive one-half of the difference between the current close futures price (specifically, the price of the futures contract close to expiration) and the contracted delivery price, multiplied to the entire outstanding quantity of scheduled deliveries. According to Mello and Parsons (1995) the firm-flexible contract allowed the customer to receive the full difference between the second nearest contract price and the futures price, multiplied by all remaining deliverable quantities.
During the course of May through December 1993 crude oil futures had a steady slow decline. MGRM settled most of the firm's contracts in the summer of 1993 when the energy prices were relatively low and declining and the contracts came with a cash-out option if the energy price were to increase above the contracted fixed prices. Its contracted delivery prices showed a premium of about $3 to $5 per barrel over the prevailing and general spot price of oil. As is evident in Figure 9, the energy prices were comparatively low by recent historical standards during 1985-1995 and continued to decline. As long as the oil prices kept declining, or at least did not rise significantly, MGRM stood to obtain an attractive profit from this marketing program or arrangement. But a significant increase in the energy prices could have exposed the firm to huge losses unless it hedged its exposure.
Figure 9. Crude Oil Prices: 1985-1995 (Kuprianov, 1995: 7)
Figure 10 shows the Spot price of crude oil which also led to the emergence of an oil derivatives market and a variety of the hedging instruments specifically forwards, futures and options with different maturities. In 2001, oil futures were among the most dynamically traded futures in the world. Crude oil, heating oil #2, unleaded gasoline and natural gas were traded on the New York Mercantile Exchange (NYMEX) and Brent crude and gas oil are traded on London's International Petroleum Exchange (IPE).
Figure 10. Spot price of crude oil (1948-1999) (Medova and Sembos,2001)
Figures 11-13 (all traded on the NYMEX) show the 1-month to 15-month crude oil futures from (Financial Year) FY 1983 to 1999, heating oil #2 futures from FY 1978 to 1999, and unleaded gasoline futures from FY 1984 to 1999. The data is created from the daily data by extracting all Fridays in order to obtain weekly data and estimating all missing data using the linear interpolation.
Figure 11. Crude oil futures prices (Medova and Sembos, 2001)
Figure 12. Heating oil #2 futures prices (Medova and Sembos, 2001)
Figure 13. Unleaded gas futures prices (Medova and Sembos, 2001)
To offset the exposure resulting from the delivery commitments, MGRM wanted to buy a combination of short-dated oil swaps and futures contracts, which is a strategy known as a "stack-and-roll" hedge. In its simplest form, a stack-and-roll hedge strategy involves frequently buying a bundle, or "stack," of short-dated futures or forward contracts in order to hedge a longer-term exposure. Each stack is rolled over just before the expiration by selling the existing contracts while buying another stack of the contracts for a more distant delivery date; thus the term stack-and-roll. MGRM implemented its hedging strategy by maintaining long positions in a large variety of contract months, which it shifted between the contracts for different oil products (crude oil, gasoline, and heating oil) in a manner intended to reduce the costs of rolling over its positions.
Had oil prices increased, the additional gain in the value of the MGRM's hedge would have produced a positive cash flow that would have offset the losses stemming from its assurances and commitments to deliver oil at below-market prices. In late 1993 as it happened, the oil prices fell even further. In addition, declines in the spot and near-term oil futures and forward prices drastically exceeded declines in the long-term forward prices. Thus, contemporaneous recognised losses from the hedge exceeded any possible offsetting gains accumulating to MGRM's long-term forward commitments.
The steep decline in the oil prices caused funding problems for MGRM. The practice in futures markets of marking futures contracts to market at the end of each trading session forced the firm to recognise its futures trading losses immediately, triggering huge margin calls. On the other hand, forward contracts have the advantage of allowing hedgers to defer or suspend recognition of losses on long-term commitments.
MGRM's stack-and-roll hedge substituted short-term forward contracts (in the form of short-term energy swaps maturing in late 1993) for long-term forward contracts. As these contracts matured, MGRM was forced to make large payments to its counterparties that placed further pressure and burden on its cash flows. At the same time, most offsetting gains on its forward delivery commitments were delayed.
Reports on the MGRM's problems started to come out in early December of that period. In response to these developments, the New York Mercantile Exchange (NYMEX), the exchange on which MGRM had been trading energy futures, increased its margin requirements for the firm. This particular action, which was intended to protect the futures in case of a default, worsened MGRM funding problems even further. Reports on the firm's financial difficulties led many of its OTC counterparties to start terminating their contracts. Others demanded that it posts collateral to secure contract performance.
When realising about the incident, MG's board of supervisors fired the company's chief executive and formed a new management team. The board of supervisors ordered the new managers of MG to liquidate MGRM's hedge and to enter into negotiations to cancel its long-term contracts with its customers. However, this action made matters worse as NYMEX cancelled its hedging exemption after MGRM announced the end of its hedging program. Hedging exemptions allow firms to take on much bigger positions in the exchange-traded futures than those allowed for un-hedged, speculative positions. According to Culp and Miller (1994) the loss of its hedging exemption forced MGRM to reduce its positions in the energy futures further.
MG's boards of supervisor's decisions in this incident have urged widespread criticism and debate, as well as several lawsuits. Some observers and analysts argue that MGRM hedging program was seriously inconsistent and that MG's board was right to terminate or close off its position. Others, including the Nobel Prize-winning economist Merton Miller, argue that the hedging program of MGRM was sound and that MG's board worsened any hedging-related losses by terminating the program impulsively.
Hedging Alternatives
The use of the word hedging as a means to explain protection and safety against losses is very generic and in fact this means a variety of different strategies for firms. Elementary finance textbooks are full of examples of perfect hedges, in which a firm uses futures or forward contracts in order to offset perfectly some given exposure. The hedging strategies utilised by the firms tend to be relatively more complex. In practice, a perfect hedge can be difficult to position or arrange. Even when possible, such a strategy frequently leaves little room for profit.
MGRM had at least three hedging options open to it: physical storage, long-dated forward contracts, and some variant of a stack-and-roll strategy. Physical storage would have required MGRM to purchase the oil products it had committed itself to deliver in the future and then store those products until the promised delivery dates (Edwards & Canter, 1995). However, physical storage would have been an expensive option. It would have required MGRM to finance the cost of the required inventories and it would have entailed the cost of the requisite storage facilities. Together, these two costs comprise what is known as the cost of carry. Available proof suggests that the costs related with physical storage would have made MGRM marketing program unprofitable (Mello and Parsons, 1995).
On the other hand, MGRM could have selected among several derivatives-based hedging strategies with either forward or futures contracts, or a combination of both. Putting together a perfect hedge using such instruments would have involved the purchase of a certain package of oil futures or forward contracts with expiration dates just matching the MGRM promised delivery dates. However, oil futures normally trade only for the maturities of up to three years or less. Furthermore, liquidity tends to be poor for the contracts with maturities over 18 months. Therefore, MGRM would have had to buy a package of long-dated forward contracts from an OTC derivatives dealer in order to put together a hedge that just offset its exposure to the long-term energy prices.
The cost of buying a bundle of long-dated forward contracts would have most likely been high-priced or prohibitive. To understand why, one must note that when buying a forward or futures contract is equivalent or similar to physical storage in the way that both hedge strategies guarantee the future availability of an item or product at some predetermined cost. For this particular reason, the strategy of buying forward or futures contracts to lock in the cost of future delivery is sometimes called "synthetic storage." Hence, Arbitrage Pricing Theory foresees that the forward price for a commodity should reflect its cost of carry. Derived from the factors considered to this point, then, the theoretical no arbitrage or benchmark forward price should be:
THEORETICAL FORWARD PRICE = SPOT PRICE + COST OF CARRY.
The arbitrage pricing theory (APT) model suggested by Ross (1976) and extended by Huberman (1983), Shanken (1982), Dybvig (1983), Grinblatt and Titman (1983), and Stambaugh (1983), among others, assumes that the investors behave and act as if security returns are generated by a k factor generating function. The generating function is assumed to be of the form:
(1) R = E + BF + d
where:
R = n vector of asset returns;
E = n vector of expected returns;
F = k vector of the random deviations of the factor outcomes from their expected zero values;
B - n x k matrix of the sensitivity of the n asset returns to the k deviations in F; and
d = n vector of mean zero random error terms.
Other than stipulating that the number of factors is small, the model is mute on the number and nature of the factors.
Because the factors are exogenous to the model, tests of the statistical significance of a given factor structure are not tests of the APT. Tests of the APT focus on the implication that the expected returns E are linearly related to the factor sensitivities B:
(2) E = a + bF + [Epsilon]
Note this particular relationship means that buyers of futures and forward contracts should pay a premium for deferred delivery. This premium is known as contango in the parlance of the futures markets. Figure 14a, which shows the term structure of crude oil futures prices as of August 20, 1993, provides an example of a contango market.
These theoretical considerations imply that futures prices should always show contango. As is shown in Figure 14b, though, they do not always do so. Arbitrage only guarantees that the forward price of the commodity can never go beyond the theoretical standard price, but it clearly does not prevent forward and futures prices from falling below this theoretical standard price. For example, considering the opportunities for arbitrage that would occur if the futures prices exceeded the standard or benchmark forward price derived above. In this situation, an arbitrageur could get riskless profits by purchasing and storing the commodity in question at the same time as selling it forward at a price beyond the purchase price plus the cost of carry. Futures prices can fail to reflect the commodity's full cost of carry if the firms place the premium on current availability; nevertheless, as they sometimes do when available supplies of the commodity are limited. In such situations there is said to be a convenience yield related with physical storage. The simple cost-of-carry price relation presented in the figure fails to take account of the convenience yields, but it recommends a way to measure them. The convenience yield for an item can be measured by computing the difference between the standard forward price (the amount of the current spot price and the cost of carry) and the current market-determined forward price.
CONVENIENCE YIELD=SPOT PRICE + COST OF CARRY − ACTUAL FORWARD PRICE
At times the convenience yield is high enough in order to offset the cost of carry, triggering forward prices to be lower than the spot prices, as illustrated in Figure 14b. This trend is known as backwardation.
Figure 14. Term Structure of Crude Oil Futures Prices (Kuprianov, 1995: 10)
Backwardation in the commodity markets tends to be evident only in the short-term futures and forward prices. Carrying costs increase with time to delivery so that longer-term forward or futures contracts normally sell at a premium even when prices for short-dated contracts exhibit backwardation. Figure 14b above shows the pattern of the backwardation extended out to 18 months as at August 21, 1992. At other times, nevertheless futures prices start increasing at shorter horizons. On the other hand, figure 14c shows the term structure of the crude oil futures prices in April 20, 1994. On this figure, the futures prices showed backwardation only on the first four months of delivery and then started increasing.
The relationship between the spot and future prices identify the market conditions. The market is in backwardation when the futures prices are lower than the spot price and in contango when the futures prices are above or more than the spot price. For commodities such as oil products which incur significant costs of physical storage over time in normal market conditions this lead to the backwardation.
Oil companies typically enter forward supply contracts which commit them to supply final product volumes, such as unleaded gas and heating oil, to end-users at specific time points in the future at fixed prices. The companies also enter forward contracts with their suppliers of crude oil, which commit them to purchase crude oil at specific time points at fixed prices. If the crude oil prices decline below the fixed price indicated in the forward-supply contract, then the company finds itself in the unprofitable position of being contracted to buy crude oil at prices above spot prices. Likewise, if the oil product prices increase above the fixed price indicated in the contracts, then the company is in the position of having to sell its products at prices below the spot prices at a loss or possible profit (if sold at the prevailing spot price). Certainly, when crude oil prices move in the other way the company may also find itself in a profitable position. In a perfect situation, one can realise a so-called perfect hedge which totally eliminates the risk related to a future commitment to deliver by taking an equal and opposite position in the futures market. Conversely, this strategy involves the existence of the futures contracts that accurately match the supply assurances. Depending on the maturities of forward contracts, the availability of matching futures and the creditworthiness of other derivative product alternatives varies. Yet, there is no oil futures contract with maturity greater than 36 months ahead (i.e. 3 years). Using simply long-term over-the-counter (OTC) - specifically tailor-made, derivatives might expose the company to huge credit risk -- setting aside the complexity of finding a suitable counterparty in the first place given the illiquidity of the long-term OTC derivatives. In fact, choosing an appropriate hedging strategy to reduce price risk is a complex practical problem that needs careful consideration.
Based on the analysis it shows that a hedging strategy based on the long term forward contracts can be almost as expensive as physical storage, even when short-term futures and forward prices exhibit backwardation. So even though MGRM could have hedged its exposure by buying long-term forward contracts from an OTC derivatives dealer, this would have abridged, if not removed, any profits from its marketing program. Moreover, any dealer selling such contracts would have faced similar hedging problems.
The stack-and-roll strategy seemed to provide a means of avoiding such carrying costs because short-dated futures markets for oil products historically have tended to exhibit backwardation. In markets that exhibit persistent backwardation, a strategy of rolling over a stack of expiring contracts every month can generate profits. Consequently, MGRM management apparently thought that a stack-and-roll hedging strategy provided a cost-effective means of locking in a spread between current spot prices and the long-term price guarantees it had sold to its customers.
MGRM on Basis Risk
The term basis risk is the difference between the price of the instrument and the price of the primary asset being hedged. Basis changes over the life of a contract, typically for essential economic reasons but sometimes for reasons that are not well understood. MGRM stack-and-roll hedging strategy exposed it to the basis risk--the risk that the price behaviour of its stack of the short-dated oil contracts might vary from that of its long-term forward assurances. As it happened, in 1993 the behaviour of the energy futures prices acted strangely-in that, short-term energy futures revealed a pattern of contango rather than backwardation. Once the near-dated energy futures and forward markets started to show contango, MGRM was forced to pay a premium to roll over each stack of short-term contracts as they expired. These rollover costs reflected the cost of carry usually related with physical storage.
Figure 15 shows the behaviour of the turnover costs for three different energy futures contracts (heating oil, crude oil and gasoline) from 1985 through the end of the 1995 (Edwards & Canter 1995). In addition the figure also shows that for most of FY 1993 rollover costs were on a positive trend. However, the expected profitability of MGRM combined marketing and hedging program in 1993 was predicated on the assumption that the energy futures markets would continue to show a pattern of backwardation. MG's board of supervisors actually feared that the need to pay these turn over costs could add further to the losses of MGRM and chose to liquidate the subsidiary's hedge and end its long-term delivery contracts with its customers.
Note: Rollover costs are measured as of three days before contract expiration.
Figure 15. Rollover Costs for Three Energy Future Contracts (Kuprianov, 1995: 12)
Criticism of MGRM Hedging Program
MGRM hedging program is based on an extremely different analytics. According to Culp and Miller (1994) MGRM based their argument in favour of the 1:1 hedge ratio on a 3 period case with a numerical example in which a firm's market value is completely protected against the spot price risk by using a 1:1 hedge strategy. As Figure 16 shows, in 1994 the oil prices started to increase, soon after the MGRM's new management raised the firm's hedge. It therefore appears that MGRM could have recovered most if not all of its losses by merely sticking with their hedging program. Whether management should have been able to anticipate the outcome is the issue of active arguments and debate.
Figure 16. Crude Oil Prices: 1985-1995 (Kuprianov, 1995: 10)
Criticisms of the MGRM hedging program have focused on two significant issues. The first dealt with the assumptions that the persons involved on MGRM's hedging strategy made regarding the expected future behaviour of basis in oil futures and forward markets. The second issue concerned the steps MGRM could have taken to lessen the unpredictability of its cash flows.
Both Mello and Parsons (1995) and Edwards and Canter (1995) showed that MGRM hedging program would have created huge losses if contango energy markets had continued throughout 1994. A key question during 1993 was whether MG's board of supervisors should have viewed the behaviour of energy futures prices as a temporary irregularity or whether it had sufficient grounds to believe that this price behaviour could have continued indefinitely.
The MGRM strategy was not adjustable to market conditions. In 1993, MGRM's strategy was put into practice, the company's forward-supply assurances and the related derivatives positions extended for a horizon of 10 years during which prices could move in any direction and the prevailing market state, specifically market in contango or backwardation could be reversed. Edwards and Canter (1995) concluded that permanent changes in the behaviour of basis are likely and have occurred in other futures markets. As evidence, they cite experience with two other commodity futures contracts: soybeans and copper. Both the markets experienced backwardation from 1965 to 1975, but then started exhibiting permanent contango. Therefore, while a stack-and-roll hedging strategy for either commodity would have created positive cash flows on average before 1975, such a strategy would have lost money constantly over the ensuing ten-year period--meaning that a hedger using a stack-and-roll strategy of the type used by the MGRM in either copper or soybean futures markets would have experienced huge and continuing losses after 1975.
Mello and Parsons (1995) also argue that MGRM was over-hedged because short-term oil futures prices tend to be much more volatile than prices on long-term forward contracts. According to Mello and Parsons, MGRM's managers could have and should have planned a hedge that would have decreased the variability and inconsistency of the firm's short-term cash flows. On the other hand, Edwards and Canter (1995) found out that the relationship of short-term energy futures and forward prices with long-term prices is about 50 percent. Hence, they both argue that MGRM could have reduced the variance of its cash flows with a hedge about 50 percent less than the total of its future delivery commitments. Mello and Parsons (1995) also observed that the exact size of a minimum-variance hedge is difficult to calculate because MGRM's contracts gave its customers options to end their contracts after three years. They found out that the minimum-variance hedge ratio might be as high as about 75 percent if one presumes that all such options would be used at the end of three years.
The assessment done by Edwards and Canter shows that there are doubts as to whether the MG's board was correct to terminate or end its U.S. subsidiary's oil-hedging program. Mello and Parsons (1995) argue that MGRM's hedging strategy was speculative in its design and intent. They base their views on the written strategic plan prepared by MGRM management, which outlined a plan to use backwardation in futures markets as part of its hedging program. According to them, the plan went wrong because it assumed that the firm could benefit from the backwardation, pricing its long-term customer contracts lower than the full cost of carry. After examining MGRM's stack-and-roll strategy, they concluded that as a hedge it reverses the order of cause and effect. They argued that it should be perceived as a misguided speculative attempt to profit from the backwardation usually present in futures markets for the petroleum products while using forward delivery contracts as a partial hedge.
MGRM's hedging strategy is unequivocal according to Mello and Parsons. They argue that MGRM's strategy was seriously flawed, and they defend the decision to terminate the hedging program as the only means of limiting even bigger potential future losses. They also stressed the difficulty that MG's new management would have had in securing the financing necessary to continue MGRM's hedging program and argue that funding considerations should have led the subsidiary's managers to synthesise a hedge using long-dated forward contracts. In this context, Mello and Parsons noted that in 1988 and 1993 the parent firm already had collected a cash flow deficit of about DM 5.65 billion. This deficit had been financed largely by bank loans. Considering these circumstances, they find the reluctance of MG's creditor banks to fund the continued operation of the oil marketing program understandable.
Culp and Miller accepted the fact that MGRM's hedge was planned to use the backwardation usually present in energy futures markets, but they reject the argument that its hedging program represented reckless speculation. They emphasised that few, if any, commodity dealers always hedge away all risks, citing the results of previous studies on the behaviour of the commodity dealers to support their statements (Culp and Miller 1995a, b). Thus, they conclude that short-term cash flow constraints should not have presented any insurmountable problems in view of MG's long-standing and close relations with Deutsche Bank, which they feel should have been willing to continue financing MGRM's hedging program. These disagreements over the efficacy of MGRM's hedging strategy seem unlikely ever to be resolved, based as they are on different assumptions about the goals management should have had for its strategy. The main issue, then, is whether MG's senior management and the board of supervisors fully appreciated the risks the firm's U.S. oil subsidiary had assumed. If they did, the firm should have arranged for a line of credit to fund its short-term cash flows. Indeed, Culp and Miller (1995a, b) claim that MGRM had secured lines of credit with its banks just to prepare for such possibilities. However, the subsequent behaviour of MG's board suggests that its members had very little prior knowledge of MGRM's marketing program and were uncomfortable with its hedging strategy, despite the existence of a written strategic plan.
It is very difficult for outside analysts to assign responsibility and blame for any misunderstandings between the MG's managers and its board of supervisors. MG's board ultimately held the firm's executive chairman, Heinz Schimmelbusch, accountable for the firm's huge losses, asserting that he and other senior managers had lost control over the activities of the firm and hidden evidence of huge losses. In response, Schimmelbusch has filed suit against Ronaldo Schmitz and Deutsche Bank, seeking about $10 million in general and punitive damages (Taylor 1995). Former head of MGRM and architect of the firm's unlucky hedging program, Arthur Benson, sued the MG's board for about $1 billion on the charges of defamation. As a result, it appears that the issue of responsibility is intended to be settled by the U.S. courts (Taylor 1994).
Analysis on MGRM's Hedging Strategy
Both Culp and Hanke (1994) and Culp and Miller (1995) argued against MG's board of supervisors decision to terminate MGRM's hedging and marketing program. These authors argue that the MGRM's hedging strategy was sound and that the firm's huge losses are attributable mainly to the way the MG board ended the program.
Recognising that the unpredictability of short-term oil prices did make the MGRM's cash flows unstable, Culp and Miller argue that the short-term cash flow volatility is irrelevant to the judgments regarding the effectiveness of MGRM's hedging program. Culp and Miller base their argument on two significant considerations. The first stems from the theoretical analysis of the assets of the stack-and-roll hedge, the second from the practical analysis of the MG's ability to continue funding the program.
Culp and Miller (1995) revealed that a stack-and-roll hedge of the type employed by MGRM would offset completely any changes in the value of a long-term forward commitment so long as the factors determining basis--interest rates, storage costs, and the implicit convenience yield related with physical storage--do not change. Hence, Culp and Miller explained that it is misleading to blame MG's huge losses on changes in the term structure of oil prices. Whereas short-term price volatility can make cash flows volatile, it does not affect the net present value of the hedged exposure as long as basis remains unchanged.
In the summer of 1993, the behaviour of basis risk did change. Culp and Miller recognised that MGRM's hedging strategy exposed the firm to basis risk, but they argue that this risk was comparatively small considering the historical behaviour of the energy futures prices. Culp and Miller analysis explained that changes in basis risk influence only the part of carrying costs borne by the hedger. The hedger bears no carrying costs as long as the convenience yield is larger than or equal to the cost of carry(that is, when the market shows backwardation)--but must stand at least some part of carrying costs in the contango market. These carrying costs resemble rollover costs.
Culp and Miller's assumption and analysis on the MGRM hedging strategy where not challenge or argued. Rather, other authors and observers questioned the assumption that oil markets would always tend to demonstrate backwardation, while Culp and Miller argued that any long-run expected loss due to the basis risk were minimal considering historical trends of backwardation in the energy markets.
Moreover, the outcome of Culp and Miller's analysis could not concord with the $1.3 billion loss auditors attributed to the MGRM's hedging and marketing program. Culp and Miller (1995b) argued that MG's auditors underestimated the value of MGRM's contracts with its customers. Culp and Miller argue that taking appropriate account of unrecognised gains in the value of such contracts results in a net loss of about $170 million rather than $1.3 billion. According to Culp and Miller (1995b), most of the MG's reported losses were attributable to the manner in which its new management chose to end its subsidiary's marketing program, not to shortcomings in its hedging strategy. It is not strange for the parties to such agreements to negotiate termination of the contract before it expires. The normal practice in such circumstances involves payment by one party to the other just to offset for any changes in the value of the contract. On the contrary, it seems that MGRM's new management basically agreed to terminate its contracts with its customers without asking for any payment in order to reflect changes in the value of those contracts. The hedge, however lacking, was after the fact efficiently changed by this action into a large speculative transaction.
Culp and Miller found that MGRM's hedging program had experienced losses (although much smaller losses than those calculated by the MGRM's auditors),but they both argue that those losses did not substantiate terminating the MGRM's hedging program. They stress that any past losses were sunk costs. At the same time, at the end of 1993 they found out that the hedging program had a positive expected net present value. Therefore, they argue that MGRM had good reason to continue the program. Culp and Miller reject the board's statement that terminating MGRM's hedge was the only way of dealing with the subsidiary's huge cash outflows. Culp and Miller stressed that the firm could have bought options to remain hedged while it sought solutions to its longer-term funding difficulties.
By tabulating MGRM's cash drains on its hedge transactions, the special auditors of MGRM estimated MGRM's total gross derivatives-related loss from June 1, 1992, through December 31, 1993, as $1.277 billion. What matters to stockholders, however, are the net losses after allowing for gains on the other leg. To arrive at their net loss estimate, the auditors subtracted $233 million for the positive value of MGRM's various fixed-price delivery contracts on the other leg of the hedge. Adding another $16 million for interest and other costs, the auditors arrive at a net loss of $1.06 billion.
Just how the auditors arrived at their estimate of the value of MGRM's contracts on the other leg is far from clear. Without access to the company books or to the precise valuation formulas the auditors used but did not present, outsiders have no way to verify the calculations. Culp and Miller (1995a, b) argue that the auditors' estimate for the value of MGRM's customer contracts was far too low, and their net loss estimate thus was far too high. They contend that the firm's net 1993 loss was about $200 million-a far cry from the auditors' $1.06 billion.
Losing even $200 million is hardly pleasant, but even a $200 million net loss for 1993 does not justify the supervisory board's decision to wind down the program by liquidating part of the futures/swaps hedge and cancelling some of the customer contracts with no compensation required from customers. First, MG AG might have used MGRM's positively-valued hedged customer contracts as security for loans to finance the continuation of the combined marketing/hedging program after 1993. Culp and Miller's (1995a) $200 million estimated 1993 net loss, after all, was simply the cumulated loss through the first year of the program's operation. That loss was not guaranteed to persist for the remaining nine years. Had the program continued, in fact, it would likely have shown a profit in 1994 and thereafter. Assuming MGRM set the fixed-selling prices in its contracts above the spot price when the program was started, as Culp and Miller (1995b) argue, it would have locked in a gross profit margin on its hedged contracts sufficient to provide security for at least some form of bridge loan.
Second, if MGRM's major creditors and shareholders--including Deutsche Bank and Dresdner Bank--had been unwilling to continue funding the program, the supervisory board might have directed that MGRM's hedged customer contracts be sold to another firm. Culp and Miller (1995a) estimate that if MGRM had been able to sell the combined program for its year-end 1993 capital asset value, it would have received nearly $800 million from the sale. MGRM's net 1993 loss would still have been about $200 million, or roughly the same as if the program had been continued. However, the sale would at least have halted the cash drains with which the supervisory board had become so concerned.
Third, the supervisory board could have instructed MGRM to buy back its customer contracts by unwinding them. When the market smells trouble, unwinding bilateral contracts rarely nets the unwinding firm a cash flow equal to the actual capital value of the contract. That MGRM might not have collected from its customers the same $800 million it could have made by selling the program to another firm is thus plausible. But between the time MGRM negotiated the fixed prices on its customer contracts and year-end 1993, the oil spot price had fallen by nearly $5.75/bbl. Unless MGRM negotiated its contracts at a massive initial loss, customers should have been willing to pay something to get out of their contracts.
A former MGRM employee explained that on December 22, 1993, one of MGRM's biggest customers paid MGRM $2 million to unwind its fixed-price contracts. Two months later when many of MGRM's similar contracts were cancelled with no compensation required from customers, MG refunded the $2 million it had been paid earlier. Although it is not clear whether the $2 million paid was a reasonable estimate of that customer's actual contract value or much less than what other customers would have paid, it is likely that if one of them was willing to pay, so were others.
In general, MG AG's supervisory board had at least three viable alternatives in December 1993: secure additional financing and continue the program intact, sell the program to another firm, or unwind the contracts with the original customers. Instead, the supervisory board chose the profit minimising solution of liquidating much of the hedging program and then letting its customers off the hook. The supervisory board thus pursued the worst possible course of action in December 1993 and increased, perhaps dramatically, the price tag paid by shareholders for MGRM's ultimate bailout.
Moreover, they argue that the short-term cash flow constraints should not have presented any impossible problems in view of the MG's long-standing and close relations with the Germany's largest commercial bank, Deutsche Bank. Culp and Miller emphasised that Deutsche Bank was not only a creditor to MG but also one of its major shareholders. In addition, Ronaldo Schmitz, a Deutsche Bank executive, was chairman of the MG's board of supervisors at the time. Thus, Culp and Miller concluded that Deutsche Bank should have been willing and eager to continue financing MGRM's hedge program in view of its close relations with MG and its expertise in finance.
Culp and Miller also suggested that MG's management could have bought options to hedge its oil exposure while looking for a longer-term solution to its funding problems, as suggested by the MGRM's management. As a longer-term solution, they argue that the firm could have spun off the combined hedging and marketing program into a separate subsidiary, which could have been sold to another firm. This argument is supported by Edwards (1995), who reported that at least one major U.S. bank had tried to provide secured financing to MGRM based on the plan to securitize its forward delivery contracts.
Policy Concerns
Considering the argument over the advantages of the MGRM's hedging strategy, it would seem naive merely to blame the firm's problems on its speculative misuse of derivatives. In the analysis, it is true that the MGRM's hedging program was not without risks. However, the firm's losses are attributable more to the operational risk--the particular risk of loss caused by inadequate systems and control or management collapse - rather than to market risk. If MG's supervisory board is to be believed, the firm's previous management lost control of the firm and then acted to conceal its losses from board members. If one argues in favour of the firm's prior managers (as well as with Culp, Miller, Hanke), one should also consider the fact that at that time MG's supervisory board and its bankers miscalculated the risks related to MGRM's hedging and marketing program and shied away when faced with large, short-term funding demands. Either way, the loss was attributable to poor management.
