Metallgesellschaft Corporation (MG) is a subsidiary of Metallgesellschaft AG; a German conglomerate with 15 major subsidiaries closely held with over 65% of stock owned by institutional investors including banks such as Deutsche Bank AG, the Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait Investment Authority. Under MG, they have several subsidiaries in its 'Energy Group' with MG Refining and Marketing Inc. (MGRM) in charge of refining and marketing petroleum products in the U.S. It had been revealed publicly that on December 1993; (MG) was effectively bankrupt after huge losses in its oil business that was conducted in its New York based subsidiary MG Refining and Marketing (MGRM). On 1991, MGRM began expended venture into the derivatives world by hiring Mr. Arthur Benson from Louis Dreyfus Energy. Apparently, Benson's strategy did not work which lead to the massive cash flow crisis experienced by MG.
By September 1993, MG had entered contracts obligating it to deliver 102 million barrels of refined products under firm-fixed contracts which specified delivery schedules and 58 million barrels under firm- flexible contracts that allowed buyers to choose the delivery schedule with certain restrictions. The contracts had long term tenor up to 5 years and 10 years. It summarized that overall fixed price long term forward contracts sold by MGRM was equivalent with 160 million barrels.
As MGRM in the short position of forwards contracts, they were vulnerable towards rising in oil prices. Therefore, in order to protect the profit margins in its forward delivery contracts they hedge their exposure by energy futures contracts of between one to three months to maturity at New York Mercantile Exchange (NYMEX) and Over the Counter (OTC) swaps. MGRM employed a "stack and roll" strategy where it placed the entire hedge in short dated delivery months, rather than spreading this amount over many longer-dated. In other words they long short term stack let say with maturity one month, just at expiration they closed that out, then enter into another short term stack and keep doing that repeatedly month to month. For OTC energy swap agreements were also of relatively short maturity which they decided to receive floating and pay fixed energy prices. MGRM also used 1:1 hedge strategy which they hedged barrel-for-barrel which summarized total 160 million barrels of futures swap were bought to cover its 160 million barrel cash market position. Generally the hedging strategy above relied on the continuation of backwardation in the market place, where the forward price is lower than the spot price (FP < SP). As long as backwardation persisted this hedge is generally effective.
However, things did not go as expected. During the later part of 1993, energy prices fell sharply ($19 a barrel in June 93 to $15 a barrel in Dec. 93) resulting in unrealized losses and margin calls on derivative positions. As news of MGRM losses by $1.6 billion began to leak to the public, it eventually lead to the assumption that MGRM were speculated betting the oil prices would rise because based on a logic perspective of viewing, if they were hedging they would be indifferent to a change of price as losses in the short positions of forward contract were offset by profits in the long position in futures contract and vice versa. Besides that, flaws in MGRM hedging strategy also believed contributed to the losses.
As oil price dropped, the normal backwardation (FP<SP) shifted to contango (FP>SP). As spot prices dropping rapidly relative to forward price, MGRM long position of short term futures contract were being rolled over with losses. Although the long term forward were hedge by short term futures, the time maturity mismatched had exposed MGRM into very significant basis risk. Under the German accounting rules which exist at that time, that futures were being mark to market on a daily basis. So, those hedge instruments were losing as they were rolling over the lower spot prices. The losses were recorded immediately, while forward contract had to wait for the gains to be realized. As negative cash flow occurred in the short run while no cash received for the gain in the value of the forward contracts until the oil was sold it resulted to funding crisis in MGRM which forced them to receive margin calls.
The inability of MGRM to handle the cash flow problem created by the decrease in oil price in conjunction with the large volume of future contract longed by them also lead them to this financial crisis. The rollover risk that the oil market might go into contango should have been expected when they decide to go through with hedging strategy explained above.
When this kind of matter was taking lightly by the risk management part, then losses were predicted to strike them. As derivatives initially proved to be successful instruments to hedge risk, inappropriate strategy eventually brought opposite result which in this case of MGRM the rollover loss was unrecoverable and was not offset by another position.
2.0 The Aftermath
The failure in the derivatives hedging implemented at MGRM not the only cause that lead to the financial distress experienced by parent company, Metallgesellschaft AG. Based on research, over the year 1989 to year 1992 the crisis and subsequent financial distress at Metallgesellschaft AG had started which weaken their earning position. In year 1991, it was reported that the pretax profit fell 35% to DM 316 million from DM 483 million in the previous year. By September 1992, the pretax slid further to DM 245 million because of the recession and a flood of cheap metals from the former East bloc that generated losses of more than DM 150 million. Then on 1993, Metallgesellschaft AG faced a long-term liquidity crisis caused by MGRM. MGRM case start after their parent company, Metallgesellschaft AG announced that subsidiaries were treated as independent profit centers. Thus it resulted to the adoption of speculative investment strategy by MGRM as stated before which worsened the liquidity crisis at Metallgesellschaft AG during 1993, and lead to the financial distress on them in December 1993.
In order to ensure the survival of Metallgesellschaft AG, corporate governance as well as bankruptcy laws played the important roles. The process of recovery was initiated immediately as after the financial distress was formally indentified by the internal auditors, steps were taken to control the damage and begin the process of financial recovery at MG AG. On December 1993, the CEO Heinz Schimmelbusch was replaced. On 24 February 1994, the management board was called to a meeting to announce that the company's reserves were depleted by a loss which exceeded half of the company's nominal capital. Then, they decided to restructure the company by implementing the financial restructuring plan in the wake of the huge losses the company incurred. The plan was approved by the creditors and shareholders of the company and was made up of two components. The first component was the nominal capital of the company was increased by DM 280 million through cash contribution and the second component was Metallgesellschaft AG issued convertible participation rights of an aggregate nominal value of DM 267 million to its creditor banks. These measures resulted in an increase in the Group's liquid funds by DM 2.7 billion. Initially, the plan was refused by important creditor banks as they were required to contribute much more than the shareholders. However, the role of corporate governance helped to persuade the banks to approve the plan. Metallgesellschaft AG did not rely on a single bank for credit. The bankers' voting power came from direct ownership of stock, from control over other investment companies, and most importantly, from authority to vote stock that the bank's brokerage customers owned but deposited with the bank. This voting power on the supervisory board enabled their removal of the CEO and the other members of the management board.
Approval for the financial restructuring plan by the creditors and shareholders of the company was possible because at least 150 creditors controlled by the major German banks were encouraged by the active financial involvement of the two main contributors, Deutsche bank and Dresdner Bank in the debt restructuring process. As the creditors approved a plan which required write-down, it encouraged the shareholders in their approval of the plan. The outcome was clearly the result of the greater incentives of the creditor-shareholder banks to act as shareholders interested in the survival and long term growth of the organization. The actions of the banks are consistent with their incentives during the pre-financial distress and recovery phases of Metallgesellschaft AG.
3.0 Lesson Learnt
It is management's responsibility to fully understand the key risks in the business
Some economists believe that the strategy to hedge long term forward contracts with short term futures contracts were correct. But, the problem is, when oil prices drop, the gains from the sale of the oil are realized over the long-term, while the losses on the hedges will be realized immediately as margin calls come in. At the end, this strategy leads to a funding crisis where MGRM executives should have foreseen the possibility of large negative cash flows. So, in order to prevent further losses, the management panicked and decided to close out the position. Thus, in December 1993, the company cashed in its positions at a loss totaling $1.6 billion.
Failure to set limits/boundaries
Here, the funding risk was existed where the risk that may be profitable in the long term can bankrupt a company in a short term if the negative cash flows are mismatched with the positive cash flows. In MG strategies, they would have made a profit in a long term and cover up the losses in the futures. However, MG shareholders claimed that the 56 million barrels of the long term had a negative value of about $12 million where the value of the contract could never have an offset the losses even in the long term.
Failure of communication
It shows that MG not fully understands what MGRM was doing. If the MG had understood the strategy in beginning, it might have prevented the strategy from being used or if they support the plan, the parent company shouldn't closed out the position at the worst possible time that later on contribute to a loss of such a large amount might have been avoided.
From a financial risk perspective, it is important to assess the relationship between market risk, liquidity risk, and basis risk
In the MGRM case, the losses resulted from the relation of significant market price movements, liquidity issues from cash flow mismatch and concentrated futures positions, and basis risk between the forward and futures prices. Therefore, it is important to fully observe the relationships between those three risks as to prevent futures losses or any negative consequences.
