Metallgesellschaft – How not to hedge
Metallgesellschaft : The background
Metallgesellschaft, the name is quite a mouthful to say, was a German corporation. They were a conglomerate with interests ranging from metals, shipping to mining. They also had a financial trading arm,Metallgesellschaft Corporation , a subsidiary based in the US. Another piece of the empire was MG Refining and Mining and this company was involved in oil trading activities. Metallgesellschaft Refining obtained a 49% stake in a company called Castle Energy in the US. This was the start of changing Metallgesellschaft into a proper refiner. Through this deal Metallgesellschaft was able to to secure long term output of refined products at long-term contracts.
The next step for Metallgesellschaft was to agree long-term contracts with retailers for the delivery of gasoline, heating oil and jet fuel. There were 3 types of contracts that Metallgesellschaft devised :
- Firm-Fixed – Customer agrees to fixed monthly delivery at a set price. Metallgesellschaft had agreements to supply 102 million barrels over 10 years.
- Firm–Flexible – Similar to the firm-fixed but the client had greater flexibility over the delivery schedule. Metallgesellschaft had agreements to supply 52 million barrels over 10 years.
- Guaranteed Margin – Metallgesellschaft would deliver at a fixed margin relative to the local area retail price. Metallgesellschaft has agreements to supply 54 million barrels over 10 years subject to Metallgesellschaft’s renewal.
Overall this meant that Metallgesellschaft would get a premium of $3 to $5 over the spot price. There were long term supply contracts in place out to 10 years for 160 million barrels.
There was also an option embedded in these contracts. The option allowed the counterparty to sell any remaining forwards back to Metallgesellschaft in the event of energy prices rising above contract price. The sell-back would be at 50% of the difference between the near term futures price and the contracted forward price.
The risks now that Metallgesellschaft faced are as follows :
- Default risk of customers as they are unwilling to buy at above spot prices. So a price drop is clearly a problem for Metallgesellschaft.
- Customers use the cash out option to exit at a fraction of the price of the contract.
Metallgesellschaft : The Hedge
To counter these risks Metallgesellschaft used a hedging strategy that combined futures and swaps. Their total position in the derivatives market was 160 million barrels – pretty much a 1 to 1 position with respect to the underlying long term position.
The hedge can be thought of as a hedge that amortizes over time reducing on a month by month basis as some of the deliveries occur. The hedges were therefore pretty much fully based on short term futures and swaps.
This type of hedge again opens up some sources of risk :
- Basis Risk – This is from the mismatch that is caused by the long term contracts and the short term nature of the hedge.
- Liquidity risk from margin calls, the monthly roll over
Metallgesellschaft – Basis Risk
The hedge that Metallgesellschaft used is what is known as a stack and roll hedging strategy – stack up the hedge to the next most liquid contract and roll over at expiry. This as have already discussed means a hedge where the maturity of the underlying risk being hedged is not matched by the hedging instrument. Basis risk is a problem because it means that the movements in the futures market might not have a direct relationship with the movements in the longer dated contract. This brings us onto the question of if the hedge was appropriate. Clearly there are several reasons why a 1 to 1 hedge might not have worked.
- The time value of money would mean the two contracts do not have the same relationship
- Longer dated contracts are less volatile
The intuition here is that while there may be quite volatile fluctuations in the short term futures market , the long term expectation may not really change. This may be due to reasons like short term shocks like war or weather dont apply to the longer term which is likely to be more fundamentally based on aggregate supply and demand requirements. This means that any losses on the short term stack futures hedge will not be offset by the gain on the longer term contract.
We know that the gain on the longer term contracts was about $480 million , which was less than half the losses on the futures. So there is some justification for suggestion that the hedge ratio that Metallgesellschaft used should have been 0.5.
The other problem for Metallgesellschaft was that while the hedge works well in a situation where markets are in backwardation (where forward prices are lower than spot). However when markets are in contango (where forward prices are higher than spot) the stacked hedge becomes expensive as you are buying high and selling low with every roll. This is exactly what happened, the oil markets moved from being in backwardation (which was the norm for this market at the time) to a contango situation. The interesting question is why did this change happen. The positions that Metallgesellschaft was taking was no secret, they were huge and by some estimates made of 20% of NYMEX outstanding oil contracts. There are some who theorise that Metallgesellschaft itself became on of the main reasons for the switch from backwardation to contango of the curve.
This was due to investors taking the opposite position to Metallgesellschaft as their position was so well known. Speculators shorted the futures contracts to take the opposite position to Metallgesellschaft. In some ways the position that Metallgesellschaft took in the markets can be deemed quite speculative itself. The relied on a single futures contract despite the possibility of basis risk. They had an inclination to profit from the basis , which would have worked as long as the market was in backwardation. Its also interesting to note that they used a 1 to 1 hedge, rather than a minimum variance hedge which would have been much better for a “true” hedging strategy.
In the end the hedge that Metallgesellschaft put together ended up costing them $900 million. The management of Metallgesellschaft decided to start unwinding the hedge. Metallgesellschaft as a firm suffered quite badly from this disastrous foray , it had to restructure its business and enter into agreements with its creditors. In short the whole long term contract business ended quite badly for Metallgesellschaft.
Metallgesellschaft : Lessons
There are several lessons that can be learnt from the whole Metallgesellschaft debacle. The importance of a minimum variance hedge cannot be overstated. Metallgesellschaft would probably have been much better served by a hedge that was half the size. For start their hedge would not have been too much of the market size. This would have also meant it was easier to unwind.
A smaller hedge would also have been harder to detect for other market participants. As it is there was too much attention on the position that Metallgesellschaft was taking. This meant that other participants thought they could try and exploit the situation to their own advantage (which they did).
There are some commentators who think Metallgesellschaft unwound the hedge too soon. However this is not necessarily true as we have already discussed how Metallgesellschaft became too much of a factor in the market price itself. So had it continued to remain in the market the market would potentially have stayed in backwardation for longer.
The hedge was too simple and naïve. They should have used a more realistic hedge that used more contracts than just the nearest month. They could also have used options in their strategy to hedge the risk out further. However we have the benefit of hindsight and there may have been liquidity constraints which dictated what sort of hedge they could in fact out on.
However the point does remain, a study of Metallgesellschaft does seem to indicate that there was not enough analysis done before this strategy was embarked upon. So the best lesson to take away is to analyze the market as thoroughly as possible before embarking on such a big hedging program.
There is a full tutorial on stack hedging with worked examples in Thinx Finance – Futures And Forwards module, available from ThinxLabs.