Metallgesellschaft Case Study Example | Topics and Well Written Essays - 1000 words

Metallgesellschaft - Case Study Example MGRM's Supervisory Board avoided bankruptcy by liquidating its forward delivery positions in December 1993. MGRM had begun to experience significant growth since 1989 when it acquired 49% stake in Caste Energy as part of its efforts to become a fully integrated oil business in the United States. As MGRM continued to make a series of costly expansions, its fixed-assets values tripled between 1989 and 1991. In a continuing effort to expand its US business, MGRM entered in to forward delivery contracts with Energy end-users at historic low prices during the summer of 1993. However, these contracts exposed MGRM to the risk of rising energy prices. To hedge this price risk, MGRM acquired energy futures at NYMEX and entered into OTC swaps with large OTC swap dealers. However, since future markets do not trade in very long term (10 years in this case), MGRM's strategy was to concentrate its derivatives positions in stacks or short-dated futures. Similarly the swaps had to be rolled forward continuously. MGRM's strategy exposed it to various risks. Its short-dated positions left it exposed to rollover risk. If the prices had risen, MGRM would have made substantial profits. And the opposite was true in case of the prices falling. However historically, energy prices have always shown an upward trend. Over a period of ten years prior to 1993, the energy market had been predominantly in backwardation. MGRM was betting on Energy prices continuing to rise. However, as shown by Edwards and Canter, its rollover risk was only about 15% of its price risk. Had the market been in backwardation, MGRM would have made handsome profits. But in 1993, crude oil was in contango every month, heating oil was in contango every month except March and April and gasoline was in contango every month except August. As a result, MGRM made substantial rollover losses during 1993. MGRM was also exposed to funding risk since its strategy was that of one-to-one hedge instead of a "minimum variance" hedge. This strategy would have worked had there been a one-to-one relationship between forward and spot energy prices. In that case, a fall in the spot prices would have been balanced by an equal and opposite change in the value of its forward delivery contracts. However, as shown by Edwards and Canter, a one-to-one relationship between spot and forward prices does not exist in the energy market. MGRM was also exposed to credit risk due to the long duration of its forward-supply contracts. And once the prices started to fall, this risk further increased as with the increased disparity in spot and contractually fixed price, the risk of the smaller firms defaulting also increased. Finally, MGRM was also exposed to basis risk due to the one-to-one hedge ratio. The timing of the investment in derivatives also went against MGRM. As stated above, 1993 proved to be disastrous year with energy market in contango for most part of the year. The huge size of MGRM's rollover trade was also responsible for increasing these risks. MGRM's huge holdings, equivalent to 160 million barrels, meant that other firms would have looked at MGRM before taking any steps. The size of MGRM's rollover trade could have also been indirectly responsible for pushing down energy prices. Hedging or Speculating There is some debate over whether MGRM's strategy was hedging or speculation. Culp and