THE HEDGING DISASTER.

- Rushank Mehta

Metallgesellschaft AG was formerly one of Germany's largest industrial conglomerates based in Frankfurt. It had over 20,000 employees and revenues in excess of 10 billion US dollars. It had over 250 subsidiaries specializing in mining, specialty chemicals (Chemetall), commodity trading, financial services, and engineering (Lurgi). Henry Merton & Company, Ltd was previously a branch of the Metallgesellschaft. MG had a subsidiary named UMG. The subsidiary was into oil refinery, they used to sell oil refinery products, they entered into long term forward contracts with their customer e.g., 3 years, 5 years, 10 years and so on the average maturity of their contracts was 10 years. They used to sell their oil refined products at a fixed price, therefore they faced a risk of the price of their product going up so they hedged their risk by taking long future position in the oil product with shorter maturity. The prices of oil futures in 1992 were in backwardation which means that the future price was lower than the spot price. They followed a hedging strategy in 1992 called stack and roll strategy in which they stacked the entire lot of oil and they used to hedge it. E.g. If you have 50 million tons of oil to be delivered by May (10 million tons should be delivered to each client every month). Therefore, in January they hedged 50 million tons of oil because they had an exposure of 50 millions tons of oil, then they delivered 10 million tons in January, now they have an exposure of 40 million tons left in the month so they hedged 40 million tons of oil in February (this is called rolling of a hedge), in march they had an exposure of 30 million so they hedged 30 million of oil in march. So this is how they hedged their risk. In 1993 there were bearish signals from the OPEC in production quotas. At this time the market took a turn from backwardation the market went into contango which means the future price is more than the spot price. This led to high margins calls due to the fall in future price (the future price started to fall to match the spot price) , this led to the cash flow problems because the profit would be realised in the future as per the forward contract, they were having long term maturity. High margin calls led to the liquidity problems in the company. The company couldn’t sell the oil futures smoothly as they couldn’t sustain therefore they had to sell with a huge position e.g. If the market would trade on 10 million or 20 million barrels the company went on selling 50 million barrels which led to the drop of oil futures further more. Their position in the fall of 1993 was estimated to be between 160 to 180 million barrels stretched out over the following 10 years. Now due to the German accounting standards recent losses had to be booked in the books of the company and the profits the company made couldn’t be realised because it would come in future as the trade would get over in the future which showed that the company is making losses and it created a negative image that the company is speculating in the market is respect to the oil futures due to which no loans were given to the company. These were the reasons which led to the hedging disaster to the company.