Metallgesellschaft Risk

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MetallgesellschaftRisk- Crisis Management,
INSR 811Professor Neil A. DohertyOctober, 2005

• Case Analysis by
• Federico Chiaromonte
• Pablo Gentile
• Jose Miguel Irarrazaval
• Matthew Kondratowicz
• Cecilia Rabess

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Agenda

• Introduction
• Description of MGs business plan
• Analysis of MGs hedging strategy
• MGs strategy Hedge or Speculation?
• Hedging Alternatives
• Outcome
• Lessons from the case

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Metallgesellschaft1. Introduction
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Company Overview

• Metallgesellschaft A.G.
• 14th largest corporation in Germany
• Conglomerate with interests in metal, mining and
  engineering businesses and 15 major subsidiaries
• Metallgesellschaft Corporation, the U.S.
  subsidiary
• Trading in U.S. government bonds, foreign
  currency, emerging market instruments and various
  commodities
• MG Refining and Marketing (MG)
• U.S. oil trading subsidiary
• New entrant to US Market, low market share
• Goal to develop a fully integrated oil business
  in US.

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MG Refining and Marketing

• 1989 Obtained a 49 stake in Castle Energy, U.S.
  oil exploration company
• Helped finance transformation into refiner
• Purchased output of refined products at
  guaranteed margins on a long term contract
• 1992, 1993 Signed a large number of long-term
  contracts with independent retailers
• Delivery of gasoline, heating oil and jet fuel
  oil

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Metallgesellschaft2. Description of MGs
business plan
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Purchase Contract

• MGRM contracts to buy all refined output from
  Castle Energy for 10 years.
• Guarantees a fixed margin to Castle Energy
• Estimated volume 126,000 barrels/day (about
  460M barrel over next 10 years)

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Delivery Contracts

• MG developed 3 types of novel contract programs
• Firm Fixed under which customer would agree to
  a fixed monthly delivery of oil products at set
  price. By September 1993, MG was obligated for a
  total of 102M barrels (95 for up to 10 years).
• Firm-flexible similar to the previous but
  giving customer extensive rights to set the
  delivery schedule. MG was obligated for a total
  of 52M barrels (90 for up to 10 years).
• Guaranteed Margin under which MG agreed to
  make deliveries at a price that would assure
  customers a fixed margin relative to the retail
  price offered by its geographical competitors. MG
  was obligated for a total of 54M subject to MGs
  renewal, which in the end meant these volume were
  not a firm obligation.
• 3-5 built in margin per barrel (above spot).
  Estimated value of 640M.
• Consequence have long-term supply contracts for
  160M barrels over next 10 years at Fixed Prices

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Delivery Contracts - Rationale

• MG was a new entrant to the US oil market and
  didnt have a significant market share.
• MG had no competitive advantage in its cost of
  supply
• Following US oil market deregulation and
  commoditization in the early 1980s, the situation
  of independent gasoline retailers greatly
  worsened.
• MG spotted what it thought was a innovative
  marketing strategy to sell financial petroleum
  products to independent and quasi-independent
  retail service stations to help them manage the
  variations in the relationship between retail
  prices in their area of service and the wholesale
  prices at which they purchased their fuel.
• Result Purchase fixed volume with variables
  prices and resell at fixed prices

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cash-out options

• MG embedded a cash out option in its supply
  contracts
• If energy prices rise above contract price,
  counterparty can sell-back remaining forward
  obligations for ½ difference between near-term
  futures price and contracted futures price
• Implication Grants customers option (similar to
  default put) if oil prices get too-high
• Why Put This In?
• 20 restriction on customers needs (MGs
  protection to customers default risk), creates
  liquidity risk for customer (need to purchase 80
  at spot prices)
• Liquidity risk offset by cash inflow from
  cash-out option

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Profit Structure Upside Price Risk
Price to MGRM

• Created Large Exposure to Upside Oil Price Risk
• Solution Hedging through Energy Futures and Swaps

Sales Revenue
Purchase Costs
Summer 1993 Prices
Oil Price
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Risk Adjusted Profit Structure even worse

• As Prices Drop, increasing default risk from
  customer unwilling to buy at above-spot prices
• As Prices Rise, cash-out option allows customers
  to exit at fraction of contract value
• Originally, MGs concern is was about oil prices
  going up, but the overlooked the implications of
  a drop in oil prices.

Price to MG
Sales Revenue
Purchase Costs
Summer 1993 Prices
Oil Price
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Hedging Strategy

• MG hedged the risk of rising energy prices with
  both short dated energy future contracts and OTC
  swaps.
• MGs total derivative position was about 160M
  (i.e. barrel-for-barrel)
• Key aspects of MGs Rolling forward hedging
  strategy
• Concentrated on short-dated futures and swaps.
• Position had to be rolled-forward (monthly),
  with downward adjustment for delivered oil to
  keep 11 ratio
• Largest time spread ever undertaken in commodity
  markets

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Metallgesellschaft3. Analysis of MGs
hedging strategy
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Basics on Commodity Forwards Storable
Consumption Commodities

• Because of storage cost and convenience yield
  (opportunity cost of having the physical asset
  instead of the forward), there are bounds for the
  price of commodity forwards determined by the
  no-arbitrage assumption
• Convenience yield are subjective and depends on
  profitability of each business
• Prices within these bounds are determined by
  supply and demand

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Basics on Commodity Forwards Storable
Consumption Commodities

• BACKWARDATION When spot prices are HIGHER than
  future prices
• CONTANGO When spot prices are LOWER than future
  prices.

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Risks of MGs hedging strategy

• MGs hedging strategy exposed the firm to three
  significant and related risks
• Basis or Rollover Risk
• due to the mismatch maturity between its long
  term fixed contracts and its short term futures.
• Liquidity Risk
• due to the margin calls associated with the mark
  to market conventions,
• the need to roll over its futures each month,
• the embedded cash out options in its contracts.
• Credit Risk
• due to the risk of the independent contractors
  default on their long term obligations to
  purchase oil at fixed prices.
• the non transparency of its supply contracts.

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1. Basis Risk Was the firm Value hedged?

• Rolling forward strategy hedge with a maturity
  structure that did not match that of its delivery
  contracts
• This exposed the firm to a significant amount of
  basis risk, this means variations in the value of
  the short dated futures positions not compensated
  by equal and opposite variations in the value of
  the long-dated delivery obligations
• For a company to be value hedged means that
  losses on its long term delivery contracts are
  match exactly by an equivalent increase in the
  value of its future positions and vice versa
• MG hedged its long run supply contracts with a
  one-to-one hedge ratio (h1)

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1. Basis Risk Was the firm Value hedged?

• Because of the mismatched maturity between the
  two positions, a h1 could have never hedged the
  value of the contracts perfectly, for the
  following reasons
• Time Value of Money
• Volatility of more distant future prices is much
  smaller than the volatility of spot prices
• As Oil prices dropped in late 1993 due to
  conflicts within the OPEC, the expectation of the
  long term spot price 3 years into the future was
  largely unchanged
• Therefore, losses on the stack of futures were
  actually matched by little if any, change in the
  capitalized value of the supply contracts
• In fact, the cumulative increase in the value of
  the supply contracts during 1993 was 479M. Less
  than ½ the total loss on the futures portfolio

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1. Basis Risk What was the Optimal Hedge Ratio?

• To value hedge the contracts, MG would have had
  to adjust (tail) its hedge, meaning used a hlt1
• Taking into account the two factors already
  mentioned, MG should have used a hedge ratio not
  greater than 0.5
• hedge ratio should be the beta between asset that
  produced the basis mismatch
• What about the cash-out options?
• Because the maximum customers could receive was
  only 50 of the gain and because the probability
  that all contracts are exercised at the same time
  would certainly be significantly less than one,
  even after accounting for this option, a h0.5
  would have been closer to the optimal ratio

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2. Liquidity Risk Was the firm Cash flow
hedged?

• Three sources of liquidity risk
• Rollover losses
• MGs hedging strategy relied on derivative
  positions that were stacked in short-dated
  futures
• Monthly basis had to be rolled forward to
  maintain those positions. Each month, to continue
  with their one-to-one hedge, MG reduced the
  derivatives positions by the amount of the
  product delivered to customers
• When markets are in contango (future prices
  higher than spot prices) this strategy results in
  losses. MG would have been force to buy high and
  sell low in rolling its positions
• Sensitivity analysis shows that it required only
  a period of 14 months of contango to wipe out
  MGs entire profit over its 10 year contracts

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2. Liquidity Risk Was the firm Cash flow
hedged?

• 2. Margin Calls
• Future contracts are marked to market. This
  means that gains and losses are settled daily and
  the holder pays/receives an amount equal to the
  daily change in the futures price
• Therefore, when prices fall, MG is obliged to
  incur in daily negative cash flow to fund margin
  calls

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2. Liquidity Risk Was the firm Cash flow
hedged?

• 3. Cash-out options
• The cash-out options embedded in the forward
  supply contracts could generate negative cash
  flows that increase the liquidity risk
• The cash payments depend on spot prices
• These options would be in the money for the
  customer only if the cash-out payment were
  greater than the net present value of the
  remaining forwards deliveries on the contract
• But, if liquidity constrained, customer could
  still exercise

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2. Liquidity Risk Was the firm Cash flow
hedged?

• Between June and December 1993, MGRM had to fund
  900 millions to maintain its hedge positions
• Even though there is some evidence that
  backwardation is a permanent feature of energy
  markets (it happens 67 of the times in crude-oil
  futures), MGs assumption was somewhat naïve and
  reckless for the following reasons
• The sensitivity of its strategy to a period of
  contango was too high. 14-months string of
  contango, though unusual, were not without
  precedent.
• The cash-out options could have caused MG to end
  its hedging strategy unexpectedly without being
  able to offset all its rollover losses
• To obtain the expected long term roll over gains,
  MG implicitly assumed it could fund whatever
  rollover losses it sustained in the short term

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3. Credit Risk

• If energy prices dropped, MG faced an increasing
  risk of default from its customer thus
  potentially leaving the firm with an uncovered
  position of the forward market
• Lack of transparency, creditors unable to
  evaluate level of counterparty risk embedded in
  forward delivery contracts
• Substantial Non-performance risk, due to long
  duration of contracts
• Cumulative default rates. Probability of
  default rises with time
• Sufficiently diversified?
• As a consequence, MG lacked the ability to use
  supply contracts as collateral to fund its
  liquidity needs

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Another Theory Was MGs position too big?

• MG could only find sufficient liquidity in the
  short term market
• Size matters. MG's positions reached 20 of the
  open interest outstanding in the NYMEX oil
  contracts (equivalent to 85 days of all Kuwait
  output)

• Consequently, MG itself became one of the
  dominant variables in the backwardation -
  contango equation
• There is evidence that MG's need to roll over its
  large long contracts became a factor that by
  itself helped to push crude oil prices into
  contango

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Another Theory Was MGs position too big?

• There is evidence in the Commitment of Traders
  reports that speculators jumped into the market
  against MG. The traders systematically took large
  net short positions in the WTI contract,
  effectively exploiting MG's position
• Futures term structure has been strongly
  influenced by speculators' net positions a
  strong net long position tends to contribute to
  backwardation, a strong net short position to
  contango

• These relationships are intuitively reasonable.
  If speculators are strongly net long, they are
  contributing to strong prompt demand for crude.
  If they are strongly net short, they are
  contributing to strong prompt supply.

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Metallgesellschaft4. MGs Strategy Hedging or
Speculation?
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MGs Strategy hedge or speculation?

• MGs business plan provides significant clues
  that the management motivation under its
  derivatives strategy was speculative rather than
  hedging
• it is important to recognize that if a hedge
  program is carefully designed to lock in a
  favorable basis between spot and futures prices,
  hedging can generate trading profits which can
  substantially enhance the operating margin
• With the existence of the energy futures market
  we can create a paper refinery by taking
  advantage of the inefficiencies created in the
  illiquid contract months in the futures market
• The rolling stack was a bet on the common
  backwardation exhibited by the energy markets
• One-to-one ratio was not the minimum variance
  hedge ratio.

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MGs Strategy hedge or speculation?

• There is ample evidence of MG being actively
  involved in trading
• Actively unbinding existing positions, instead of
  waiting for futures to expire.
• Alternating subjacent assets (heating oil,
  gasoline or crude oil) to exploit seasonality
  differences in the backwardation pattern among
  the energy commodities.
• Emerging Markets Group already was taking
  positions in stock and debt instruments on EM in
  1993 added corporate finance group

American Metal Market, June 21, 1993 MG adds
unit for financing NEW YORK --
Metallgesellschaft Corp., the New York trading
arm Metallgesellschaft AG, is adding a corporate
finance unit to the company's emerging markets
unit, company officials said. The new unit will
consist of a team of investment bankers formerly
associated with CS First Boston and will advise
clients on principal investments. The MG emerging
markets unit specializes in the trading of debt
and equities of emerging economies with high
growth potential.
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MGs Strategy hedge or speculation?

• In general, it is not optimal to rely upon only a
  single hedging instrument. The very fact that MG
  employed only the nearby contract strongly
  suggests that they were not interested in hedging
  alone, but were also speculating on movements in
  the term structure.

• Basis variability in the oil market is quite
  high. The very fact that MG put such a large bet
  on the oil basis is a further prove of its
  underlying speculative motives

There were at least 4 periods were spot prices
fell relative to the future prices by amounts and
durations similar to MGs relevant period
Period were MGs Strategy was in place
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Metallgesellschaft5. Alternatives
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Alternative 1 use lower hedge ratio

• Pros
• Minimize cash flow variance (liquidity risk)
• Take into account basis risk (use correlation of
  assets as hedge ratio)
• Cons
• Dynamic adjustments could be expensive (high
  transaction costs)

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Alternative 2 hedge with longer maturity forwards

• Pros
• Minimize basis risk
• Cons
• Less liquid market
• Cash-out option is calculated with spot price, so
  hedge with short term forward has more sense

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Alternative 3 include options as part of hedging
strategy

• MG could have used options to limit downside
• Long zero cost collar
• Limit downside
• Give up upside when probably cash-out option
  would be already exercised
• No initial cost
• Use stream of long call options with similar
  maturity
• No downside
• All upside
• Up-front cost

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Alternative 3 include options as part of hedging
strategy

• Profit with different hedging strategies

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Alternative 4 sell delivery contracts

• Pros
• Transfer all the risk to a third party
• Obtain an origination fee (profit for sure)
• Cons
• Give up most of the expected profits
• Complex contracts could be hard to sell (non
  transparency problem counterparty risk, embedded
  option, long term maturity contracts, etc.)

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Alternative 5 Physical storage

• They had a large network of storage facilities
  through Castle
• Cons
• Costly (storage cost)
• Not very practical to store oil for 10 years!

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Alternative 6 do not hedge

• Pros
• Do not expose the company to liquidity risk on a
  downward movement of prices
• Cons
• Company is highly exposed to price changes
• High liquidity risk of prices are up and cash-out
  options are executed

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Metallgesellschaft6. Outcome
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Outcome What happened?

• Total MGs losses amounted to aprox. 900M in a
  period of only 12 months since the hedging was
  set in place. Note however, that prices did move
  in favor of MG for the first 5 months
• Plus aprox. 106M loss (net of unrealized gains)
  in its swaps contracts not shown here
• If one admits that liquidity strains reduce firm
  value, this total loss of 1.06 Billion
  understates the true total loss suffered by MG

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Outcome What happened?
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Outcome What happened next?
MGs new Supply Contracts
MGstarts selling off business as part of its
rescue plan

• MGs 2nd restructuring plan.
• Changes name to GEA
• Focuses on new business line

MGs Rollover and Canceling Losses
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Outcome What happened next?

• American Metal Market, Jan 13, 1994
• Metallgesellschaft asked its 120 creditors to
  accept the rescue plan swiftly and "as a
  whole."Self-interest dictates the need for an
  agreement Creditors could only expect to
  receive 40 to 50 percent of their 9 billion DM in
  loans to the company if it declared insolvency
• American Metal Market, Jan 17, 1994
• Big German banks have saved the destitute mining
  and metals giant Metallgesellschaft AG from
  bankruptcy, ending weeks of uncertainty with a
  clear pledge to help the company back to its
  feet. The company immediately announced plans on
  Saturday to sell several unprofitable
  subsidiaries and cut its annual payroll by
  one-sixth, or 700 million Deutsche marks (400
  million).
• American Metal Market, Jan 29, 1996
• In April last year and more recently in the
  December-January period, customers exercised the
  blowout option Metallgesellschaft Corp., the
  U.S.-based trading arm of Germany's
  Metallgesellschaft AG, is restructuring its
  energy marketing business, ending long-term
  supply contracts with blowout clauses."

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Outcome What happened next?

• American Metal Market, Apr 5, 2000
• LONDON (CNNfn) - Germany's Metallgesellschaft is
  facing legal claims that could cost it as much as
  1 billion, after 17 oil companies filed suit in
  New York for breach of contract, according to
  published reports Wednesday.
• The suit says the German company's former
  U.S. subsidiary MGRM terminated contracts
  unilaterally after oil trading activities in the
  U.S. almost bankrupted Metallgesellschaft in
  1993. Since then the parent company has
  restructured to focus on engineering and
  chemicals.
• As of today
• In 2005, Metallgesellschact AG, changed its name
  to GEA, which stands for Global Engineering
  Alliance
• In 2004, the groups disposed of the vast majority
  of its chemical activities
• Most of the proceeds were used to pay the groups
  debt
• Company restructures its business focusing on
  process engineering and equipment, especially for
  the food, pharmaceutical and petrochemical
  industries

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Outcome Did MG cut its hedge too soon?

• In retrospective, MG supervisory board made its
  decision when WTI prices reached their lowest
  level (less than 14), and when MG's ongoing
  losses were at their peak.
• Critics, like Merton Miller, say that MGs board
  cut the hedge too soon.
• With the benefit of hindsight, we know from Dec.
  17, 1993, when the new management team took
  control, to Aug. 8, 1994, crude oil prices
  increased from 13.91 to 19.42/bbl.
• However, this post-event analysis doesnt take
  into account that had MG remained in the futures
  markets in such large volumes, the price recovery
  and return to backwardation that did occur likely
  would have been slower.
• By the fall of 1993, some traders had come to
  anticipate the rollovers of MG's positions. At
  that point, MG had entered into a "can't win"
  situation. It was big enough to have its needs
  noticed, but not big enough to impose its will on
  the market.

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Metallgesellschaft7. Case Lessons
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Case Lessons

• The importance of Value hedging Cash flow
  hedging
• A hedge with mismatched maturity can create
  enormous risks
• It is a flaw to set up a hedging strategy without
  a careful regard for the financing it may require
• Both cash flow patterns and firms value should
  have been the main concern in MGs strategy and
  not an after thought.
• In times of distress, cash is king
• MGs delivery contracts were highly illiquid and
  difficult if not impossible to sell at a
  reasonable price
• Since the strategy wasnt self-financing, MG had
  to reach into its general borrowing lines to pay
  its liquid market debts and avoid bankruptcy

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Case Lessons

• Financial Markets are too efficient for naïve and
  simple strategies to give sure profits
• Prices reflect all up to date information
• They are populated with astute traders whose
  business is processing information and profiting
  from it
• There is too much competition in the markets for
  any spread bet (in the case of MG, a time spread)
  to consistently make money
• In the end, market fundamentals prevail. The drop
  in oil prices was a consequence of an external
  OPEC supply shock which completely disrupted MGs
  bet on backwardation.

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Case Lessons

• A big position in the markets never goes
  undetected
• When a single company commands such a large share
  of open interest, markets can become
  dysfunctional in one of two ways
• the company can obtain the power to squeeze other
  participants, if those participants remain
  fragmented and disorganized
• or the company itself can be squeezed, if other
  market participants begin to trade against the
  company in an organized manner
• With their huge short delivery positions,
  specialists in the oil markets knew that MG
  would have to roll their expiring positions.
  These traders were waiting eagerly when they did
  so.
• It is very costly to move a big position
  particularly when everyone is watching

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Case Lessons

• Complexity Matters for Risk Management
• While MGs strategy was relatively simple, its
  implementation and analysis was not
• The complex delivery contracts and cash-out
  options, and the huge size of their derivative
  positions made a simple evaluation of the
  economics of MGs oil trading very difficult
• Complexity creates obscurity and this makes a
  business vulnerable the more obscure and complex
  a business is, the more difficult it is to
  finance
• Complexity makes Risk Management all the more
  difficult

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Case Lessons

• Agency costs can have a substantial impact on a
  firm
• MG traders and the US Subsidiary management were
  employees of MG however, that doesnt mean their
  interests were aligned with the interests of the
  shareholders
• Instead of putting in place a reasonable hedging
  strategy to secure the firms operations, MG
  traders saw a big bonus opportunity and pursued a
  very reckless speculative strategy turning MG
  from an oil company into a financial intermediary