Metallgesellschaft Ag free essay sample

For example, if fuel prices rise, the profit margin for MGRM could decrease or could turn into a loss position. As such, MGRM chose to hedge this exposure by using offsetting long positions with gasoline, heating oil, and crude oil futures on NYMEX. It’s important to note that the magnitude and complexity of contracts for MGRM made it difficult to hedge this position. One of the complicating factors for MGRM was that although these contracts had the same term, the details of delivery varied per contract. Some contracts stated monthly, and others stated longer term delivery. MGRM was also only able to hedge 55 million of the 160 million barrels through long futures on NYMEX. The remaining 105 million barrels were hedged using bilateral swaps. Due to the aforementioned issues, MGRM entered into a â€Å"stack and roll† strategy. In this case, MGRM would enter into short term (1 month) long positions for the entire exposure. We will write a custom essay sample on Metallgesellschaft Ag or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page At the end of each month, MGRM would swap out the 1 month position for another 1 month long position for the remaining exposure. This sounds like a reasonable hedging strategy. In this case, any changes in the value of the contracts would be offset by the hedge. However, there are additional risks to be considered before entering into a hedging program of this size. First, each futures contract would require an outflow based on the current oil price. If oil prices fall, then MGRM would be required to pay a large cash outflow (again, based on the magnitude of the hedged position) to keep the hedge. This scenario occurred in late 1993, when oil prices fell drastically and MGRM had to pay 900 million to meet margin calls and extra collateral requirements. Also, due to the fact that MGRM rolls the hedges on a monthly basis, this opens MGRM to month to moth spot risk. If the spot rate moves against MGRM in the month (contango), this creates a cash outflow for MGRM. (Historically, oil futures were in backwardation – so MGRM would have received cash inflows if this continued). Based on the size of the hedges and the contango position in the market, MGRM ended up paying a cash outflow of up to 30 million each month (solely on rolling the hedge). Another issue with this strategy is the mismatch of the MGRM contracts versus the hedge. MGRM chose to hedge long term forwards with short term futures. There is an additional risk in that the basis points of long term forwards versus short term futures may differ even though spot at the time is the same. This is known as basis risk. Due to all these factors, MGRM senior management decided to remove the hedge position. Unfortunately, this left MGRM vulnerable to price volatility on their 5 to 10 year customer contracts. As such, MGRM closed their hedges near the bottom of the market – oil prices rebounded during 1994. This caused additional losses for the company of greater than 1 billion, which bankrupted both MGRM and the parent company Metallgesellschaft AG.