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Metallgesellschaft AG and its New York-based subsidiary encountered mistakes in its oil trading and hedging strategies. Hence, the company encountered great losses. Would you say that the company was just unlucky or was there something fundamentally wrong with its strategy?
David F. Hawkins and Guy Weyns
Harvard Business Review (194097-PDF-ENG)
February 11, 1994
Case questions answered:
- Why did the US subsidiary of Metallgesellschaft AG, MG Refining and Marketing Inc. (MRGM), want to offer a price guarantee on purchase contracts for its customers? What were the basic features of the hedging strategy?
- Explain the difference between a hedger, speculator, and arbitrageur. Was Metallgesellschaft AG really hedging or speculating in the financial markets?
- What is a hedge constructed with a ‘stack’ of short-dated contracts? What is a hedge constructed with a ‘strip’ of futures contracts? How do ‘stack’ and ‘strip’ compare as far as funding or cash flow risk is concerned?
- Imagine that you are a member of the Board of Directors of Metallgesellschaft at the end of 1993. Why did MGRM generate such a huge loss in 1993? Assuming MGRM has access to free capital, is MGRM’s strategy sustainable in the long run? What are the options available for MGRM at the end of 1993? What would you recommend?
- MGRM unwound its position at the end of 1993 after suffering a huge loss. Should MGRM have kept the position? Would you say that MGRM was just unlucky or was there something fundamentally wrong with MGRM’s strategy?
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Case answers for Metallgesellschaft AG
1. Why did the US subsidiary of Metallgesellschaft AG, MG Refining and Marketing Inc. (MRGM), want to offer a price guarantee on purchase contracts for its customers? What were the basic features of the hedging strategy?
When Metallgesellschaft AG, MG Refining and Marketing Inc. (MRGM), put on trades with its customers, it was subjected to different and significant kinds of risks that could greatly affect the company (both positively and negatively) based on the market movements.
The most classic and attractive contract among many others that MRGM offered to its customers was that every month for up to 10 years, they could buy a fixed amount of oil production at a fixed price. They could terminate the contract early if the NYMEX futures price was higher than the fixed price they were paying to MRGM.
Obviously, the company is expecting the fixed price to be greater than the current price of the oil in order to make a profit.
Still, such a contract had huge market risks considering the fact that MGRM had no oil in its inventory, which made the company engage in a future’s contract where it would buy oil on a future date at a fixed price which was the same as storing the oil in its storage.
By doing this, they were buying the same volume of oil as they needed to sell to their customers through the contracts.
In addition, the industry of petroleum has huge fluctuations due to problems such as cyclicality (boom and busts), safety concerns and natural disasters (products are flammable), lack of control (price is controlled by supply and demand), production costs, etc., which increase the risk (Peng, Li, & Drakeford, 2020).
The most basic feature of the hedging strategy that Metallgesellschaft AG, MGRM employed was using the front-end month contracts on the NYMEX to mitigate the risk of the spot price.
Considering that the call options were connected to the front-month contracts, the company used stack hedging by placing the hedge in short-dated delivery months instead of placing it in many long-dated delivery months.
This strategy allowed the company to gain profit when the prices of oil increased and lose money when the opposite happened (the price of oil decreased).
The strategy worked as a hedge against the company’s customer contracts, where the company would make a profit only if the price of oil would decrease and vice versa.
Another feature of the MGRM’s hedging strategy was going long on futures and engaging in OTC swap agreements. This was performed for the purpose of paying fixed energy prices and receiving floating energy prices.
To hedge the contracts entirely, the swap positions reckoned for 110 million barrels, which made the company exposed to credit risk.
2. Explain the difference between a hedger, speculator, and arbitrageur. Was Metallgesellschaft AG really hedging or speculating in the financial markets?
Hedgers are, on much simpler terms, investors that try to…
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