Investing in derivative market is a risky option. Derivatives refer to a financial instrument that derives its own value from the price of the underlying assets and are used for the hedging purposes. In theory, hedging should not cause any problems. Derivatives are risky investment and therefore it is highly advised that the organizations investing in the future derivatives market must invest carefully (Edward). The poor analysis of the derivatives results in the failure and causes much loss to the company investing in it (Krapels). In addition, the theory also supports that the organizations must not suffer loss by hedging in the derivates market, however, in reality this case is not true always. Metallgesellschaft invested in derivatives market and faced failure with loss up to of $900 million that has largely affected the company’s financial position.
Metallgesellschaft AG was one of the previous organizations of Germany's biggest industrial conglomerates that are based in Frankfurt. The company had more than 20,000 employees with revenues of approximately 10 billion US dollars (Aglietta). Moreover, the Metallgesellschaft had more than 250 subsidiaries that were specialized in specialty chemicals (Chemetall), mining, commodity trading, engineering (Lurgi) and financial services. Previously, Henry Merton & Company, Ltd has also remained a part of the Metallgesellschaft. The Metallgesellschaft Refining had gained a stake of 49% in Castle Energy in the United States which as the first step taken by the company to invest in a proper refiner. This deal had enabled Metallgesellschaft to ensure its long term output for the refined products on the basis of long-term contracts (Edward). After this, the company decided to have a long-term contract with jet fuel, heating oil and gasoline retailers for which Metallgesellschaft devised were 3 types of contracts:
- Firm–Flexible was similar to the firm-fixed contract; however, the customer had increased flexibility on the delivery schedule. The company had made agreements to provide 52 million barrels throughout 10 years.
- Firm-Fixed in which client agree to provide fixed monthly delivery on the agreed price. On the basis of this contract, Metallgesellschaft had made agreements to provide 102 million barrels for 10 years.
- Guaranteed Margin in which the company will provide at a fixed margin in relation to the local retail cost. Metallgesellschaft has made agreement to provide 54 million barrels throughout 10 years subject.
This meant that the company will receive a premium between $3 and $5 on the spot price. In addition, the long term supply contracts were made for 10 years at agreed deal of 160 million barrels. These contracts had also embedded an option that would allow the counterparty to put up for sale any remaining forwards again to the Metallgesellschaft in case if the energy prices increases more than the contract price. However, the return will be at a 50% different price between the contracted forward price and short term futures price. However, the following risks were faced by the Metallgesellschaft:
- Chances of default risk by customers as they prefer buying at a price that is above spot prices that shows an issue for for Metallgesellschaft as there will be a decrease in price.
- Customers prefer using cash out option that helps to exit at a lower price of the agreed contract.
In order to respond to these risks, the company used a hedging strategy in which both swaps and futures were combined (Krapels). The company’s total position was nearly 160 million barrels in the derivatives market that was similar to one to one position regarding the long term position. Usually, an organization uses two different types of hedge against the risks that include basis Risk (a type of mismatch that emerges as a result of the hedge’s short term nature and long term contracts) and liquidity risk (results from the margin calls on the basis of monthly roll over).
Metallgesellschaft used a hedge that is known as “stack and roll” strategy in which an organization stacks up the hedge against the most liquid contract that is rolled over at the time of expiry (Aglietta). The use of this strategy refers to the using a hedge in which the maturity of the risk is not matched through the hedging instrument. However, a basis risk creates an issue because it refers to the future market movements that do not necessarily have a direct association with the changes in the long term contracts (Edward). This raises a question whether the hedge of Metallgesellschaft was appropriate. However, there are many reasons that supports that one to one hedge don’t works. Firstly, the time value of money might have meant that the two contracts cannot have same association between them and secondly, the contracts with long dates are less volatile (Krapels).
A problem in the case of Metallgesellschaft was that there may exist volatile fluctuations in the contracts of short term futures market that does not change the long term expectation. A reason behind this can be that the short term affects are like weather or war that does not have any effect on long term contracts that are more principally based on the aggregate demand and supply. This means that in case of any losses on the short term stack futures, the gains on the long term contracts cannot be used as a hedge (Aglietta). The gain or profits on the long term contracts was around $480 million that was 50% less than the losses incurred on the futures. Therefore, there is a justification that the hedge ratio of the Metallgesellschaft was 0.5 or one say of 50%. Another issue for the Metallgesellschaft was that hedge works correctly in situations in which the markets have lower forward prices than the spot price, i.e., backwardation (Aglietta). However, in case if the markets are in contango position in which the forward prices are more than the spot prices than the stacked hedge becomes costly as one buys at high price and sells at low prices with every roll. This is exactly what happened with the Metallgesellschaft, i.e., the oil markets moved from backwardation to the contango situation (Krapels). The Metallgesellschaft positions was no secret as the company was very huge and estimated nearly around 20% of the outstanding NYMEX oil contracts.
However, one of the reasons behind loss of Metallgesellschaft was the company itself among other reasons of the backwardation to contango. This was mainly because the investors took opposite position against the Metallgesellschaft. The speculators have shorted that the futures contracts can take opposite position to that of Metallgesellschaft (Edward). However, in some ways it can be said that the position that the company took in the derivative market was much speculative itself. The company relied heavily on the contract of single futures despite of the chances of basis risk (Krapels). Moreover, the company had the liking to get profit from the basis that has worked in case of backwardation. However, it is interesting to highlight that the Metallgesellschaft used a one to one hedge, instead of a minimum variance hedge that could have served as a better strategy. All the different problems together have contributed to cause Metallgesellschaft to cost upto $900 million. The Metallgesellschaft’s management decided to proceed for unwinding the hedge. In addition, the company who was itself a key player suffered much loss from the future derivative risks (Aglietta). The management then decided to restructure the business and engage into contracts with its creditors. However, for the short basis, the complete long term contract itself ended badly for the company (Krapels).
The failure of Metallgesellschaft in the derivative market shows that an organization must carefully evaluate the derivative market as improper analysis causes huge losses to the company. Moreover, the failure in the derivative market shows that future investors must analyze the significance of the minimum variance hedge and it must not be overstated. Moreover, initially, when an organization decides to hedge, then they must consider the size of the market and must not hedge on huge market size. However, a small hedge can also make it difficult to detect for others who are the participants in the market. As in the case of Metallgesellschaft, the company paid too much attention on the position that made other players to think that they can exploit the market situation or their own benefit advantage that they have also done.
Other factors that caused company loss include funding, size of market and Contango effect. These losses are often frequent in the derivatives market that is due to the poor understanding of the derivatives market. Besides this, the Metallgesellschaft was successful initially in hedging the market risk, particularly when there was an increase in oil prices. However, the company failed in evaluating the funding risk regarding its hedge position. In case if there was constant rise in the price of hedge, then the case would have been favorable for the Metallgesellschaft. Moreover, with respect to the contango market, the company must also have projected the downtrend of the prices and correctly adjust the hedge contract price to future avoid losses. Moreover, the difference in time between two sides of agreed contract reduces the effectiveness of hedging that is similar to the problem of asset – liability mismatch. According to some commentators, Metallgesellschaft had unwounded the hedge too early.
Nevertheless this cannot be held necessarily true because the Metallgesellschaft became a much considered factor in the derivatives market price itself. Therefore, in order to remain in the market, the Metallgesellschaft must have continued its position in the backwardation for longer period of time. However, the study of Metallgesellschaft failure in the derivative market shows that the company had not done much analysis before pursuing this strategy due to which they had faced huge losses. Thus, the decision-makers and CFOs of Metallgesellschaft must have understood their position in the market before taking step of hedging as the consequences of market movements had negative impact on the financial position of an organization.
Aglietta, Michel. “Financial Market Failures and Systemic Risk”. 1 January 1996. Web. 22 November 2014.
Edward, Franklin. “Derivatives can be Hazardous to your health: The case of Metallgesellschaft”. 1995. Web. 22 November 2014.
Krapels, Edward. “Re-examining the Metallgesellschaft affair and its implication for oil traders”. 26 March 2001. Web. 22 November 2014.