Table of Contents
2. The business idea of MGRM
3. The risks of a non-hedging situation
4. The Hedging strategy and its associated risks and criticisms
4.1 Evaluation of MGRM ’ s hedging strategy based on Kuprianov
5. How reality turned out
6. Managements reaction and actions
Specializing in mining, commodity trading, specialty chemicals and financial services, Metallgesellschaft AG (hereafter MG) was one of largest German Industrial Corporation, with over 20,000 employees and an average revenue of $10 billion annually, who’s headquarter was located in Frankfurt. The financial statements presented by the board in December 1993 reported that the U.S subsidiary Metallgesellschaft Refining and Marketing (hereafter MGRM) suffered huge derivative-related losses of over $1bn dollar.
Due to the gravity of the losses, it caused a serious threat of bankruptcy to the parent company MG. Luckily, for the firm’s financial credibility, Deutsche bank, one of the largest banks in the world, and many other German banks were MG’s largest creditors. Because of this, MG’s board was able to negotiate a $1.9 billion rescue package with a total of 120 banks being the creditors in the loan (Kuprianov, 1995).
Many theories try to explain the management failure at MGRM that caused the huge speculative loss. The commonly accepted theory is that the management and board of MG were ill informed about its subsidiaries activities and speculation, making them vulnerable for making irrational decisions, which is represented by their overreaction, in particular to liquidize the outstanding contracts, which MGRM had with their clients. Many critics believe this heavily amplified the risk exposure of MGRM and caused the loss to increase in the long run. However, other empirical studies and economists argue that the liquidation of the contract was the best-case scenario at that time, but that the speculative contracts should have been constructed differently.
Whether the board and management team responded properly to the situation or not, both parties tend to agree with the fact that MGRM speculated with a different reason than normally assumed in financial markets. Namely, considering its expertise and global influence in the oil market, the assumption that MGRM used derivatives to exploit arbitrage in the market seems commonly accepted. In other words, MGRM did not hedge to minimize risk, but to maximize profits. This strategy might have played a role in the cause of the losses MGRM made in the following years after the hedging program was initiated.
This case will provide an overview of the business idea of MGRM and the hedging strategy that was initiated to mitigate the risk. Furthermore, this case will provide a brief overview of Culp and Miller’s opinion about MGRM hedging strategy. Substantiated by this article, this paper will provide an overview of the risks of the hedging strategy initiated by MGRM. Lastly, the management response will be analyzed in more detail after which a short conclusion is provided.
2. The business idea of MGRM
In 1991, MGRM recruited a new management team with one clear goal: constructing a new strategy to guarantee long-term customer relationship while simultaneously increase market share. This strategy was to be implemented solely for the oil market (gasoline, oil and diesel fuels). The new strategy proposed by the new management team entailed long-term contracts, with time spans of up to 10 years, with fixed prices. Furthermore, customers could choose between a firm-fixed and a firm-flexible contract. A firm fixed contract provides fixed monthly delivery at fixed prices at a customer, whereas the firm-flexible contract provided the customer with more flexibility to change it delivery schedule (Kuprianov, 1995).
Compared with the current state of the oil market, the 1990s had a deregulated market in which large companies enjoyed almost all of the bargaining power. Therefore, these longterm contracts offered an opportunity for smaller companies or retailers to protect themselves from price fluctuation and ergo, their profitability. Furthermore, if the market price was to rise above the spot price, customers of MGRM were presented with an opportunity to cash-out their obligations to MGRM depending on their contract.
Multiple advantages could be achieved by pursuing this strategy. The contracts would provide a long-term customer base and therefore more stable cash flows, lowering the cost of debt and securing revenue in the future. Secondly, the fixed price strategy provides a competitive advantage for the firm, attracting more customers and succeeding the market share increase objective the management was facing.
Considering the fact that the fixed prices were $3 to $5 more per barrel than the current spot price, MGRM would make vast profits if the oil price was to decrease, simply by buying low and selling high. However, a steady increase in the oil price (high enough to offset the $3 to $5 dollar per barrel difference) would impose great losses to MGRM, forcing them to sell barrels at the fixed rate while buying them at a higher spot price. This risk exposure motivated the management team of MGRM to hedge itself against increasing oil prices (Kuprianov, 1995).
In summary, at the time the strategy had been implemented, the oil price had seen a steady decrease over the recent period, making this strategy a viable one. Furthermore, the contractually advantages that eliminate or shift the risk for customers would provide MGRM with a stable cash cow.
3. The risks of a non-hedging situation
Although MGRM business idea was viable at the time since the oil price had seen a tendency to decrease, the risk exposure for a price increase was far too high to remain unprotected. The key issue was that MGRM did not produce or own the oil itself that it was going to sell to its customer. This forced the company to commit to forward contracts, securing the oil to sell them at a later point in the future. This also exposed MGRM to delivery and contractual risk; since MGRM is dependent of a third party that delivers the oil. Other risks, for example, political, governmental and legislative risk may then in turn also be a risk factor for MGRM. For example, the 1990 oil price shock, which more than doubled the oil price due to the Iraqi invasion in Kuwait, would have incurred a major threat to MGRM. However, the steady decrease after Desert Storm presented a financial opportunity for the firm. Considering all these risk factors, since the strategy of MGRM was completely dependent of the oil price, the risk exposure of MGRM towards the oil price is one-to-one. In other words, with oil price as a benchmark, MGRM has a beta of 1.
Consider an example where MGRM engages in a 10-year contract with a fixed price per barrel of $4. If the current spot price were $3.20, MGRM would make a profit of $0.80 per barrel, neglecting transportation and overhead costs. However, as the spot price would increase to $4.10, MGRM would face a loss of $0.10 per barrel. The fact that MGRM had a contractual agreement to its customers of 150 million barrels of oil in 1993 depicts a financial threat if the spot increase would be higher than the fixed price.
- Quote paper
- Maximilian Wegener (Author)Quint Hintjes (Author)Bing Yin (Author), 2013, Hedging Strategy. The case of Metallgesellschaft Refining and Marketing, Munich, GRIN Verlag, https://www.grin.com/document/272249