Background of the case
This German conglomerate is owned largely by some very big banks in Germany like Deutsche Bank, Dresdner Bank to name a few as well as the Kuwait Investment Authority. The Energy group subsidiary of this conglomerate (MG Refining and Marketing (MGRM – hereinafter referred to as the firm) which deals with petroleum products reported a loss of round-about $1.5 billion in December 1993.
The Firm had exposure to short forward positions of certain amounts of petroleum every month over 10 years. These positions were slated to make profits since the forward price was at a premium over spot. These deals had an “option” clause involving the NYMEX futures contract on oil. The Options clause entailed that if the front-month NYMEX futures price exceeded the forward price the counterparties could terminate the contracts early. On exercise The Firm would be required to pay in cash one-half of the difference between the futures price and the fixed price times the total volume to be delivered of the contract. This would be attractive to the customer if they were in financial distress and simply no longer in need for oil.
Given the fluctuations in the oil market prices, The Firm employed a “stack and roll” hedge strategy using long NYMEX futures contracts. The delivery months used were short-dated along the lines of the call options used. The Firm went long in futures and entered into OTC energy swap agreement to receive floating and pay fixed. The futures positions accounted for 55 million barrels and the swap positions accounted for 110 million barrels and these positions introduced credit risk for The Firm.
Causes of the losses
The hedge was created with a view that the market would be in backwardation (where spot prices are higher that futures prices) which is normally the case. However, the market shifted to contango (where futures prices are higher than the spot prices) greatly increasing the cost of the hedge. The gain due to the short positions was more than offset by a loss due to the futures positions.
This caused the following problems:
- The contribution due to the size of the The Firm’s total open interest was a considerably larger percentage of the total and liquidating these positions would be very difficult. There was also a danger of not having adequate funding in case of immediate margin calls.
- Over the life of the hedge the cash flows would have matched out. But the firm encountered problems in finding necessary funds to maintain the position.
- A hedge is supposed to transfer away the market risk entirely. But the firm was accused of speculation instead of hedging due to the funding issues caused by the contango effect. Official records state that they were exposed to a position 85 days worth of the entire output of Kuwait.
- If oil prices were to drop, MGRM would lose money on their hedge positions and would receive margin calls on their futures positions. Although gains in the forward contract positions would offset the hedge losses, a negative cash flow would occur in the short run because no cash would be received for the gain in the value of the forward contracts until the oil was sold. Although no economic loss would occur because of their hedge strategy, the size of their position created a funding risk
- The stack and roll strategy future aggravated the losses because in a contagno market the spot decreased more than the futures prices. US versus German accounting methodologies – German accounting standards also compounded MG’s problems. Lower of Cost or Market (LCM) accounting is required in Germany. In the U. S., MGRM met the requirements of a hedge and received hedge accounting. Therefore, in the U.S., MGRM actually showed a profit. Their hedge losses were deferred because they offset the gains of their forward fixed rate positions. Using LCM, however, MG was required to book their current losses without recognizing the gains on their fixed-rate forward positions until they were realized. Since German accounting standards did not allow for the netting of positions, MG’s income statement was a disaster. As such, their credit rating came under scrutiny and the financial community speculated on the demise of MG. This drastically changed the market arena for MGRM. Their swap counterparties required additional capital to maintain their swap positions and the NYMEX imposed supermargin requirements on MGRM more than doubling their performance bond requirement. If hedge accounting had been acceptable in Germany, MGRM’s positions may not have alarmed the marketplace and they might have been able to reduce their positions in the OTC market without getting their eyeballs pulled out.
The major cause of the losses was actually the size of the position which created a funding risk.
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MG was a huge, German industrial conglomerate that decided to open an energy trading office in the US in the early 90s.
The original plan was threefold:
- Sell refined products in the forward, physical market.
- Invest in refining capacity to produce the products.
- Hedge the forward sales through financial derivatives.
When the strategy was first implemented in 1992, current physical prices were lower than the futures prices. So the sales contracts were set at those higher future prices. And it meant that purchasing the "near" month futures contracts would be profitable. So MG developed a strategy whereby they would cover the long-term, fixed-price sales by buying contracts in these few, near months. As each month "rolled-off," they would merely buy contracts in the next month. It was their intent to continue this process until the physical product sales contracts expired in (10) years. This strategy worked as long as the futures market was "backwardated," whereby each successive month is lower than the prior one (Lesson 3).
One of the major flaws in this approach, however, was the volume of contracts being traded since they were "loading-up" on closer month contracts. Add to that the fact that they would not get paid for the product sales for years out, and you begin to have a cash flow problem where margin calls are concerned. Their position in the Fall of 1993 was estimated to be between 160 to 180 million barrels stretched-out over the following (10) years.
In 1993, prices fell as the market received a "bearish" signal from OPEC on production quotas. This lowered futures prices and reversed the market from "backwardated" to "contango," whereby each successive month's price is higher than the prior one (Lesson 3). Faced with this position, MG management was changed and the new team was directed to close all positions. This resulted in losses on the futures purchases totalling almost ($1.5) billion USD. The had to seek bailout funds from one of their banks, and in return, had to sell-off several divisions.Today, the German industrial giant no longer exists having been bought-out by a competitor.