In 1993, Metallgesellschaft AG, lost $1.8 billion after speculating that oil prices would rise. This is commonly believed to be one of the largest losses in modern trading history. I am here to reanalyze what went wrong, and why it’s important to reflect on the past in order to maximize efficiency into the future.
Now that both a thorough explanation and corresponding analysis of MG’s transpired derivative strategies have been offered to the public, several pertinent questions and debates continue to loom with regard to the firm’s astronomical, “hedged” losses and the stain it leaves upon the market for derivatives. Many not only question the assumption of energy market backwardation that MGRM had so widely embraced, but too, scorn the firm for implementing a “stack-and-roll” futures strategy. In hindsight, sentiment still exists that this was not the only means MGRM had at its disposal to hedge its natural short position exposure due to its promised, long-term client gas and oil contracts. For example, it would have been possible for the conglomerate to physically take delivery of a number of barrels of oil sufficient enough to cover the entire amount of their future deliveries. However, had MGRM employed this tactic, they would have been subjected to two very significant expenses. Firstly, the initial large cash outflows resulting from the purchase of all those barrels could have severely strained the firm’s balance sheets over such a short period of time. Secondly, there exists a heavy cost in actually storing those barrels, an expenditure known as “cost of carry.” Alternatively, MGRM critics suggest that the firm could have chosen another hedging technique, though equally as expensive and thus, profit limiting, as physically storing barrels in inventory. MGRM could have entered into longer-term futures/forward contracts, which would have eliminated the problem it experienced resulting from the timing mismatch between its long-term deliveries and “rolling” shorter-term hedges. However, synthetically, such long-term futures contacts are nearly identical to physically holding the commodity since the forward price includes not takes the current spot price into account, but the cost of carrying it as well. Too, the market for long-term oil contracts, such as ten year settlements, is incredibly thin and illiquid. As a result, the only true, viable hedging strategy MGRM could have employed, as many financiers see fit, was the ill-fated “stack-and-roll” in short-term futures contracts.
While dissent does indeed exist in how MGRM went about its hedging, a far more widely-debated question begs why the subsidiary chose to “hedge” its bets in this manner. You will notice that I enclosed the term ‘hedge’ in quotation marks – for good reason. MG critics argue that, through its “stack-and-roll” policy, the firm was not off-setting or hedging its exposure, but rather, was simply speculating on the price of oil and gasoline. The goal of gedging, these critics claim, was to mitigate the market and basis risks naturally borne by MGRM’s short positions. Instead, MGRM compounded its risk by assuming the futures market would continue to place a premium on convenience yields and thus, continue to demonstrate backwardation behavior. Through their massive positions and dominance in oil futures throughout 1993, this assumption was short-lived as the market shifted into contango, which cost MGRM heavily as its “stack-and-roll” strategy garnered more and more losses with each monthly contract expiration.
Whether or not energy markets would have persisted in contango mode throughout the year-end of 1993 and beginnings of 1994 is a source for contention, however. In hindsight, we know that oil prices began to boom in the early stages of 1994, thus shifting back into a backwardation frameset. Had MG’s executive management stayed put and had not ordered MGRM to withdraw its hedging strategy, it is more than likely that MG’s $1.87B loss would have amounted to a mere $200M, some criticisms reveal. The issue was not only that MGRM was unwinding its positions, but rather how quickly it was unwinding them. By dumping nearly all of their holdings at once, they flooded the market, and, consequentially, their positions sold at severely depressed prices. On the other side of the coin, there is some support for management’s decision to cut its “stack-and-roll” platform. Though, generally, backwardation has been the norm in commodity futures markets, there are cases when certain futures contracts have shifted into contango for multiple years. This was exactly the environment for copper and soybean contracts between 1965 and 1975. Had this been the case for oil contracts at the tail end of 1993, management would have been deemed as heroes for “saving” the firm because its losses would have only continued to mount had it stuck to its initial “stack-and-roll” technique. Executives were at a crossroads and made the best the decision they could. In hindsight, they found themselves in a “damned if you do, damned if you don’t” type of scenario. Either way, they would have been and most likely will always be condemned as the individuals responsible for ultimately forcing the firm into bankruptcy.
Other naysayers target management for being over-hedged. By utilizing short-term futures contracts, which are indubitably more volatile than longer-term ones, MG was susceptible to extreme volatility with respect to its short-term cash inflows. Criticisms persecute management for not creating some type of strategy that would have somehow softened the ebbs and flows of these cashflows. Because research has demonstrated that short-term energy futures/forwards are 50% correlated to long-term contracts, maligners state that MGRM should have implemented a hedge 50% smaller than what it originally had on its books.
Others contend that the surmounting losses were not grounds for management’s dismissal of their “stack-and-roll” strategy. Researchers, after analyzing MGRM’s holdings, contracts, and pertinent financial documents, found that MGRM’s hedging platform enjoyed a positive NPV at the time of their bankruptcy filings. Though short-term capital resources were somewhat scarce, some argue that options contracts would have provided the necessary hedge to hold over MGRM for the time being until it secured some type of longer-term financing. These same critics shift the blame from MG management towards Deutsche Bank, not only Germany’s largest bank, but one of MG’s chief creditors and shareholder. On account of this close-knit relationship, some scorn Deutsche for not injecting the necessary capital to aid the firm in its cash crisis. The cash complications of not only a bombarding of numerous margin calls, but too, increasing margin requirements, could very well have been abated or at least softened had Deutsche offered up some type of short-term funding. Too, some blame the New York Mercantile Exchange for skyrocketing the margin requirements MGRM had to heed based upon Wall Street rumors of its liquidity crisis. This only intensified MGRM’s short-term strains on its cash account. These same critics remain further puzzled by management’s decision since, according to one researcher, one major U.S. bank was willing to provide the required liquidity in the form of securitized forward delivery contracts.
Ultimately, much, if not nearly all, of the demise attributed to MGRM’s derivative losses can be attributed not to adverse market changes or unforeseen yield changes, but to catastrophically poor management. While, to some degree, MGRM subjected itself to risks innate in the world of trading, the underlying risk that impacted the firm far more gravely was an excess of operational risk. Through feeble and faulty systems of control and managerial oversight, executives managed to drop the leash it once used to orchestrate the firm’s operations and risk mitigation. Embarrassment and shame, even more so than the financial repercussions of their actions, forced management to hide their mistakes from other board members. Fueled by a desire to reap rolling profits from backwardation futures market, Metallgesellschaft lost dearly by “hedging” with the one tool designed to eliminate such losses – derivatives. Ironic, isn’t it?
In summation, while the derivatives market can be utilized to hedge bets conducive to any firm’s operations, it is evident that the assumptions underlying such market behavior can prove just as detrimental to profits as unhedged positions. We see the importance of having some type of contingency plan – if plan “A” fails, there should be some type of alternative means of short-term credit or funding one can rely on. MGRM’s naivety in this arena needlessly exacerbated its cash crisis during the autumn months of 1993. Too, we see that matching long-term obligations with short-term funding may not be the best means of hedging risk, as the market for these two types of contracts can demonstrate incredibly different characteristics and behaviors. We learn that, even after one has perfectly “hedged” its positions, human inadequacies in the form of excessive greed and pride can ultimately destroy even the best-laid strategic plans. Don’t blame the markets. Don’t blame the level of interest rates. Sometimes, the only person to blame is yourself.
David John Grillo