Question

background: Metallgecellschaft Refining and Marketing Company (MGRM) that lost $1.3 billion on energy derivatives from 1991 to 1993.

1.What major risks did MGRM identify? What major risks did MGRM fail to identify?

2.What are contango and backwardation and why were they important to MGRM’s situation?

3.Why is there often backwardation in the oil markets?

4.What should the MG’s board of directors have done differently? Did corporate governance fail?

5.Was MGRM hedging or speculating?

Answer 1

1. MGRM identified that it is exposed to market risk and therefore used stack and roll technique of hedging where you trade short term futures contract (for example, 3 months) to hedge long term exposures (say, for 10 years).

They took a short position in forward contracts (to sell gas and oil commodities) for a long term and hedged this exposure by taking a long position in gas and oil futures contract for short terms.

MGRM failed to identify liquidity risk i.e. how would they finance the short term futures contract margin calls if the price of the oil and gas falls.

2. When futures price is greater than the spot price, then it is known as contango

When spot price is greater than futures price, then it is known as backwardation

In the case of MGRM, it was the contango market where the futures price is greater than the spot price which led to a great loss in stack and roll strategy. Because the spot price was falling, it was incurring a great loss in the long futures contract, which was to be settled with margin calls, that has to be paid by the MGRM.

3. Why is there often backwardation in the oil markets?

Because of the shortage of oil in the spot market. In this case the spot price is greater than the futures price and the investors with a long position gains from the futures market. But in MGRM case, the markets were contango and therefore, there was huge loss on the long position in the futures market.

4. a) Proper risk controls must have been applied by the board.

b) If the stack and roll strategy was to be used then a valuation reserve should have been made for the key risks.

c) Hedging a long term exposure with short term hedging is a risky task. Trade-offs between risk and rewards should have been analysed thoroughly before performing something like this.

Corporate governance did not succeed in the case of MGRM, the board should have issued stricter guidelines regarding the risk-taking capacity of the firm.

5. MGRM was hedging its long term forward contracts (short position) with short term futures contract (long position).