Problem
In the 1990s a German multinational conglomerate, Metallgesellchaft wanted to overcome their industry issues and decided to develop a new strategy to increase sales.
1989 MG was split into raw materials, services, and industry, focusing on trading, foreign sales, and rapidly growing pollution-abatement industry.
1980s MGRM made a decision to get involved in Us Oil. Purchasing a 10-year commitment of ownership in Castle Energy.
1990- 1991 Persian Gulf Conflict and end of Soviet Union. Causing raise in spot energy prices above forward energy prices.
1990 to 1994, energy prices fell dramatically due to a combination of macroeconomic and industry-related factors. One of the major reasons for the reduction in energy demand was an eight-month recession in the United States that began in July 1990.
1991 Arthur Benson offered a palette of popular Energy Derivatives.
1993 MGRM sold 160 million barrels of its fixed-rate, long term forward contracts to about 100 independent heating and gasoline retailers. MGRM's forward contracts offered these independent retailers an opportunity to stabilize their future margins by locking in relatively low oil prices for periods as long as ten years.
In this environment, MGRM felt confident that it could use its energy market expertise, hedging knowledge, and huge financial resources to make a profitable business by selling long-term, fixed-rate, forward energy derivatives.
MGRM embedded a cash out option to their 10-year contracts. Independent companies liked this idea because if the market price rose, they could cash out for a profit. It also gave a security to small companies that who might have to deal with bankruptcy.
MGRM didn't have the best Hedge because the oil market future was not available for a 10-year period. Estimation could only be carried out less than 4 months. They decided that buying oil and storing it was too expensive and decided against it.
They also failed at stack-and-roll hedges that were a combination of short-term contracts and over-the-counter swaps. Due to falling oil prices neither of these worked.
The company was hedging 160 million barrels of forward contracts, margin calls in some months approached $90 million and reduction in energy prices went from backwardation to Contango, MGRM decided to liquidate futures positions.
German markets felt MGRM was failing but the US Market thought they were on average with other companies. Due to the Board deciding to liquidate so quickly, if MGRM had hung in there they might have realized that there was less risk in their future plans.
The new management of MGRM liquidated most of its positions between December 20 and 31, 1993, when oil and gas prices were at their lowest levels. Therefore, futures market losses were at their highest levels. By July 1994, they had increased to nearly $19.65/bbl. Gasoline and heating oil prices followed the same pattern. IF MGRM had found other ways to change their liquidity they could of continue to be a big contender in the oil business.
Task
I. What major risks did MGRM identify? What major risks did MGRM fail to identify?
II. What are contango and backwardation and why were they important to MGRM's situation?
III. Why is there often backwardation in the oil markets?