Metallgesellschaft Ag Derivatives Analysis

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Introduction Metallgesellschaft AG (hereafter, MG) is a large industrial conglomerate was involved in a variety of business activities starting from mining and engineering to trade and financial services. In December 1993, the firm reported huge derivatives-related losses at its U.S. oil subsidiary, Metallgesellschaft Refining and Marketing (MGRM). These losses were later estimated to be over $1 billion which is considered to be the largest derivatives-related losses ever reported by any firm at the time. In 1992, MGRM implemented a marketing strategy which it believed to be profitable. The company agreed to sell specific amounts of petroleum products every month for up to ten years, at fixed prices which were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term commitments - a "stack" hedging strategy. The concept here was that, if the prices of the oil dropped, the hedge would lose money whereas the fixed rate position would increase in value. However, if the oil prices rose up then the hedge would gain. This gain in turn would offset the losses on the fixed rate position. While some economists believe that this theory is correct. However it has a flaw. The flaw is that when oil prices drop, the gains from the sale of the oil are realised on a long-term basis, however, the losses on the hedges will be realised immediately as margin calls come in. This leads to a negative impact on the cash flow, leading to a funding crisis. This is what has happened in the late 1993 with MGRM. The cost of rolling over the futures contracts was a staggering $88million in October and November. In order to cover these costs, MGRM had to obtain funding from its parent company, Metallgesellschaft (MG). MGRM management decided to close out the positions to reduce the further losses. Thus, in December 1993, the company
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