Financial Management of Risks 427What makes the Metallgesellschaft case so intriguing, is that the company
seemed to be using derivatives for all the right reasons. An American sub-
sidiary of Metallgesellschaft, MG Refining and Marketing (MGRM) had em-
barked on an ingenious marketing plan. The subsidiary was in the business of
selling gasoline and heating oil to distributors and retailers. To promote sales,
the company offered contracts that would lock in prices for a period of 10
years. A variety of different contract types was offered, and the contracts had
various provisions, deferments, and contingencies built in, but the important
feature was a long-term price cap. The contracts were essentially forwards.
The for ward contracts were very popular and MGRM was quite successful at
selling them.
MGRM understood that the for ward contracts subjected the company to
oil price risk. MGRM now had a short position in oil. If oil prices rose, the
company would experience losses, as it would have to buy oil at higher prices
and sell it at the lower contracted prices to the customers. To offset this risk,
MGRM went long in exchange-traded oil futures. The long position in futures
should have hedged the short position in for wards. Unfortunately, things did
not work out so nicely.
Oil prices fell in 1993. As oil prices fell, Metallgesellschaft lost money on
its long futures, and had to make cash payments as the futures were marked to
market. The for wards, however, provided little immediate cash, and their ap-
preciation in value would not be fully realized until they matured in 10 years.
Thus, Metallgesellschaft was caught in a cash crunch. Some economists argue
that if Metallgesellschaft had held on to its positions and continued to make
margin payments the strategy would have worked eventually. But time ran out.
The parent company took control over the subsidiary and liquidated its posi-
tions, thereby realizing a loss of $1.3 billion.
Other economists argue that Metallgesellschaft was not an innocent vic-
tim of unforeseeable circumstances. They argue that MGRM had designed the
entire marketing and hedging strategy, just so they could profit by speculating
that historical patterns in oil prices would persist. Traditionally, oil futures
prices are lower than spot prices, so the general trend in oil futures prices is
upward as they near expiration. MGRM’s hedging plan was to repeatedly buy
short-term oil futures, holding them until just before expiration, at which point
they would roll over into new short-term futures. If the historical pattern had
repeated itself, MGRM would have profited many times from the rollover
strategy. It has been alleged that the futures was the planned source of profits,
while the for ward contracts with customers was the hedge against oil prices
dropping.
Regardless of MGRM management’s intent, the case teaches at least
two lessons. First, it is important to consider cash f low and timing when con-
structing a hedge position. Second, when a hedge is working effectively, it
will appear to be losing money when the position it is designed to offset is
showing profits. Accounting for hedges should not be independent of the po-
sition being hedged.