Metallgesellschaft AG (MG) was previously a corporation based in Frankfurt, Germany. It was founded in 1881 by an Anglo-German merchant Wilhelm Merton and his two partners, Leo Ellinger and Zachary Hochschild. Prior to 1881, Metallgesellschaft was originally involved in banking and trading metals. By 1890, MG traded copper, lead, zinc, nickel, aluminum and silver. As the industry began seeing new signs of light and continued expansion across the globe, the company rapidly expanded to reach cities in the United States, Mexico, Australia, France, Russia and Germany. By 1897, the company created its first subsidiary, Metallurgische Gesellschaft Aktiengesellschaft, which was responsible for their industrial and technological interests. This subsidiary later grew to be the leading worldwide engineering business. Metallgesellschaft AG was also renowned among the German communities. Merton, Ellinger and Hochschild offered their employees a pension fund and aided the creation of numerous institutions as subsidiaries in order to research social questions and to provide practical assistance. The concept was to create an academic background in commerce, economics, and social sciences through the Akademie für Sozial-und Handelswissenschaften. By 1910, Metallgesellschaft AG was steadily growing through international trading and engineering technology. In this same year, Merton was finally able to create a finance subsidiary called Metallurgische Gesellschaft.
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Although Metallgesellschaft AG was a very successful international company, World War I created many problems both in Germany and internationally. MG saw most of their international relations end and their raw material imports drop to almost zero. Metallgesellschaft AG watched their sister company in Great Britain disappear because of the British Non-Ferrous Metals Industry Bill of November 1917. This bill was designed to eliminate competitive influence and control over the British ore and metal trade, however, it forced MG to find new sources for their metal supplies in neutral countries and domestically. During this time Metallgesellschaft AG was presented with many tough decisions to recover from World War I despite the deaths of the company’s founders between 1912 and 1916. Between 1919 and 1922, the company was reorganized into five constituent parts.
Metallgesellschaft AG was able to recreate a peaceful and favorable business environment following World War I, but little did anyone know, a world depression and political changes would cause a dark future for MG and the world economy. After the National Socialist party took control of Germany in 1933, Metallgesellschaft AG became a desired asset due to the enterprise’s reach. Throughout the Aryanization process lasting between 1935 and 1938, the company saw eight of the eleven members of the board of directors removed, including Alfred and Richard Merton, from their positions for being Jewish or having Jewish connections. Following World War II, Richard Merton returned from his exile in England to retake the position of chairman from 1947-1960. During the rebuilding process, Metallgesellschaft AG focused on consolidating and expanding the company’s technical capabilities.
Starting in the 1960’s, under Karl Gustaf Ratjen (1973-1984) and Dietrich Natus (1984-1989), Metallgesellschaft AG attempted to re-expand into the world markets through new enterprises into France, Lurgi Paris SA, and later into Canada, Thailand, Papua New Guinea and England. To remove the Financial Times nickname “disorganized giant” from MG, the company chose to restructure its enterprises and subsidiaries into five subsequent divisions: metals processing, plant construction, chemicals, transport, and communications. In the early 1980’s, Metallgesellschaft AG increased their focus and involvement with raw materials and a larger interest in trading activity, engineering services and specialty chemicals used in the processing industries. During the rest of the decade, MG worked to improve their productivity and financial basis. The company increased their dividends and attempted to end problematic commitments in order to concentrate their resources on core activities.
In 1989, Dietrich Natus stepped down as chairman of the board to allow Dr. Heinz Schimmelbusch to takeover and again refocus the intentions of Metallgesellschaft AG. The company was attempting to combine many separate subdivisions of industry into a unified enterprise that would allow the company to work efficiently together in order to create an effective business model. Under Schimmelbusch, MG concentrated its efforts on creating and improving environmental technology. The company also continued to expand its enterprise through the creation of Berzelius Umwelt-Service (BUS), a company that would dispose problematic industrial waste and recycled valuable materials back into the production cycle. Metallgesellschaft AG’s ranges of activities were diversified, yet closely connected. The company covered the discovery, development and processing of ores in conjunction with the finance, transportation and marketing sectors of their discoveries. Schimmelbusch, following his award as manager of the year in Germany, invested a large sum of corporate money into a recycled metals operation following the Cold War. The combination of depressed pricing and the German economic recession created many hardships for this investment and MG quickly looked for a new investment in the American oil business through the U.S. financial subsidiary Metallgesellschaft Corporation and its MG Refining and Marketing (MGRM) business. The company chose to offer gasoline stations and other small businesses long-term contracts (up to ten years) to buy fuel at a fixed price. This unique opportunity quickly gave the company two percent of the oil-products market.
MG’s Strategy
Starting in 1993 MG’s trading subsidiary, MG Refining and Marketing, decided to create a new energy derivatives product in which they could market to American heating oil and gasoline retailers. This product was designed and targeted to American retailers who wished to hedge their oil and gasoline purchases. Many of these retailers previously faced many risks when the price of gasoline and oil unexpectedly rose. MG devised a forward contract product in which they would offer these retailers five and ten year fixed-price contracts. This innovative forward contract was not previously widely available. This contract allowed many retailers to take monthly deliveries of either heating oil or gasoline. The forward contracts locked in the price of oil and gasoline purchases for these retailers in their respective determined contract length. MG’s forward contract delivery prices were set at $3 to $5 higher than the current spot price.
By offering this forward contract to oil and gasoline retailers, MG has entered into a short position on oil and gasoline. As the position currently stands, MG would benefit from a decrease in the price of oil and gasoline. However, an increase in the price of oil and gasoline would lead to devastating losses for the company. MG believed that an arbitrage opportunity existed between the spot price of oil and gasoline and the forward/future prices. By using the correct derivatives and entering into the right positions, the company believed it would be able to earn a profit from their short positions hedged by other derivatives. We will now examine how MG strategized to hedge their short positions.
In order to hedge their short oil and gasoline positions, MG decided to enter long positions in futures contracts. MG implemented an interesting strategy when choosing between futures contracts. MG entered into short term futures contracts ranging from one-month contracts to three-month contracts. MG’s strategy called for a “stacked” hedge, which used only one contract rather than spreading the contracts out to different periods. Essentially this strategy stacked all of MG’s short positions into one contract. In order for MG to continuously keep their short positions hedged, they would roll over to a new short-term contract after each expiration date. Since MG is delivering oil and gasoline to retailers every month, the value of their short positions decreases with each delivery. Since MG entered into such short-term futures contracts to purchase oil and gasoline they were able to adjust their hedge every month. Once MG closes out their long futures position, they are able to open a new position adjusted to hedge their current delivery obligations.
This hedging strategy that MG implemented is known as a “stack-and-roll” strategy. MG is stacking their long positions with short-term futures contracts that are liquidated after each period. They then enter into a new futures contract and repeat the process, rolling over the position. Their short forward contracts mature in the long-term future and oblige the company to make deliveries during the length of the contract. By using this strategy they are able to earn a profit margin from their short forward contracts while hedging price increases with their long futures contracts.
MG’s Strategy: Put To the Real World Test
Up to this point we have laid the foundation of MG’s strategy and presented the profit and hedging implications. However, what sounds like a sound and hedged strategy proved to be a fatal error for the company. We will now examine the events that led to the failure of this derivatives strategy. MG’s strategy hedged away the risk of price increases and actually allowed the company to realize a larger profit in the event of price increases. In a market where the price of oil would increase, the company would make a profit margin on their forward contracts hedged by their long futures contracts. This strategy is particularly affective when the market is in “backwardation”. Backwardation describes a market in which the spot prices are higher than futures prices. However, during 1993 when the majority of MG’s contracts were written, the market experienced a contango period in which futures prices were greater than spot prices. When this occurs, the company is losing money each time they are rolling over their futures contracts. Since MG has to roll over their futures contracts almost monthly, they are incurring significant losses every month.
We would expect the losses on the long futures contracts to be offset by the gains from the short forward contracts they have with oil retailers and this would hold true in a long-term economic valuation. However, German accounting standards make this scenario invalid. MG has to continuously account for losses on their futures contracts because it is accounted marked-to-market. However the economic gains from their forward contracts would not be realized until maturity, which would not have occurred until 5-10 years. This created a cash-flow crisis for MG as they are not able to continuously take losses on their futures contracts. In addition, they incur credit risk as their oil retail customers start defaulting on the forward contracts as faith is lost in MG. This downward spiral continued as oil prices fell and ultimately accounted for a $1.5 billion loss for the company. What seemed like a perfect hedge for the company transformed into a strategy that brought unnecessary risk to MG.
Who is Responsible?
The two parties that appear to be responsible for Metallgesellschaft’s major loss appear to be Arthur Benson, chief oil trader, and the Metallgesellschaft Management and Supervisory Board. Prior to Metallgesellschaft’s huge loss, Arthur Benson believed that the oil market would move with normal backwardation and presented a hedging strategy to MG. His strategy was soon discovered to be wrong since the lowering of prices would be the reason that Metallgesellschaft suffered such a huge blow. Metallgesellschaft blamed Benson for providing the wrong strategy and fired Benson following the aftermath. Benson filed a lawsuit of $500 million against Metallgesellschaft claiming that he had presented MG with a sound strategy, and they turned it down and advised him to fix the price of oil. Many critics would agree with Benson, that Metallgesellschaft tried to use Benson as a scapegoat for the major losses suffered.
The MG Management Board and Supervisory Board have also been widely blamed for their lack of risk-management. The Supervisory Board pleaded ignorance which shows that they did not review the positions thoroughly. Critics have held the boards accountable for not understanding that Metallgesellschaft’s positions were very risky. The size of their position was far larger than any other positions which also added more risk. The board did not properly evaluate Benson’s strategy and should have been concerned with the high amount of risk associated with their position.
Overall, the main party responsible for the huge loss suffered by Metallgesellschaft has to be the Supervisory Board and the Management Board. They both oversaw any strategies that Arthur Benson endorsed, and in doing so the boards should have conducted a more in depth analysis of Metallgesellschaft’s position. They also should have better understand the dangers of speculation and how such a huge position can actually add risk to their position. Ultimately the boards did not properly manage their position and determine if Metallgesellschaft would be able to tolerate such a risk with such a huge position.
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Risk Management Errors :Economies of Scale and Timing of Cash Flows
Metallgesellschaft had thought large economies of scale would benefit their overall position, but in the end it led to their downfall. Their long position in short-term future contracts made any immediate margin calls cause immediate losses for Metallgesellschaft. They also attempted to hedge away the risk of rising prices by taking the short position in 5-10 year forward contracts. In the end the decreases in prices is what caused Metallgesellschaft to go into financial distress (Digenan, Felson, Kelly, & Wiemert, 2004).
Another problem was the timing of cash flows for forward and futures contracts. This problem was due to Metallgesellschaft having the long position in short-term future contracts, while simultaneously having the short position in long-term forward contracts. This strategy was based on the backwardation of oil prices, which means that the there will be higher oil prices with lower inventories (Bühler, Korn, & Schöbel, 2004). A change to lower oil prices and higher inventories, known as contango, ultimately killed MG’s hedging strategy. Over the entire life of the hedge the cash flows would have balanced out (Digenan, Felson, Kelly, & Wiemert, 2004). Metallgesellschaft’s problem was that they did not have any funds to cover margin call for any immediate losses on future contracts. The mistiming of cash flows did not allow MG to maintain its position thus causing them to lose about $1.5 billion.
Minimum-Variance Hedge Ratio
When Metallgesellschaft formulated their hedging strategy, they decided to use a variance-minimizing hedge ratio of 1. Metallgesellschaft has been criticized for using a much higher hedge ratio than should have been used. The ratio based on previous crude oil prices should have been a hedge ratio around 0.5 (Pirrong, 1997). Critics argue that Metallgesellschaft’s use of a one-to-one hedge ratio was the riskiest of all strategies and that it actually caused Metallgesellschaft to increase its price risk (Bühler, Korn, & Schöbel, 2004). Metallgesellschaft would have been in a much better position if they had not entered into any long term commitments at all. Empirical research also suggests that the long time horizon used by Metallgesellschaft to forecast risk was not properly represented. The time horizon for hedging should have been forecasted for the last few years of the time horizon instead of a 10 year horizon. This shows negligence on Metallgesellschaft’s part for not anticipating their correct amount of exposure to price risk. Metallgesellschaft actually increased their risk by trying to hedge for a 10 year horizon, when they should not have hedged at all or much closer to the end of the 10 year horizon.
The Aftermath
Between 1993 and 1997, Kajo Neukirchen, a corporate rescuer, saved Metallgesellschaft AG from filing the largest post-war bankruptcy in German history. Neukirchen was able to secure a bank bailout of roughly $2.06 billion U.S. and a subsequent cost-cutting program to create another $1.63 billion U.S. By mid-1995, Metallgesellschaft AG was able to repay their bank bailout in its entirety and also receive a new line of credit to provide flexibility for future initiatives. By 1996, Metallgesellschaft AG had completely exited the American oil market. As of the year 2000, Metallgesellschaft AG has been a member of the GEA Group. With its headquarters in Bochum, Germany, GEA Group is one of the largest system providers for food and energy processes in the world. The company’s main focus is still process technology and components for demand production processes in various markets. The GEA Group is currently broken down into six segments: Convenience-Food Technologies, Farm Technologies, Heat Exchangers, Mechanical Equipment, Process Engineering and Refrigeration Technologies. Although Metallgesellschaft AG no longer exists; its deeply routed history in process technology has allowed GEA Group to continue its growth and success in many industries across the globe.
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