Metallgesellschaft

In the early 1990s, Metallgesellschaft AG, a German conglomerate that had evolved from a traditional metals company into a provider of risk management services, was one of Europe's most successful businesses with approximately $15 billion in annual sales. However, that success was marred when, in December 1993, MG Refining and Marketing Inc. (MGRM), a subsidiary of Metallgesellschaft AG, revealed that it had lost $1.5 billion from trading in energy derivatives.

The tale of MGRM's troubles starts with their marketing strategy. MGRM committed to sell to their customers set quantities of fixed-price petroleum products every month for up to 10 years. These contracts proved to be very popular. Each MGRM contract contained a sell-back option allowing MGRM's customers to terminate the contracts early if the next-to-expire (i.e., “front-month”) New York Mercantile Exchange (NYMEX) futures contract was greater than the fixed price at which MGRM was selling the oil product.

To manage the risk from these contracts, MGRM established large futures and swap positions in gasoline, heating oil, and crude oil as hedges. These positions involved about 155 million barrels of underlying oil products. It is not clear that there was anything conceptually wrong with MGRM's hedging strategy. But it is clear that MGRM had not adequately communicated its intentions to its parent company and financial backers. In late 1993, MGRM's futures positions lost money as spot energy prices fell, requiring the immediate cash outflows to meet margin calls. Presumably, their other assets involved in the hedge were increasing in value in a way that offset those outflows, but these increasing values could not be turned into cash flows.

By the end of 1993, the heavy cash outflows required to maintain the hedge program, combined with concern about the credit risk taken on with the large swap position, caused MGRM's parent to change its assessment of the potential risks involved in its customer contracts. After reviewing the program in December 1993, MGRM's parent decided to end MGRM's participation in the hedge program, a decision that proved very costly to the firm.

Because the liquidation was publicly announced in advance, other traders were able to extract a large premium from MGRM. The net result is that MGRM lost on the futures and swap side of the transaction while failing to realize the offsetting gains they had reasonably anticipated. In total, MGRM lost $1.5 billion in the disaster.