Metallgesellschaft, 1993

At a glance

What happened

MG's US subsidiary promised customers petrol and heating oil at fixed prices for up to ten years, around 160 million barrels in all. Because there was no deep market in ten-year oil futures, it hedged by holding the whole quantity in the nearest contracts and rolling them forward every month. When oil prices slid through 1993, the futures lost money immediately and in cash, while the offsetting gains on the customer contracts would only arrive as the oil was delivered, years later. The parent's supervisory board stepped in, closed the hedge and took losses of about $1.3bn.

Why it went wrong

On paper the book was close to balanced. In cash it was not. Daily variation margin on the futures ran to hundreds of millions while the profits on the supply contracts stayed locked up for a decade. At the same time the shape of the oil curve turned against the roll, so keeping the hedge on cost money every month instead of earning it. The combination turned a hedged position into a large, open-ended funding need, and the decision to liquidate fixed the loss at the worst moment.

What it teaches

Matching quantities is not the same as matching risk. A short-dated hedge on a long-dated obligation creates a funding gap that has to be sized for the worst year, not the average one, and rolling exposes you to the shape of the curve. Closing a hedge is itself a trading decision, and the people who make it need to understand that.

Key terms

Stack and roll

Holding the whole hedge in nearby contracts and rolling it forward, because distant months are not liquid enough.

Backwardation

A curve where nearby prices exceed distant ones, which makes rolling a long position cost money.

Contango

The opposite shape, where distant prices exceed nearby ones, and a long roll earns rather than costs.

Maturity mismatch

A hedge whose settlement dates differ from the exposure’s, leaving a funding gap even when the economics offset.

Roll yield

The gain or loss from replacing an expiring contract with a later one, which accumulates every month.

Liquidation decision

The choice to close a hedge, which converts an unrealised offset into a realised loss.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of funding liquidity and hedge basis risk. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

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The instruments behind it

OTC Learn lessons on the products this case turns on:

• Commodity SwapFixed price for floating market price
• Commodity ForwardAgree a price today for delivery later