Lakhasly

The Problem In 1993, they entered a short position in the forward contract to sell oil products such as heating oil, and gasoline to customers, at a fixed price for up to 10 years.By December of that year, Metallgesellschaft had long positions in energy derivatives equivalent to 185 million barrels of oil.Their objective was that if oil prices fell, the hedge would lose money as the fixed-rate position would increase in value; if oil prices rose, the hedge gains would offset the losses on the fixed rate position.However, a problem with this strategy became evident as oil prices tumbled throughout 1993 in the aftermath of the war in Kuwait.The futures positions accounted for 55 million barrels and the swap positions accounted for 110 million barrels and these positions introduced credit risk for The Firm.(Wrong Hedging Ratio).The market turned from backwardation to contango.

The Problem In 1993, they entered a short position in the forward contract to sell oil products such as heating oil, and gasoline to customers, at a fixed price for up to 10 years. In order to avoid the loss from forward contract, MG using a hedging program - stack and roll hedging strategy ( long position in the future contract). At that time, the average trading volume for gas was only between 15,000 and 30,000 barrels. By December of that year, Metallgesellschaft had long positions in energy derivatives equivalent to 185 million barrels of oil. They used Backwardation as their strategy for getting the profit at that time. The Firm went long in futures and entered into OTC energy swap agreement to receive floating and pay fixed. The futures positions
accounted for 55 million barrels and the swap positions accounted for 110 million barrels and these positions introduced credit risk for The Firm. (Wrong Hedging Ratio). Their objective was that if oil prices fell, the hedge would lose money as the fixed-rate position would increase in value; if oil prices rose, the hedge gains would offset the losses on the fixed rate position. However, a problem with this strategy became evident as oil prices tumbled throughout 1993 in the aftermath of the war in Kuwait. The decline in the price of oil (spot price) and the increase in the price of future contract that ultimately led MGRM to financial distress. The market turned from backwardation to contango. As a result, they had big losses including the loss from the daily settlement led to huge margin calls (1.5 billion dollars). The hedging program was not so faulty, the only problem that they have cash flow problem for the daily settlement, then the hedging program was a mismatch for the company