APRIL 2000

METALLGESELLSCHAFT

INVESTIGATION OF A RISK MANAGEMENT STRATEGY

By: FARHAD MIAN

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THE TABLE OF CONTENTS: Introduction 2

Chain of Events 3

Structure of the Delivery Contracts 4

Hedging and Exposure to Risk 6

The Involvement of German Banks 8

The Role of Management and Public Disclosure of Information 10

Financial Rescue and Reforms 13

Bibliography 16

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INTRODUCTION: MG Refining and Marketing, Inc. (MGRM), a subsidiary of Metallgesellschaft, a German metal and oils conglomerate pursued an aggressive strategy wherein they contracted to supply heating oil and gasoline products to users on the east coast of the US. The contracts were for 5 to 10 years in the future and the contract price was 6 to 8 cents above prevailing market prices at that time. By September 1993, MGRM had sold forward the equivalent of over 150 million barrels of petroleum products in its long term flow delivery contracts They attempted to hedge the forward cash market exposure, at least in part, with futures contracts on the NYMEX. One difficulty they encountered was that the futures offered on the exchange only went out around 24 or 36 months; nonetheless, MG carried tremendous net long futures positions. Although MG, had OTC type hedges in place, it can be certainly argued that the futures length and the far forward cash shorts were two distinct positions--especially given the difficulties and relatively high costs associated with a hedging activity ten years into the future (an illiquid market). The energy markets were in a bear market in late 1993 and the futures went into a deep contango, which exacerbated their losses on their longs. Markets are said to be in contango when the futures prices are higher than spot prices. It cost MG a significant amount of money just to roll their long position in the expiring front month into the next few months due to the negative carry present at that time. Adding to this was the fact that the news of their positions got out over time and the market made them pay. Locals on the floor of the exchange would line-up in the days leading to expiration and put on bear spreads in advance of MG's rolling thousands of contracts. A bear spread is defined as a combination of futures position, where long positions are taken on longer term maturities and short positions are taken on shorter term maturities. Depending on the focus, it can be verified by analyzing the spread and outright activity during that time and looking for any patterns of spread distortion and volume. Right around the time MG was forced to liquidate, the market made its low around $13.90 a barrel and rallied sharply for a period. Some argue that if only the exchange, banks, and regulators hadn't stepped in, MG would have done just fine since oil prices rallied into 1994, but the hard cold fact is that they had tremendous "paper losses" that needed to be recovered. The losses had been accumulated due to huge margin calls made by the exchange as well as the huge rollover costs that came as a result of the contango. It has been debated as to what would have happened if MG hadn't been forced to close out its hedge positions; crude could have fallen even further and the exchange, its members, and the banks could have been faced with allegations of negligence and a billion dollars in default payments. The primary banks involved were Deutsche Bank and Dresdner Bank. Their representatives appear to be, at separate times, on MGs supervisory board. In addition these banks had been holding tremendous debt as well as equity holdings with MG. In order to prevent closing out of the futures positions held by MG, Dresdner Bank -- and later Deutsche Bank -- had been arranging extensions of multicurrency credit facilities. Most importantly these arrangements had been kept away from the knowledge of the public and the disclosure of the default of MGs position

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would have meant investigation of questionable management of MG by these banks. This later lead to restructuring of German corporate management regulations. CHAIN OF EVENTS: December 1993 - Early 1994 Beginning of December 1993: MG started having extreme difficulty meeting margin

calls on NYMEX. MG required liquidity support of $1 billion to finance futures and swap positions.

December 6, 1993: Revelations of losses appeared in German press. MG share price fell 13 percent.

December 10, 1993: Deutsche Bank and Dresdner Bank agreed to provide a DM1.5 billion collaterized bridge loan.

December 10, 1993: NYMEX notified MG that it could not expand its futures positions and that higher margin calls would be assessed.

December 17, 1993: MGs supervisory board fired four members of MGs management board including the CEO and CFO.

Late December, 1993: Some counterparties in OTC swap transactions refused to roll over position with MG Crop. without significant collateral. Some banks showed hesitance to lend money for financing MGs position, while others canceled credit lines.

December 28, 1993: NYMEX notified MG that it had to reduce positions on the exchange, and that in the future, positions could not exceed limits imposed by NYMEX.

December 30, 1993: By this date, approximately 80 percent of the firm-flexible supply contracts had been terminated.

End December, 1993: Share price had fallen an additional 20 percent since December 6.

January 5, 1994: MGs new management announced revised losses of DM1.8 billion, stating that the concern would require a sizable capital injection to avoid bankruptcy.

This paper deals with this case from the following aspects: The trading strategy used by MG using energy futures. The structure of the contracts offered by MG to its customers. The role of German Banks in the scenario. The role of MG management during the course of the strategy.

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STRUCTURE OF THE DELIVERY CONTRACTS: MG had decided to enter US oil markets in 1980s, because after the oil crisis of the late 70s, the retailers and wholesale suppliers had become cautious and were willing to enter into long term supply contracts with large suppliers of heating oil. At that time, the major supplier of the contracts in US was Enron. So MG also started to offer heating oil and gasoline supply contracts to retailers. The contracts had a term of maturity up to 10 years and the contracts were fixed-price, i.e. they promised to deliver a certain volume at a fixed price upon delivery. The fixed-price contracts, however, were being offered by MG in three forms. Firm-fixed Contracts Firm-flexible Contracts Guaranteed Margin Contracts Firm-fixed Contracts: The firm-fixed contracts -- as the name implies -- were fixed supply contracts. These contracts involved MG delivering a specified volume of heating oil or gasoline during a specified time period for an agreed upon price. Under these contracts the buyer, or MGs customer had to accept the delivery of the oil and purchase it at the specified price every month for the duration of the contract. The term of the delivery was mostly 5-10 years. This, however, has been subject to much debate by the analysts as to how was MG able to determine the creditworthiness of the firm which was obligating itself to buy oil from MG at a certain price within certain time period. Obviously MG appeared to have exposed itself to a credit risk on behalf of their customers. MG never disclosed how the firms qualified to enter into these contracts. However it has been speculated that these firms were able to obtain letters of credit from the bank or use a collateral to qualify to enter into these contracts. The most important aspect of the firm-fixed contracts was the determination of the price by MG. The contract price was calculated on the basis of the prices of the futures contracts expiring within next 12 months. The contract price was simply the average of the futures price plus a fixed premium which was determined by MG. The strange aspect of the pricing formula was the fact that the prices of the contracts was being determined by the same near term futures prices -- regardless of the maturity of the supply contract. It means that the price of the 5-year contract was same as 10-year contract. This formula disregards the time valuation as well as the credit risks of the firms in the long term as compared to the firms who were buying oil in the short run. MG did not offer an explanation or the rationale behind determination of the prices. They also never explained whether the fixed premium should have been different based on the riskiness of the firm in terms of having enough liquidity in order to take the delivery. One of the more attractive feature of these contracts was the fact that many of these contracts included a automatic closeout option. These options allowed the customer firm to close out the contract, if the spot prices rose to or above the contract price. If the spot prices did go above the contract price, the contract could be closed at the contract price. In addition the difference of the nearest month futures price and the contract price

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and multiplied with the volume of the undelivered oil. At the time of closeout, the customer would receive half the amount of the difference and MG would receive the other half. Later, from mid 1993, MG decided to modify the structure of the fixed-firm contracts. MG started to repurchase the automatic closeout options from the oil buyers. Under this modification, now cash settlement would be done as soon as the near month futures prices went above the contract price. The loss of the option to closeout by the firms was being compensated by the new discount co