Strategic Corporate Finance: Applications in Valuation and Capital Structure

ERM CASE STUDY: METALLGESELLSCHAFT AG

In 1992, the U.S. subsidiary of Germany’s 14th largest industrial company, Metallgesellschaft (MG), implemented a risk management strategy. With a natural long position in petroleum products, the company hoped to insulate itself from oil price risk. The company agreed to sell specified amounts of petroleum products every month, forward up to 10 years at fixed prices that were higher than current market prices, and then purchased short-term futures to hedge the long-term commitments, otherwise known as a stacked hedging strategy.

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 short-dated stack hedging strategy exposed the company to two significant risks: liquidity risk and credit risk.

Liquidity risk arose because, as oil prices fell and markets were in cantango (spot prices below future prices), losses on the hedges were realized immediately, the offsetting gain was longer dated, and cash flows for margin calls became extraordinarily burdensome. Though the company had unrealized gains on long-term contracts, this hedge tenor mismatch created negative cash flow and a funding crisis emerged in late 1993.

Credit risk arose when the cost of rolling over ...