Metallgesellschaft Hedged Correctly and Still Lost a Fortune
A German industrial group's American subsidiary sold long term oil contracts and hedged them with short term futures. The hedge was conceptually sound and the cash flow timing destroyed it.
The Business
The American subsidiary of Metallgesellschaft sold customers contracts to deliver petroleum products at fixed prices over periods extending up to ten years. Customers valued the certainty, and the fixed prices included a margin over prevailing market levels.
Having promised delivery at fixed prices, the firm was exposed to rising oil prices. If oil rose, it would have to buy at high prices to fulfil contracts sold at low ones. Hedging that exposure was correct and necessary.
The Hedge
The difficulty is that liquid futures contracts extend only a limited distance into the future, while the obligations ran for years. There was no ten year futures contract to match the ten year commitment.
The approach used is called stack and roll. Rather than matching each future delivery obligation with a corresponding contract, the firm stacked its entire hedge into near dated futures, then rolled the position forward each month as contracts approached expiry.
The hedge matched the total quantity of oil. It did not match the timing, and in derivatives the timing is the whole problem.
The Two Things That Went Wrong
The first was the direction of the market. Oil prices fell substantially. Because the firm was long futures as a hedge against its short physical position, falling prices produced large losses on the futures leg.
Those losses were offset economically by the fact that its delivery obligations had become cheaper to fulfil. The hedge was doing its job in economic terms. But the offsetting gain was spread over a decade of future deliveries, while the futures losses were realized immediately.
The second problem was the roll. When the futures curve is in contango, meaning later contracts cost more than nearer ones, rolling a long position forward means repeatedly selling a cheaper expiring contract and buying a more expensive later one. Each roll costs money, and over many months in a persistently contangoed market the cumulative drag is substantial.
The Funding Mismatch
This is the core lesson. Futures positions are marked to market daily and losses must be paid in cash immediately. The offsetting economic gain on the physical contracts would arrive gradually over years and generated no cash today.
The firm therefore faced enormous immediate cash demands against a benefit it could not access. That is a funding mismatch, and it kills positions that are economically sound.
The parent company, facing mounting margin calls, ordered the positions liquidated at a loss reported in the region of over a billion dollars. Economists subsequently debated the decision at length, with some arguing the strategy was fundamentally sound and would have recovered had it been funded, and others contending the hedge ratio was inappropriate and the roll costs were never adequately understood.
What to Take From It
Both criticisms can be correct simultaneously. A hedge that matches quantity but not timing carries basis risk, meaning the hedge and the exposure do not move together precisely. And any strategy requiring cash today against a benefit arriving later requires funding capacity to match its horizon.
Before entering a hedge, the question is not only whether it offsets the exposure but whether you can fund the worst plausible interim path.
The Bottom Line
Metallgesellschaft hedged the right quantity on the wrong schedule, and the daily cash demands arrived years before the offsetting benefit. A hedge you cannot fund is not a hedge.