MG case study
I. What was the business model for MG? What were they trying to do?
MG is a traditional metal company. Last four years, it has evolved into a provider of risk management services. MGRW is one of its subsidiaries in “Energy Group” and is in charge of refining and marketing petroleum products in the U.S.
MGRM committed to sell certain amounts of petrolun every month for as long as 10 years at fixed prices which were set in 1992. The futures contracts MGRM used to hedge were the unleaded gasoline and the No. 2 heating oil. They used a “stack” hedging strategy, which placed the whole hedge in short-dated delivery months because of sell-back options. MGRM also longed some West ...view middle of the document...
III. What risks were they taking on? What could go wrong? What went wrong?
First, MG was exposed to funding risk. When the price of oil went down, MG lost money for taking the long position in futures, while the value of their forward contracts actually increased. It seems that their gain in the forward contracts would offset their loss in future market. However, the problem was that the loss in their hedge position led to margin calls. Although they made money on forward contracts, no cash would be received till the exercise on the contracts. Therefore, they met a problem cash flow and ultimately cannot meet the margin calls.
Second, MG had the basis risk. MG entered into many forward contracts with different maturities. The mismatches in maturity resulted in basis risk.
MG also faced reporting risk because of Germany’s different accounting methodologies. According to Germany’s accounting standards, MG was required to record the current losses in hedging but cannot recognize the gains in forward contracts. Finally, their income statement became terrible and negatively affected their credit rating and increased their capital requirement to maintain the position.
The above risks exposed MG to dangers. What actually happened is as follows:
MG took long position in futures therefore faced risk of rising price of oil. In order to hedge this risk away, MG used the stacked hedging strategy, but unfortunately, the price of oil went down and caused problem in liquidity. It turned out that MG lacked enough funds to keep their position, which was one of the main causes of their financial distress.
Moreover, oil market is normally a backwardation market....