German Firm Finds Hedges Can Be Thorny
By Jeffrey Taylor and Allanna Sullivan

01/10/1994 The Wall Street Journal PAGE C1

Metallgesellschaft AG , the big German engineering and metals conglomerate, stunned its shareholders last week by announcing potential losses in energy "derivatives" of nearly $1 billion. Like falling dominoes, the company's losses in these complex, risky instruments have precipitated a wider financial crisis that has pushed the group to the edge of insolvency in a matter of weeks.

It wasn't reckless speculation in derivatives trading that drove the German giant to the brink, people familiar with its activities say. Instead, the losses seem to have stemmed from an ill-starred attempt by MG Corp., Metallgesellschaft's U.S. trading unit, to hedge its business risks as a wholesaler of oil products. An MG spokesman in New York declined to comment.

Derivatives are financial contracts whose values are derived from the price of some underlying asset -- in this case, crude oil and other energy products. At the New York Mercantile Exchange, the largest U.S. energy market, MG held hedging contracts representing billions of dollars of crude oil and oil products, energy traders say. MG arranged additional hedges in the privately traded, "over-the-counter" derivatives market, traders add.

But late last year, falling world energy prices hammered the value of these huge derivatives positions, producing total losses for MG of roughly $660 million, people close to the situation say.

Despite Metallgesellschaft's reputation as a sophisticated trading outfit with massive financial muscle, the resulting financial crisis has been dire: The company's shares have plummeted 50% on the Frankfurt stock exchange from their 1993 high in mid-November; most of the company's top brass was fired abruptly in late December, with the group's former chairman, Heinz Schimmelbusch, targeted Friday for criminal investigation.

On Thursday, Kajo Neukirchen, the turnaround specialist newly named as Metallgesellschaft's chairman, announced a loss for the year ended Sept. 30 of more than $1 billion at current exchange rates -- and another roughly $870 million in potential derivative-related losses still to come. Without an emergency bailout from its banks by Jan. 12, he said, Metallgesellschaft would be insolvent.

How did this come to pass?

Apparently, the saga began 18 months ago, when MG began aggressively marketing gasoline, heating oil and diesel fuel on a long-term, fixed-price basis to oil distributors and marketers, traders say. In an unconventional move to win business, the company even negotiated contracts as long as five to 10 years with individual service stations around the U.S., industry experts say.

By agreeing to buy oil from MG at fixed prices over the years, these companies locked in the supplies they needed at predictable prices. But entering into these agreements subjected MG to a big risk: If oil prices rose, MG would be forced to buy oil at the higher price and deliver it to customers at a loss.

To hedge that risk, traders say, MG used derivatives. For example, on the Nymex, it bought "futures" contracts, committing itself to buy oil at fixed prices in the future. On the private derivatives market, it entered into "swap" contracts, enabling it to receive payments linked to energy-price fluctuations in return for a more stable stream of payments, such as those linked to short-term interest rates.

The idea was that all these derivatives contracts would gain in value if oil prices rose, thus offsetting MG's potential losses in supplying its customers with oil at low fixed prices.

A potential glitch was the mismatch in timing between the payments due from customers -- most of which MG wouldn't receive for years -- and the maturity of MG's Nymex contracts, which extended only a few months into the future, market professionals say. In order to maintain its hedges long-term, MG was obliged to constantly "roll over" its Nymex futures into new contracts as the old ones expired.

Evidently, MG was confident that these rollovers wouldn't be a problem. And indeed, the common belief among derivatives experts is that rolling over energy futures tends to make money, because prices of these contracts often edge up as they age. As a result, a company like MG might expect to eke out small profits by consistently selling its expiring futures and buying new, lower-priced futures to replace them.

Trouble started brewing when other Nymex traders -- aware that MG would have to execute its rollover maneuver each month -- began trading against the company, energy experts say. This helped upset the historical price relationships between expiring futures and longer-term futures, so that MG began losing money, rather than making money, whenever it rolled its hedges. Philip Verleger, senior fellow at the Institute for International Economics in Washington, D.C., estimates that MG may have lost as much as $30 million each time it rolled over its contracts in this way.

Meanwhile, as the number of MG's fixed-price arrangements to sell oil increased, so did the number of derivatives it needed for hedging those operations, exchange traders and others in the energy business say. Eventually, MG's supply commitments grew so large that its hedging needs exceeded limits on the number of contracts it was allowed to purchase at the Nymex, they add.

The exchange sometimes exempts companies from these limits if they have significant risks to hedge. Nachamah Jacobovits, Nymex spokeswoman, won't say whether the exchange granted an exemption in MG's case but says it "isn't uncommon" for a company with substantial supply agreements and legitimate price risk to receive such an exemption. In any case, traders say, MG's Nymex position was far bigger than the exchange's 24,000-contract limit.

MG's hedging operation lumbered along without close scrutiny from its German parent until the price of oil started to drop last September, bankers and traders familiar with the situation say.

Then, the price of West Texas Intermediate, the U.S. benchmark crude oil, began slipping on burgeoning global oil supplies. In November, the Organization of Petroleum Exporting Countries decided not to cut output, causing prices to fall even more sharply, with the price of the benchmark crude tumbling below $14.50 a barrel.

The steep price drop devastated MG's massive derivatives positions, people close to those activities say. The timing mismatch between the hedging costs and MG's oil-wholesaling revenues then set off the chain of cash difficulties that has driven the conglomerate close to collapse, these people add.

At the Nymex, a 20% drop in the value of MG's futures contracts precipitated "margin calls" of $200 million in late 1993, according to people familiar with those trades. (To guarantee that traders make good on their obligations, the Nymex requires them to set aside "margin" money as collateral against their contracts. Margin calls are demands that collateral be increased as potential losses mount.) Besides the Nymex problems, MG also suffered heavy losses in its private derivatives contracts, energy traders say.

Worsening MG's woes, meanwhile, was the fact that some of its customers backed out of their long-term commitments to purchase oil, according to Lawrence Goldstein, president of Petroleum Industry Research Foundation.

While no one knows for sure to what extent the company's big positions have depressed -- and will continue to depress -- oil prices, there's no question that worries about MG have "exacerbated an already bearish market," Mr. Goldstein says.

Mr. Verleger thinks gasoline prices may, in recent weeks, have been depressed by as much as five cents a gallon. And because gasoline prices in the U.S. are linked to futures prices, U.S. refiners may have seen their profits reduced by as much as $200 million, he says.

While Metallgesellschaft apparently hasn't defaulted on its financial obligations to other big energy traders, the turmoil has forced those firms to re-evaluate their approach to that business.

"After this, people will probably be more circumspect about the way they manage credit exposure to each other," says Julian Barrowcliffe, director of global commodity swaps for Merrill Lynch.

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Terence Roth in Frankfurt contributed to this article.