It is often stated that the market moving from backwardation to contango finished off MG Refining & Marketing (MGRM), the US oil trading arm of German metals heavyweight Metallgesellschaft (MG), during its annus horribilis of 1993. But even a cursory glance at that year’s price chart also shows the contributory factor that the underlying market fell sharply from $20/bl to $15/bl.
MGRM had to make enormous margin calls to finance its short-dated long futures positions. Moreover, if we believe the firm’s bete noire, its trader Arthur Benson, it had built up considerable excess net length due to his trading strategy, or rather an ill-defined hedge programme (as discussed in part two), that exacerbated the problems.
While MGRM’s deferred shorts remained profitable, margining was not called on over-the-counter trades with their customers that might have offset some of the margining the exchange was asking for. As a result, MGRM had a full-blown liquidity crisis, which many observers shortly after did not view as an outright risk but as a reason for failure.
“Oh, the parent should have sent more money and it would have been OK,” seems a common view from the time. Post the 2008 global financial crisis, liquidity has become one of the first risks we focus on in any commodity business; looking back to the academic papers of the time, there was naivety in thinking about the issue. ‘It will come back’ is not a risk management strategy, which is why so many lousy market positions get worse and worse.
Several other significant issues occurred towards the end of 1993 that helped sound the death knell:
- The market knew how big their positioning was and that MGRM needed help making margin calls. This happens in nearly every squeeze and most frauds as they unravel.
- At the time, German and US accounting principles were different, leading to auditor Arthur Andersen—of later Enron infamy—reporting a profit for the US subsidiary and the German parent a massive loss. This was in September 1993. This confused and upset investors and creditors and caused external sources of liquidity to dry up, making margin payments harder. Banks get spooked when such anomalies become public, and if they have trouble understanding a situation, they halt the flow of credit. This is prudent risk management of their loan books, if harsh on their erstwhile borrower.
- MGRM fell afoul of regulator the Commodity Futures Trading Commission and the Nymex exchange. The full extent of their regulatory issues would cover a book, but in a nutshell, margins went up, hastening the death spiral MGRM was now in. Similar things occurred at the end of the Hunt silver debacle, culminating in ‘Silver Thursday’, when silver prices dropped precipitously, forcing the Hunts to liquidate and bankrupt themselves.
US exchanges are nearly always on the ball. In 1996, the Comex metals exchange also sounded warning bells on Hamanaka and the copper markets as it correctly observed that, as its stocks drew, its market was backwardated. But, as London stocks drew, the market there grew in contango. It was a clue as to what the metal was being used for—or was not, as it transpired.
When the full extent of the liquidity crisis became known, MG sacked trader Arthur Benson and his team and installed new management. Together with a new CEO and chairman, they immediately liquidated the futures positions—because they were causing the biggest margining headaches—locking in losses to the tune of $1.3bn.
Group of 30
When researching this event, I found a reference to the ‘Group of 30’ derivatives report. It was published in July 1993. I read it, and I think everyone working in commodities today should read it. It has 24 significant recommendations for those engaged in derivatives trading.
The very first recommendation concerns the role of senior management. Dealers and end-users should use derivatives consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market circumstances change.
Policies governing derivatives use should be clearly defined, including the purposes for which these transactions are to be undertaken. Senior management should approve procedures and controls to implement these policies, and administration at all levels should enforce them.
Boards of directors are not supposed to be directly involved in companies' operations. Instead, they protect shareholders by ensuring that the right talent is employed and that early warning systems are in place to identify risks and catch exposures before they become too large. Unfortunately, such systems do not appear to have been in place, and on these grounds, MG’s board should be criticised.
Brink of ruin
The board can also be blamed for its knee-jerk response to the MGRM problem once it became known. The CEO and four other members of MG's management board were fired by chairman Ronaldo Schmitz, who brought in corporate rescuer Kajo Neukirchen to save the company from what would have been Germany's largest post-Second World War bankruptcy. He quickly pulled together a $2bn bank bailout working with over 150 banks.
He then began a $1.63bn cost-cutting programme that included slashing 7,500 jobs and cutting inventory and materials. Neukirchen also started in 1994 to sell off non-core businesses, hoping to raise $600mn in the process.
A former founder of bank Morgan Stanley’s commodity trading operation Nancy Kropp Galdy, who had five years prior supervised the bailout of another German metals conglomerate, Kloeckner & Co., from losses in oil trading, was asked by Deutsche Bank and MG’s chairman to oversee the termination of most of the oil positions. The New York Times published several 1994 articles about her and her excellent work.
MG suffered another considerable loss—of DEM2.63bn—in the 1993–94 fiscal year. By early 1996, however, Neukirchen could boast of having returned a much-smaller MG to modest profitability in the 1994–95 fiscal year—DEM118mn in net income on revenue of DEM17.64bn (down from the peak of DEM26.09bn in 1992–93). Moreover, nearly all of the bailout money had by then been paid back; MG was able in mid-1995 to secure DEM1.26bn in new credit, providing flexibility for future initiatives.
Having already abandoned the fixed-priced contracts that had led MG to the brink of ruin, the company completely exited the US oil marketing business early in 1996. In early 1994, Arthur Benson filed a $500mn suit against the MG board and Deutsche Bank; however, in 1996, an arbitration panel ruled in favour of MG. As a result, the firm is now part of the GEA conglomerate, mainly focused on food and beverages.
MGRM built up substantial energy price risks while ignoring huge credit and liquidity risks. It needed to understand how its eventual size in the oil markets would also contribute to its downfall.
Today, it would be unthinkable to ignore credit, liquidity and sizing risks. It would also be disingenuous to claim such a strategy was a hedge. Under the post-Dodd-Frank rulemaking on bona fide hedging, MGRM’s hedging strategy would not be considered anything of the sort. It is a risk management strategy at best and, arguably, was outright speculation.
Did Benson understand the implications of his supposed ‘hedging’ strategy? Did he know what could go wrong? Did he know he was just long and was he hoping the market would rally and backwardation would return?
Why did the MG board not take a greater interest in what they were doing? Were there no reports or risk managers internally who could opine on the size and nature of the risk? Margin calls were happening over the second half of 1993; why did no one wake up sooner? Perhaps these are questions that only someone who can utter the immortal words “I was there” can answer. If anyone reading is an insider and knows more, please get in touch—Petroleum Economist and I would be delighted to hear from you.
This is the third in a three-part series on the Metallgesellschaft debacle. The first part, Oil trading’s biggest bust – MG: What started to go wrong? , and the second part, Oil trading’s biggest bust – MG: Enter Arthur Benson, are also available to read for free on the Petroleum Economist site.