This hedging theory failed to take into account one detail: when oil prices drop, the gains from the sale of oil are realised in the long-term, but the losses from the energy futures will be realised immediately. Thus, when oil prices dropped, the company faced a cash flow crisis. In December 1993, the company cashed in positions at a loss that totalled more than $1 billion.

MGRM then purchased short-term energy futures to hedge the long-term commitments - a "stack" hedging strategy. The idea was that if oil prices dropped, the hedge would lose money while the fixed-rate position increases in value; if oil prices rose, the hedge gains would offset the losses on the fixed-rate position. While some economists believe that this theory is correct, the problem is that when oil prices drop, the gains from the sale of the oil are realised over the long-term, but the losses on the hedges will be realised immediately as margin calls come in. This creates a negative cash flow, leading to a funding crisis.

This is exactly what happened in late 1993. The cost of rolling over the futures contracts was a staggering $88 million in October and November. In order to cover these costs, MGRM had to obtain funding from its parent organization, Metallgesellschaft (MG). MG management, either not understanding or disagreeing with the strategy, decided to close out the positions to curtail further losses. Thus, in December 1993, the company cashed in its positions at a loss totalling over $1 billion.

There is still disagreement as to whether the marketing strategy was sound. Proponents of the strategy maintain that had MG been able to persevere, they would have made a profit in the long-term and recouped the losses on the futures through profits on the monthly sales of petroleum. However, an auditors' report commissioned by MG shareholders maintained that 59 million barrels worth of the long-term contracts had a negative value of about $12 million, so the value of these contracts could never have offset the losses, even in the long term.

This episode illustrates a concept that can be referred to as "funding risk" - the risk that positions which may be profitable in the long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows. These funding issues interacted with communication problems in the structure of the organisation to create the MGRM fiasco. If proponents of the strategy are correct, then better communication between subsidiary and parent might have persuaded the parent company not to prematurely close out the open positions. If the auditors were correct, then better communication could have led MG to point out the fallacy of the strategy in enough time to prevent such large losses from mounting. In either case, there clearly was a disconnect between two parts of the organisation, a condition that probably made it only a matter of time before problems arose.

1993: Oil prices fall throughout much of the year. Additional long-term contracts are sold to offset the losses on futures positions.

June 1993: According to the auditors' report commissioned by MG's shareholders, MG head Heinz Schimmelbusch is by this point attempting to convince the CFO to reduce MGRM's positions, which amount to 100 million barrels.

December 1993: MG has long positions in energy derivatives totalling 185 million barrels of oil resulting in an immense cash drain. Rolling over the contracts costs $88 million in October and November alone. Mr. Schimmelbusch and other senior MG managers are removed from the board, and contracts are closed out to avoid further losses.

It is management's responsibility to fully understand the key risks in the business

MGRM executives should have foreseen the possibility of large negative cash flows creating a liquidity crisis.

From a financial risk perspective, it is important to assess the interrelationships between market risk, liquidity risk, and basis risk

In the MGRM case, the losses resulted from the confluence of significant market price movements, liquidity issues from cash flow mismatch and concentrated futures positions, and basis risk between the forward and futures prices.

Failure to set limits/boundaries

The positions continued to grow larger even as oil prices fell. By the time the petroleum positions were liquidated, they had grown to equal 85 days worth of the entire output of Kuwait, according to an MG spokesperson.

Failure to listen to warning signals

Schimmelbusch's warning in June apparently went unheeded, as did the cash burn of the rolling over of contracts ($88 million in October and November alone).

Failure of communication