Mg Case Study

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 Texas Intermediate sweet crude contracts. MGRM really held a vast amount of swap positions which may have accounted for as much as 110 million barrels of gasoline and heating oil.

II. How did they set up hedges. Provide some details

MGRM sold special forward contracts to its customers and used a "stack" hedging strategy to set up hedges.

MGRM sold special forward contracts to its customers by september1993. If the price of front month NYMEX futures contract was greater than the fixed oil price of MGRM, its customer could end this contracts early. And what is more, MGRM would pay one-half of the total difference which means that the total volume on the contract times the difference of prices, if the counterparties exercised this call option.

To completely hedge their forward contracts, MGRM used stack hedging strategy and tied to the front month futures contract at the NYMEX due to the call option. MGRM entered into OTC energy swap agreements, so MGRM could pay fixed energy prices to go long in the futures by the contracts of unleaded gasoline, the No. 2 heating oil and West Texas Intermediate sweet crude contracts.

Thus, by their hedge strategy, no economic loss would occur because the hedge positions make them lost money when oil prices decreased, but the value of their...