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Basis Risk As discussed, Metallgesellschaft AG made use of the ‘stack and roll’ hedge strategy. This strategy brought about basis risk, the risk of no direct relationship between movements in the futures market and movements in the longer maturity contract. What Went Wrong? In 1993, oil prices began to plunge because of a bearish market signal. The value of the futures purchased decreased drastically and the market reversed from backwardation to contango. From Backwardation to Contango Another issue, which compounded MG’s problems, was the shift of the oil market from normal backwardation to contango. Refer to Figure I for a better understanding of these concepts. In normal backwardation, the strategy worked fine, however the contango market created losses that were unrecoverable and the longer the market stayed in contango, the losses continued to accumulate on the rollover. Had the market stayed in normal backwardation, MGRM hedging strategy would have been highly profitable, making a gain on all rollovers. MGRM’s main undoing was that the rollover loss was unrecoverable and not offset by another position. Although the contango market was not the only cause for MGRM problems, it did help to compound the cash flow crunch of the company. The main people responsible of such losses will be discussed later. The Company’s advisor, Deutsche Bank, convinced Metallgesellschaft AG to close all positions, taking $1.5 billion in losses, with the aim to prevent additional losses. As can be seen from the Figure II below, Deutsche Bank should have been calmer as the market rebounded with oil prices starting to soar in 1994, an increase of about $8 dollars per barrel in few months. This increase would have highly benefited the MGRM... ...vernance Metallgesellschaft AG should have ensured that the parent company’s traders and MGRM’s employees worked on behalf of the shareholders’ interests. Instead of undertaking a reasonable hedging strategy, Metallgesellschaft AG traders were motivated by big bonuses opportunities, resulting in a more reckless speculative strategy and as a result developing the company into a financial intermediary. Their users, such as employees, creditors, and supervisors, had to fully understand the purpose of the hedging strategy. This was highly important since the hedging program should not be separable from the business strategy. Conclusion To conclude, the main motive of the losses sustained was the minimal study made on the hedging strategy before adoption. Metallgesellschaft AG should have thoroughly analysed the market before entering into such a big hedging program.