mettalgesellschaft case

[Arka Bose]

I was watching Mr Harpers video of the same, he said that the company (when in backwardation) short futures and to hedge against the same, implemented a stack and rollover approach in short term (long position) futures. Thus it was making gains (as it would in a backwardation).

He also said that the hedge was against the price of the oil rising which would mean loss on the short position.

I agree, but I am confused with the relationship of the same with basis risk.
If I am short on futures, then I am long on the basis, and thus if there is a strengthening of basis, the short position will profit, and strengthening of basis means spot price being higher than futures, isnt that contradictory?

I am confused over the link of backwardation/ contango with basis. Please help

 

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Yes, Mettalgesellschaft was short the long-term oil futures and in order to hedge the position they went long the short-term oil futures and applied a stack and roll strategy. Their strategy became insolvent because market went into backwardation, meaning that short-term futures that they have to buy to keep the hedge became more expensive than the long-term futures prices. So, every time they rolled the hedge, their cost went up.

Strengthening of basis does not necessarily mean that spot price > futures price. It means either that, over the life of the hedge:

• Percentage increase in the spot price is more than the percentage increase in the futures price, or
• Percentage decrease in the spot price is less than the percentage decrease in the futures price.

Does this answer your question?

 

[Arka Bose]

Strengthening of basis does not necessarily mean that spot price > futures price. It means either that, over the life of the hedge:

• Percentage increase in the spot price is more than the percentage increase in the futures price, or
• Percentage decrease in the spot price is less than the percentage decrease in the futures price.

Does that mean there has to be a positive correlation?

 

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I have to correct a couple things in my previous post:

Market went from backwardation to contango (futures price > spot price):

They sold oil through selling long-term forward contracts. This means that the company would have to buy oil to deliver at some point so they bought short-term futures contracts to lock-in a price. Thus, their hedge was against the oil price going up. However, oil price declined, meaning that they would be better off buying oil in the spot market. As a result, they had significant cash outflows on this hedge since they stacked the near-term futures.

Their stack-and-roll would only be sustainable if they could endure the cash outflows on the hedge. However, they had to realize the losses on the near-term futures because they were marked-to-market regularly. In contrast, under German accounting rules, they could not realize the profits on their short forward contracts because the tax code did not allow marking-to-market these forward contracts.

Regarding the correlation; yes there has to be a positive correlation (since F0=S0. e^rt and r is always positive) but when the correlation is not perfect due to various reasons (maturity mismatch, different underlying etc.), basis risk arises. This means that the change in futures and spot prices will not be 1-to-1.

 

[Arka Bose]

Thank you very much