MG Case Specifications

[Priyanka_Chandak23]

Hello, my doubt is with regard to MG's much widely discussed hedging strategy failure.

Although I am aware of their hedging strategy but I would like to ask the meaning of a particular explanation I came across,' MGRM offered the customers contracts to buy fixed amounts of heating oil and gasoline at a fixed price over a 5-or-10 year period. The fixed price was set at $3 to $5 per barrel premium over the average futures price of contracts expiring over the next 12 months. Customers were given the option to exit the contract if the spot price rose above the fixed price in the contract,in which case MGRM would pay the customer half of the difference between the futures and contract price . A customer might exercise this option if she were experiencing financial difficulties. In later contracts the customer could receive the entire difference in exchange for a higher contract price.'

I am not being able to comprehend the meaning of the lines in bold. Why would the customer wish to exit if the spot price rose above the fixed price ? Wouldn't she want to stick to the lower fixed price ? Maybe,the language is ambiguous here but it would be very helpful if someone could help me out with this.

Thanks a ton.

 

[David Harper CFA FRM]

Hi @Priyanka_Chandak23 Although I've read a lot about MGRM, I don't know why exactly they sweetened the long-term price guarantees with an option for cash settlement. My guess would be that their customers, who were generally end-users like downstream (eg, retail) gasoline provider, were generally sensitive to elasticity of demand: if prices increase, demand would decrease and they'd actually want to pay for delivery of fewer gallons than anticipated. If that's true, or even if it's not, it seems like a valuable option to sell to their customers. If you don't have a copy, our Resource section contains Gallati, who was previously assigned to the cases and who has a more extensive review of MG than the current assignment: https://forum.bionicturtle.com/resources/risk-management-and-capital-adequacy.98/

 

[Priyanka_Chandak23]

Thank you so much, David. Although, I am still not being able to comprehend their strategy but I shall refer to the resource link shared by you. Thanks for your time.