Backwardation in Energy Future Markets: Metallgesellschaft Revisited

Abstract

In this paper, we revisit the debate on the merits of the stack-and-roll hedging strategy employed by Metallgesellschaft's American subsidiary, MGRM. Since the profitability of this hedging strategy depends on whether or not backwardation was the norm in energy futures contracts, we first provide the evidence on backwardation with an updated data set. We then examine the two major risks that such a hedging strategy faces margin call risk due to price declines and contango risk. Based on the data up to 1992, we find that the strategy could be expected to be profitable while the risks were not very high. Based on the updated data (up to 2000), the program's expected profits are smaller but still significant, however, the risks are higher. The probabilities of encountering a similar problem to the one MGRM faced are twice as high with the updated data than with the data up to 1992. In other words, the risk-return pattern of such a strategy is less appealing now than when MGRM implemented its hedging program.