From my understanding now, the problem seems to be coming from the fact that MG took such large positions without adequate cash. Contango and backwardation were not the true problems because they were only losing/gaining a little when they would roll over their futures positions. The problem came when Oil prices dropped combined with position size.

The hedge hypothetically worked because the loss on the futures position would be a gain on the forward position. BUT they did not factor in the Margin Call they would face on their Futures positions. Thus they would need to meet the margin requirement with cash that they did not have available. So, the next measure would be to liquidate their futures positions to meet the margin call. Since they were so heavily exposed you can imagine the amount of money they would need to raise to reach their margin requirement and price shock that would occur for selling off such a large position.

I have not ran into any actual pricing on any of these contracts, but I would imagine that the premium they were receiving from the forward was not adequate to cover the cash needed to meet margin requirements. They would also be taking a loss with the swaps they had engaged in as they were paying fixed and receiving variable (which I would assume eat up most of the gain from the Forward Contract premiums).

I think that their position would have worked if they had done it in moderation and have been able to let it run its course over the long run. I really don’t see this as a true Hedge because they are going to face gains and losses (but breaking even doesn’t keep a business going).

Lastly, Yh WU, you had mentioned only buying futures when spot was equal to or higher then the forward price. I think you could really start getting yourself into trouble with Naked positions.

Let’s assume MG’s fixed price was $20.00, the spot prices on the following dates were

$20.00 on 01/01/19xx,
$25.00 on 02/01/19xx,
$20.00 on 03/01/19xx,
$15.00 on 04/01/19xx,
$20.00 on 05/01/19xx,

reflecting oscillations and returning to the mean, and the difference between the one month future and spot price was $1.00 . Let’s also assume MG’s counterparties either cashed in or bought oil at the end of every month.

On 01/01/19xx, the spot price was $20, MG bought one month future price at $21 in contango market.

On 02/01/19xx, according to the contract, MG needed to pay buyer half the difference between spot and fixed price. So MG needed to pay buyer 0.5*(25.00-20.00)=2.5 .
Now the future that MG bought on 01/01/19xx would worth about the spot price. So, MG actually made $25.00-21.00=$4.00 in future. So, on 02/01/19xx, MG’s monthly net earning was 25.00-21.00-0.5*(25.00-20.00) = 1.5 .

On 02/01/19xx, MG bought one month future at price $26.00.

On 03/01/19xx, the spot price dropped to $20. The margin account lost $26.00-20.00=6.00. MG also bought oil from market at spot price and sold it to buyers. So, on 03/01/19xx, the monthly net earning was 20.00-26.00+20.00-20.00 = -6.0.

On 03/01/19xx, MG bought one month future price at $21.

On 04/01/19xx, the spot price dropped to $15.00. MG lost 21-15 =6 in future. MG also bought oil at $15.00 and sold it to buyer at $20.00 and made $20-15=$5.00. So, on 04/01/19xx, the monthly net earning was 15.00-21.00 + 20.00 – 15.00 = -1.0.

On 04/01/19xx, MG bought one month future price at $16.00.

On 05/01/19xx, the spot price was $20.00, MG made $20-16=$4 in future. MG also bought oil at spot price $20.00 and sold it to the buyers at $20.00. So on 05/01/19xx, the monthly net earning was 20.00 – 16.00 + 20.00 -20.00 = 4.00.

So, at the end of the price wave circle, MG’s 4 month net earning was 1.5-6-1+4=-1.5 .

If during the next circle the market was backwardation, the situation would be totally different. Suppose the difference was still $1, but the future price was lower, then

For month 5, MG’s net earning would have been 25-19 – 0.5*(25-20) = 3.5 .
For month 6, 20-24+20-20= -4.0
For month 7, 15-19 + 20 -15 = 1.0
For month 8, 20-14+20-20 = 6.0

So, at the end of the circle, the 4 month net earning would be 3.5 – 4.0 + 1.0 + 6.0 = 6.5 .

If during the following circle, future prices were equal to the spot prices, MG would have made $2.5 for the 4 month.

At the end of the first year, MG’s first year earning would have been

-1.5 (contango) + 6.5 (backwardation) + 2.5 (spot) = 7.5 .

So, on paper, MG was in a very good position. The problem was that the buyers would cash in when the spot price was higher than the fixed price. But they wouldn’t buy when the spot price was lower because the contract was too long. So those 20.00 – 15.00 never realized. When those future profits are taken out of the equations, the 4-month net earnings are -6.5 for contango, 1.5 for backwardation and -2.5 for spot. In case the difference between the future and spot prices is $0.5 instead of $1.0, those net earning are -4.5 for contango, -0.5 for backwardation, and -2.5 for spot.

So, the problem was not contango or backwardation, it was that buyer would not buy. The contract was simply too long.

I wonder what if MG had only bought futures when the spot price was equal or higher than the fixed price.