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...And The Flames Singe Castle

International Business


Joseph L. Castle II, chief executive of Castle Energy Corp., has been getting a harrowing crash course in international economics. Based in Radnor, Pa., Castle is 40% owned by Metallgesellschaft. A refiner that produces 126,000 barrels of oil a day, Castle is especially vulnerable to Metallgesellschaft's woes because MG Corp., the German conglomerate's U.S. unit, is Castle's only customer. "We're sort of the other side of what happens to them," says CEO Castle. If Metallgesellschaft collapsed, Castle would have a hard time surviving as an independent company.

Castle has been the vehicle for Metallgesellschaft's grand scheme to break into the U.S. energy market. In an effort to become an integrated U.S. energy company, MG took control of large supplies of oil through Castle and marketed it directly to U.S. companies. At its peak, MG supplied 2% of U.S. oil consumption. MG declined comment.

EXPANSION BINGE. MG's plunge into the U.S. began in 1989, when it agreed to buy into Castle and finance a huge expansion binge. Castle was then a debt-free exploration company largely owned by Joe Castle and his family. By 1993, Castle had bought refineries in Illinois and California. MG then agreed to buy all of their output, guaranteeing a $5-a-barrel margin to the Illinois refinery and an eye-popping $10.20 to the California plant through 1998. Most refiners have recently earned gross margins of only $2 to $4 a barrel.

Why did MG give Castle such a great deal? MG needed to lock up a source of oil to build its retail business, says Joe Castle. And since MG owned a big chunk of Castle and had invested heavily in it, "they would," by paying Castle handsomely for its production, "be largely repaying themselves," says Castle.

MG's management also had an interest in Castle's success. When MG agreed to act as a standby buyer of oil as a backup to one of Castle's supply agreements, some MG managers were personally rewarded with Castle stock.

At the same time, Siegfried K. Hodapp, then president of MG Corp., was carrying out big plans to make MG Corp. a major oil supplier. To lure customers, MG offered unprecedented monthly guarantees. For example, MG Corp. guaranteed delivery of heating oil at low prices, say 55 a gallon, for 10 years. Moreover, if prices rose, the customers had the right to sell all of these now very lucrative contracts back to MG Corp. "There was nothing like it in the size, scope, and length of it," says Castle.

In order to guard against a sharp rise in price, MG had to hedge 10 years, or 120 months worth of obligations with short-term futures contracts, chiefly on the New York Mercantile Exchange. The idea was that MG's futures contracts would gain in value if oil prices rose. This would offset any losses from the long-term guarantees to customers and from losses if customers exercised their right to sell back their contracts to MG.

"STUPID POSITION." The rub was that MG had no hedge against falling prices. Traditionally, a supplier that buys futures to hedge against rising prices is also protected if prices fall. What he loses on the futures contract is offset by the fall in the price of the commodity he must deliver. That only works, though, if the amount of futures matches the amount of the commodity to be delivered. But MG's problem was that it had to buy as many as 120 times as many contracts as it needed to deliver each month to its customers. When prices fell, it gained only a fraction of what it lost in the futures market.

The result: margin call after margin call after margin call. All told, traders say, MG lost about $660 million. In essence, MG was really speculating instead of hedging. "It was a stupid position," says Philip Verleger, senior fellow at the Institute for International Economics.

The job of rescuing MG will fall to Karl M. von der Heyden, the former co-CEO of RJR Nabisco Inc., who replaced Hodapp after his resignation as president of MG Corp. on Dec. 20.

Joe Castle is optimistic that MG will honor its commitments to Castle. But he's not kidding himself. "If they keep [control of] their company, we're profitable," he says. "If they don't, we have a lot of work to do."Leah Nathans Spiro in New York

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