October 13, 2006
Energy Commodity Hedge Funds and Impacts on Energy Markets
By Gary M. Vasey, Ph.D.
Vice President, Europe
The recent well-publicized blow ups of Amaranth and MotherRock have brought the question of energy commodity hedge funds and energy trading back into the spotlight. In the United States there are once again calls for increased regulation and oversight of natural gas markets and questions are being asked about the role of hedge funds in energy markets. There is no doubt that ever-increasing amounts of investor money have surged into energy commodity trading over the last two to three years, but not all of it in the form of hedge funds. "But isn't this a North American phenomena?" you ask. I say, "No, it is not."
Background
The run up in energy commodity prices that, for the time being, has reversed itself, was as much caused by fundamentals as it was by speculation. Twenty years of insufficient investment in energy infrastructure had resulted in a situation where almost all energy commodities from crude oil to Uranium were in supply/demand tightness either globally or regionally. The energy industry can, and has, responded to this situation but it simply takes years if not decades for new investment to translate into oil production, power generation or efficiency gains and during that time Asian and North American demand show no real signs of slowing.
Once in a situation of supply/demand tightness, external events served to heighten anxieties about future supply. These events include terrorism, Middle East tensions, geopolitics such as the Iran stand off and of course, weather events such as last autumn's hurricanes in the Gulf of Mexico. At times, the emphasis on these other factors was such that market sentiment resulted in a disconnection between fundamentals and prices. We saw historical trends evaporate and some unusual market behaviour in response to that sentiment.
At the same time, developments in electronic trading, exchange clearing and, indeed, the launch of a variety of new indices and electronically traded funds reduced the barrier to entry for participants in energy commodity trading. And not just for hedge funds, but also for the average investor who, for the first time, can invest/speculate in energy futures and options without having to use an oil company equity as a proxy.
The New Speculators
In the wake of the collapse of the North American energy merchant sector, there was plenty of experienced trading talent available for hedge funds and investment banks to pick up. Indeed, large multi-strategy funds such as Chicago-based Citadel and Amaranth were among the first to recognize the unique opportunity and hired ex-merchant energy traders quickly. The success of these initial forays into energy trading spurred other funds to enter along with ex-traders themselves who started to form new hedge funds. In 2004 there were maybe 20 or so funds truly trading energy commodities. Today there are at least 120. But it wasn't just the hedge funds that saw the opportunity. The investment banks also hired trading talent and entered energy markets while multi-national oil companies like BP also built up their trading operations.
Initially making money was easy; they simply went long as prices rose in response to fundamentals. Early funds produced large returns exciting investors and imitators alike. But in late 2005, the Gulf of Mexico hurricanes meant that many funds and investment banks got severely burned. Expecting natural gas prices to decline, funds and banks went short natural gas losing money as prices rose in response to production shortfalls after the first hurricane. Some funds and banks stuck with their short positions only to have another hurricane make things worse. Some investment banks were rumored to have lost up to $1 billion each last October.
Earlier this year, prices continued their upward run, but driven by market speculation about geopolitics and other issues. Prices had disconnected from the fundamentals as more and more money poured in to energy commodities. Again betting on historical lines, some funds that had made great returns early in the year doubled up and tripled their positions using leverage. They simply got greedy and apparently forgot that energy is a risky business. The rest is now history. Amaranth lost as much as $6 billion on its natural gas bets and is finished as a hedge fund.
EuropeThe Next Frontier
Meanwhile, over the last 12 months or so, more and more new energy commodity funds have been started in Europe. Primarily in London, Scandinavia and Switzerland, now new funds are being launched in France and the Netherlands, too. Barriers to entry are low in Europe too. Money is even easier to come by using London's Alternative Investment Market (the AIM) or listing on similar exchanges. Electronic trading and exchange consolidation has occurred here too. The number of European funds engaged in trading energy commodities has rapidly increased from a handful to around 30 and more are in formation. U.S.-based funds also have operations in Europe and recently interest in NordPool for example has been high.
Energy MarketsBack to Fundamentals?
In recent weeks, energy markets have appeared to return to price formation based more on fundamentals again. Prices have been choppy and some believe the commodity bull market is over. But is it? My view is that little has changed. The fundamentals still suggest supply/demand tightness in global and regional markets for most energy commodities, hot money continues to pour into energy trading via a number of vehicles including the rising number of hedge funds and Asian demand has yet to show signs of any significant slow down. Add to that the environmental aspect of energy these days that adds costs, complexity and time to infrastructure projects while creating a number of new investment opportunities too. All it takes is some unexpected outside event to start energy prices on an upward track again. All the signs are there to be read. Even the MotherRock and Amaranth closures and losses seem to be half forgotten and by the time this is published may already be out of the news headlines.
Conclusion
There are a number of implications to the entry of speculators into energy markets and I cannot cover them all here. However, for traditional energy commodity traders (i.e., those utilities and other businesses that have to procure and/or provide energy) there are some real issues to consider. First, if energy markets periodically break with fundamentals and historical trends, how do your risk models, tools and metrics stack up in the future? Increased volatility, particularly intraday volatility can have a serious consequence on certain risk metric too essentially invalidating their results. Energy markets are simply more risky than ever and more volatile than ever before. This impacts not just price risk management, but also market price forecasting tools and more not to mention counter-party credit risk.
But, on a final note, if you have already discounted this article as being all about energy financial markets, then think again. Many of the hedge funds and investment banks are involved in physical markets, too. Not all of them use a fundamentally-driven strategy eithersome use quantitative models in both physical and financial markets. As an example, one fund makes small bids on hundreds of electric power nodes in North America and has a track record of winning on 70 percent of its positions, and another is buying and holding yellowcake in storage facilities. The funds are now ubiquitous in energy commodities and their impacts must now be a part of any utility's or energy user's planning.
Energy Commodity Hedge Funds and Impacts on Energy Markets
By Gary M. Vasey, Ph.D.
Vice President, Europe
The recent well-publicized blow ups of Amaranth and MotherRock have brought the question of energy commodity hedge funds and energy trading back into the spotlight. In the United States there are once again calls for increased regulation and oversight of natural gas markets and questions are being asked about the role of hedge funds in energy markets. There is no doubt that ever-increasing amounts of investor money have surged into energy commodity trading over the last two to three years, but not all of it in the form of hedge funds. "But isn't this a North American phenomena?" you ask. I say, "No, it is not."
Background
The run up in energy commodity prices that, for the time being, has reversed itself, was as much caused by fundamentals as it was by speculation. Twenty years of insufficient investment in energy infrastructure had resulted in a situation where almost all energy commodities from crude oil to Uranium were in supply/demand tightness either globally or regionally. The energy industry can, and has, responded to this situation but it simply takes years if not decades for new investment to translate into oil production, power generation or efficiency gains and during that time Asian and North American demand show no real signs of slowing.
Once in a situation of supply/demand tightness, external events served to heighten anxieties about future supply. These events include terrorism, Middle East tensions, geopolitics such as the Iran stand off and of course, weather events such as last autumn's hurricanes in the Gulf of Mexico. At times, the emphasis on these other factors was such that market sentiment resulted in a disconnection between fundamentals and prices. We saw historical trends evaporate and some unusual market behaviour in response to that sentiment.
At the same time, developments in electronic trading, exchange clearing and, indeed, the launch of a variety of new indices and electronically traded funds reduced the barrier to entry for participants in energy commodity trading. And not just for hedge funds, but also for the average investor who, for the first time, can invest/speculate in energy futures and options without having to use an oil company equity as a proxy.
The New Speculators
In the wake of the collapse of the North American energy merchant sector, there was plenty of experienced trading talent available for hedge funds and investment banks to pick up. Indeed, large multi-strategy funds such as Chicago-based Citadel and Amaranth were among the first to recognize the unique opportunity and hired ex-merchant energy traders quickly. The success of these initial forays into energy trading spurred other funds to enter along with ex-traders themselves who started to form new hedge funds. In 2004 there were maybe 20 or so funds truly trading energy commodities. Today there are at least 120. But it wasn't just the hedge funds that saw the opportunity. The investment banks also hired trading talent and entered energy markets while multi-national oil companies like BP also built up their trading operations.
Initially making money was easy; they simply went long as prices rose in response to fundamentals. Early funds produced large returns exciting investors and imitators alike. But in late 2005, the Gulf of Mexico hurricanes meant that many funds and investment banks got severely burned. Expecting natural gas prices to decline, funds and banks went short natural gas losing money as prices rose in response to production shortfalls after the first hurricane. Some funds and banks stuck with their short positions only to have another hurricane make things worse. Some investment banks were rumored to have lost up to $1 billion each last October.
Earlier this year, prices continued their upward run, but driven by market speculation about geopolitics and other issues. Prices had disconnected from the fundamentals as more and more money poured in to energy commodities. Again betting on historical lines, some funds that had made great returns early in the year doubled up and tripled their positions using leverage. They simply got greedy and apparently forgot that energy is a risky business. The rest is now history. Amaranth lost as much as $6 billion on its natural gas bets and is finished as a hedge fund.
EuropeThe Next Frontier
Meanwhile, over the last 12 months or so, more and more new energy commodity funds have been started in Europe. Primarily in London, Scandinavia and Switzerland, now new funds are being launched in France and the Netherlands, too. Barriers to entry are low in Europe too. Money is even easier to come by using London's Alternative Investment Market (the AIM) or listing on similar exchanges. Electronic trading and exchange consolidation has occurred here too. The number of European funds engaged in trading energy commodities has rapidly increased from a handful to around 30 and more are in formation. U.S.-based funds also have operations in Europe and recently interest in NordPool for example has been high.
Energy MarketsBack to Fundamentals?
In recent weeks, energy markets have appeared to return to price formation based more on fundamentals again. Prices have been choppy and some believe the commodity bull market is over. But is it? My view is that little has changed. The fundamentals still suggest supply/demand tightness in global and regional markets for most energy commodities, hot money continues to pour into energy trading via a number of vehicles including the rising number of hedge funds and Asian demand has yet to show signs of any significant slow down. Add to that the environmental aspect of energy these days that adds costs, complexity and time to infrastructure projects while creating a number of new investment opportunities too. All it takes is some unexpected outside event to start energy prices on an upward track again. All the signs are there to be read. Even the MotherRock and Amaranth closures and losses seem to be half forgotten and by the time this is published may already be out of the news headlines.
Conclusion
There are a number of implications to the entry of speculators into energy markets and I cannot cover them all here. However, for traditional energy commodity traders (i.e., those utilities and other businesses that have to procure and/or provide energy) there are some real issues to consider. First, if energy markets periodically break with fundamentals and historical trends, how do your risk models, tools and metrics stack up in the future? Increased volatility, particularly intraday volatility can have a serious consequence on certain risk metric too essentially invalidating their results. Energy markets are simply more risky than ever and more volatile than ever before. This impacts not just price risk management, but also market price forecasting tools and more not to mention counter-party credit risk.
But, on a final note, if you have already discounted this article as being all about energy financial markets, then think again. Many of the hedge funds and investment banks are involved in physical markets, too. Not all of them use a fundamentally-driven strategy eithersome use quantitative models in both physical and financial markets. As an example, one fund makes small bids on hundreds of electric power nodes in North America and has a track record of winning on 70 percent of its positions, and another is buying and holding yellowcake in storage facilities. The funds are now ubiquitous in energy commodities and their impacts must now be a part of any utility's or energy user's planning.
