Energy is used in virtually all manufacturing, transportation and distribution; therefore, energy price increases are in effect a tax on all production and transportation. Furthermore, the consumer sector is directly impacted through cost of gasoline, heating, air conditioning, and more. When energy costs go up, discretionary income goes down. It’s not surprising that the energy sector has historically displayed low or negative correlation to the broader stock market. The industry’s high return potential and low correlation characteristics have made it an attractive sector allocation in portfolios.

The high volatility of oil and gas commodity prices has complicated matters and caused even higher volatility of certain energy stocks. This can occur because a company’s earnings can be more volatile than hydrocarbon oil prices. For example, if oil is at $40 per barrel and production costs plus overhead total $20 per barrel, then a 50% drop in the price of oil brings about a 100% drop in profit as operating costs are mostly fixed costs.The commodity price is very volatile itself. The price of oil has touched prices below $10 per barrel and above $35 per barrel in each decade ’73-’82, ’83-’92, ’93-’02. Whenever oil prices hit new highs analysts announced they were moving up forever – they didn’t. After the 1973 Arab oil embargo and the 1974 Iran-Iraq war the consensus was nowhere but up for oil. However, by 1983 energy prices had fallen and the credo for independent oil companies became “stay alive ’til ’85”; then “Chapter 11 in ’87” as oil came back to $9.50 per barrel.

The world has changed but energy prices are still driven by a combination of short and long term factors relating to supply and demand. Dan Yirgen, highly acclaimed author of The Prize: The Epic Quest for Oil, Money and Power, says that with evolving technology a 20% increase in world oil production over the next five years is possible. In addition, current increases in capital expenditures on exploration and development can be expected to increase oil and gas production.

On the other hand, the National Commission on Energy Policy, a group of economists and politicians, studied the effects of a disruption of 4% to the world’s oil supply concluding that a price jump to $160 per barrel would be likely. Oil prices have tripled since late 2001 as a result of faster demand growth than supply. Nevertheless, I expect price cycles and volatility will continue to characterize energy prices.Emerging market demand, the world economy, hurricanes and other natural disasters, reserve depletion, new technology, terrorist activities, OPEC and other factors will all have a bearing on energy production and pricing. Given the unpredictability and potency of these factors we can probably expect price swings and volatility to persist.

Since 2002 incremental demand has exceeded incremental supply and, world consumption has gone from approximately 77 million barrels per day to 84+ million barrels per day pulling up prices and increasing volatility in the process. Indeed the prices of oil and natural gas are balanced on a razor’s edge today. A small shift in supply or demand for energy causes an imbalance that dramatically moves prices. This phenomenon is due to the price inelasticity of both supply and demand in the short and medium term. An increase in price does not bring forth much more oil production because it’s just not available. The same price increase does not discourage much consumption because fuel switching and conservation are limited – people must drive to work and heat their homes.

As the quantity of hydrocarbons consumed has increased, both supply and demand curves have steepened (as in Fig.1). Natural gas has been similar with the spot price for natural gas touching a low of $4.33 and a high of $15.39 in the last 12 months. There have also been unusually large differentials between spot and futures contract pricing. These conditions have wreaked havoc with commodity traders particularly if leverage was involved. In this environment, which is in many ways not so different from the past, hedged equity hedge funds have demonstrated their merit. Of course, we’re not talking about leveraged speculative commodities funds trading oil and gas physical commodities, electricity in the grid, and futures.

That is a much riskier category which from time to time may result in spectacular gains or losses. Such a high profile “blow-up” in the sector recently occurred. Hedged equity generally involves holding positions in energy company equities which are expected to appreciate for fundamental or technical reasons and selling short those companies’ equities which are expected to decline. Sometimes options are bought or sold either to limit risk exposure or increase return potential.

There is considerable room for diversification within the energy sector. Examples of sub-sectors include exploration and production, pipelines, oil refining, gas processing, power generation, contract drilling, oilfield services, tanker operations and others. Several of these sectors tend to be countercyclical to others and have very different investment characteristics.

A look at the performance of one index of energy hedge funds, the HFRI Sector Index: Energy may be useful. The accompanying bar chart shows the annual hedge fund index results in comparison to the S&P 500 Energy Index which is comprised of the energy companies in the S&P 500. It also shows performance in comparison to oil prices as represented by both the West Texas Intermediate Crude Oil price and the CBOE Oil Index. The energy hedge fund index shows superior results in cumulative absolute performance since 2000. This period includes a down cycle for the industry in 2001 and part of 2002. Of course, the comparative benchmarks represent an unmanaged index and an unmanaged commodity price. In certain environments, particularly bull markets, a hedged investment approach may lag long only positions. However, in a declining market the hedged strategy should mitigate losses. In fact, when looking at Fig.2 this is what we observe. The energy hedge fund index outperforms the other benchmarks by the greater amounts when their results are lowest. The strategy has been described as “winning by not losing”.

A positive example of the hedged strategy is demonstrated by considering the performance of the hedge fund index as a percentage of the long only stock index in down months for the stock index and in up months. In fact since January 1995 the HFRI Sector Index: Energy has lost only about half of the average loss of the S&P 500 Energy Index in its losing months (specifically -52.3% of the index). More surprising is that in up months the hedge fund index on average outperformed the long only index with a +106.1% average participation in gaining months for the index.

Perhaps most important in this sector is volatility control. The HFRI Sector Index: Energy has accomplished its results with less monthly volatility over the last five years ended August 2006 with a standard deviation of 11.5% versus 19.1% for the S&P 500 Energy Index, 30.4% for West Texas Intermediate Crude and 17.74% for the CBOE Oil Index.

Given the high return characteristics and low correlation of the energy sector for the economy and capital markets it can be an important investment portfolio component. When one considers the volatility of the sector and its cyclical but hard to predict nature, a hedged approach has undeniable appeal. As tight world supplies serve burgeoning world demand the situation is only exacerbated. Energy hedge funds, as represented by the HFRI Sector Index: Energy have demonstrated reduced loss exposure and significant long term potential. The average annual index return since 1995 has been in excess of 25%. It is up 11.07% through August this year.

Furthermore, energy hedge funds have shown an ability to mitigate volatility while maintaining exposure to this important industry sector. Energy hedge funds are not going to solve the world’s energy problems, but they can address many investors’ concerns when it comes to energy investing.