Energy Hedge Funds

Why have they appeared now?

Peter C. Fusaro & Dr. Gary M. Vasey, The Energy Hedge Fund Center

Until 2004, most hedge funds had steered clear of the energy sector largely because commodities were an asset class not very well known to investors. Today, hedge funds trade crude oil, petroleum products, natural gas, physical and financial power, coal, emissions and renewable energy. They are also active in distressed generation and other energy industry physical assets and both equity and debt for energy companies. Some are even extending their platform into carbon and renewable energy trading. Across these different sub-strategies there are over 400 hedge funds globally that are dedicated to energy, and this total continues to grow.

What is attractive about energy?

To put this in some context, there are more than 8,100 hedge funds globally managing over $1 trillion in assets today. Energy is still a relatively small but rapidly growing component of the universe. There are many factors responsible for this change in hedge fund strategy. For one thing, traditional equity returns continue to be marginal and hedge funds are not making the kinds of returns they were.

There is a flood of new money coming into the energy hedge fund arena while investors are pulling investments from other sectors of the hedge fund universe. The energy complex has shown higher prices, rising volatility and greater trading volumes. It is attractive to investors.

Hedge funds however are a double-edged sword for energy markets. While they have provided some of the needed market liquidity that was lost through the demise of Enron and energy merchants in general, they are also bringing greater intra-day price volatility to oil and gas markets. Additionally, managers are often trend followers, and they trade the Goldman Sachs Commodity Index with 'black box' models in that manner, and often tend to be long. That's great for as long as oil prices keep rallying. The question is, will they head for the exits when prices fall? Only time will tell as over $40 billion now trades the Goldman index.

From our research, we have seen a marked increase in both energy futures trading and OTC trading via NYMEX's Clearport trading platform. The fundamental factors of oil supply tightness this year and next promise to bring even more volatility. These market fundamentals in the energy complex are – continued supply tightness in oil and gas production and refining capacity, coupled with robust demand through 2005 and probably extending into 2006.

Energy markets promise to continue to be more volatile than ever before. One reason for this is the sustained lack of investment in the upstream productive capacity by OPEC over the past 20 years as well as a hesitancy by the oil majors to invest because they have been burned by prior oil price collapses. This time they are reluctant to step-up with new drilling programs and instead are collecting their rent cheques as prices continue to appreciate. They make money by maintaining a business-as-usual approach, as evidenced by their highest profits ever, and their status quo investment programs for more production. Rather than using profits to expand exploration and production budgets, many are returning the money to their shareholders through increased dividends or stock buy-backs. Expect more great quarters for the majors and a rise in their stock prices. Many securities analysts have been slow to grasp this fundamental change i.e. the lack of new investment, except for some independent drillers whose activities are unlikely to do much to quench the increased demand. Led by the US and China once again, oil demand promises more of the same in 2006.

Due to these market driven factors, the funds are scaling up their oil trading operations particularly in Europe and Asia, as well as in North America. In the US, the latest play by the investment banks and hedge funds is to buy physical oil and gas reserves in the ground. This action has not only pushed out the forward curve and created greater open interest in the back months on the NYMEX WTI contract, but also suggests that higher prices through 2010 are to be the order of the day. What our research has also demonstrated is that hedge funds are now investing in the energy complex in growing numbers and with a longer-term viewpoint. They are, and always have been, involved in distressed asset securities – both debt and equity – but increasingly now they seem to be taking a longer-term view with respect to these investments. This has been evidenced by the funds flexing their shareholder muscle at British Energy, Aquila and in other situations. Buying oil and gas reserves in the ground is just part of a picture in which hedge funds are acquiring assets across the energy value chain in the upstream, midstream and downstream energy sectors.

The global oil markets have not yet reached a new plateau in oil prices. The majors have been slow to react to this phenomenon, but are now studying the longer-term price impacts. Another factor that has brought hesitancy to stepping-up oil and gas drilling by major oil companies is that other commodity prices have also increased this year which has increased costs within their exploration and production budgets.

What is different this time in the energy complex is that the entire sector is benefiting from higher prices. We see higher prices in the upstream, downstream oil and gas markets but also a bull market in tankers, storage and every conceivable part of the energy supply chain. That has never happened before. Usually, when the upstream is making money downstream refining is losing money. It wasn't so long ago (only three years) that refining margins were depressed. Today they are extremely robust.

A multiplicity of factors can be seen in oil price formation including supply/demand fundamentals, weather, geopolitical factors, a terrorist premium, and hedge fund and other speculative activity, to name a few. The fact is that higher intra-day price movements will now be the order of the day and oil traders particularly will have to get used to this change. The same is happening in North American gas markets. It has not started in European gas markets yet, but it will as they mature.

The relatively secretive and unregulated nature of the funds and their activities helps to cloud an assessment of their true level of activity. From our continued research through The Energy Hedge Fund Center we are seeing returns that are literally all over the map. Some funds have very good to great returns and then some have experienced poor returns through the first half of this year. Some of the newer funds have already exited the business as they find that investors can be fickle and that strategies pursued in the context of a merchant energy company don't translate so well into a hedge fund context.

Energy commodity focused funds

Many of the existing macro funds pursue long/short commodity strategies taking bets in a variety of markets such as grain, softs, metals and energy. These funds tend to be larger and well established with significant assets under management. Many of them are increasing their exposures as the trend in energy prices is upward, taking long positions. Some of the macro funds engage in playing the spread between commodity markets and equities going long energy commodities and short energy equities. While the amount of money coming into these funds is growing, they are also shifting their investment mix towards a heavier energy component.

Another indirect indicator of hedge fund activity is the formation of energy-specific hedge funds. Ex-energy traders from the merchant sector have set up hedge funds specifically to trade energy commodities. Although most are still relatively small in comparison to the macro, largely commodity-based funds, the new energy hedge funds are actively trading physical energy as well as derivatives, using their prior experience in energy markets to attract investors. Many new energy-specific funds are in formation currently and range in size from $1m to $2 billion. In fact, traders with prior energy experience are now in great demand, with funds and investment banks paying hefty salaries and bonuses.

Most recently, the activity in the energy industry has also attracted the attention of funds of funds. There are now over 20 funds of funds in natural resources and/or energy, and they are bringing increased institutional monies in to the sector.

What is readily apparent from all of this activity is that the fund community now sees the energy complex fundamentals trending to higher prices and that it offers them an attractive sector in which to inflate sagging returns for investors. It is this factor that leads us to believe that the funds are here to stay for the medium-term at least and to suggest that this is not a short-term phenomenon.

There is a school of thought that the funds will enter energy trading and then leave. We don't believe it. The scale and momentum that is now underway is unprecedented and signals a structural change in energy trading itself. The new triangle of trading is energy hedge funds, investment banks and multinational oil companies who have the balance sheet, risk appetite and trading acumen to take energy trading to the next level.

Summary

Today, we only trade $2 trillion in notional value for all energy commodities for all structures, compared to a physical global energy market of $4 trillion and a foreign exchange and government securities market of over $200 trillion. Energy is still at the beginning of its financial market maturation process as commodities usually trade six to twenty times the physical underlying market. This indicates that the energy complex should be trading at least $10 trillion by 2010. The hedge funds will provide much of that trading liquidity but so also will the banks and the energy industry. The energy markets have now re-bounded from the Enron debacle but have surprisingly been rebuilt with a stronger balance sheet and in quite a rapid time period. They are now ready to continue to soar, which will bring both greater risk and greater rewards to investors.

Peter C. Fusaro is best selling author of What Went Wrong at Enron, and co-founder of the Energy Hedge Fund Center (www.energyhedgefunds.com) with Dr. Gary Vasey. Together they advise energy & environmental hedge funds, publish a "Directory of Energy Hedge Funds" and publish their financial newsletter Energy Hedge.