This article will present two forces responsible for driving the surge in the number of hedge funds trading energy, an outline of some of the entry barriers to starting and investing in an energy hedge fund, and a checklist of things investors should know before investing in energy hedge funds.

In 2003, there were less than 10 hedge funds trading energy. In 2005 there are over 120 and the number is expected to trend increasingly upward in 2006. Why the surge in hedge funds trading energy? One reason is the number of available talented traders that have come on the market as a result of nine energy merchants going out of business since 2003. This has created a labor shock in terms of the number of traders starting or joining hedge funds.

Chart 1: NYMEX ClearPort Trading Volumes For the six months ended June 30

Another significant factor facilitating the increase in the number of hedge funds is the advent of NYMEX ClearPort. ClearPort allows hedge funds to trade bilaterally with banks by having the contracts cleared through NYMEX. Why is this significant? ClearPort reduces the capital barrier to trading with multiple counterparties. Consequently, volumes for hedge funds have exploded and, as such, the opportunities to make money trading energy.
 

Entry Barriers for Starting and Investing in an Energy Hedge Fund

There are a number of entry barriers to hedge fund investing. For reasons that will be explained in this article, energy markets do not behave like commodity markets and are notoriously opaque and complex. The domain expertise needed to successfully run an energy hedge fundis different, for example, than trading equities, and remains a significant challenge for new market participants.

Another barrier is the inability or unwillingness of a hedge fund manager to construct a portfolio of diverse investments if the hedge fund is single strategy. Since a hedge fund with a single strategy has a finite capacity for investment, capacity being a function of a particular strategy, a hedge fund may resist excess funding or over capacity if there is a dearth of alternative strategies which can be employed.

Investors also need to verify the track records of the hedge fund manager. If the manger came from a bank, for example, did the PnL come from order flow or trading strategies? Was the PnL benchmarked on the amount of risk they were taking? It is important to understand returns relative to the amount of capital and not just absolute numbers as indicators of performance.

In terms of operations, does the hedge fund have the right domain expertise in the form of commodity specific risk management best practices, e.g. valuation, Value at Risk, market data and operational risk? Does the hedge fund have the right models and controls in place to provide transparency and auditability of its trading positions and operations? Many don't.

What You Need to Know Before Investing in Energy

There are four fundamental attributes of energy markets investors need to know before investing in energy:

1. Valuation is more challenging
2. Data is less transparent
3. Energy is more volatile
4. Trades are more operationally complex

Valuation is more challenging

There are two unique attributes of energy markets, seasonality and mean reversion, which create an analytical challenge for hedge funds valuing contracts. Models used for other markets such as equities will not work for energy markets. Another layer of complexity, present in every energy market is the fact that a wide variety of events can give rise to a significant amount of volatility in the short term market, even if a short term price exhibits mean-reversion towards a long term price, as energy markets do. Traditional methods of valuation in equity or fixed-income markets don't capture this dynamic and are not useful in energy markets. The requisite model is one that captures the behavior of a spot price and the long-term price of the underlying commodity.
 

To illustrate the difference in valuation between a single and a multi factor model, consider buying a European call option with the following attributes:
 

• Market: Crude Oil
• Commodity: NYMEX WTI December 07 Future Contract
• Expiration Date: 63006
• Strike: $65.00

Furthermore, unlike cash and carry markets where the forward curve is usually upward sloping, the state of the forward curve of commodity markets is often backwardated. The convenience yield of actually holding a commodity, which leads to the backwardated curve, is a fundamental difference from cash and carry markets.

Chart 2 shows the percentage of observation days spent in a state of backwardation for the following commodities.

Chart 2

(1) The GSCI futures data begins on 29 Jul '92 (2) The Unleaded Gas futures databegins on 4 Dec '84.
(3) The Aluminum futures data begins on 11 Jun '87. Source: Goldman Sachs

Market Data is Less Transparent

A high proportion of energy deals are OTC. Consequently, market data further than a few months into the future is not readily attainable leading to difficulties in valuing a trade or the overall NAV of a hedge fund. The importance of third party independent market data and forward curves in order to provide accurate valuations can not be overstated. Otherwise, your ability to know the NAV of a fund is guesswork.
 

Energy is More Volatile

For the past 15 years, commodity markets have experienced extended periods of oversupply, lowering prices and dampening volatility. Today, a tighter supply and demand balance has increased volatility in commodities as markets oscillate between marginal surpluses and shortages.

Commodities also exhibit "shocks" such as the 1973 Arab oil embargo, the increase of natural gas in the Chicago markets from $1-$2 to $40 in a few days due to pipeline constraints, and, more recently, Hurricane Katrina, which caused unusual price movements between power and natural gas in the US.
 

During all of these "shocks", a few things happen:

1. Historical patterns break down
2. Prices "jump"
3. Historical correlations break, e.g. higher natural gas prices while lower power prices

Example of a Shock: Assume you had a short power and long natural gas position and Katrina hit the US: loss of 2x capital in just three days.

Trades are Operationally More Complex

There are thousands of energy commodities (defined by product or location) and most of them have unique settlement mechanisms, holiday calendars, and OTC averaging conventions. This variety dramatically increases the risk of transaction processing mistakes if any of the particular attributes of a given commodity are incorrect.

In summary, the following is an investor checklist of things that any investor should know before investing in energy hedge funds.

1. Event Risk: stress test for "shocks"
2. P&L Attribution: know how you make and lose money
3. Value at Risk: Non-catastrophic worst case scenario
4. Independent Market Data: ensure your portfolio is valued off a third party independent marks
5. Multifactor Model: capture the mean reversion, backwardation, seasonality
6. Greeks: know your sensitivities to multiple risks
7. Auditable system: ensure that you can capture all the attributes of the commodity transaction – don't let Microsoft fail you

If you are not able to put a "check" next to each item of this list, you're not giving yourself the full benefit of the tools and strategies available today, leaving yourself exposed to the myriad of market and operational risks that have historically challenged energy market participants.

Chart 3