Peter C. Fusaro
Global Change Associates
New York City
Dr. Gary M. Vasey
UtiliPoint International
Houston
The world of hedge funds is highly secretive and largely unregulated, which makes it difficult to get a clear and true measure of just how significant an impact they will have on energy markets and energy prices. However, based on our extensive research and what we now know, we believe the entry of hedge funds into the energy trading sector will create a sea change in energy trading markets.
Take global oil markets as an example. To date, most energy hedge funds are located in the United States and the United Kingdom and are primarily concerned with oil trading activity in those two countries. These funds have barely touched the surface in internationally traded oil. Hedge funds are currently being formed that are targeting oil markets in Europe and Asia. They are being fueled by pension funds and institutional investors seeking greater returns on their investments.
A new commodity index developed specifically for energy hedge funds will be launched early in 2005, according to our sources. This will further catalyze more hedge fund energy trading.
Increased price volatility
Energy commodities are attractive to the funds because of sustained price volatility. The funds generally are trend followers, but they are also primarily financial traders. More and more are now entering energy attracted by rising prices and price volatilities as other commodity markets, such as the agricultural and metal commodity markets, crest.
The funds tend to follow one another to the next hot market, and as a result, they will exacerbate price movements for oil, gas and coal for the foreseeable future. The funds' activities will hasten the financialization of energy markets, which were badly crippled by the demise of Houston-based Enron Corp. and the merchant power segment over the past three years. That is, energy markets will begin to change from predominantly physical trading to predominantly financial (paper) trading in futures and other instruments. Most mature commodities markets trade paper at approximately a 6:1 ratio to physicals, but this has not yet happened in energy trading.
The true total impact of the hedge funds' energy trading activities do not show up that well in the US Commodities Futures Trading Commission data (the CFTC is the federal regulatory agency that monitors the New York Mercantile Exchange). Since many hedge funds trade through the banks, it is difficult to disaggregate CFTC data sufficiently. However, according to the commission's September 2004 reports, there were 688,084 crude oil futures contracts outstanding, with 128,187 in long positions for the purchase of oil in non-commercial interests that include the hedge funds. The non-commercials basically bet on higher prices and accounted for 32.4 percent of all oil futures bets.
While the CFTC reports show futures and options positions on the NYMEX, they do not reflect the OTC energy markets at all. This is still where most oil and gas trading takes place. Futures dominate short-term trading, while the OTC markets dominate the long-term energy markets.
While the NYMEX is setting records on its trading floor, the OTC markets are also exploding in trading volume. The best indicator is the increased trading activity on NYMEX's Clearport, the exchange's clearinghouse for OTC transactions. The volume of off-exchange transactions cleared at the exchange through September 17, 2004, has totaled 8,217,901 contracts for crude oil, refined products, natural gas, electricity and coal. This compares with 4,226,238 contracts cleared through a comparable period in 2003 and the 6,004,276 contracts cleared during all of 2003. Inspection of other exchange data supports this evidence.
The hedge funds also bring in new risk capital, which stimulates trading liquidity due to increased price volatility for oil, gas and coal. This will also bring a different kind of trading acumen to the fore. We expect that electric and gas utilities will be increasingly marginalized in the new era of deep-pocket energy traders by multinational oil companies, investment banks and energy hedge funds.
This new millennium of energy trading will require trading acumen, credit worthiness and risk-taking – the likes of which we have never seen before. It is also causing grousing at more traditional oil trading and futures operations that do not like the rise in price volatility and adapting to these new market dynamics.
Many existing trading enterprises are reluctant to change their trading style and practices, but they have no choice. The funds are here to stay, and market participants must be able to play the redesigned game.
The nonsense of NYMEX floor traders saying, "The [hedge] funds are in," then later saying, "The funds are out," – also echoed by many energy journalists – is in the past. The new trading credo will be adapt or die. This is a structural change in energy trading that is just beginning.
Quite ironically, we are now also experiencing a sustained bull market in oil, gas and coal markets, the likes of which haven't been seen since the 1973-1974 oil embargo, which impacted mostly the oil markets.
The increased price volatility in oil is also causing an uptick in the emissions trading market, which has been unexpected. The well-talked-about multi-commodity market is finally emerging.
Back to basics
The market fundamentals in the energy complex are of increasing supply tightness in oil and gas production and refining capacity, coupled with robust demand that will continue next year. 2004 has become the prelude to 2005. Next year's energy markets promise to be even more volatile.
The reasons are geopolitical. There has been a sustained lack of investment in the upstream productive capacity by the Organization of Petroleum Exporting Countries (OPEC) over the past 20 years. And the oil majors "won't be fooled again," as they were in the previous price collapses. More geared by Wall Street performance, they are not stepping up drilling this time around and will collect their checks as prices continue to appreciate. They make their money by maintaining business as usual and by acquiring reserves in the ground. 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 – namely, that the lack of new investment except on the part of some independent drillers will not be sufficient to quench demand.
Led by the United States and China, oil demand promises more of the same. This supply tightness – not an actual shortage – is what many people are missing while they hide behind the weekly API or DOE inventory statistics as an explanation of what is now occurring in oil and gas markets on the NYMEX. We are in a sustained bull market for energy and will be for many more years.
Ironically, there has been no "conservation effect" with these record-breaking high prices, as there was during the 1970s embargo. We still drive our SUVs, fly in airplanes for business and pleasure, and heat and cool our homes in the most inefficient ways possible. This energy crisis is not going away anytime soon, and the hedge funds have arrived at our door.
Although hedge funds have been blamed in some quarters for adding a premium to energy prices as a result of their speculative activities, we believe that it is the tightness of supply, coupled with the current uncertain geopolitical climate, that is largely to blame for rising prices.
The hedge fund managers are good at spotting macro trends to follow, and this is certainly one on which they can capitalize. In fact, some of the recent price volatility may be causing the funds to look farther out in the futures markets to take positions in 2005 and 2006, where volatilities are low but expectations are for higher prices (Figure 1).
Fund activity increases
There are many more funds forming throughout the world to take advantage of continuous price volatility driven by supply tightness and higher-than-expected demand. Traditional energy companies are either exiting or becoming further marginalized by these activities.
Energy funds are not just playing in the commodities markets either. Attracted by the energy complex situation, hedge funds are active in energy equities, acquiring interests in energy industry assets, both distressed and non-distressed, and in the physical commodity markets themselves.
While the larger macro funds are generally following the trend into energy commodities, a number of ex-energy traders are also setting up funds that are focused on trading in physical natural gas, coal and even electric power.
The performance statistics of many of the hedge funds involved in energy are quite spectacular. For example, BP Capital, led by T. Boone Pickens, is reported to have had about a 240 percent return so far in 2004 from its energy commodity speculative activities, and the AAA Energy Fund has gained 40 percent after losing ground last year. These types of returns are attracting others to follow suit and in large numbers.
On the other hand, many of these funds do not actually understand the specific of the energy industry, and though they have sophisticated tools and models, there remains a very real danger that this lack of energy knowledge and modeling will result in additional market fallout at some stage in the near future.
The authors
Peter C. Fusaro [[email protected]] is chairman and founder of Global Change Associates, a New York-based energy and environmental consultancy. He is recognized as an international expert on energy and environmental price risk management, industry restructuring, energy security and the Asia Pacific region. He has two new books – Green Trading: Commercial Opportunities for the Environment (October 2003) and Energy Hedging in Asia (Palgrave Macmillan, 2004). He has written four books on energy trading and risk management, including the New York Times best-seller, What Went Wrong at Enron (John Wiley, July 2002); Energy Convergence: The Beginning of the Multicommodity Market (John Wiley, May 2002); Energy Derivatives: Trading Emerging Markets (Energy Publishing, 2000); and Energy Risk Management (McGraw Hill, 1998). A frequent speaker at energy conferences worldwide, Fusaro holds a bachelors degree from Carnegie Mellon University in Pittsburgh and a master's degree in international relations from Tufts University, Medford, Massachusetts.
Gary D. Vasey [[email protected]] serves as vice president for UtiliPoint International's trading and risk management practice. He has industry experience with BP Exploration, Price Waterhouse, Cap Gemini Sogeti, Sybase Inc. and TransEnergy Management Inc. He has worked as an energy industry software end-user, consultant, implementer, creator and seller. He specializes in energy trading and risk management business processes, software and technology, while maintaining an interest in production, midstream, pipeline, refining and marketing, and environmental, health and safety issues, software and technologies. His consulting company, VasMark Group, was acquired by UtiliPoint International in January 2004. A frequent speaker at energy conferences and a published author, Vasey holds a bachelors degree (with honors) in geological sciences from Aston University in Birmingham, England, and a Ph.D. in geology from the University of Strathclyde, in Glasgow, Scotland.
