Structural changes in energy trading impact hedge funds
The structure of energy trading has changed fundamentally and is impacting energy commodity hedge funds. Changes in the energy markets are leading to significant losses by both hedge funds and investment banks and closure of several energy hedge funds.
Despite that fact, there are still more energy hedge fund launches underway. However, new risk factors are impacting many energy hedge fund strategies. It’s not just higher oil prices but the breakdown of traditional hedging strategies derived from fundamentals, technical charts, weather, seasonality, weakness in the US dollar, and the usual risk factors.
Several experienced fund managers with decades of experience trading the energy commodity complex in oil, natural gas, and electric power have thrown in the towel and shut their funds. Plus, there were major losses in energy markets this past winter as big banks and some hedge funds lost hundreds of millions of dollars shorting natural gas over the winter months. (Incidentally, this past winter’s weather in the US was colder than normal.)
“[Economists have] estimated that over $250 billion is in the [energy] sector compared to $46 billion three years ago. With so much new, dumb money in the sector, we are seeing even more uncertainty and price volatility in daily markets.”– Peter Fusaro
Energy markets have become dysfunctional and the cause is dumb and dumber money from sovereign funds, recycled petrodollars, and other funds moving oil prices up and down the energy commodity complex – much like the stock market. In fact, one established energy trader in London can’t see why there is a correlation between the S&P index and oil, but it exists. Oil goes up, the stock market goes down.
What I think is occurring is big money, algorithmic trading, and more intraday volatility. Some of the energy hedge fund managers can’t deploy enough capital without upsetting their VaR limits. Intraday $5 up and down price moves will do that and are becoming more common. The news has not been spectacular in any direction.
Dumb money moves markets just like electronic trading moves markets. Yes, energy is an asset diversification play and a rapidly financializing market. But energy hedge funds are essentially small businesses without the balance sheet of a big bank, so their performance risk is greater. In effect, they need to manage their risk more conservatively.
Some of the risk factors that are playing out fundamentally have been known for a long time. For example, the Saudis won’t up their oil production to 15 million b/d anytime soon. Also, Russian oil production is on the decline because the Russians played hardball with the majors and forced their expertise out of their country.
Hedge funds and other speculative buying are fueling both energy and agricultural complexes. The entire commodity complex is in hyper market status. Food prices are also marching to historic highs as rising fossil fuel costs on fuel and fertilizer, coupled with the global biofuels fiasco, drive all agricultural commodities through the roof. Corn and sugar biofuels are not a panacea, and next-generation biofuels are still a science experiment and not commercial.
Sugar futures have been on an upward trend line since December 2007. Rice is being allocated in the United States for the first time ever. And Australia’s wheat and rice exports are dropping with seven years of drought impacting storage probably due to climate change.
The Russian oil and gas czars have clearly overplayed their hand. Gazprom heavy handedness is pushing the European Union to look for alternatives like a nuclear power plant in Finland. Russia as “The OPEC of Gas” is a long way from being a reality. Oil companies such as BP, Exxon Mobil, and Shell have been beaten up by the Russian oil barons, whose tax regime and nationalization program of private assets is a disincentive to invest. Access to new fields is problematic; the new Russian law wants 51% Russian ownership. The consequences are a projected decline in oil production this year, and not so bright a future going forward.
Russia, the second-largest oil producer in the world, is not the only big oil producer on the decline. Production in Venezuela and Nigeria is also on the wane. And, while Shell touts that it has 55 years of oil reserves, that is not available for the market today. Market prices continue to signal tight supply.
While academic research [including Energy and Environmental Hedge Funds: The New Investment Paradigm by Fusaro and Vasey, 2006] suggests that commodities are not correlated to other asset classes, commodity futures seem to be following performance chasing and that has lead to momentum chasers entering this asset class. The momentum chasers, in effect, have given the energy and agricultural commodity sectors its own momentum.
Besides pension funds and macro hedge funds, there is also the effect of a new breed of exchange-traded notes backed by commodity futures. Moreover, commodities are playing their traditional role as a hedge against inflation. The outcome of all these trends is that cash has poured in.
How much? No one seems to know. I said last fall in our publication, Energy Hedge, that it is was at least 20 times NYMEX and that was over eight months ago.
Phil Verleger, the best energy economist tracking this money flow, has estimated that over $250 billion is in the sector compared to $46 billion three years ago. With so much new, dumb money in the sector, we are seeing even more uncertainty and price volatility in daily markets.
Besides the basic litany of supply/demand, weather, weakness of the dollar, and fundamental factors that are well known, it seems that the impact of this wall of new money from fund managers, controlled by people new to the commodity world, is passive. Verleger thinks that has given index compliers passive power over oil producers.
The natural state of oil markets is “backwardation” with forward month prices below the underlying spot month. In that way, producers use the spot market futures as its hedge. However, because low inventories and backwardation are correlated with higher commodity futures returns, they are likely to attract more interest from institutional investors. But the dumb money has caused the opposite effect. The markets are in a long “contango,” which means the forward month prices are higher than the spot. This impacts producers as they are encouraged to stockpile oil and carry large inventories.
The impact on prices is that the index money caused prices to diverge from market fundamentals until index rule changes eliminated the contango. How long this will last is anybody’s guess, but oil prices seem to be marching to higher highs.
Increased demand for commodity futures has also impacted supply. That is, if prices are high now producers are less interested in selling forward and carrying oil in storage. This creates a situation where producers offer fewer futures contracts, which drives up demand and prices spiral upward, according to Verleger.
The big questions going forward are:
- What will be the impact of all this new investment demand on world prices for oil and food?
- And will the commodities bubble burst?
It is too soon to know. Silver in the late 1970s went from $5 to $50 per ounce and then collapsed when the Hunt Brothers tried to squeeze the market. So, oil can hit $150 pretty easily, or even $200 as Goldman Sachs has speculated. Recent economic analyses suggest that oil is 6.6% of US GDP compared to 8% of GDP in 1980 even with 20% of new car sales being small cars and signs of lower gasoline demand in the US.
But the global oil markets, particularly in Asia, will pick up that slack in demand. Asians are now buying bigger cars and SUVs as status symbols, just as Americans have for decades. This will offset any decline in demand for these gas-guzzlers stateside.
Stay tuned, as it looks like we will have a bumpy ride going forward. It’s a hard time for energy hedge fund managers in this unknown and uncertain energy environment.
About the author
Peter C. Fusaro [[email protected]] is co-founder of the Energy Hedge Funds Center in New York. He is the author of What Went Wrong at Enron and is well-versed on emerging energy and environmental issues. He has more than 30 years’ experience in the global energy industry.