HEDGE FUNDS DRIVING ENERGY TRADING ACTIVITY

Don Stowers, OGFJ Editor

Improved functionality helps reduce trading risk

High commodity prices have made the energy industry as dynamic as it has been in some time, and the energy trading and risk management (ETRM) sector is no exception. Competition is fierce among energy traders, software vendors, and business and IT consulting companies.

In late 2004, Oil & Gas Financial Journal published an article about the role of hedge funds in petroleum markets and how they had begun to drive energy trading activity. Although physical trading of energy commodities continued out of necessity in the post-Enron era, much speculative trading had dropped precipitously in the wake of the scandal. To many, energy trading had taken on a bad connotation. But this image was soon to change.

By 2004, according to a study by JP Morgan, hedge funds had already begun to take over from the traditional energy marketing companies. In the three years since that article was written, hedge funds have assumed an ever-increasing role in the energy trading arena.

Hedge funds are attracted to energy because of sustained price volatility, and investment methodology and strategy are the primary focus of the portfolio. It is difficult to know how much daily energy trading volume is from hedge funds. The funds often trade through banks, which makes it difficult to disaggregate data sufficiently.

Banks and other financial institutions have led the way in the development and implementation of fundamental risk management principles for highly volatile energy markets. In doing so, they often team up with vendors to develop similar standards for risk management that they traditionally used in the financial markets.

The performance of many of the hedge funds involved in energy has been spectacular. Some funds have reported returns as great as 250% from their speculative activities. Returns of this type are attracting other traders to follow suit.

However, there have been some spectacular collapses as well. Amaranth Advisors, a large hedge fund based in Greenwich, Conn., is a case in point. Last year, a 32-year-old trader for Amaranth began to take gigantic positions in natural gas on the NYMEX exchange and later on the ICE exchange when NYMEX ordered him to reduce his holdings. He traded highly volatile futures contracts and at one point in the summer of 2006 reportedly controlled up to 70% of natural gas commodities on the exchange. Eventually the trader gambled and lost. Prices did not move in the way he had bet. Amaranth lost more than $6 billion and the company had to shut its doors.

It is essential for trading operations to deploy risk mitigation strategies and techniques to help prevent such catastrophic losses. As energy traders recognize the inherent dangers in volatile markets, software vendors have developed solutions to help them in decision making and execution. Real-time decision support has become an important feature in most ETRM packages. This improved functionality helps make energy trading less of a gamble.