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Energy Hedge Funds: Market Makers or Market Breakers?

Should utilities and consumers be concerned about these obscure investment groups?
Fortnightly Magazine - April 2006

The total hedge-fund universe currently approaches $1.1 trillion, about 5 percent of which is dedicated exclusively to energy. These numbers for energy hedge funds are likely to grow at unprecedented rates. How can your company benefit?

“Mysterium tremendum et fascinans”: The Latin phrase, coined by German theologian Rudolf Otto, which characterizes humans as being overwhelmed and fascinated by experiences that are totally different from ordinary life. 1

The energy hedge fund sector is booming despite perception of mismanagement, and even outright fraud. The reason? Investors have developed a sudden fascination with, and attraction to, energy hedge funds, sparked by incredible returns.

A handful of investors have enjoyed the benefits of these hedge funds and have not been dissuaded by their deleterious reputations. In an ironic twist of fate, their mystery has served to increase their popularity.

The total hedge fund universe currently approaches $1.1 trillion, 2 out of a global capital market exceeding $30 trillion. Based on our calculations, about 5 percent ($50 billion) of the $1.1 trillion is dedicated exclusively to energy (other sources place this figure at upward of 10 percent). Energy hedge funds are small in number (relative to other sectors) but given the continued worldwide interest in energy and institutional preparedness, these figures are likely to grow at unprecedented rates.

Since 2000, the total number of hedge funds worldwide has more than doubled, going from 3,873 to 8,532 at year-end 2005. Exact dollar figures are hard to determine, but industry sources report that in 2000 roughly $324 billion in assets was under management, compared with today’s estimates of $1.1 trillion.

The explosive desire to invest in energy funds has led to the development of alternative funds, namely “fund-of-funds”—hedge funds that invest in other hedge funds. Fund-of-funds have become one of the fastest growing investment vehicles, based largely on the lower-entry financial requirements.

Sectors Under Management

Average investors, especially those with high wealth, are accustomed to the double-digit returns common in the 1980s, so fund managers aggressively must seek opportunities that well exceed those currently available in traditional stocks and bonds. A typical hedge fund portfolio might consist of:

• Swaps

• Equity volatility

• Emerging markets

• Yield-curve arbitrage

• Merger arbitrage

• Junk bonds & junk bond arbitrage

• S&P 500 stocks

Why are energy hedge funds suddenly so popular? Above-average performance, deregulation initiatives, increasingly unstable energy prices, rapid growth in global energy demand, and strategic withholding of supply. Esoteric products, notably derivatives, emission credits, and power contracts also hold considerable profit potential. Deregulation was thought to yield lower consumer prices and increased profitability, but this never was realized. Regulators disrupted the natural equilibrium of the supply-and-demand curve allowing for market prices to reach equlibrium.

Mutual Fund Envy: More Energy Investors Coming

Several mutual funds recently have developed “hedge

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