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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

fund envy” and have petitioned the Securities and Exchange Commission (SEC) to liberalize their charters and emulate hedge-fund investment practices. Since mutual funds currently are faced with historically low stock-and-bond market returns, the competitive need to expand portfolio options is vital to maintaining existing and attracting new money. So important is the need to jump-start the business that firms are seeking approval to revise policies relating to:

• Use of derivatives

• Short selling

• Buying on margin

• Owning illiquid securities

Despite the demise of Enron, the Iraqi war and other geo-political events, energy hedge funds have positioned themselves where others (including “big oil”) have feared to tread. Traditional energy corporations continue to restrict or completely avoid cash expenditures, dissuaded by erratic political uncertainty, energy policies, and unpredictable character, particularly relative to the risk/reward profile of other industries.

Hedge funds have avoided the new capital raised by energy companies, have limited their activity in the secondary market trading of these securities. Energy companies have offered comparitively modest returns, thereby discouraging aggressive investors. Fund managers prefer “special situations” that may include distressed companies, emerging markets, fixed- income securities, long/short equity, relative value, and various arbitrage positions. Until recently, energy has not fit the special situation criteria and, as a result, has represented only a small percentage of the fund universe.

Today the energy field is radically attracting money managers, many of whom lost their jobs in the 2000-2003 shakout. Some traders have formed their own hedge funds. In 2002 John Arnold, Enron’s former star trader, established Centaurus, with $8 million in seed capital. Today Centaurus has $1.5 billion in assets under management. Centaurus’ success has not gone unnoticed by Wall Street, which is now following Centaurus’ lead. Brokerage firms have seized the momentum, believing that their skilled in-house traders can compete with energy hedge-fund professionals. It would not be surprising to discover well-known investment firms such as Merrill Lynch, Goldman Sachs, Bear Stearns, Deutsche Bank, Bank of America, Barclays Capital, and Lehman Brothers sponsoring energy hedge funds.

Dissecting Hedge Fund Secrets

Hedge funds have pursued innovative strategies and tactics, with enormous profits. New legislation, however, effective Feb. 1, 2006, calls for hedge funds to register with the SEC as investment advisors (ADVs). For the first time, hedge funds are “compelled” to start airing some of their secrets.

Hedge funds are designed as partnerships, where the general partner ( i.e., fund manager) develops investment policies and provides initial capital. Until this year, funds enjoyed two regulatory exclusions: one under the Investment Company Act of 1940 and the other under the 1996 Investment Company Act. But the SEC long has questioned the growing financial clout of hedge funds and instituted this year a modest disclosure program. Firms registering with the SEC must give details on limited company facts, from their personal business experience to fee arrangements, total assets under management, and any prior disciplinary actions. Advisors are not required to make public details of their funds performance, holdings, or trading secrets.

The Deregulation Boomerang

The Enron scandal became public knowledge in October 2001