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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

and nearly undermined all energy companies, as well as related financial instruments or products. Trading energy as a commodity suddenly was viewed as improper and corrupt. Enron’s fraudulent actions, in concert with the California energy crisis, which could have spelled the demise of deregulation. Ironically, Enron’s transgression endowed energy trading with an ever greater elusive attraction. Although this attraction was not immediately evident, the stage was set for energy funds to proliferate and prosper in the few short years ahead.

Meanwhile, project development came to a halt. Power-plant construction reached a standstill ( i.e., no supply) leading to depressed stock and bond values. The California meltdown and the frequent bankruptcies (seven between 2000 and 2005 compared with two since the Great Depression) heightened fears among traditional investors. Another group, however, found an opportunity in the distressed industry: energy hedge funds.

The Dow Jones Utility Average between 2001 and 2005 could be characterized as a distorted “V”-shaped curve, except the “recovery” side of the “V” is somewhat distorted (not perfectly symmetrical). Depending on weather an investor is positioned on the left (bearish) or right (bullish) side of the not-so-perfect “V,” profits and losses will approach equality. During the 60-month period under review—2001 through 2005—an initial 22-month (October 2002) bear market was experienced, followed by a 38-month (December 2005) bull market.

In January 2001, the utility index stood at 412.8, a historic high, albeit a very short-lived “high.” By the summer of 2002, the high was gone. Utility bankruptcies were frequent, with an alarming list of potential Chapter 11 candidates ready to file. In addition, dividend cuts and eliminations were now routine, eradicating the industry’s bond-surrogate quality. In July 2002, the index reached an interim low of 214.9, but the worst was yet to come. By October 2002 the index hit a 15-year low of 167.6. The most disturbing aspect is not the index per se, but the break in the contra-correlation between interest rates and dividend yields. Uutility stocks have long been viewed as bond surrogates. If interest rates decline, utility stocks theoretically should rise, and vice-versa. The disturbing failure of this relationahip suggested an endemic crisis in fundamentals.

Brave New Energy World

Energy is fast becoming, if it hasn’t already, a pure financial commodity. The price of an energy instrument can assume an ever-changing, world commodity profile. No longer are energy investments and products solely tangible. In fact, we now have an array of intangible products, a sampling of which is listed below:

• Crude oil & petroleum products

• Natural gas

• Physical and financial power

• Coal emission and renewable energy credits

• Distressed power plants & related contracts

• Carbon trading

Expect energy hedge-fund prospects to expand in upcoming years. Today energy funds account for a relatively small percentage of the fund universe; some estimates place energy funds in the 5 to 10 percent range. An exact percentage is not publicly available. Prospectively it can represent an abundant source of liquidity and effectively improving the breadth and depth of the market.

Energy hedge funds at year-end 2005 were