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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

valued at $50 billion, in relation to a $1 trillion total fund market. Whether or not hedge funds disrupt orderly markets cannot be simply or definitively answered. Knowledgeable and wealthy investors are less prone to pressure hedge funds for withdrawal, thereby allowing the pool of funds to remain predictable. By participating in the market, hedge funds contribute to market continuity ( i.e., by having a bid and an offer where conventional investors would fear to tread).

Consumer prices for electricity, oil, and gas are a function of the global supply/demand equation. Demand currently outpaces supply, resulting in less predictable short-term prices and a certainty that long-term prices will trend higher. As many know, this upward bias might be slow and gradual, or highly disorderly.

Market Makers or Market Breakers?

The somewhat “cowboy” reputation of hedge funds has been reinforced by several highly publicized scandals, not the least of which was the $4.6 billion loss in less than four months in 1998 by Long-Term Capital Management (LTCM). LTCM’s use of leverage shocked the public when it revealed $124 billion in standard debt borrowing and $1.25 trillion in off-balance sheet balance obligations, against a $4.7 billion equity. The balance sheet approximated 99.7 percent debt and 0.3 percent equity. LTCM’s philosophy was that its sheer dollar size and investment diversity conveyed virtual immunity to any single investment disruption. In the end, the leverage was so large and quality of the asset base so weak that a Federal Reserve bailout was necessary.

Proponents believe the hedge fund’s higher risk tolerance and the willingness to purchase structured securities exponentially raises the availability of capital to finance all types of power projects and propels secondary market activity. Energy funds, therefore, can offer financing where conventional capital market gaps exist. Accordingly, hedge fund market participation can alleviate extreme pricing gaps and thus act as an alternative and supplement in erratic markets. By aiding a continuous market, hedge funds enhanced energy project viability.

Do aggressive and speculative hedge-fund policies contribute to stock price volatility? A “yes” answer is compelling. As the pool of hedge-fund money increases, the ability of an ever growing number of participants, having greater buying power, should reduce the bid offer spread as these funds need to be “invested.” By buying and selling “energy” where traditional order flow is lacking, hedge funds are in a role similar to that of the stock market specialist in that they help to counteract market imbalances and lessen price gaps.

Another school of thought argues that hedge funds merely increase volatility because of their opportunistic profiles of buying and selling not based on major fundamental change but on daily price fluctuations. The presence of energy funds note the trading of energy products by companies like Enron and Calpine took advantage of unstable wholesale prices in California during the 2001-2002 energy crisis. Non-traditional products permitted energy traders to devise schemes to manipulate prices and earn exorbitant profits exposing the public to unsupervised and manipulated electricity prices. Could the market withstand another shake-up as the number of these forceful investors’ increases? If