Energy Hedge Funds: Market Makers or Market Breakers?

Deck: 
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 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 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 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 so, hedge funds easily could be characterized as “market breakers.”

Endnotes:

1. Rudolf Otto: from his Numinous.

2. Barron’s, Jan. 30, 2006: “Will Registration Hamper Hedge Funds?”