Hedge Funds, Hurricanes and Energy Markets
In the past week, the energy markets have sold off steeply, even in the face of as-still-unknown damage from (a weaker than expected) Hurricane Gustav. If you were reading theoildrum.com of late, you have seen Kinetic Analysis Corp periodic updates on modeled damage/shut in production to Americas oil and gas facilities. We are also continuing to accumulate stories, data, and observations about the effects of Gustav on oil, natural gas, and gasoline production in another thread below.
Tonight another hurricane (of sorts) was announced in the financial press when CNBC reported that Ospraie, a $4 billion hedge fund partially owned by Lehman Brothers (and a major energy player), is closing it's doors after being down nearly 40% in 2008 following a -26% August. While this example is possibly unrelated to the current energy market meltdown, it serves as a good example of what may be a continued theme in natural resource markets - their small size in relation to the nominal amount of dollars seeking financial returns.
BACKGROUND:
2006 Natural Gas Futures daily prices (black arrow - announcement of Amaranth failure)
When Amaranth blew up in September of 2006, the world learned about a swashbuckling trader named Brian Hunter. In the Summer of 2006, Brian was reported to be massively short near dated NG futures, and long spring futures in NG for the following year. (I wrote about this and analyzed the crash in the winter/summer NG strips in "A Tale of Two Markets"). There is some indication that his position was so enormous, that when it went slightly against him, the information leaked out to the street, and then other funds and speculators ran in front of him. This revealed a rather Darwinian and carnivorous aspect of Hedge Funds: they all have prime brokers--i.e. access to capital from large banks--in order to put on their trades using leverage. When the trader runs into trouble, he has to call his prime broker. Having worked in this business, I can assure you that invariably, information migrates from the prime broker to other market participants (via mini tribal-cliques), who then take you out by putting on large trades against the direction of your position ala Soros vs Bank of England. If you read stories of trading in the tradtional pits, alot of this used to happen by seeing who looked scared. The other traders in the pit knew where everyone stood and were good at smelling blood (same as good poker players).
From the above chart, AFTER the Amaranth blowup was announced (the black arrow), futures made a slight new low and then continued to rally the rest of the year (even with another mild winter).
FAST FORWARD 24 MONTHS....
October 2008 Natural Gas futures - new yearly low today
I believe that based on fundamental deterioration in oil and gas fundamentals (e.g. hard to find, costlier to procure, etc.) that we are in a long term higher high, higher low, environment for energy prices, one not caused by speculators but by more people wanting something that is less available. However, speculators have a great deal of impact in very short time horizons. (If we had more, better, smarter speculators, then volatility would probably be reduced!!)
I have no idea what Ospraie's positions were other than the CNBC mention of bad bets in natural gas and copper, but in the letter to shareholders tonight, manager Dwight Anderson said this:
"The losses were primarily caused by a substantial sell-off in a number of our energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years."
We can surmise they were doing well along with everyone else until the end of June, which means they were likely very long everything, from energy futures to energy equities. Funds like Ospraie are usually levered at least 3 to 1. Peter Thiel's Clarium Capital, one of the largest similar funds, has routinely had about 3 billion under management but is often reported to be carrying positions worth 9-12 billion. In general it's nigh impossible to measure or quantify how these funds move price around when they start liquidating. What's certain is that other players are sucked/forced into the moves, and the entire event gets magnified. (REFCO was another relevant example). Usually, it's not until weeks or sometimes months later that the people not in the know that have been scratching their heads finally get an explanation other than 'the hurricane was a Cat 3 not a Cat 5' or some such....
Bottom line: hedge funds pull alot of weight with their capital, and added leverage via credit, and when their shark brethren get a whiff of pending trouble, a positive blood-in-the-water feedback mechanism ensues, which exaggerates moves, first in one direction, then in the other. (This was discussed in Peak Oil, Reflexivity and Peak Oil)
OSPRAIE>GUSTAV?
Though we are told that we import 60% of our oil, the truth is somewhat less benign. The US pumps about 5,100,000 barrels of crude oil a day. The figure the US government likes to quote is total liquids, which was 8,457,000 barrels a day in 2007; (8,703,000 barrels per day so far in 2008). This total liquids includes a lot of stuff, including "refinery gain" on oil we import. Once we refine it, the volume is greater, and it magically transforms into domestic production. Total liquids also includes natural gas liquids (NGPL), which only have about 60% of the energy as WTI oil. Total liquids also includes ethanol, now amounting to about 600,000 barrels a day. So of our total consumption of petroleum (including ethanol) of about 20,700,000 barrels a day in 2007, 8,457,000 or 60% of total liquids were imported, but if we look at the good stuff alone, 20,700,000/5,100,000=75% imports. (This post points out the dangers from confusion of defining 'what is oil').
But I digress from my main point.
The news is still trickling out about damages in the Gulf oil and gas platforms and rigs. The amount of shut-in production from Hurricane Gustav won't be fully known for a while. The latest estimates from Chuck Watson's analysis for the next 30 days is 13 million barrels (or 40% of normal GOM production lost) and 70 billion cubic feet (or 29.3% of normal GOM production lost). There are longer expected outages and damage but let's just use the 30 day numbers for a calculation.
With between $10,175 and $12,000 in margin (depending on member, or non-member), an investor, end-user or speculator can control 1,000 barrels of crude oil on the NYMEX. So, to "control" the same amount of oil shortfall expected by Gustav, ceteris paribis, one would need 13,000,000/1,000=13,000 contracts, which would require margin of $132,275,000, (a tidy sum for you and I, but for one (or several) of the behemoth hedge funds, not so much). On the natural gas side, the margin requirement for 1 mmcf contract is also about 10% - (higher than it used to be for sure), or $8,150. With 70 billion cubic feet as the latest 30 day shut-in production estimate, this equates to 70,000,000,000/10,000,000 =7,000 contracts - a notional value of $495,000,000 but requiring around $50 million in margin to control. So with $182 mil, someone could 'offset' the expected oil and natural gas production loss for the next month from this hurricane (i.e. sell via the futures market the same amount of production that users might need to buy)...Money is a powerful thing. It's like Cat 10.
This real life example shows that when energy competes with money, it is liable to get run over in the short run. As I have written about frequently during the past few years, the amount of paper currency (and related credit) circulating the planet seeking a 'return' dwarfs the amount of underlying physical resources. Here is the conclusion in my post on Amaranth, 2 years ago:
"In addition to position limits for non-users or hedgers of energy, we should create a floor price for oil and gas, so that financial market-led volatility or intermittent gluts of product do not derail the development of alternative forms of electricity and liquid fuels. The achilles heel of the big two fossil fuels in their use in our world, is the time it takes to replace them. The natural gas market, in its current price dichotomy, is a prime example of the high standard deviation potential in our current system. Heads everything is rosy. Tails there are power outages.
I have no idea whether it will be cold this winter."
DAVID (energy) VS GOLIATH (hedge funds)
The accumulation of financial capital accretes incremental social power in modern society. Everything else being equal, more money gives one more access to information, resources, flexibility, energy and leisure. As high quality fossil fuel abundance morphs into a fervent scraping for all things energy, 'money' may increasingly represent a poor proxy for the real wealth embodied in natural, built, social and human capital. Until that time, large concentrated digital accounts around the world (e.g. hedge funds) will likely continue to toss commodity futures prices around like my dog shakes a chicken - up down and all around, at least in the short run. To the chagrin and confusion of energy policymakers these same commodities form the foundation of the basic necessities used in our interconnected global economy, and volatile prices cannot send consistent long term signals to our leaders. The urgency of diverting our quality, remaining cheap fuels towards high energy surplus, long duration renewable infrastructure is lost when prices drop. Indeed, natural gas used for electricity is up 34% in the past 5 years. Each time we have price dumps influenced by financial fence-swingers closing their doors, we retreat from any momentum for action that had built up during high price regimes. Then, when prices rocket again based on fundamental supply/demand gaps, the price hikes are too steep and are not well adjusted to by consumers and businesses, who then conveniently blame speculators.
CONCLUSION
We now have 4 named storms in the US/Atlantic: Gustav, Hannah, IKE and Josephine (also a large wave off Africa which may be Kyle). I wonder between today and quarter end how many financial 'hurricanes' we will witness due to the recent, (and coming) volatility in energy. But the important longer term question is how many corporate/industrial executives are adding long range natural gas electricity plans based on this (in my view) artificially low price of $7 per mcf....Energy fundamentals win out in the end, and the marginal costs of both oil and gas are rising rapidly. But I fear the intervening steep roller coasters in price will act as policy camouflage until our time window for change is too short. Time is a critical commodity too. (Maybe we could trade that as well, using leverage...;-)
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