Recent sharp gas futures declines have undercut a second hedge fund in as many months. Greenwich, CT-based Amaranth Advisors LLC revealed last week that bad bets in natural gas futures have cost the company about 65% of its $9.5 billion asset value. Even more troubling is that other funds could follow, according to industry sources.

According to industry sources and The Wall Street Journal, Amaranth’s energy trading desk co-head Brian Hunter allegedly lost billions by betting on the future direction of natural gas prices. With a 65% month-to-date net asset value decline, Amaranth’s losses are reported to be somewhere in excess of $6 billion.

“[His] role in the losses his fund expects to suffer as it unwinds its natural gas position is not yet known,” said Wall Street tabloid DealBreaker.com. It said one source believed that Hunter “made trades this year similar to his winning 2005 bets and got caught…when 2006 produced a much calmer hurricane season and new oil discoveries in the Gulf of Mexico.”

Milder temperatures throughout the country combined with the absence of hurricanes in the Gulf of Mexico and the nation’s ever-growing natural gas storage glut brought the natural gas futures prompt month below $5 last week for the first time in two years. The October natural gas futures contract declined 12.2% from $5.675 to $4.982 during the week ended Sept. 15, which was the week much of the losses occurred, according to Amaranth. Even more impressively, the January 2007 contract declined by 16.5% from $10.185 to $8.504 for the week. The all important October-January spread (January premium over October) declined from $4.51 on Sept. 8 to $3.52 on Sept. 15.

Earlier this month, technician Rich Bruskoff talked about the October-January spread. “The Oct-Jan spread recently peaked at $4.70. That compares with a low of just $1.20 back in November.” Historically, that spread runs between $1-2, Bruskoff noted, adding that at $4.70 — the spread was ripe for selling.

While the Amaranth news was eerily reminiscent of MotherRock’s demise in early August, Amaranth’s rumored losses — if confirmed — are 30 times greater (see NGI, Aug. 7; Aug. 14). After less than two years of operation, energy hedge fund MotherRock LP said it was closing its doors following an alleged $200+ million loss in natural gas trading over June and July.

“Amaranth obviously was long the winter market and short next summer. Now they are neither,” said one Northeast broker. “They were billed as a ‘multi-strategy’ hedge fund. I don’t know what that is supposed to mean. Prices went down and they lost money — that doesn’t sound like multi-strategy to me.”

The broker noted that the public may never know what exactly happened. “He was probably forced to liquidate due to a run on the bank. That is what happened at MotherRock,” he said. “These hedge funds are privately held, so they probably aren’t going to talk about the loss at length. They don’t have to have a response to this.”

In a conference call Friday afternoon, the company’s founder Nick Maounis said Amaranth plans to continue operations while working to restore the confidence of investors. According to multiple reports, Maounis said the firm increased its energy trading position in 2006 because it was making substantial returns. During the call, Maounis disclosed that Amaranth earned $1.26 billion in energy and commodities trading in 2005. Through August of this year, he said the firm recognized energy and commodities trading profits of about $2.17 billion.

While taking no questions from investors during the brief conference call Friday afternoon, Maounis said that the fund had received a “substantial” number of requests from investors for their money back. He added that Amaranth has engaged Skadden, Arps, Slate, Meagher & Flom attorney Phil Harris to evaluate the requests.

In the call, Maounis explained that market conditions deteriorated rapidly during the Sept. 11 week with material losses beginning early in the week and Amaranth accelerating its efforts to reduce exposure. He added that on Sept. 14, the fund experienced roughly $560 million in trading losses on its natural gas positions alone.

“MotherRock was just a minor tremor compared to Amaranth and there could be more,” said Tom Saal of Commercial Brokerage Corp. But rather than pouring over the details of these downfalls or speculating who might be the next, the futures broker is consulting his clients and customers — natural gas buyers and sellers — how to protect themselves and even possibly take advantage of the hedge funds’ impact in the market.

“The behavior of the hedge funds has changed over the past several years,” Saal said. “There are now trend- and counter-trend funds. The first type, trend or ‘black box’ funds use a very systematic approach, trading around a pre-defined model or set of technical parameters. Counter-trend, or ‘discretionary’ funds, are the new breed out there and they are the ones we have to take a close look at. Understanding their behavior can help you manage your risk in the futures or options markets.”

Saal and Kennedy are hosting a workshop to discuss this and other strategies for trading and hedging natural gas purchases and sales on Oct. 4-5 at the New York Mercantile Exchange. For more information visit https://workshops.gasmart.com/hedging .

Late Wednesday, Maounis updated investors on the size of the fund’s losses while reporting that the gas trading book had been sold to third parties. There were also reports Wednesday and Thursday that Citigroup — the largest U.S. bank — was interested in purchasing a stake in Amaranth, but the company declined comment.

“During the week of Sept. 11, 2006, we experienced significant mark-to-market losses in our natural gas derivatives portfolio,” Maounis told investors in a letter. “The resulting margin calls on these positions created serious constraints on the funds’ liquidity. In order to prevent further mark-to-market losses on the natural gas positions, and to reduce the risk of defaulting on margin calls, we transferred these positions to a third party at a price that resulted in additional significant losses. To generate the liquidity required to avoid defaults under our counterparty documents, we also sold a significant number of positions in the funds’ other portfolios.”

According to sources close to the situation, Amaranth Advisors sold its energy portfolio at a loss to J.P. Morgan Chase & Co and Citadel Investment Group LLC, although none of the three companies would comment on the transaction. Citadel, a large hedge fund run by Kenneth Griffin out of Chicago, currently manages more than $12 billion for a wide range of investors.

Maounis told investors that Amaranth has “continued to meet all margin calls,” adding that “our major financial counterparties have confirmed that they are now comfortable with our portfolio and overall liquidity position.” A New York Mercantile Exchange spokeswoman backed this claim up on Wednesday, telling NGI that Amaranth’s clearing member on the exchange was in the clear.

“The account and carrying clearing member are in good standing,” said Nymex spokeswoman Anu Ahluwalia. “Nymex continues to actively oversee and maintain orderly markets.”

Maounis said that Amaranth intends to begin scheduling one-on-one meetings with investors this week. “Amaranth is determined to earn back its investors’ trust, and one step towards that end is to share as much information as we reasonably can,” he said in the letter. “We assure you that we are eager to do so.”

Commercial Brokerage Corp. broker Ed Kennedy, said, “It appears that [the Amaranth trader] talked himself into a ridiculous trade. The position was so huge it was unmanageable. He was so big, he was literally meeting himself going out the door while coming back in the door. Yes, you can put these huge positions on in the over-the-counter market, but when you get out, someone has to take the other side going the other way. I just think he got into too big of a position that he couldn’t get out of.

“He was selling this summer and buying the winter, while selling next summer against it,” Kennedy added. “The real question is why? He pushed the summer ’06-to-winter ’07 spread way out. There was no reason for it. Evidently, when he went to get out of it, nobody wanted to take the other side of it. That is a little more than a small problem in this business.”

Brokers and traders alike said Hunter became a target because he was running over both commercial and local traders through his massive position. Nymex local Eric Bolling said it best on CNBC, according to Kennedy. “Bolling mentioned that once locals realized that [the Amaranth trader] had this huge position on that no one really wanted to take the other side of…’they all tried to help him out.’ When Bolling said ‘out,’ he made a hand gesture signaling towards the door. I think they smelled blood in the water and they went for it.”

Kennedy said the moral of the story is, “You have to have a position on that you can manage. That is just basic 101 trading knowledge.”

Amaranth might not be the last fund to break the bank either, according to industry watchers. As for the likelihood of other hedge funds going bust in a similar fashion, Kennedy said, “You better believe it. There is no regulation on funds, so it absolutely could happen again. We saw it with MotherRock and now Amaranth, and that is only in the last two months.

“You have position limits in the futures world, but you don’t have any position limits in the over-the-counter world,” Kennedy added. “You can do anything you want. Standard & Poor’s has been trying to come up with a way to calculate the risks that these hedge funds face. They are not getting any support from the hedge funds because the funds don’t want to report to anybody…and as of now, they don’t have to. Without some sort of regulation, we will definitely see more of these blowouts. As a matter of fact, there is a rumor on the floor that there is somebody else in the same trade as Amaranth. I don’t know who it is, but the rumor is out there.”

Another broker with knowledge of the situation agreed with Kennedy’s synopsis. Without hedge fund regulation the market will “definitely see more of these blowouts” down the road,” the broker said. “A lot of these guys talk to each other. A lot of them operate in the same way.”

Citigroup analyst Tim Evans said when these things happen, it is normally a string of companies making the bad call. “When we see a company having trouble like this in the market, there is usually more than one company having difficulty,” he said. “I don’t think we should just assume that this is the end of it. We had the MotherRock situation in August and now this Amaranth blow-up.

“I think this is indicative of a larger problem that some traders or funds have been very highly leveraged in their approach to the market,” he added. “With these aggressive position sizes, it does not take long to erase all of your profits.” With these larger-than-market position sizes, Evans said “profit from five years can evaporate in five weeks.”

Schaeffer’s Investment Research analyst Bill Feingold said news of Amaranth’s “catastrophic natural gas losses” is probably the “most shocking thing I’ve read in my career.” He said the news would be “shocking enough for a small fund,” but it was “particularly astonishing” because Amaranth is a huge diversified firm. “One has to assume that a large part of [the week ended Sept. 15th’s] natural gas losses were triggered by forced Amaranth sales made to meet margin calls,” he added.

Feingold said that Maounis is a very good “convertible bond guy” who got started in the mid-1980s on a small proprietary trading desk and went to Paloma Partners, a “dominant hedge-fund family specializing in convertibles,” several years later. The analyst said that in 2000, Maounis spun off Amaranth from Paloma and had “grown the firm spectacularly up until this remarkable setback.”

Despite the shake-up caused by Amaranth on the market, the analyst said it is unlikely to have more than a relatively short-term impact on the market and funds in general. Feingold said “as shocking as the whole situation is, most things will be back on the same course they were heading within six months from now if not sooner. This is a business with very short memories.”

While the industry does have a short memory, regulators might make sure people never forget. Connecticut Attorney General Richard Blumenthal reiterated last Tuesday his long-standing call for more oversight of hedge funds in general. Blumenthal said there needs to be “greater transparency and disclosure” in the hedge fund industry.

“We are collecting evidence and reviewing facts relevant to recent hedge fund losses,” Blumenthal said. “Particularly problematic are alleged representations made to investors in recent weeks by the management of Amaranth that may be contrary to apparent facts. Such claims — if made — would contradict the spirit and letter of current law. The facts about mammoth losses by Amaranth offer additional powerful and compelling evidence about the need to reform disclosure and oversight requirements.”

Blumenthal became proactive on monitoring hedge funds in 2005 following the fraudulent activity from 1996-2005 of Stamford, CT-based Bayou Management, which resulted in the guilty pleas of two top managers there. The SEC’s complaint alleged that the two managers defrauded investors in the funds and misappropriated millions of dollars in investor funds for their personal use.

In the wake of the Bayou scandal, the attorney general in 2005 endorsed SEC Chairman Christopher Cox’s statement that he would support and implement requirements that hedge fund advisors register with the SEC.

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