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Consultant: Funds May See Better Returns in Energy But Also Face Great Risks

Consultant: Funds May See Better Returns in Energy But Also Face Great Risks

While there has been a lot of speculation about the impact of hedge fund trading on natural gas futures prices and market volatility, Peter Fusaro, chairman at New York City-based consulting firm Global Change Associates, said he also believes the hedge funds themselves that enter the energy space face serious risks despite the promise of attractive returns.

"The bottom line is the energy complex has the most volatile commodities ever created and they require a deep knowledge of the physical market as well as the financial markets to trade these things effectively," Fusaro said in an interview with NGI. "We see a lot of funds coming in with very little energy talent or none, and it seems to me that there could be tremendous failures next year.

"Nothing has happened yet because they are still in the ramping-up stage and the market has been tracking as a bull market and everyone has been long." But if prices crash hard because of high storage levels exiting a warm winter, many new entrants could be unprepared, he said. Few fully understand the fundamentals at play, and while the funds can push the market around on an intra-day basis, the fundamentals eventually could surprise them.

Fusaro said that he has identified about 260 hedge funds in the energy trading business and the number is growing dramatically. "I've met with many of them. Some are going to do real well because they have the energy trading talent and some aren't. There is a lot more trading going on by funds than people realize."

Fusaro's report, "Hedge Funds Enter the Energy Trading Space," concludes that there is significant evidence to suggest that the funds and the investment banks are here to stay, bringing back liquidity and a risk taking culture to energy markets. The new surge of speculative trading activity also is bringing greater financialization to the energy markets.

"This is just the beginning," he said. "I just came back from Canada; there are one or two funds up there and many more coming in. We have gotten calls from Switzerland and London and have been shown business plans of funds in formation. There are a number of funds in New York that will be launching on Jan. 1.

"They are looking at oil and gas futures, coal, power in the short-term markets, stressed asset plays, oil and gas reserves in the ground, renewable energy, carbon trading. They are looking at the entire energy complex and we are just seeing the beginning.

"They have really been underweighted in this sector. And frankly the funds have traded flat or negative this year and have not shown returns to investors. Oil and gas prices are in the papers all the time. There are a lot of funds coming into this space because of the returns," he said. "We have the most volatile market and that is attracting them."

The growing activity by the funds will continue to have unexpected impacts on prices. "It is having no impact on the price [per se], but it's having a lot of impact on intra-day price volatility," said Fusaro. "Long term, it is de minimus. They trade volatility.

In October they started scaring away some of the traditional gas futures traders, and they've done the same thing in the oil complex. Because of the bigger swings in price volatility -- and by the way, we expect more of this next year -- it scares a lot of traders."

Traditional energy companies are either exiting the trading business or becoming further marginalized by the entrance of the funds into trading. On the other hand, many of the funds do not understand energy and though they have sophisticated tools and models there remains a very real danger that this lack of specific energy knowledge and modelling will result in further market fallout at some stage in the near future, Fusaro believes.

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