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Debate Over Hedge Funds in Gas Market Continues After Nymex Report

A new analysis released last week by the New York Mercantile Exchange (Nymex) found that hedge fund trading activity during the first eight months of 2004 represented only a modest portion of total volume and open interest in the natural gas and oil futures markets. Furthermore, the exchange used proprietary data to determine that hedge fund trading also seemed to decrease price volatility, rather than cause it or increase it as some large industrial companies and market analysts have charged.

That finding didn't sit well with several market experts who said publicly available data, particularly the Commodity Futures Trading Commission's Commitments of Traders (COT) report, has clearly shown over the years that the noncommerical sector, which includes hedge funds, has contributed to price volatility on many occasions.

Nymex's 2004 Market Participants Study shows that hedge funds represented only about 9.05% of natural gas futures trading volume in the first eight months of 2004 and 20.4% of gas futures open interest. The exchange said it found in its benchmark light, sweet crude oil futures market, hedge fund activity constituted only 2.69% of trading volume and 13.4% of open interest.

"The findings of the study are consistent with our belief that hedge funds do not negatively impact our markets," Exchange President James E. Newsome said in a statement. "They generally hold positions significantly longer than other market participants, which supports the conclusion that hedge funds are a nondisruptive source of liquidity to the market.

"With regard to price volatility in the natural gas futures market, when hedge fund activity alone [is examined], as well as in connection to inventory changes, the data strongly suggests that changes in hedge fund participation result in decreases in price volatility," Newsome added.

In short, the exchange said in its study, "it appears that hedge funds have been unfairly maligned by certain quarters who are seeking simple answers to the problem of substantial price volatility in energy markets, simple answers that are not supported by the available evidence."

The study was undertaken in response to public criticism last year from large end-users, including Huntsman Chemical, a major global manufacturer of diversified chemicals and a large natural gas buyer, about high gas futures prices, increasing price volatility and what many believed was growing market participation of noncommercial traders (including hedge funds) -- which are those traders who cannot make or take physical delivery.

"Media attention developed due to complaints from a small number of companies who have expressed concern about substantial price volatility for energy commodities such as natural gas," the exchange said. "These companies have suggested this result is somehow attributable to the trading activity of hedge funds in energy markets. These assertions have been forwarded to the public arena without analysis or facts to support such claims...

"Confused or inaccurate assertions can do harm to the public dialogue on the issues of the day," Nymex added.

In order to conduct its review of hedge fund trading activity, Nymex said it analyzed proprietary market data available to the exchange through a special reporting system used to conduct market surveillance. However, Nymex released very little of the data used in its analysis, choosing instead to present participation percentages and their implications.

In conclusion, it said that rather than focus on the influence of hedge funds for the cause of price volatility, observers should instead be looking at shifts in gas supply and demand over the last few years. They can easily be cited as "clear contributors to the price levels and volatility to which participants in this market have been exposed. [The] dramatic increase in [gas] demand has been the driving force in eroding excess productive capacity."

While not denying the underlying market fundamentals that have triggered numerous price spikes over the last five years, analysts, such as Tim Evans at Thomson Financial, said the exchange is making a major error in its analysis about the influence of hedge funds on the market.

"If you look directly at the COT report, you can basically verify that the net [hedge] fund exposure relative to the total open interest is roughly what they [Nymex] say it is." He said noncommerical net short positions recently reached at about 13% of total open interest and currently are a much smaller percentage of the total (15,105 out of a total open interest of 457,961).

"But where I have a lot of questions about the report is in terms of its conclusions regarding volatility. My complaints come in two forms. First of all, if you want to learn something about volatility, you should study a price period in which you had peak volatility. January to August of last year omits the big rally we had from November to December of 2003, when prices rallied on cold weather and fund short covering -- thank you very much -- [and] the September-through-October 2004 period, where the funds were short ahead of hurricane Ivan and prices doubled in a six-week period. The trading range between Sept. 16, 2004 and Oct. 28, 2004 was wider than the entire period they studied.

"I question their methodology," said Evans. "If you wanted to conclude that the funds don't contribute to volatility, if you had that conclusion in mind, the way you would try to prove that is by looking at a period in which volatility was benign. It looks to me that is what they did. If you really want to know about volatility, study a period in which prices were volatile. They didn't do that."

Evans said that if you look at CFTC data during these periods of high volatility you will clearly see noncommerical traders buying up 25,000-50,000 contracts in a matter of a week or more during which prices were going sharply higher. For example on Nov. 18, 2003, noncommericals held a net short position of 52,684. The near-month futures contract was at $4.55 on Nov. 20, 2003. But by Dec. 10, the near month contract had reached $7.55 and the noncommerical sector (the funds) was net short only 16,721 contracts, showing that they had bought 35,963 contracts.

"If prices were rising and they were buying, they certainly were not trying to dampen price volatility," Evans said.

However, this does not mean that hedge fund trading activity is bad for the marketplace, he said. "They absolutely serve an economic purpose." He noted that they may recognize future market tightness before others do and accumulate length because they think the market is going to get tight. In that case, prices rise sooner than they would otherwise, and that sends an economic message to the market -- to producers to crank up production, to consumers to cut back on demand.

"There are a lot of excellent economic values to what the funds do," said Evans. "They add liquidity to the market. But the one thing that they do not do is dampen volatility."

So why would Nymex want to create such a false impression? Tom Lord, president of Volatility Managers LLC, who will present his own analysis of the market influence of hedge funds Wednesday in New Orleans at GasMart, NGI's annual conference, said he believes Nymex is just trying to dispel recent criticism. Lord said the exchange has an "economic incentive to assure that no one constrains the participation of large actors in the market.

"My expectation is Nymex is highly concerned that there could be a conclusion that hedge funds were negatively impacting the ability of commercials to hedge in their market space effectively," he said. Commercial traders might turn away from the exchange and go to the bilateral markets to do more business.

But Evans said coming up short on a market analysis like this also may serve to create the very thing Nymex is trying to avoid. "The problem with trying to 'bend this like Beckham' is that you are damaging your credibility," he said.

If Nymex was trying to sweep something under the carpet, it's not even clear that was necessary to begin with said Evan. It's not clear that the growth of fund participation in the energy futures market is outpacing the growth of the overall market itself, he said. "There's no empirical data that says we should somehow reign them in. Remember volatility was bad in 2000, five years ago," he noted.

However, Gary Vasey of UtiliPoint International said the presence of the funds is growing on the exchange. "We think there are about 75 commodity funds active in energy commodities, up from 10 this time last year. We estimate they have about $10-20 billion at play, which is still a relatively small amount. Some of the funds trade through banks and so they don't show up in noncommercial category of CTFC COT reports for example."

Vasey said that there is a new trading triumvirate developing, made up of hedge funds, banks and multi-national oil companies. "BP announced that they had made $1.99 billion trading oil, gas and power last year," he said.

"However, we do not believe that this speculation is a bad thing for the market. The funds tend to be 'trend followers' and as such, they may accentuate a trend, but they are not responsible for it. Speculators bring increased liquidity, a broader view of the market and risk acumen. The impact is also increased volatility at least in the short-term."

Vasey said that Nymex was right in pointing to supply and demand tightness but was wrong about the growing influence of hedge funds and their impact on price volatility. "We are seeing a paradigm shift in prices, market participants and supply/demand situation," he said. "There will be no mean reversion this time - or if there is, it will revert to a higher mean."

The participation percentages Nymex presented are really indisputable, said Evans, but "the conclusion about the funds dampening market volatility just makes me go, 'Huh?!'

Lord said that since last October the market participation and influence of hedge funds has skyrocketed. He said that last October was the first time ever that they exceeded 30% of open interest for more than a week.

Both Lord and Vasey will be participating in a panel about hedge funds and the gas and oil futures markets at GasMart, which runs March 16-18 in New Orleans. Also on the panel will be Dan McElduff, senior director of natural gas research at Nymex; David Kass, senior economist of market surveillance at the Commodity Futures Trading Commission; and Tom Matthews, director of risk management at Kinder Morgan. For details go to

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