The $6 billion collapse in the value of the Amaranth Advisors LLC fund may go down in history as perhaps the best example of how not to attempt to corner the natural gas market. It also may provide some lawmakers with the ammunition they need to regulate the over-the-counter energy market and gain greater oversight of hedge funds, according to several analysts.
Amaranth’s founder Nicholas Maounis told investors last month that “a series of unusual events” led to the fund losing a significant portion of its value over just a few days in September. He said the net asset value of the multi-strategy funds had declined “approximately 65% month-to-date” through Sept. 19 and “approximately 55% year-to-date.” This would put month-to-date losses for the company — which managed $9.5B as of August — somewhere in excess of $6 billion (see NGI, Sept. 25).
“Amaranth was basically trading on steroids,” said veteran energy analyst John Olson of Poole Capital Partners LLC, the general partner of three equity hedge funds. “They would take positions 20 or 30 times the size of what were considered normal transactions. It appeared Amaranth was applying a strategy of overwhelming force in the marketplace, and they did not have enough ammunition to sustain themselves in a falling market.”
One Washington, DC-based futures broker said that while Amaranth wasn’t the first hedge fund to lose big, it also won’t be the last unless regulation finds its way into hedge funds and over-the-counter markets.
“No one really knows what is going on in the over-the-counter market,” the broker said. “It’s not like it is a bunch of guys trading over in the corner somewhere… This is a market that is very substantial and it affects a lot. It is very unfortunate that we have something like this going on. It’s hard to believe that someone would put so much of their portfolio into a single trade. When there is no regulation, you have a serious problem.”
Looking at the repercussions, Olson told NGI there are probably other funds that are likely in a similar position in the market to Amaranth. “There probably are more casualties; we just haven’t heard from them yet,” he said. “There is a rumor that one New York bank is going to build some character here.”
He said that with funds entering the energy marketplace all of the time, the Amaranth story should serve as a warning. “This will probably serve as a shot over the bow, if you will, of the newcomers to this game,” Olson said. “Keep in mind that something around $60 billion of new funds went into energy commodity hedge funds over the last three years, and they have certainly contributed to the volatility of Nymex and the marketplace in general. How that $60 billion plays out remains to be seen.”
Despite the lack of hard facts in the case, Olson said more details are likely to trickle out in the following several weeks.
In an attempt to quell rumors regarding Amaranth’s impact on trading exchanges, both the IntercontinentalExchange (ICE) and the New York Mercantile Exchange (Nymex) have said they are conducting business as usual.
“With regard to Amaranth and its recently reported losses in the energy markets, Amaranth’s business is not individually material to ICE’s revenues,” ICE said last week. “In addition, Amaranth’s losses do not appear to have resulted in any disruption to the operation of the natural gas markets.”
Similarly, Nymex said last month that the fund’s significant losses had not created a ripple in operations or on the markets. “The account and carrying clearing member are in good standing,” Nymex spokeswoman Anu Ahluwalia said. “Nymex continues to actively oversee and maintain orderly markets.”
Echoing Olson’s belief that Amaranth attempted strong-arm tactics in the natural gas arena, Robert McCullough, manager of McCullough Research, said he believes Amaranth gas trader Brian Hunter quite possibly attempted to corner the natural gas market. Various reports within the industry last week stated that Calgary-based Hunter, age 32, was no longer with Amaranth and that the rest of the fund group might liquidate soon. According to the Financial Times, Amaranth informed investors that Hunter had left the firm and had received no termination pay.
McCullough said while the financial disaster is significant, “an issue of far more concern is how a small player in the natural gas business amassed a natural gas position significantly larger than Nymex without comment or intervention by [the Federal Energy Regulatory Commission (FERC), the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC)]. The evidence suggests that Amaranth had accumulated a natural gas position in March considerably greater than that required to corner the North American natural gas market.”
While noting that raw data regarding Amaranth is hard to come by, McCullough’s report titled “Did Amaranth Attempt to Corner the March 2007 Nymex at Henry Hub?” describes what has occurred based on the evidence that has appeared so far. “Even if the current data is scant at this point, we think that Amaranth was a situation waiting to happen, given the lack of federal oversight of energy markets by FERC and the CFTC,” he said. “Although some pundits assert that ‘the market’ is strong enough to absorb Amaranth’s ripple, we are deeply concerned that a single, somewhat small hedge fund in effect may have attempted to corner the natural gas market.”
In the report, McCullough theorized that for Hunter to lose $6 billion from a small change in the spread between March and April 2007 natural gas futures, he must have accumulated a position of 9,128,000,000 billion MMBtu. “This is an overwhelming position,” McCullough noted, adding that “Nymex’s open interests for March 2007 are a mere 900,060,000 MMBtu. In other words, Amaranth’s position may well have been 10 times the entire size of Nymex for March 2007 forwards.”
McCullough surmised that given Amaranth’s limited financial resources, it is likely that the majority of its position was options. He added that it is also likely that most of the positions were OTC, since the position dwarfed Nymex. “Data from ICE is more difficult to acquire, but all indications are that Hunter’s position would have dwarfed ICE as well,” McCullough said. “The rapidly rising amount of open positions in March and April would seem to indicate that Amaranth was expanding its positions over time — perhaps trying to ‘buy ahead’ of falling expectations for next spring. At the end of December 2006, open interests for March and April were 5% of the total Henry Hub open interests. As of September 22, 2006, March and April contributed 16.5% of total Henry Hub open interests. This is consistent with a desperate trader supporting the market by additional purchases, but hardly definitive, given the fragmentary state of the data.”
Of greater concern for policymakers is the fact that U.S. consumption of natural gas in March 2006 was only 2,120,047,000 MMBtu. “Simply put, Mr. Hunter had accumulated an overwhelming corner of natural gas for March 2007,” McCullough said.
“Amaranth had a massive forward position for a specific month in which the primary alternative to current production, storage, was at a minimum,” McCullough said. “The size of his position was such that physical delivery would have been impossible.”
Speculating on Hunter’s objectives, McCullough said if the trader sought physical delivery in March 2007 for only a portion of his portfolio, Hunter would have been able to dictate spot prices. If his position was only financial, Hunter raised the prices to end-users when utilities and manufacturers attempted to compete in this market for hedges.
Is Regulation the Answer?
However, McCullough noted that there is very little information on the contracts Amaranth was purchasing, adding that neither the CFTC nor FERC currently has the ability to determine the nature of Amaranth’s position. “While the CFTC would be able to detect Amaranth’s position if taken within Nymex, the commission has no powers over either ICE or the OTC market,” he said. “FERC has traditionally restricted market surveillance to the centrally administered markets within regional transmission organizations and price reporting by industry journals. ICE and the OTC market do not fall within FERC’s existing market surveillance.”
In addition, McCullough said that while opinions on the need for increased regulation of hedge funds has been mixed over the years, Amaranth’s “staggering losses” again bring up the need to revisit the issue.
On the topic of hedge fund regulation, Bill Feingold, an analyst with Schaeffer’s Investment Research, said last week that the “knee-jerk call for regulation” brought on by the media could be a good thing — if the regulation is implemented correctly.
“Let’s concede for a moment that further regulation is necessary,” Feingold said. “How do we make sure that the cure isn’t worse than the symptoms? Is it better to limit vastly the universe of assets pension funds and other investors can buy? One effect of this would be to go directly against Nobel-winning portfolio theory, which argues that a group of seemingly risky but uncorrelated assets can make up a portfolio that provides the best possible return for any given level of risk.”
Feingold said realistically more regulation “may well be necessary,” but he noted that the regulators that are needed are the ones who are comfortable with the strategies they follow. “It’s not easy for regulatory bodies to hire sufficient numbers of talented workers who understand the strategies and can supervise appropriately,” he noted. “Simply put, their private market value is usually too high. How do you address this?”
As for reports in the media that regulators are moving too slowly on this issue, Feingold said the policy makers might be waiting until they have a complete staff ready to do the job. “If this be so, they deserve credit, not random impatience,” he said.
On the over-the-counter market regulation front, Sen. Dianne Feinstein (D-CA) last week criticized the CFTC for its failure to properly perform its oversight responsibility for energy trading markets. Feinstein also renewed her call for passage of legislation she has sponsored to increase transparency and accountability in energy trading markets for oil and natural gas. She believes the bipartisan measure (sponsored by 12 Democrats and one Republican) would give the CFTC the means to effectively exercise its existing anti-fraud and anti-manipulation authority over energy commodities traded on U.S. exchanges.
She added that the fallout from Hunter’s ill-advised natural gas trades were far-reaching. She noted that among other clients who suffered massive setbacks, the collapse of the hedge fund reportedly cost the County of San Diego as much as $87 million in investments set aside for employee pensions.
“I see no evidence that the CFTC has done anything throughout this whole affair,” Feinstein said. “The CFTC consistently says they do not need additional authority to prevent manipulation in the over the counter markets. So if that’s the case, where were they before Amaranth’s Mr. Hunter bet $6 billion on natural gas futures? How many times do we have to learn this lesson? We need transparency in and federal oversight of our energy markets. We need to pass my legislation without delay.”
Feinstein’s Oil and Gas Trader’s Oversight Act (S.2642) would:
The bill is also sponsored by Senators Olympia Snow (R-ME), Carl Levin (D-MI), Maria Cantwell (D-WA), Tom Harkin (D-IA), Barbara Mikulski (D-MD), Barbara Boxer (D-CA), Jeff Bingaman (D-NM), Byron Dorgan (D-ND), Frank Lautenberg (D-NJ), Jack Reed (D-RI), Russell Feingold (D-WI) and Joseph Lieberman (D-CT).
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