The dark matter of the electricity universe
At first glance, hedge funds appear to provide the dark matter of the energy industry, invisibly fueling physical asset acquisitions and energy trading, but detected only when exploding with enormous profits or losses.
Although an estimated 500 hedge funds invest in energy, of which a subset reportedly acquired high-profile energy traders, the role of such investment vehicles in the electricity industry has been unclear. Embarking here on an exploratory mission to uncover where hedge funds are operating in U.S. electricity markets, our preliminary conclusion is that hedge funds appear to be doing very little investment directly into physical assets and physical power trading, but are actively engaged in financial markets. Hidden from view, however, maybe more physical activity than is visible.
The Elegant Universe of Hedge Funds
The term “hedge fund” was coined in the 1960s to describe the strategy of borrowing to increase potential returns from selling short stocks to reduce the risk of long equity positions. Today, hedge funds pursue strategies very different from the original hedging concept. Fueled by increasingly liquid markets for futures, options, swaps and other complex derivatives, new strategies constantly seek the conflicting requirements of market inefficiency and liquidityinefficiency to create arbitrage opportunities that leverage can amplify into profitability and liquidity to allow for quick portfolio rebalancing. Speculative positions have also become common, with global macro strategies allowing funds to make directional bets on market trends.
Despite recent legislative debates in the United States, most hedge funds continue to operate without substantive regulatory oversight by the Securities & Exchange Commission (SEC). As long as these investment vehicles meet certain size and investor requirements or register off-shore (e.g., as a Cayman Island exempt company), fund managers do not have to report on the composition of their portfolios to the SEC. The term “hedge fund” therefore no longer reflects a risk management strategy, but rather signifies an investment structure with the ability to operate largely outside standard financial sector regulation.
With the growing impact of hedge funds, it would seem easy to obtain a map of the stars in this galaxy. Alas, no such list publicly exists. Thus, we must cobble together hedge fund data from various public sources, pure logic, and Internet searches in order to know where to begin. Armed with our own list of hedge funds and proprietary trading companies, we can embark on an analysis of their participation in electricity marketsan analysis more akin to the art of navigation than science.
The Physical Setting: Power Markets
Despite rampant speculation that hedge funds would contribute significant capital investment in generation assets, funds do not appear as direct owners of power plants.
One hedge fund consortium, which included Perry Capital Management Inc., Cerberus Capital Management LP, Caxton Associates LLC and Seneca Capital Management LLC, did bid on Texas Genco in 2004, but lost to a private equity group led by Blackstone, according to a January 2005 article in Investment Dealers Digest Magazine. And, based in part on a recent SNL Energy report, it seems hedge funds have not been significant investors in generation assets since then although private equity is rampant. A review of the Energy Velocity Electronic Database of generation plant ownership in North America (V. 2006-10) supports this conclusion, identifying D.E. Shaw as a minority owner of two separate facilities, and very few other hedge funds as direct owners.
Lack of investment directly into generation assets by hedge funds makes sense. Physical plant ownership is not a liquid investment. Buying and selling generating facilities requires extensive engineering review, due diligence, legal contracts and regulatory approval. It is much easier for a hedge fund to invest in generating companies through publicly-traded equity markets for which liquidity benefits outweigh direct ownership arbitrage opportunities. Thus, although hedge funds are experimenting with new development and technology ventures through alternative configurations such as side-pocket funds and alliances to hold these illiquid, non-transparently priced assets, their current positions seem to be limited to equity ownership in companies that do own power plants as opposed to direct ownership of assets.
The next place to search with respect to physical markets is power trading. If a hedge fund wishes to trade power through a power pool, it must register with the Federal Energy Regulatory Commission (FERC) for market-based rates. FERC docket orders indicate that hedge funds began requesting regulatory approval to sell power under market-based rates with Citadel’s application in 2002. Since then, the number of hedge funds submitting applications to FERC has grown annually such that more than 12 applications were submitted in the first nine months of 2006 (see Figure 1). Saracen alone registered at least three hedge funds for market-based rates in 2005. D.E. Shaw registered three separate funds in 2003. Combining sister companies, only two dozen hedge fund families currently have FERC permission to trade physical delivery of power under market-based rates, and this number grossly overstates the number of hedge funds actively trading power under their own names.
FERC approval to sell power under market-based rates requires electronic quarterly reports (EQRs) that describe trading counterparties, geographical markets and products. According to the EQRs filed for January 2004 through second quarter 2006, very few of the registered hedge funds actively trade power in physical markets. Citadel is the lead hedge fund engaged in physical trading, with multiple partners in multiple jurisdictions. DC Energy and the Saracen funds sell power directly into various power pools. Most of the registered hedge funds report no sales, or trade intermittently. Of course, this does not capture trading performed under agency agreements or on behalf of another entity.
The Non-Local Universe: Financial Exchanges
In comparison to physical markets, financial exchanges offer hedge funds a more comfortable space in which to operate. The New York Mercantile Exchange (NYMEX) is a commodity futures exchange that specializes in energy and precious metals under regulatory oversight of the Commodity Futures Trading Commission (CFTC). The Intercontinental Exchange (ICE) offers an electronic over-the-counter (OTC) venue for a subset of the energy commodities traded on NYMEX, including oil and refined products, natural gas, emissions and electricity, with limited oversight by the CFTC.
These two financial exchanges offer hedge funds three benefits: anonymity, clearing mechanisms and liquidity.
Although public transparency is limited regarding what hedge funds do in these financial markets, we can examine who is registered with NYMEX. Many of the same players in the physical markets are listed as participants of NYMEX ClearPort, an electronic trading system NYMEX uses to support the trading and clearing of Exchange futures contracts in energy. The ClearPort membership list also includes other hedge funds that reportedly acquired established energy traders, including Centaurus Capital and Vega. There are a significant number of additional hedge funds listed on NYMEX.
Although ICE publishes a list of its futures members, which includes a handful of hedge funds, it does not publicly provide a list of the more than 800 trading firms that participate in the OTC markets. ICE does report in its public filings that the fastest growing participant segment of OTC commission revenues is the financial services sector. ICE also reports that the share of commission fee revenues from hedge funds, locals with floor or electronic trading privileges, and proprietary trading shops grew significantly from 4.6 percent of OTC commission revenues in 2003, to 30.7 percent in 2005 (see Figure 2).
This does not indicate the growth in commissions for power only, but if it is similar, there has been a significant growth in power trading by hedge funds and proprietary traders. These trades could be speculative bets or could be part of a more complete package of hedges to a portfolio of equity investments, physical power contracts, or positions in other energy commodities.
Converging Realities: Financial Transmission Rights
Another informative place to search for hedge funds is in one of the few fully transparent financial markets in North America: auctions for financial transmission rights (FTRs), also known as Transmission Congestion Contracts. Analysis of these markets in the Midwest (MISO), New England (ISO NE), New York (NYISO) and Pennsylvania-New Jersey-Maryland (PJM) control areas indicates that at least 18 different hedge funds participate in these auctions. Players with the longest tenure and trading scope include Citadel and DC Energy (in all four markets since inception). Saracen jumped into FTR markets in 2005, and now trades in MISO, PJM, and New York. Other funds trade in FTR markets selectively.
Combining FERC physical trade data with FTR financial information sheds some light on hedge fund activities in these markets. Some funds actively trade transmission rights in the same markets to which they are selling physical power, implying an arbitrage play between the physical and financial electricity markets. In contrast, DC Energy’s large profits across multiple markets and Citadel’s significant losses in PJM in the 2005-06 auctions could indicate large speculative positions in FTRs.
An Understandable Practical Reality
In the North American electricity market universe, hedge funds tend to be most visibly active in financial trades. Although a few hedge funds do trade in physical power markets under their own names, such trades appear to serve as arbitrage opportunities to counterbalance financial positions and potentially arbitrage across commodities. Very few hedge funds appear to have assumed long positions in physical power through acquisition of generation assets outside of consortium alliances, quity positions, or side pocket funds.
This pattern of behavior, however, constantly changes with the agility represented by the unregulated hedge fund structure. Although most hedge funds currently operate outside the regulated physical domain, some such as Citadel, DC Energy, D.E. Shaw and Saracen are operating under their own names. Others may be positioning to expand into those areas when the benefits outweigh the exposure.
Special thanks to Ethan Levine at CRA for his assistance in pulling together the information used in this article.
Tanya Bodell is vice president, leader trading and institutional structures, in the energy and environment practice at CRA International Inc., an economic and management consulting firm. In trading and risk management, Bodell’s work spans all energy-related commodities, including regulatory compliance, tradebook valuation and portfolio optimization. Contact her at [email protected]