hedge funds see energy’s potential

Dr. Gary M. Vasey, UtiliPoint International, &
Peter C. Fusaro, Global Change Associates

2005 is the year that energy will come of age as an alternative investment class. Already, hundreds of hedge and pension funds have seen the year’s potential and are active across the industry from commodities trading through distressed assets, debt, equities and arbitrage. New funds are in formation, both in North America and in Europe, and with vast amounts of new money flooding into the funds from institutional and private investors, 2005 will see a sea change in the energy landscape. But, what is driving this level of interest, and why is energy so attractive now?

hedge funds increasing popularity

Despite increased interest from regulators such as the SEC and others, hedge funds are being funded at a record pace. Once the exclusive domain of private wealthy individuals, institutional money is now flooding into hedge funds seeking promised better returns. The $38.2 billion that flowed into the funds in Q1 2004 was a record, and that pace has continued as public and corporate pension funds now allocate an average of 5 percent to 7 percent of their assets for investment in hedge funds.

But, as hedge funds gain access to increasing amounts of capital, so too has the average hedge fund return declined to something less than spectacular. Hedge funds returned less than 9.64 percent last year, compared to 15.44 percent in 2003, and underperformed more conventional asset classes according to the CSFB Tremont hedge fund index. Hedge fund managers attribute their lower performance in 2004 to low volatility and low interest rates. As a result, the hedge funds have been looking for other asset classes to invest in. Seeking new opportunities where the sparkle can be put back on their reputation for producing a significant return on investment they have identified the energy industry as having that potential. Early indications have only served to raise energy’s profile since some of the better performing funds last year were focused on energy.

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Today, those ex-energy traders from the merchant era are back in demand. They are being snapped up by hedge funds and, in some instances, forming their own hedge funds based on their trading expertise. Indeed the number of specialist energy commodities trading funds with between $1 million and $25 million in assets under management is growing rapidly. Not all the energy funds are so small. Several of the better known energy focused funds are quite large, between $400 million and over $1 billion in assets under management. But, we are also seeing a trend for much larger (greater than $1 billion under management) macro funds to switch more of their assets into energy too. Today, our research has identified over 285 hedge funds that are active in the energy industry and that number continues to grow.

why now?

Perhaps those of us in the energy industry have been too comfortable and too close to the business to notice the lack of sustained investment in our industry. Whether it be oil and gas exploration, development of reserves or investment in power industry, we are now seeing supply tightness in most energy commodity markets and a historical under valuation of energy companies and their assets. There is also supply tightness in transportation markets as well. At the same time, demand has continued to grow robustly, and we are now reaching a stage at which unforeseen events such as terrorism, industrial disputes or accidents, and transmission constriction is enough to cause considerable concern about supply. This has resulted in increased volatilities, particularly in oil markets, and the funds love that price volatility.

There is now a growing awareness and even acceptance that in global oil markets supply tightness is such that OPEC no longer holds the swing vote on oil price formation. Today, oil prices are set by the trader’s views on the NYMEX as much as anything else. Events such as those in Iraq, Nigeria, Russia and Venezuela that result in the potential for disruption, combined with reserve estimate reductions by major oil companies and the lack of transparency into the true nature of OPEC’s own reserves are now sufficient to cause $2 daily swings in the oil price. Over the last two decades, oil companies have been more interested in buying back their stock to increase share prices than in new exploration or production. Wall St. just hasn’t rewarded explorers and risk takers, and the majors have not increased their exploration and production budgets partly because other commodity markets, like steel, have also risen accordingly.

The fact is that for each energy commodity the picture is similar. While oil is a global market and impacted by global events regional natural gas, coal and electric power markets are now often subject to similar supply tightness. The rush to natural gas fired generation has helped to increase the perception of supply tightness in gas markets and the 2003 blackout did likewise for electric power.

Hedge funds like volatility. They like to identify trends and bet on those trends. Today, they see that the trend in commodity prices is up, and, as they place their bets, they are accentuating those trends. They are also followers and will follow each other chasing the money and the returns. Some of the energy commodities trading funds had returns over 40 percent last year, and that has not gone unnoticed.

Similarly, as oil companies make money on increased commodity prices, their equities look undervalued. Energy stocks look undervalued. At the same time, the collapse of the merchant sector has created distressed asset and debt plays for the funds. As ex-merchants seek to raise cash by selling perfectly good assets, the hedge funds have seen their opportunity. Today, hedge funds are among the leading holders of ex-merchant debt backed by valuable collateral. Even as the industry seeks answers to its own problems, the hedge funds see opportunities in renewables and green trading, for example.

hedge funds in the power industry

While the emphasis for fund commodity and physical trading has been in oil, natural gas and oil products, there are a smaller number interested in electric power including trading financial electric power, the most volatile commodity ever created. Several have registered already to trade, one or two are actually trading and many more are looking at their options. Although electric power markets were de-regulated more recently, they are more complex in terms of their regionality and the physical nature of the commodity itself. Additionally, there is a preference for bilateral trading on the part of traditional power companies. But the power markets are maturing and Over the Counter clearing mechanisms are being introduced that will help.

From a distressed assets and debt perspective, there has been much opportunity for the funds in the form of asset sales. Today, hedge funds are sizable owners of electric utilities and generators such as British Energy, the Drax facility in the UK and even Aquila. There will be more coming this year as M&A activity accelerates and the values of distressed assets start to dissipate.

The funds are here to stay. The mainstream media reports that the “funds are in and the funds are out” misses the true structural change that is occurring in energy markets. The funds see value in energy, and the market fundamentals of underinvestment in the upstream, downstream, midstream and transportation markets will continue to bring a large influx of money in from Europe and Asia as well as the US. Energy hedge funds are just starting their long ascension into commodity trading. 2005 promises to be bumpy and volatile.

Vasey and Fusaro have issued their second energy hedge fund report available and created an Energy Hedge Fund directory both available at the Energy Hedge Fund Center: www.energyhedgefunds.com.

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