 Energy Prices, Hedge Funds and the Coming Energy Crisis - By Gary M. Vasey, Ph.D. Daily IssueAlert 9/26/2005 Free Over the last 12 months or so UtiliPoint®, in conjunction with affiliate consultant, Global Change Associates, has followed the entry of hedge funds into the energy industry. The funds have been blamed by the media, politicians and others for running up the price of energy commodities through speculation activities. In 2004, energy commodity hedge funds returns seemed to bear out some of this sentiment as they made spectacular returns in the 20-100+ percent range, but 2005 has so far proven to be a much tougher year. Recently, a small number of funds (and investment banks for that matter) focusing on electric power and natural gas trading have apparently suffered large losses (estimates put losses at larger individual funds and the banks at between $100 million to as high as $1 billion). In recent weeks, several energy hedge funds have closed shop pointing to an inability to deliver on investment strategy in certain energy commodity markets. Yet Interest in Energy Funds Continues To Grow Today, we are tracking more than 420 energy-focused hedge funds in the Energy Hedge Fund Center's Directory of Energy Hedge Funds. Each month, we add between 5 and 15 more funds that we have discovered. About half of these are funds in formation while the remainder are funds that have existed for some time. Since U.S. fund managers are restricted from advertising themselves and their activities, it is often difficult to find and identify them. It is this regulatory requirement that creates the sense that funds are secretive. While commodity focused funds are having a difficult year, it often gets overlooked by the media and others that many of the 420+ funds do not trade energy commodities at all. Most are equity long/short funds while an additional minority are focused on alternative energy, distressed assets, debt or environmental plays. 25 or so more funds are actually funds of funds that invest in a portfolio of other energy focused or natural resource oriented hedge funds. There are about 110 energy commodity focused energy hedge funds that we are aware of. Meanwhile, equity long/short funds continue to perform very well across all energy industry sectors this year by contrast to the difficulties experienced by the commodity funds. While investor interest in energy hedge funds has grown over the last 12 months, so has interest in energy as a sector for all investors. While you have to qualify as independently wealthy to invest in a hedge fund, ordinary investors now have a wealth of energy-focused mutual funds, Exchange Traded Funds (ETFs), Master Limited Partnerships (MLPs) and Canadian income trusts to invest in. In other words, interest in the energy sector as an investment opportunity is not restricted to the wealthy! Many ordinary people have shifted some IRA and other monies into energy and been rewarded with 30+ percent returns to date this year. There is even now talk of new retail investment products that allow you and me to "speculate" in commodity markets too. Plainly, all this interest in energy investing has been driven by the rise in energy commodity prices and the knock on impact on earnings and spending levels in the industry. Are Hedge Funds Really to Blame For High Energy Prices? All the research that we have performed this last year suggests that energy price rises have been dictated by fundamentals in our industry. The lack of adequate investment in industry infrastructure over the last 20 years combined with some degree of complacency around supply and demand is primarily to blame. The complacency arose as a result of a prolonged period of relatively modest energy prices punctuated only by mini crisis events. Each crisis event certainly drove up prices but was followed by "mean reversion:" or a return to a lower price level after a short space of time. Since last winter, Peter Fusaro and I have been stating that there would be no mean reversion this time because something fundamentally had changed in the energy world. What had changed was that demand caught up with supply and it did so very quickly, largely due to the rapid growth of Asian economies such as China and India. However, it should be noted that energy demand has also been growing a quite a clip in North America too. In fact, we have gone further and argued on many occasions that this fundamental change in energy markets would create some unusual market behavior. In other words, the past is no longer the predictor of the future. We cited the case of heating oil exceeding the price of gasoline this past driving season as one example of this phenomena ( Turbulent Markets Ahead: Why the Energy & Environmental Crisis Will Continue For Many Years.) Now it seems as if the historical and somewhat predictable seasonal cycle of natural gas price formation has also changed and it is that break with historical precedent that has resulted in hedge fund and bank losses as they looked to short natural gas going into the shoulder months. Yes, in part this market behavior has been a factor of unforeseen events such as the hurricanes but it too is symptomatic of the fact that these markets have fundamentally changed. The paradigm has shifted. As German politicians, amongst others, continue to blame hedge funds for the run up in energy commodity prices, I am forced to ask just how they can make such claims. All the evidence suggests that 110 or so funds with around $50 billion (even if highly leveraged) just cannot have that kind of an impact on markets. Additionally, having researched how many of these funds actually operate, their impact should be on intra-day volatility as they trade large and fast. We have also discovered that most energy commodity hedge funds pursue strategies based on their view of industry fundamentals and it is the Commodity Trading Advisor (CTA) that most often use trend-following strategies. Finally, the fact that the funds and the banks have had such a hard time this year making returns and have even lost money suggests that they too are capable of making bad "bets." Evidence has also been produced by various organizations including NYMEX to show that the funds are not responsible for the run up in energy prices. Today's energy prices reflect the fundamental shift in supply/demand factors that has taken place over the last 18 months superimposed with mini crisis price spikes such as that caused by Hurricane Katrina and other events. The energy commodity funds, as well as the ordinary average investor, have simply taken note of the rise in prices and seen an opportunity to make superior returns in energy in my view. The Heart of the Issue Central to this issue seems to be an inability to actually address it. What politician wants to draw the public's attention to the fact that we are in the beginning of an energy crisis? It's far easier to blame speculators and hedge funds, after all they aren't allowed to respond to those allegations and therefore won't argue. Without belaboring the point, this is an issue that needs to be addressed through a comprehensive national energy strategy (We Got an Energy Bill, But Now it's Time for an Energy Strategy) that incorporates environmental issues, energy conservation and efficiency, technology and new energy sources. Peak Oil? Despite the fascination with theories such as "peak oil." there is no real shortage of energy or oil. Peak oil (or Hubbard's peak named after M. King Hubbard, the Shell geologist that first put forward the idea) is reached at the point when demand outstrips our ability to add new supply through new reserves. This point occurred in 1970 in the United States and was accurately predicted by Hubbard who determined that global peak oil should have occurred in the late 1990s. It is true that we are experiencing a period of supply/demand tightness but it isn't necessarily true that this represents the onset of peak oil. What the peak oil theory, as promoted by its most avid followers, doesn't appear to allow for is human ingenuity. Firstly, as oil prices rise, increased efficiencies and conservation ought to follow. It certainly did after the last oil price shock. Secondly, as oil prices rise, so does the interest in finding more of the stuff. It is true that the majors have not really increased their E&P budgets preferring instead for a less risky strategy of giving money back to shareholders but usually, increased E&P activity is led by independents. And the evidence we see in the market shows that once again, it is the independents and the "junior" oil companies that are now driving rig utilization rates back up. Peak oil theorists also talk about new exploration frontiers being in inaccessible of politically unstable areas as if, somehow, that discounts the idea that these reserves will ever by developed. Surely the lure of oil revenue is simply too much for those involved to ignore and oil companies have shown no loss of appetite for exploring and producing in the most remote and/or dangerous places on earth! Thirdly, and I think most importantly, is that grey area of unconventional reserves. These are usually glossed over as simply adding a small amount of cushion prior to peak oil. Well, tell that to the Canadians who estimate tar sand reserves at 1.6 trillion barrels and 178 billion barrels recoverable. In fact, with rising oil prices and improved technology (i.e. man's ingenuity), the recoverable reserves could be more than 300 billion barrels. What about the attention that is now being paid to oil shales in Colorado, Wyoming and Utah? Again, with oil prices this high and with ingenuity in terms of technology, those reserves are estimated at 500 to 1.1 trillion recoverable barrels. And that is just two sources of non-conventional crude oil in North America. Similar deposits occur around the world and can yet be tapped. UtiliPoint's IssueAlerts are compiled based on the independent analysis of UtiliPoint consultants. The opinions expressed in UtiliPoint's IssueAlerts are not intended to predict financial performance of companies discussed, or to be the basis for investment decisions of any kind. UtiliPoint's sole purpose in publishing its IssueAlerts is to offer an independent perspective regarding the key events occurring in the energy industry, based on its long-standing reputation as an expert on energy issues. Copyright 2005. UtiliPoint International, Inc. All rights reserved. |
