September 12, 2007

First it was Enron. Then it was Amaranth Advisors, a hedge fund that collapsed. The changing face of energy trading has left regulators scurrying to catch up. The questions now before U.S. lawmakers are to what extent big traders move markets and the means by which such outfits should be monitored.

Traders merely match buyers and sellers and profit those transactions. It's a risky business, with many traditional energy outfits having shed their marketing and trading ventures so that they could focus on their core strengths. When they vacated the market, the investment banks then filled the void. Hedge funds also emerged, which are essentially unregulated mutual funds comprised of sophisticated investors.

Hedge funds seek to find "arbitrage" opportunities whereby they might buy power for a low price in one part of the country and sell it for a higher price in another region. They often carry out "over-the-counter" transactions that are private and outside the purview of regulators thanks to the so-called Enron loophole. That provision, which is part of the Commodity Exchange Act and which Enron requested in 2000, exempts some commodities from government supervision.

Hedge funds may not be able to evade government scrutiny for long. Amaranth's demise is the catalyst. And now, other major hedge funds that include two run by Bear Stearns have lost huge bets in the mortgage lending sector.

It's not just the problem of the rich and famous. In the case of Amaranth, an independent congressional panel concluded that its large position in natural gas markets caused market volatility. That, in turn, forced average people to pay much higher prices. And hedge funds with mortgage assets are a separate problem. Their losses have constrained lending practices, which means ordinary businesses like utilities may not borrow and subsequently add jobs or new technologies.

Certainly, most of the pain will be centered on the housing sector. But the energy sector needs to cooperate with federal lawmakers and regulators to determine how hedge funds that trade key commodities can be monitored. The Senate Permanent Subcommittee on Investigations conducted a nine month investigation into the collapse of Amaranth. It concluded that Congress needs to enact laws that would curtail "excessive speculation," allocate more money to the Commodity Futures Trading Commission and delete the "Enron exemption."

"Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened price spreads and increased price volatility," the panel wrote. The fund, which lost about $6.5 billion before it finally went bankrupt in September 2006, held 100,000 natural gas contracts that accounted for 5 percent of all natural gas consumed that year.

Restraining Amaranth

Most of the trading takes place on the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE). The Senate panel's report says that neither regulators nor the exchanges had a complete picture of Amaranth's holdings. Nevertheless, it finds fault with NYMEX, saying it failed to help restrain Amaranth. When the exchange asked the hedge fund to reduce its holdings in the summer of 2006, Amaranth then transferred the transactions over to ICE.

The exchanges find the criticisms unfair. And, naturally, so do Amaranth's representatives. All of those parties note that the Senate report acknowledges that there were times when the hedge fund was responding to market conditions and not driving them. NYMEX adds that hedge funds account for a modest share of futures markets and those funds are unable to cause large movements in price. Specifically, such holdings represented about 9 percent of the natural gas futures trading volume in 2004 - an amount that the exchange says adds liquidity and contributes to a more vigorous market.

"If Amaranth really dominated the market, wouldn't they still be in business?" asks Geoffrey Aronow, a lawyer representing the hedge fund's founder. The report's findings are "a novel theory of causation that is not supported by economic logic," he says.

The Amaranth debacle, however, comes in the wake of the 2001 Enron mess and subsequent allegations of price manipulation in natural gas markets. While key Republicans in Congress say that strict oversight in the hedge fund industry could lead to trades taking place in darker corners, the Democrats say more needs to be done. In 2005 alone, U.S. consumers and businesses spent about $200 billion on natural gas.

Amaranth dominated trading in U.S. natural gas markets, holding about 40 percent of all outstanding natural gas contracts on the NYMEX during 2006. Specifically, it held at times 100,000 natural gas contracts in a month. NYMEX says it will examine those positions if they exceed 12,000 in a month. In any event, critics say that such large holdings were the driving force behind higher natural gas prices.

"Market prices are supposed to be the result of the interaction of many buyers and sellers, not the result of massive trades by a dominant speculator with market power to affect prices," says Senator Carl Levin, D-Mich., who heads the Senate panel overseeing the Amaranth investigation. "But in 2006, Amaranth dominated the market, and winter prices remained at extreme levels despite ample supplies. Later, as Amaranth collapsed in September 2006, winter prices fell dramatically, but by then many natural gas consumers were already locked in and couldn't take advantage of the lower prices."

Congressional inquiry into the hedge fund business is justified. Major losses incurred by those investors don't just affect speculators. They also impact ordinary people who -- if the Senate panel is correct -- absorb the price spikes. Such funds, however, are largely exempt from any form of regulation. But in the aftermath of Amaranth and the current credit collapse, changes may be coming.

More information is available from Energy Central:

ICE Gets Hot, EnergyBiz, March/April 2006

Gas Price Disconnect, EnergyBiz, May/June 2006

Respond to the editor. (Ken Silverstein EnergyBiz Insider Editor-in-Chief )