Hedge funds play interesting role in oil & gas escalating prices

Pipeline & Gas Journal, April, 2008 by Carol Freedenthal

In late February and early March, crude oil and natural gas prices continued their steep, upward spiral. Crude oil prices at around $108/bbl surpassed the inflation-adjusted all-time high reached in the early 1980s. The high crude prices have pushed the national average for gasoline at the pump into the $3.20 range with even higher pump prices forecast. Natural gas prices, despite the large quantities in storage, still broke high ground going over $9/MMBtu at Henry Hub during the same time period.

Though this was still winter, there were no supply shortages. The global political scene is as tense as usual between Venezuela, Nigeria, Russia and Iran but that's still not enough to justify the high prices, The dollar is weak against foreign currencies and this does impact the price of crude. Overall, there was no real reason for the heavy upward price movement of both fuels.

Without going into a major treatise on fuel pricing, there are four major factors that affect where prices go: supply/demand balances which would include supply, weather, demand and all the real-life facets of fuel use; political, which includes political unrest, especially with nations supplying energy raw materials; economics, which would include the value of the U.S. dollar and other global economic forces; and lastly, but maybe the most important right now, financial, which many times is referred to as "paper trading" since neither buyer nor seller might take physical possession of the commodity.

Financial includes all of the buy, sell and other "paper" trading activities with energy products. It does not omit buying and selling of physical products since this might be a part of the overall trading action. Financial traders care little about the product itself. It is only the use of the commodity as a means of playing market swings and price changes to make money. And that is big money!

It's estimated that paper trading of crude and natural gas on financial markets on any given day can be 10-20 times more than the actual physical trading volume. This opens up the concern of what trading companies, especially those that are known as "hedge funds," might be doing to the volatility of crude and natural gas prices.

Two major factors play a role in arousing this suspicion--first, the trading is strictly for the potential of profitability since they have no use for the commodity other than as a money maker and second, they have such large sums of money to play with that they can influence the markets. While many producers and consumers have trading companies, it is the financial traders--many of which are hedge funds--that are of special interest.

Defining hedge funds is interesting. Simply put, it is a group comprised of a limited number of wealthy investors--individuals or institutions--and a manager who has almost unlimited flexibility in his trading operations. Many compare hedge funds to mutual funds. But there are some drastic differences.

Hedge funds come under very few regulations which allow them almost complete freedom in trading activities. They are very secretive compared to the required openness of mutual funds. Mutual funds are open to anyone joining by buying shares. Hedge funds require the investor have a minimum amount of around $2.5 million in investments so that it can be said that only knowledgeable wealthy people are participating.

Anyone can start a hedge fund because no license or expertise is needed. A fund manager is paid a management fee and gets a slice of the profits. Usually, the management fee is 2% of the assets and the slice is around 20% of profits but can be as high as 50-60%. No reporting is required or registration with the Securities Exchange Commission. Some activities do come under review of the Commodities Futures Trading Commission (CFTC) and if the trading is in natural gas, under the Energy Policy Act of 2005, the Federal Energy Regulatory Commission has some oversight.

Hedge funds are big in assets--big in the dollars they have control over. A recent Wharton Alumni Magazine article gave the estimated value of hedge funds as $1.8 trillion. On top of this, it is easy for them to borrow more money to leverage their investments. While they take part in all kinds of financial investments, dealing in the energy markets has proven very effective at money making. The tremendous dollar volume of the energy markets--just world crude oil on an annual basis of physical product is about $2.6 trillion--is ideal for generating profitability. When natural gas and all the derivatives of the basic energy products are considered in total, the dollar value is staggering.

Though there is no direct correlation that trading companies, including hedge funds, contribute directly to higher commodity prices, there are some strong indications they do influence oil and gas prices. In the trading business, there are basically two type of trading operations: functional and technical. Functional traders look at markets, economics and politics to develop their trading strategy. The technical trader basically looks and works with only one element in developing his trading strategy--the price and volume history of the given product.