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Energy as an Asset Class for Hedge Fund Diversification
Global Change Associates Inc., April 2005, Pages: 130
Hedge fund returns have disappointed investors over 2004 even lagging behind that of mutual funds. Consequently, the funds are seeking new areas of investment where returns may be better and the volatile world of energy is seen as potentially providing such an opportunity.
Today, there are more than 8,100 hedge funds with at least $820 billion at work . This is double the number of funds over 1999. The flat or sideways trading of global equity markets for the past year has not shown the rates of return that investors have become accustomed to. Meanwhile, the energy complex is volatile. It is capital intensive. The energy industry is just plain interesting. You can't put down the paper today without every angle of the energy complex being under intense scrutiny and interest.
What is ironic is that hedge funds trading oil are not doing anything that the large investment banks such as Goldman Sachs, Bank of America or Morgan Stanley already do. The proprietary trading desks of these and other large investment banks are actually 'hedge funds in drag' just as Enron was. The banks never talk about what they do and consequently they tend to fall under the radar screen. But they must be doing something right, as Morgan Stanley and Goldman Sach's commodity trading groups have had substantial profits in recent years.
After the shock of the demise of Enron and merchant energy trading generally, it has taken more than two years to get back on track and for the energy trading market to be rebuilt. The warnings that the industry would be in turmoil for many years were likely overly exaggerated but also predictions regarding the demise of the market were wrong. We have not seen the predicted globalization of electric utilities, but instead we have seen foreign utilities retreat from American power markets. We have also witnessed the Wall Street power companies rise as they bought distressed assets and began to trade those assets through various asset optimization strategies. We have seen the resurfacing of the financial institution/utility joint ventures with Merrill Lynch's purchase of Entergy/Koch and, more recently, we have seen the entrance of financial hedge funds focusing on the energy industry for a variety of reasons.
What has occurred is the merger of big money and big energy together. This is no longer a game for small companies, including electric and gas utility companies. This is investment banking, asset-backed trading, pure commodity trading, and most importantly that of financial balance sheets that assume 'capital at risk.' The combined ongoing research of Global Change Associates and Utilipoint International has revealed that there are over 250 energy hedge funds and perhaps as many as 400 with new funds emerging on a daily basis. We classify 'energy' hedge funds as those active in the following financial sectors of the energy world:
- Energy equities;
- Energy debt;
- Distressed assets (such as power stations);
- Oil & gas commodity futures trading;
- Over-the-Counter (OTC) energy derivatives trading in crude oil, petroleum products, natural gas, electric power, and coal.
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