A good bet for 2005

One of the most talked-about trends in energy markets over the past two years has been the steady growth in hedge fund entrants. While gauging the exact extent of their involvement is almost impossible, the fact that speculative positions in US oil futures doubled between January 2003 and the middle of last year is a good indication of a growing presence of hedge funds in energy markets both on and off exchange.

But tough times are predicted for the $1 trillion hedge fund industry in 2005. The dazzling 20% average monthly returns made in 1999 had faded to under 3% by the end of 2004, and competition is predicted to get fiercer in 2005 as some markets become saturated with hedge funds.

However, the predicted contraction in hedge fund growth is unlikely to be felt in the energy markets, analysts say. In fact, as energy markets are currently estimated to be home to only 200 of the more than 8,000 active hedge funds, the saturation of the hedge funds’ traditional stomping grounds could represent an unprecedented opportunity.

“I think it’s fair to say that the increase in the number of hedge funds in conventional markets – currency and fixed income – has led to diminished returns, as they are all competing,” says Alex Wilkinson, head of exchange-traded derivatives at Dresdner Kleinwort Wasserstein (DrKW) in London. “It’s becoming difficult for these institutions to commit money to traditional places, so they are having to look elsewhere.”

And one of the most attractive areas for new entrants are the commodity markets – they are liquid, volatile and still under-explored, say experts. Commodity markets are “a natural home for new money”, says Martin Woodhams, head of structured products at Barclays Capital in London. “Underlying volatility and liquidity are very motivating reasons to get into a market.”

James Hedges, president and chief investment officer of US-based hedge fund organisation LJH Global Investments, agrees: “I think that 2005 is going to be an extremely bullish year for commodity-based hedge funds,” he says. “I believe there is a tremendous amount of positive sentiment driving capital flows toward hedge funds investing in directional as well as discretionary trading programmes.”

And the saturation of other markets effectively means that commodity markets are likely to attract a disproportionate amount of hedge fund investment flows this year, experts say.

Andrew Schneider, founder of Florida-based hedge fund database HedgeCo Networks, estimates that around 10% of hedge fund investment currently flows into commodity markets, and that this percentage is set to grow. “I think there are more opportunities right now in commodities markets than most other markets,” he says. “Equities look lacklustre. This year, a lot of investors are looking for a commodity-oriented fund, as this is one of the only markets that’s moving.”

Commodity markets were the best performing asset class in 2004, according to Deutsche Bank research, with the Goldman Sachs Commodity Index showing total returns of more than 17%, compared with just over 10% returns on the Standard & Poor’s 500 index.

The burst of fund involvement in energy markets really began once oil futures moved out of their long-term range in early 2003 and continued rallying to record highs during 2004. Last year, oil futures trading at the New York Mercantile Exchange rose 120% between April and October, hitting an all-time high of $55.65 a barrel (/bbl) on October 25.

Now down by 10% from the highs, many analysts believe the market is once again set to pressure higher in 2005. “We still think there is upside in these markets,” says Kevin Norrish, head of research at Barclays Capital. “We think supply constraints will continue, both from low spare production capacity and refinery constraints.”

In fact, the options market is pricing in a one-in-ten chance of oil prices ending the year above $70/bbl, according to Michael Lewis at Deutsche Bank in London.

Petroleum expert Michael Economides at the University of Houston points to several fundamentals that he believes will maintain upward pressure on the oil price this year and keep it well above his calculations of an equilibrium oil price of $30/bbl.

With spare capacity sparse, the Organisation of Petroleum Exporting Countries (Opec) can do little to increase production in the short term, and it is also becoming increasingly dominated by price hawks Venezuela, Iran and Libya, Economides says. And the supply story outside Opec doesn’t look much better, with Russia – the biggest producer after Saudi Arabia – in danger of losing much-needed foreign investment after the effective renationalisation of Yukos, he says.

But the demand story remains one of growth, as India and China continue major industrial expansion. “China’s 20% demand increase last year was unprecedented,” Economides says. “Even if it slows down this year, it’s still a juggernaut.”

But perhaps the most compelling attraction of the energy markets for hedge funds is that there is still relatively little information published about certain markets, making it possible for investors to gain an edge through exclusive knowledge.

“In the traditional markets – interest rates and foreign exchange – transparency of information is very complete,” says Barclays Capital’s Woodhams.

DrKW’s Wilkinson agrees. “The fact that the (US) Fed and the European Central Bank are trying to communicate with the Street with greater clarity than before means there isn’t an enormous amount of volatility in the market, but it also eradicates that knowledge edge,” he says.

While the oil futures market is very well watched, with most price-moving events – weekly storage data, Opec meetings, production problems – well-known and well-covered by reporting agencies, physical and forward markets in oil, petroleum products and natural gas and electricity markets still remain fairly opaque.

But a lot of these markets would be extremely difficult to enter without the specialised knowledge that can only be gained through years of operating in the market.

“The gas market remains an awkward market,” notes Wilkinson. “There are specific idiosyncrasies that some people can’t be bothered to deal with. But the counter-balance to that is that there are abnormalities to exploit,” he adds.

He expects that small firms specialising in trading the more obscure markets will be prime takeover targets for big brokerages hoping to gain a footing in new markets.

Another prime market for new entrants is likely to be the new carbon emissions trading market, which is expected to gain a shot in the arm this year due to new EU regulation coming into operation obliging heavy polluters to monitor CO2 emissions.

“We think newer commodity markets such European power, gas, coal and emissions are interesting new markets for hedge funds to become involved,” Woodhams says. “These markets have grown in liquidity and sophistication over recent years, while still retaining opportunities to capture value from inefficiencies.”

Barclays Capital believes investors will need to take a more sophisticated approach to trading commodity markets in the future, rather than simply trading long or short oil futures, and that there will be a growth in hedge funds employing more relative strategies rather than pure directional plays.

“We’re seeing hedge funds trading company stock versus commodities, and trading long and short bonds of companies with commodity exposure in order to gain from a company’s exposure to commodity price movements,” Woodhams says.

Short term winter-weather plays, trading crack spreads, and investing in refinery stocks given the ongoing constraint on world refining capacity are all likely to be popular plays, traders say.

Additionally, as most commodities are priced in dollars and in many cases are produced in the emerging and often volatile economies within Asia and Africa, investment in commodity markets provides exposure to a variety of phenomena.

“People want to have an exposure to hard assets, to the emerging markets, to global currencies, because they believe they’re going to be volatile, so all the commodity area is going to have a lot of capital flowing in,” believes Hedges at LJH Global Investments.

Frank Holmes, chairman and chief executive of hedge fund US Global Investor, which has nearly $2 billion in assets under management, says his company factors a country’s currency into their decisions on which commodities to invest in at the start of the decision-making process. “We look for a weak currency against the US dollar, and this has helped our performance,” he says. “Our alpha for commodities is three times the average.”

In addition, experts also expect to see an increase in funds moving into commodities as an exercise in diversifying their portfolios. The lack of correlation between commodity markets and equities makes them a sensible choice for diversifying stock market risk.

Finally, the spread of electronic trade in commodity markets is now opening up the market to more hedge fund investment, experts say. “Electronic trade is offering more and more low-cost access to commodity markets around the world,” DrKW’s Wilkinson says.

But with a potential increase in speculator money moving into the energy markets, some fear there is a danger that hedge funds could distort price movements and add unnecessary volatility to energy prices.

Woodhams believes these fears are overplayed. Taking the oil futures market as an example, he points out that the largest net speculative long position in the New York Mercantile Exchange’s light, sweet crude contract came at the beginning of 2004 before the major oil price rise, and that speculators had significantly reduced their net longs before the sharp price fall at the end of the year.

Hedges agrees: “I don’t think (the commodity markets) are areas that will be very sensitive to capital flowing in. I think they can accommodate it as, by and large, they’re very deep markets,” he says. “I’m very bullish towards the sector and I can see why investors are putting money in this space.”