Top 10 Reasons Why Energy Hedge Funds Are All the Rage
By Louis Caron
The Hedge Fund sector has grown dramatically in the past few years. Global energy supply and demand issues have made the sector a popular alternative for investors looking to allocate capital.
Over the past few years, many of the merchant energy companies who used to dominate the wholesale energy market have either collapsed or decided to exit trading and refocus on asset management. Financial institutions and the trading arms of the super oil majors currently lead customer flow for producers and end users. These firms typically clear client business and are generally not willing to carry substantial price or liquidity risks.
Hedge Funds have clearly stepped in to fill the role of the speculator in the wholesale energy market.
Hedge funds participate in fundamentally-driven strategies based on weather, inventory levels, geopolitical events and other supply and demand shocks. The underlying philosophy is to generate sustainable returns that exceed alternative investments using a variety of trading strategies including relative-value strategies such as calendar and location spreads. Capital is allocated to markets and positions that are most likely to trend. Strategies exploit the relationships between trading hubs, supply basins, export points, and city-gates. Technical analysis is also used for quantitative entry and exit levels based on historical price behavior. Option trading strategies provide profit opportunities as well as hedges for other underlying strategies within the Hedge Fund books.
The following are the top 10 reasons why Hedge Funds have become popular with investors recently:
10. Strong Global Demand Global demand for all commodities, particularly in the rapidly-growing economies of China and India has fundamentally changed the energy markets as well as the outlook for energy commodities going forward.
9. Portfolio Diversification Exposure to the energy commodity sector adds diversification to a sophisticated investor's portfolio. Energy Hedge Funds can profit from long and short investment strategies providing non-correlated returns relative to a portfolio containing traditional exposures such as equities, fixed income, and real estate.
8. Market Direction Flexibility Hedge fund investment philosophy does not rely on favorable market conditions to be profitable as positions can be long or short. The ability to trade from long or short side of the market provides double the opportunities that alternative investments offer.
7. Soaring Price Volatility The energy sector has historically been and is currently very volatile thereby creating opportunity now and for the foreseeable future. An unstable global geopolitical climate is causing added volatility to energy market prices. Managing this volatility successfully can potentially lead to enhanced returns for investors.
6. Expertise Availability Many energy traders and risk managers were left unemployed following the collapse of the energy merchant sector in 2001. Investors can now tap into teams of highly-skilled energy trading and risk management professionals possessing a great deal of wholesale market experience.
5. Little Regulation The Regulatory environment is currently very friendly to Hedge Fund participants that are backed by accredited investors and which do not require security commission registration. Unregistered Hedge Funds are not legally required to report to regulators or the public about material changes in their portfolios.
4. Greater Liquidity Hedge Funds are primarily clearing their transactions using centrally-cleared mechanisms. Recent improvements in these clearing mechanisms have resulted in a substantial increase in liquidity in the financial energy swaps, futures, and options markets. Energy futures markets trading on established exchanges now provide a fairly high degree of liquidity ensuring entry and exit from positions with reasonable ease.
3. Credit Risk Reduction Credit downgrades of large energy merchants contributed significantly to the fall of the merchant energy sector of 2001. Hedge Funds are continuously growing their level of participation on centrally-cleared exchanges which results in limiting their credit exposures to these exchanges.
2. Simplicity of Setup A hedge fund operation can be setup very rapidly. Once the office and phones are rented, the staff is hired, the broker accounts are established, and the systems are up, then turning investor capital into market positions is a piece of cake.
1. Risk Management & Measurement Advances Energy risk management and measurement techniques have traditionally lagged certain sectors such as the banking sector. However, the energy industry has progressed substantially over the last few years with respect to data management, risk analysis, and risk reporting. Software vendors now offer powerful risk solutions to help Hedge Funds compete successfully in today's volatile energy markets.