The Big Bang: Amaranth’s Lesson for Utilities
DISCLAIMER: This article first appeared in the September 29th, 2006 issue of The Desk, and is reprinted with the permission of Scudder Publishing Group, LLC www.scudderpublishing.com.
If a sophisticated speculator like Amaranth advisors can implode so dramatically – apparently losing more than half its $7.8 billion value in a week through a big, bad bet in the gas markets – where does that leave utilities? Amaranth’s mistakes in the gas market provide a good opportunity for utilities to reassure regulators and consumers that they don’t engage in questionable speculation, says Peter Sofarelli , a risk management expert at risk solutions provider RiskAdvisory.
Many utilities have a stated policy that they don’t speculate, but “even within books defined as hedge books, there is the ability to take positions that could in hindsight be construed as speculative,” he says. Those hedging programs have to be scrubbed clean of ad-hoc speculation.
“The fact that Amaranth lost that much money in a couple days, you’d wonder what the leverage was and how did they do it? Hedge funds are highly leveraged and use a lot of marginal debt to swing for the fences and get the return they need to satisfy their shareholders,” he says. “The utility reaction to Amaranth probably ranges from ‘we don’t use leverage’… to ‘wow, if someone who is actually an expert in the debt markets… got taken out, let’s re-evaluate what we’re doing and make sure we’re not engaging in anything that remotely resembles that.’”
The answer is to approach the market with mechanistic hedging, and avoid a sudden reaction and rush to hedge when the price of oil or gas goes through the roof. Following the runup in oil prices earlier in the year, airlines were badly burned by hedging in Q3 at close to $70 a barrel, only to see oil drop again into the low $60s. Southwest Airlines, by contrast, did it right: the company managed to hedge 73 percent of its fuel-burn for this year at $36/bbl, and it has hedges going out another four years.
“You can’t be reactive. You can’t look back and say the market’s going up so we need to be active in hedging. What is needed is a clear decision to run a hedge program for a certain percentage of your portfolio, irrespective of timing, meaning the price volatility,” Sofarelli says.
Consider mega-bucks shareholders like Microsoft founder Bill Gates or Amazon.com founder Jeff Bezos. To avoid even a whiff of insider trading, conflicts of interest or other stock misdeeds, these massive shareholders have a share sale program that specifies how many shares they’ll sell on what date each quarter for the foreseeable future. “It’s the same idea with mechanistic hedging. We’ve all agreed on how this will work, it will go forward for the next 12 to 24 months, and we’re going to execute this regardless of price volatility,” he says. At the end of the term, the utility can look at those benefits and consequences. “That way you’ve taken the bias out of hedging.”
Amaranth’s flaw appears to have been a lack of comprehensive scenario analysis, he says. They reportedly had a highend risk management system in place, but perhaps didn’t spend enough time on what-if scenarios. “I’d say they probably didn’t do a thorough job of running scenarios or stress-testing to see how the market could react,” he says. “A lot of people who trade in a hedge fund trade with their gut and what their experience tells them, as opposed to what the fundamentals and/or
technicals tell them.”
Sofarelli says trading with your gut is not for utilities – they need an orderly hedging program that enhances business value. And that’s where the technology comes in. An energy company needs to be able to run a robust scenario across multiple moving targets – on an enterprise-wide scale that looks at the company’s exposure from the broadest view. The silo view is out; you need a macro view of the organization from the corporate or board level.
“You can’t do that kind of analysis in a spreadsheet – you need to have a system capable of delivering results that are within the realm of possibility,” he says. “You want to run a scenario that says if gas or oil spike back up, how does that affect us, where does that leave us short, how does that scenario affect what we are trying to do? Being able to run these scenarios in multiple dimensions as well as the ability to generate an ad-hoc scenario: We have a program in place, let’s see where that
program’s going to take us a year down the road.”
Speculators have gone a long way to restoring liquidity in the beleaguered energy markets over the past five years, and speculation on the financial side has, generally speaking been a very good thing for just about everybody. So, will this Amaranth event further mar the name of the speculators? Will the capital now flow as easily out of the market as it flowed in? Not really, Sofarelli says. Two hedge fund blowups in the past couple months is notable, but it’s been nearly a decade since the last real hedge fund disaster, when LTCM came close to upending the world financial markets. “People know that hedge funds trade for the fences,” he says. “Anything that benefits liquidity is fine.”
Incidentally, LTCM’s losses were close – but less – than Amaranth’s – $4.6 billion. The difference is that LTCM was betting that correlations wouldn’t break down, and they did. Amaranth made a big bet that was counter to the fundamentals, and in the end didn’t have the cash to defend an indefensible position. The big trade went against them and they momentarily sucked the liquidity out of the market trying to cover their losses, creating a downward spiral.
“When you look at this trading game, it can be a zerosum game. Whoever loses $6 billion, someone is gaining something. The people who are inside of these trades are thinking it’s the best thing in the world,” Sofarelli notes. “Overall, liquidity can never be a bad thing.”
Sofarelli doesn’t see the need for any heavy new regulations to come out of the Amaranth blowup. Yes, the hedge fund had a lot of trades on the ICE, where position limits are not exactly an issue, but thousands of trades also graced the pits and screens of NYMEX as well. Bottom line, he says, Amaranth made the wrong bet; as yet there’s no sign of any malfeasance. “Why encumber a market when no one did anything illegal? They placed the wrong bet. I don’t think more regulation is needed,” he says.
Nonetheless, Sofarelli says, the overall message remains the same: “If someone as expert a trader as Amaranth gets it wrong, utilities want to ensure that what they are doing in terms of hedging is well thought out, well understood, collaborated on with a regulator and could not be misconstrued as anything that remotely resembles speculation.”
And what about Amaranth’s risk management solutions provider? “The car’s only as good as the driver,” he says. “But I wouldn’t want to be their vendor.”