What next for hedge funds in energy?

Hedge funds, which fled the energy markets post-financial crisis, began returning steadily in the second half of 2009. However the influx stopped abruptly at the start of this year. Rachel Morison looks at what’s next for energy hedge funds in the short and longer term

Until recently, energy and commodities had seen a steady increase in investor interest, marked by a surge of new specialist hedge funds being launched.

According to fund analysis and research company, Lipper FMI, the number of equity raw material/energy funds increased by 47% from January 2007 to January 2009, whereas the number of overall derivatives funds increased by 15% over the same period.

Since the end of January this year, this sentiment appears to have changed and investors have been withdrawing from these markets as energy and commodity prices have weakened. Industry experts agree that over the long term, energy and commodities remain an interesting space for hedge funds – however, there are challenges to be faced in the short to medium term.

According to commodity analysts, increased flows into energy futures markets began in the second-half of 2009 with hedge fund investors hopeful of a price recovery and positive outlook towards the end of the year. The beginning of 2010 was marked by a particular surge from renewed speculative and sector specialist investment buying in energy and commodity markets. Investors went long at the beginning of the year as a long-term allocation, says Andrey Kruchenkov, commodities analyst at Russian bank VTB Capital. They looked at the strong performance in 2009 and the positive prospects for global growth and decided that oil looked attractive for 2010, he explains.

According to the US Commodity Futures Trading Commission (CFTC) Commitments of Traders reports, non-commercial long positions for Nymex light sweet crude oil contracts increased by 19% from July 21, 2009 to December 22, 2009. Speculative longs continued to rally into January 2010, increasing by more than 12% within the first week of January.

However, as oil prices fell towards the end of January to US$72 per barrel (/bbl), the lowest levels since mid-December, speculative financial investors increasingly withdrew from commodity markets. During the week to January 26, speculative net-long positions in oil fell by nearly 44,000 contracts, or 25%, to 133,000 contracts according to research by Commerzbank. CFTC data for Nymex light, sweet crude oil contracts shows that by January 26, speculative long positions had fallen by 7% and the total open-interest long positions showed a marked decrease of 10,824 from the previous week. The data shows speculative short positions followed a similar pattern, falling by 6% from January 5 to January 26.

Eugen Weinberg, commodity analyst at Commerzbank says he expects this pull back to last in the short to medium term. “In the short term we see several factors, including the sharp economic tightening in China, adding to this pressure on prices and holding investors off the market,” he says. “In the medium term, I don’t think commodities are an attractive place for investors because the prices are already ahead of the fundamentals and I think that if prices do not recover soon, we will see a correction towards April/May,” he says.

Gardner Finance, a company focused on commodity-related investments, has an active fund of funds advisory for commodities, and a commodity hedge fund index that tracks between 200–250 live funds. Antje Urwyler, senior portfolio manager at Gardner, agrees that although many hedge fund managers have a bullish outlook for energy and commodities, most are not bullish over the next three to six months. “Energy and commodities in general are still a hot topic, both from a manager’s perspective seeing new investment opportunities, and from an investor’s perspective daring to invest again after being shocked in 2008,” she says.

Mirko Bischofsberger, chief executive of Gardner says that when liquidity was flooding into commodities markets, fundamentals were unpredictable and it became difficult to analyse trends and make decisions about how to go forward. The current pullback in energy and commodities markets could bring longer-term benefits, he says. “We think that some of the speculative money being withdrawn will actually favour the majority of funds in our universe in the longer term, with markets hopefully returning to more fundamental behaviour,” he says.

New launches

There have been a significant number of new energy and commodity hedge fund launches since the third quarter of last year, in line with the surge in investor flows in energy futures markets. In Q3 2009, Galena Asset Management, part of the oil trading company Trafigura, launched a new energy fund to trade oil and energy futures, options and swaps. At the end of January 2010, hedge fund manager Salus Alpha has launched a new commodity arbitrage fund investing indirectly into commodities via index derivatives such as swaps and futures.

While some see this as a signal of the return of energy hedge funds, others still see commodity funds in particular as under-represented in the context of overall start-up activity in the hedge funds industry. “Launch activity is picking up again but several of the launches we saw in Q3 and Q4 last year had been planned for some time and delayed until investment activity has picked up again, says Gardner’s Urwyler. “When it comes to commodities, we can see investors still have difficulty in determining what they get from a commodity hedge fund versus what they get when investing in commodity indices. There is still some educational work to be done,” she says.

Industry experts agree that signs of global growth should push commodity prices up and drive hedge fund interest in the longer term. John Payne and Steven Miller, fund managers of the Tiburon Terra Fund, an equity long/short fund investing in renewable energy, natural resources and conventional energy, hold this view. “Growth on a global basis will bring back demand growth and we should see a rally in prices, this will bring investors and speculators back into the commodities space,” says Payne.

The emergence of the commodities as an asset class in its own right will attract investors according to Miller. “This space will provide an inflation hedge – inflation is at a very low level now but a lot of investors are expecting higher inflation further down the road. Particularly if growth is stronger than is expected then we will see a big spike in inflation and a big spike in commodity prices,” he says.

Traditionally, direct investment in commodities has been used to enhance a diversified portfolio, invested across other asset classes. Over the past decade, commodities have developed as an asset class in their own right and this has given rise not only to broad commodity hedge funds but also specialist or niche funds.

Lorraine Homewood, head of fund sales at commodity brokerage Sucden Financial, says she has seen a trend of interest in asset management and in specific sector hedge funds within energy and commodities. “The interest in sector-specialist funds is growing in Europe. As well as investor interest in commodities as part of a broader macro strategy, we have recently seen the launch of specific fund mandates within the broader commodity and energy sector such as coloured diamond funds and precious metals funds,” she says.

This trend is part of the deepening of asset allocation, and with pension funds and institutional investors coming into the hedge funds space, more instruments are required to create a balanced portfolio, Homewood explains. “Investor interest and capital flows give impetus to a diverse range of investor funds and I think there will be a continued trend towards the sector-specialist funds in this space,” she says. There is huge interest in commodities generally and there will be a demand for more products, she says. “I talk to seeders and hedge fund investors in the early stages and commodities pop up in every conversation.”

Many experts agree that it makes sense to differentiate between different commodities. Commerzbank’s Weinberg holds this view. It makes sense to buy or invest in one commodity sector because precious metals or agricultural products are different to one another and different to other commodities, he says. “I don’t think a broad index that includes all commodities is attractive in the medium to longer term. It makes sense to buy sector indices,” he says. “We have seen a strong trend over the past month towards a more equity approach to investment and I think this will continue with investment on an equity basis, on a fundamental basis, and on a sector basis, not on broad indices looking at commodities as a whole,” he says.

Gardner’s Urwyler is more sceptical. “Commodities are still a niche area and investors are still regaining confidence and they won’t allocate to niche sectors first. Commodities are in the focus of hedge fund investors but we have to recover confidence levels and this has just begun,” she says.

New relationships & opportunities for arbitage

Gary Vasey, managing director of consultancy CommodityPoint, says that in the past investors have been interested in oil because it is relatively easy to trade, and there are a variety of accessible instruments. In the future, Vasey says he thinks interest lies in a broader range of commodities. “There are a lot of new relationships to exploit across the commodity complex and a lot of new arbitrage opportunities. Within commodities there are more exchange-based instruments and readily available instruments to trade that are liquid, fungible and transparent,” he says.

Funds like London-based hedge fund Clive Capital see opportunities in a broader range of commodities. Clive Capital covers a broad base of commodity groups including energy, base metals, precious metals, grains, vegetable oils, agricultural products, soft commodities, meats and exotics. Other funds, like the Cumulus Energy Fund, are focused on European downstream commodities, such as electricity and carbon emissions, and weather derivatives.

In general, hedge funds are increasingly getting involved in electricity via derivatives, particularly in the US. The market in the UK is not as well developed as that in the US, but this may grow in the future, says Payne from the Tiburon Terra Fund. “Freight rates are monitored closely by funds and freight indices such as the Baltic Dry and Baltic Dirty indices are traded via derivatives. However the volume is low at the moment,” he notes.

An area that could open up new opportunities for hedge funds over the longer term is renewables and sustainable energy. Hedge funds managers will be keeping a close eye on regulation and environmental initiatives and the impact these have on energy and commodity markets according to Payne and Miller, from the Tiburon Terra Fund.

Hedge funds have been quick to get involved in the renewables and sustainable energy space. Impax is a UK-based fund that invests in quoted companies involved in environmental markets, particularly alternative energy and energy efficiency, water treatment and pollution control, and waste technology and resource management. Luxembourg-based hedge fund, Athamas Capital, is focused on the energy and environmental sector. It invests in listed company in energy (both traditional and renewable energies), utilities, technology, environmental services, industrials and basic materials.

Both Payne and Miller see a number of strong conditioning factors in the future that will be play into the relationship between renewable

and convention energy, including security of supply, geopolitical risk on a global basis, and environmental concerns. “We are using fossil fuels at a rate that is unsustainable and we have to fill that gap, and we see natural resources as being very exciting in short/medium term as well as the long term,” says Payne.

Gardner’s Urwyler agrees. “Trends relating to renewable and sustainable energy are an area that is coming to life and receiving interest.” Urwyler says she is seeing more funds that are investing directly into projects, like wind parks in Germany. “The investment needed for renewable projects is huge and given how important these energies will be in the next 10–15 years, I think there is a lot of potential for creating investment and trading solutions,” she says.

Earth Capital Partners, the investment company started by hedge fund veteran Stanley Fink, joined with German utility E.ON in November 2009 to launch the ECP Renewable Energy Fund, targeting €750 million ($1.1 billion) of investment. The London-based fund invests in solar, biogas and biomass projects in Europe, the Middle East and North Africa.

Another example is Clean Resources Capital (CRC), the first Asia-Pacific public and private investment fund in the clean-technology sector. The CRC team manages four public equity funds and a private equity fund covering clean energy, environmental technology, water, waste management and sustainable agriculture.

The Swiss-based Hornet Renewable Energy fund is invested in companies involved in forms of renewable energy such as wind, water power, biofuels, solar energy, geothermal energy, wave power.

Willem Appel is a fund manager for Amsterdam-based Branta Solutions Fund, which is focused on sustainability and the use of resources and commodities. Continued economic growth in developing countries means that demand will vastly outpace supply in places like India and China, Appel says. “We saw appetite in the market for an investment approach that looks at sustainable development and we feel it is an enormous growth opportunity for investment. Commodity equities are a large component of sustainability and that is what our fund highlights,” he says.

Emissions are another area that could present interesting opportunities for hedge funds. In Europe, there have been several funds trying to capture the emissions sector but not many have been hugely successful to date. The Oslo-based Orkla Carbon Fund and the Bermuda-based Centum CO2 Fund are both live but have not achieved much success, while the London-based CF Carbon Fund did not launch, despite a lengthy marketing period.

Climate Change Capital (CCC) stands out as one of the more successful emissions funds. CCC develops and manages funds that invest in companies, projects and technologies involved in climate change mitigation. One of its investment portfolios focuses on carbon finance to gain exposure not only to carbon prices but also to the value of the underlying infrastructure assets that generate emission reductions.

Experts agree that emissions are an area that will develop interest from hedge funds over time. Currently, the legal framework remains unclear, creating significant regulatory risk for investors. Many say that if that a carbon market was to develop on a more global basis, it would have more of an impact for the cost of energy production and how that is priced into the market. This would in turn strengthen the relationship between oil and carbon prices and could create an opportunity for arbitrage.

Carbon is currently seen as a sector more suited to private equity or project finance funds than hedge funds, as it is not yet a liquid or tradable market outside of Europe. “Looking at carbon pricing down the road, I think it is something that hedge funds will become very active in,” says Tiburon Terra Fund’s Miller. “Some of the large multi-strategy hedge funds with energy trading teams in Europe are already playing the carbon markets just by trading the dark spreads or the spark spreads,” he says.

However, at the moment, the major players in trading these spreads are the trading arms of the big utility companies and several of the large banks. Smaller funds, such as the Rampart Capital European Energy Fund, specialise in trading European energy and actively seek arbitrage opportunities between gas, coal, electricity and carbon.

Bringing carbon into accounting standards would really give this market the impetus it needs to attract hedge funds Payne says. Accounting standards do not require a company to show how it accounts for carbon emissions.

However, as the carbon market develops over the coming years and is used increasingly by industry to trade emissions, as well as the valuation of assets that emit carbon, it is expected that an accounting standard will develop for treatment in financial statements, and in turn create an impetus in the trading of carbon on a global basis, Payne says. “Carbon has to be brought into accounting of financial statements going forward and with these in place, the market may develop aggressively,” he says.

Energy and commodity markets did not escape the aftermath of the financial crisis, with hedge funds and investors flows slowing. While the run in commodity prices during the second half of last year seemed to bring with it the return of these flows, 2010 has thrown up some new challenges. In the long term, experts agree that the global scramble for resources will attract investors and the number of energy and commodity hedge funds is expected to increase significantly.