Hedge funds drive activity

Volatile energy markets gave corporates and funds plenty to think about in 2004 – and while banks still dominate Risk’s energy rankings, energy companies have taken over for the first time in sectors such as US natural gas. By James Ockenden, editor of Energy Risk magazine

Over-the-counter energy trading volumes bounced back during the past year to levels last witnessed before the 2002 collapse of Enron – an event that sparked the exit of a number of merchant traders from the business. Volumes were up, funds moved in,and investors wanted to diversify their portfolios using oil or energy index products. Corporates, meanwhile, realised they needed to manage the risk of a barrel of oil potentially nearly doubling in price overnight.

All this has resulted in energy dealers adapting to deal with a fast-growing customer base. And Risk’s energy rankings this year indicate for the first time that the same institutions do not win in every category; rather there is an emergence of experts in specific fields.

Meanwhile, hedge funds have continued to exploit the extreme oil price volatility since mid-2004. According to research by Incisive Media’s Hedge Funds Review magazine, nearly 300 hedge funds are now investing in energy either directly or via energy-related equities or distressed securities.

JP Morgan’s global head of currency and commodities David Puth, believes hedge funds now play a fundamentally important role in the market. “The fund business will continue to grow. Call it a bubble, call it what you will, but the hedge fund business will attract the brightest people and a lot of money,” he says.

Hedge fund activity appears to lie behind the decline in Bank of America’s position in Risk’s rankings this year. The Charlotte-based bank has consistently held top three positions overall since the survey was introduced, and in last year’ssurvey secured 35 first places. This year, it picked up just one, along with a handful of third and fourth places.

“It is likely [due to] the increasing activity of funds,” says Eric Nobileau, managingdirector of commodity derivatives, who is based in New York. “We don’t havemuch fund business – it’s minute compared with our competition.”

But Nobileau insists Bank of America is not particularly concerned: “Funds area double-edged sword,” he says. “They bring volume, but they can bring you alot of heartache as well. We have a very selective approach to the funds; we offer structured transactions rather than a full service shop. We are not just a trading shop,” he adds.

“Are we bothered we should be first or second, instead of third and fourth? No, as long as we’re up there we’re happy. There have been a lot more players this year, a lot more people getting into the market, and that will dilute the business.”

Marc Mourre, London-based managing director at Morgan Stanley, has a similar view. “We always get a pretty good position, always number one or two or three. And we’ve not really done anything different this year.” Mourre says the bank has focused more on middle distillates, a move that appears to have been noticed in the market, as Morgan Stanley took top spots in most of these areas, except the crudes.

Mourre says Morgan Stanley specialised its market coverage during the past 12 months. “We [also] found our ex- perienced traders to be at a competitive advantage. The market is extremely active– it favours a company that can quickly absorb its clients’ risks,” he adds.

Mourre also notes the growth of hedge fund activity in the market. “Funds and investors are a much bigger part of our business now, and we are optimising as such for next year,” he says. According to Mourre, this business helps Morgan Stanley offer a better service all round. “The level of oil price volatility remains high. Risk remains high. We trade more underlying, more products, we are more able to manage the risk for our clients and give them liquidity,” he says.

Power play

JP Morgan made a stronger showing than previous polls – it had never received afirst place before, yet in 2005 beat all theother banks for a strong showing in US natural gas, coming in overall third behind two physical players, Shell Trading and BP.

JP Morgan’s Puth says the bank only targeted markets where it could grow quickly. “There was a great deal of activity in 2004, but we thought there were fewer counterparties than the market needed. So we filled a void made by peoplewhose investment was less, those who stumbled a little bit. We played our role in creating something by our competitors pulling back.”

David Kitson, London-based global head of energy with JP Morgan, says banks fare better with longer-dated strategic hedging. “We don’t do short-dated phys- ical. We’re in risk management. The banks, with the risk management view, will have performed better than the energy companies.”

Energy risk management has become much more important, says Kitson. “People have taken it much more seriously given the volatility, and we’ve actually seen the risk management function shift from procurement to treasury. Energy risk, as a corporate need, will be handled by the banks,” Kitson adds. “We’ve been pulled into these markets – and we’ve been pushing into these markets. The pull comes from JP Morgan’s client bases. The push has been more and more investors, private banking clients, hedge funds; energy is becoming much more interesting to them.”

Kitson says JP Morgan’s investment in research has stood it in good stead over the year. He notes that energy markets are much more complicated than other derivatives markets. “You think forex people have complicated structures? Think, if you’re a refiner, your underlying is the crack spread [the difference between the price of crude and refined products]. To protect that, you need an option on a refinery margin. And any one refiner may be producing x% middle distillates, y% fuel oil – it all gets very, very complicated. And take Europe, where natural gas is traded on a formula basis; if you want to hedge those formulae its very complicated.”

The research teams are put to use creating new products suitable for the newer participants in energy markets. “There’s a lot of demand for barrier options from funds and investors,” says Kitson. “For example, the Brent buffer notes, for people to buy upside in oil.

The purchaser gets 150% of their investment back unless oil goes to below 60% of its starting price during the period. So that’s an embedded exotic option in the note – and went to retail investors, so the cost of working it all out is spread between tens of thousands of investors.”

For its part, Shell Trading says it has not particularly targeted any new business. “Our target group has stayed the same. But our business from those customers has grown. They’ve seen what we can do,” says Ken Gustafson, head of deal structuring at Shell Trading in Houston.

Gustafson says customers are sophisticated in their needs – and they know when pricing is sharp. “When we’re sharp with our pricing, that’s when they come back,” he says. According to Gustafson, some of the most basic funds are set up to take advantage of basis opportunity. “They’re set up to look for opportunity spreads.”

Brokers toast energy success

Brokers, like many in the energy markets, had a good deal to cheer about in 2004, as over-the-counter energy trading volumes continued to bounce back towards pre-2002 levels. And none more so than Icap, which takes 26 top spots in our rankings this year, totally dominating the natural gas and power categories. Paul Newman, London-based managing director of Icap, highlights the importance of having a well-established team. “We’ve had pretty much the same core team together in London for many years,” he says. “Such a dynamic works like a successful football team: each of us have developed a kind of semaphore in understanding how the others are thinking and working, and this translates into greater efficiency.” The overall OTC-brokered electricity market increased in size by 10–12% to 6 billion megawatt hours in 2004 compared with 2003, and the OTC natural gas market by 15% to 125 billion mmBtu. These estimates come from Michael Cosgrove, chief executive of Houston-based broker Amerex Energy, which made a stronger showing in our rankings than last year. It comes top in central North America power swaps and takes several second-place positions in both natural gas and power – which, says Cosgrove, is a far more realistic reflection of its position in the market. As for the increase in overall OTC volumes, several brokers point to the New York Mercantile Exchange’s (Nymex’s) ClearPort system as a major contributor. The electronic platform, which brokers can use to clear trades, has made it much easier for smaller companies – which previously may not have had sufficient credit quality to do OTC trades – to quickly carry out such transactions. Amerex, for one, saw its ClearPort business increase by 280% in 2004 over 2003 in volume terms, says Cosgrove. Although Nymex has developed a good system, it is one in need of further development, says Justin Wilson, vice-president at oil broker United Crude in Connecticut. “We continue to use Clearport to clear WTI [West Texas Intermediate] swaps, but remain dumbfounded as to their inability to electronically clear options in light of obvious customer demand.” While the system clears swaps, it does not accept average-price crude oil options – they must go through the floor traders. And Wilson is well placed to comment – United Crude has taken the top spots in both WTI crude swaps and options, as it has habitually done since the Risk rankings began. Meanwhile, Icap’s Newman believes Atlanta-based commodity-trading platform IntercontinentalExchange (Ice) boosted growth in OTC markets last year. “Irrespective of whether Ice has achieved its original goal of becoming the all-singing global execution platform for OTC commodity derivatives, it has certainly made a key contribution to a perception of price discovery and transparency, so it deserves credit for having improved market liquidity,” he says. In short, Ice has made the whole cake bigger, says Newman. And this process has benefited those broking firms that had already positioned themselves as large-scale players, rather than those that had chosen the ‘specialist boutique’ alternative, he adds. The main types of companies driving brokered volumes – in crude oil, at least – continue to be the investment banks, particularly Goldman Sachs and Morgan Stanley, says Wilson. There has also been continued growth and participation from the commercial banks – Barclays in particular. And with ABN Amro and Wachovia entering the market, and Merrill Lynch (having acquired Entergy-Koch Trading) and Credit Suisse First Boston in the wings, Wilson is optimistic about the growth of derivatives trading volumes. Amerex’s Cosgrove takes a similar view. “Other well-capitalised companies are likely to increase trading volumes with a view to achieving the kind of results reported by firms such as Goldman Sachs and Morgan Stanley,” he says. “For example, Entergy-Koch Trading always had a good trading operation, but now it can leverage Merrill Lynch’s balance sheet to increase trading volumes substantially.” While the usual banking suspects have traded the big volumes, other types of customer have entered the OTC market, attracted by still strong returns from energy commodities. Patrick Melia, vice-president of OTC energy derivatives at broker Man Group in New York, says: “Our typical clients remain investment banks, energy producers and refiners, and end-users, but we are also building a bigger presence among hedge funds.” Man is just coming to the end of its second year of broking crude oil, having brokered natural gas for more than five years. It builds on last year’s respectable rankings results. Amerex, too, brokered trades for several new hedge fund clients in 2004, including Acumen and MotherRock. It also witnessed an increase in the number of local Nymex proprietary traders going through brokers and clearing on ClearPort, says Cosgrove. “This started happening in earnest last year, and these guys can trade some real size,” he says. “It never really occurred to us that we’d have local Nymex traders as customers, but that’s exactly what’s happened.” And more and more big energy users – particularly state-run, municipal utilities – have been entering the traded markets, says Cosgrove. Municipalities have been looking to deal more directly in the wholesale power markets using brokers, he adds – a trend that is likely to increase in 2005. Outside the traditional energy markets, weather derivatives brokers have also noted steady increases in OTC volumes and growing interest from hedge funds. TFS, which topped both broker weather categories this year for European and US swaps, is one such company. Kendall Johnson, managing director at TFS Energy in Connecticut, attributes much of this success to the company’s global coverage of the weather market. “Unlike other weather-broking teams,” he says, “we cover the European and US time zones and also have a desk in Australia, so we can work a price around the clock.” Elsewhere, 2005 looks like being a big year for emissions in Europe, following the launch of the mandatory EU emissions trading scheme for CO2 on January 1. Six months ago, one trade a day was being done in European CO2 allowances. That figure is now closer to 100. As for coal, an OTC swaps market is finally stirring in the US. And with regard to freight derivatives, there’s much discussion about whether the forward-freight agreements market will gradually migrate towards large-scale OTC brokers or remain largely within the shipping brokers, says Icap’s Newman. “My own view is that it will be both,” he adds. Joe Marsh