Comment: Energy and commodity investing - risk is pervasive and growing

Gary M Vasey, vice-president for Europe at UtiliPoint International, argues that investors are rushing into the energy sector with little or no knowledge of its specific attributes and risks, and there are warning signs that a shortage of specialist energy expertise at hedge funds and other investment firms could prove costly.

On March 27, the Financial Services Authority issued a report in which the UK regulator warns about the increasing risks in commodity investing (Growth in Commodity Investment: risks and challenges for commodity market participants, Financial Services Authority, March 2007).

To briefly summarise the findings, the FSA warns that there is insufficient energy experience at many investment firms and that the existing experience is overstretched. Furthermore, it says that increased volatility in many commodity markets raises the 'cost of trading and the risk of financial failure' and promotes the concept of proper risk management including 'thorough testing and modelling for algorithmic trading systems'.

It goes further in recognising that many investment firms are now investing in commodities through physical assets, that is, holding and trading physical positions, such that their portfolios are 'significantly altered and risk management systems must be appropriate and senior management must fully appreciate the risks they are assuming.' Lastly, the FSA says: 'Consumers risk being exposed to unsuitable investments that they do not fully understand.'

It's also interesting to take note of two other studies recently published. The first, by Deloitte (Precautions That Pay Off: Risk Management and Valuation Practices in the Hedge Fund Industry, Deloitte Services, March 2007) looks at risk management in hedge funds and makes very intriguing and frightening reading.

Deloitte says: 'The nine areas identified as red flags include lack of position limits; tracking liquidity without stress testing and correlation testing; measuring off-balance sheet leverage without stress testing and correlation testing; lack of industry concentration limits for non-sector funds; not tracking liquidity; use of Value at Risk without back-testing; using leverage without tracking on-balance sheet leverage; use of VaR, or other models, without stress testing and correlation testing; and holding assets with embedded leverage without measuring off balance sheet leverage.' The survey found that fewer than half of all hedge funds actually utilise stress testing on their portfolios.

The second study by HedgeFund.Net, which looks at investment levels in hedge funds, finds that total assets in energy sector-focused hedge funds increased by 52 per cent to USD79.3bn in 2006, including new allocations of USD18.2bn.

Plainly, there are many danger signs for investors when the findings of these three reports are put together. Back in August 2006, colleague Peter C. Fusaro and myself issued a statement via the Energy Hedge Fund Center website (www.energyhedgefunds.com, August 20, 2006) regarding increasing investor risks in energy hedge funds.

We said: 'Energy trading markets have changed with more intraday price volatility caused by speed fund trading. Trying to use older trading strategies has failed some funds; we expect more blowups to come as many energy traders have not adapted to the new trading reality.'

The statement continued: 'To some extent, due diligence has become mechanistic following pre-prepared questionnaires that were designed for more traditional investments. This mechanistic approach also speaks to a lack of understanding on the part of the majority of investors as to the underlying additional risks inherent in the energy industry. Energy is the hot asset class for investing, but investors be warned, energy expertise is required to perform proper due diligence and to insure that effective risk mitigation is in place.'

Since then, we have observed the collapse of Amaranth and other hedge funds in energy, yet the trader responsible for Amaranth's huge losses is back in the news again, as it appears he has already raised USD1bn of investor money to start his own fund! There truly is one born every minute.

As I have written many times in the past, for example, in our recent book (Energy & Environmental Hedge Funds: The New Investment Paradigm, Peter C. Fusaro & Gary M. Vasey, Wiley, 2006), energy is a complex and physical business. But it is worth examining some of the issues one more time in the light of the three reports mentioned above.

1. There has been a 15- to 20-year lack of interest and investment in energy. This came to an abrupt halt in 2004 as essentially demand began to reach, and even exceed in some instances, supply. What this means, however, is that energy just wasn't a great career choice for the best and brightest. Why join an industry that for more than 12 years had been laying off talent and seeking to retire people early?

A forthcoming report from UtiliPoint on ageing workforce and assets in the utility industry (Aging Workforce and Aging Assets Trends 2007-2012, UtiliPoint report in preparation) shows just how significant an issue expertise in energy and utilities truly is. The FSA is entirely correct to point to lack of energy expertise as a problem in today's investment world.

The best and most knowledgeable energy trading talent was picked off early in this cycle and unfortunately this expertise was always thin. It is a serious issue that many investors are totally unaware of this lack of experience and more importantly, perhaps, would not know what energy experience is if they saw it on display, because they don't really understand what they are investing in.

2. Are investment firms overstretched when it comes to energy expertise? The answer to this question has to be an overwhelming yes. Almost every investment bank has opened energy trading operations or expanded existing operations, new hedge funds are being created at a rapid rate, and institutional investors are pouring money into energy investments.

Given the above, it is certain that many of the firms investing money in energy are doing so with a thin veneer of energy expertise. And I am not just talking about energy trading but about the entire range of investment strategies including equity and debt. To invest in energy companies, you have to understand the business, its processes and complexities and not just use standard metrics.

3. It's not just investment firms that lack energy expertise - it's investors too. People who can barely spell 'seismic' are pouring money into energy without ever truly understanding what it is they are investing in and what risks they are exposing themselves to. Even supposedly sophisticated hedge fund investors seeking good returns are doing this.

They think they are doing proper due diligence, but they are not. In many instances, they don't have enough knowledge of energy to frame the right due diligence questions in the first place, and many use standard template due diligence questionnaires available from organisations such as the FSA. These due diligence questionnaires were never designed with energy investing in mind, and they are flawed.

4. Energy and commodities in general are 'hot' today and all investors want to increase their exposure to this asset class. What has happened almost simultaneously is that energy is becoming easier to invest in. The barrier to entry has lowered significantly via the increasing availability of exchange-based instruments, exchange clearing for OTC contracts, and the emergence of numerous exchange-traded funds and indexes.

Almost every week another contract or ETF is launched that has some aspect of energy in mind. While this is a good development and is helping energy financial markets mature, it also means that anyone can invest in energy - including those who should not, as the FSA points out. It's not just professional investment firms that are investing in energy, but Mr. Average through his IRA who is buying oil futures through ETFs.

5. Finally, let's look at some of these investment firms without the benefit of rose-coloured spectacles - hedge funds, for example. They are often referred to as 'sophisticated private investment vehicles for the wealthy' by the media, but given the evidence outlined above and my own personal experience, often they are anything but sophisticated.

It is true that there are hedge funds out there that are sophisticated, run by smart people who understand what they are doing and are rigorous in their approach but for every one of those there are many more that are not. Asking the right questions easily smashes the thin veneer of sophistication, but these questions are rarely if ever asked because investors do not understand energy.

What is obvious and apparent to me after doing due diligence on more than 70 hedge funds is that many of these funds are simply small businesses that rely on one individual's talent to make money and do a poor job of managing their risks.

Let's consider one final aspect of the FSA report, that of volatility. Volatilities, particularly intra-day volatilities, are large in many commodities and energy commodities specifically, perhaps not in absolute percentage terms, since five per cent volatility in a commodity priced at USD1 (plus or minus 5 cents) versus five per cent volatility in a commodity priced at USD100 plus or minus USD5) is really what we are observing much of the time.

The issue here is that risk management needs to be performed properly and that means using the right risk analytics in the first place. Risk analytics used for foreign exchange and other asset classes do not readily work in energy, partly due to volatility and party due to the nature of the energy commodity itself. This is one of my greatest concerns - even if there is a systematic approach to managing risk, the wrong risk analytics are being used.

What the FSA did not say is this. Historical trends in energy and other commodities have broken down at times, and this has a serious impact on risk management too. Risk metrics that use a historical pricing method are therefore flawed, and one is left needing to perform more stochastic-based risk management including stress testing. According to Deloitte, this simply isn't happening.

In my opinion, the FSA is entirely correct in its assertions, and its report could not have been issued soon enough. I am not saying that investing in energy is a bad thing for anyone concerned - in fact, quite the reverse. I am simply beginning to get increasingly worried that something bad and ugly is about to happen in the investment world around energy. All the warning signs are in place and they are growing in magnitude.

I am not looking for increased regulation but increased oversight. I am not looking to stop people investing in energy, but I am looking for firms involved in the industry to start advising investors properly about the risks they face. Education is required, but unfortunately those overseeing and advising the industry need to be educated about energy too.

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