A Hedge Too Far
Published by MAC on 2007-10-21
A Hedge Too Far
21st October 2007
Amaranth Advisor's trades and its vast (US$6.6 billion) losses last year have served as the emblematic "hedge fund scandal". Led by a guy aptly named Hunter - who earlier worked for the eminently respectable Deutsche Bank - the Fund scored massive profits trading in energy derivatives (futures) between 2004 and 2005.
Among those handling Amaranth's energy trades were: Goldman Sachs, JP Morgan and Merrill Lynch (also among the six investment banks with the biggest stakes in mining)
Then, overreaching himself, similar to the way Enron had done a few years earlier, and apparently "sussed" by another hedge fund for his price fixing - Hunter was unable to pay deliver on Amaranth's forward contracts ("positions") and the Fund collapsed - virtually overnight.
One might reasonably expect that some lessons have been learned; that, just as the Enron debacle was followed by passage of the Sarbanes-Oxley Act, legislation would be rapidly introduced to ensure discipline and transparency in the "over-the-counter" and unregulated market trades engaged in by Amaranth.
Not a bit of it! Extraordinarily, Hunter is still trading in energy futures, while Kenneth Lay, former head of Enron, now languishes in jail for tantamount sins). Investment banks, such as JP Morgan, and hedge funds (including Citadal Investment Group) have cashed in on the profound market price distortion Amaranth created.
This has caused misery for millions of ordinary US gas consumers. For example, last winter artificially manipulated energy costs landed an extra US$18 billion in charges on over a quarter of a million citizens in the state of Georgia alone.
What has all this to do with mining? Just as Enron had its fingers in various minerals-related plays, so did Amaranth. Until it fell out of the sky (rather off the trading floors) Amaranth held extensive stocks in a veritable roll-call of the Great and Reprehensible mining companies. For example, its holdings in Pan American Silver amounted to some 80 million shares.
Among Amaranth's other mineral investments were one in:
Anglo American,
AngloGold Ashanti,
Arch Coal,
Barrick Gold,
CVRD,
Freeport-McMoRan,
Glamis,
Gold Fields,
Goldcorp,
Harmony,
Inco,
International Coal,
Kinross,
Massey Energy,
Newmont,
Peabody Energy,
Phelps Dodge,
Randgold Resources,
Royal Gold,
Silver Wheaton,
Southern Copper - and
Yamana Gold.
[Nostromo Research, 23 October 2007]
Energy Traders Avoid Scrutiny
As Commodities Market Grows, Oversight Is Slight
By David Cho
Washington Post Staff Writer
Sunday, October 21, 2007; Page A01
One year ago, a 32-year-old trader at a giant hedge fund named Amaranth held huge sway over the price the country paid for natural gas. Trading on unregulated commodity exchanges, he made risky bets that led to the fund's collapse -- and, according to a congressional investigation, higher gas bills for homeowners.
But as another winter approaches, lawmakers and federal regulators have yet to set up a system to prevent another big fund from cornering a vital commodity market. Called by some insiders the Wild West of Wall Street, commodity trading is a world where many goods that are key to national security or public consumption, such as oil, pork bellies or uranium, are traded with almost no oversight.
Part of the problem is that the regulator, the federal Commodity Futures Trading Commission, has had a hard time keeping up with the sector it oversees. Commodity trading has exploded in complexity and popularity, growing six-fold in trading volume since 2000 -- the year that a handful of giant energy companies, including Enron, successfully lobbied to get Congress to exempt energy markets from government regulation.
Meanwhile CFTC's staffing has dropped to its lowest level in the agency's 33-year history. Its computer systems that monitor trades are outdated. Its leadership has seen frequent turnover.
"We are facing flat budgets and exponential growth in the industry," said CFTC Acting Chairman Walter Lukken. "Over the long term this type of budgetary situation is not sustainable."
The House Agriculture Committee is holding a hearing Wednesday on whether to expand the CFTC's authority and budget. In the Senate, Carl M. Levin (D-Mich.) has proposed a bill that would require all energy commodity exchanges to register with the agency and establish trading limits on investors. But similar efforts over the last few years have failed to make it out of committee. And this year, getting the House and Senate to vote on the matter may not be easy, given their busy agendas.
Some who work in the commodities markets question whether the CFTC, even if it got more money, would be an effective monitor because much of the trading occurs in private and is untraceable. Others criticized Levin's bill as overly broad, saying it could stifle markets that, Amaranth notwithstanding, have been working well.
Lawmakers acknowledged there are issues that have to be ironed out. But they are also concerned about time running out this year.
"We need to put a cop back on the beat in U.S. energy markets to stop excessive speculation and trading abuses," Levin said. "We have all seen what can happen if we don't act."
He was talking about Amaranth and its former star trader, Brian Hunter. Hunter started trading energy commodities at age 24. After a tumultuous stint at Deutsche Bank, he was hired in 2004 by Amaranth Advisors, a hedge fund in Greenwich, Conn.
After making the fund $100 million in profits in natural gas in 2005, Hunter was promoted to head of energy trading. He began to take gigantic positions in natural gas on a regulated exchange called the New York Mercantile Exchange, or Nymex. Hunter largely traded highly volatile futures contracts, which allow investors to make complex bets on what price a commodity will fetch at various points in the future.
At one point in the summer of 2006, Hunter controlled up to 70 percent of natural gas commodities on Nymex that were scheduled to supply companies and homes in November of last year and more than 40 percent of contracts for the entire winter season, according to a report into Amaranth's activities by the Senate permanent subcommittee on investigations.
His positions were so big he could cause the price to move in the way he wanted by buying or selling massive amounts of his holdings in the last 30 minutes of trading on Nymex, a move known as "smashing the close," federal regulators say.
Nymex expressed concern over Hunter's activities and sent several warnings.
Finally, in August 2006, Nymex ordered him to reduce his holdings. Hunter obeyed, but then simply replicated his positions on an unregulated commodity exchange run by Intercontinental Exchange (ICE), one of dozens in the industry, the congressional report said. And Hunter kept making trades.
Because ICE was not subject to any oversight, neither Nymex nor federal regulators could see what he was doing. Nevertheless, the volatility in gas prices that summer became so severe that even Hunter predicted it might draw official attention.
"Boy I bet you see some CFTC inquiries," Hunter wrote in an e-mail to another trader, according to the congressional report.
"Until they monitor [unregulated exchanges] no big deal," came the response.
In August, natural gas prices remained unusually high due to Amaranth's activity, according to the Senate investigation, even though adequate supplies combined with unusually warm forecasts made it apparent there would be plenty for the winter.
At the same time, many utilities across the country were locking in prices they would pay for the natural gas they would receive in the winter. They had no way of knowing what Amaranth was doing, said David Schryver, executive vice president of the American Public Gas Association.
But a few hedge funds became suspicious.
One of those, Centaurus, appeared to figure out the pattern behind Amaranth's investment strategy and positioned itself to make a profit at Amaranth's expense. On the last day of trading in August, Amaranth started selling off its gas contracts for September, but Centaurus countered by buying up Amaranth's positions. The two funds battled frantically over gas prices until the closing bell. Prices moved in the way that Centaurus had bet on.
Eventually Amaranth's losses totaled $6 billion. It lost the ability to pay back its debtors and closed its doors.
But homeowners lost out, too, because many utilities locked in prices for natural gas at just the wrong moment when gas prices were high. The ultimate cost nationwide has not been tallied, but one utility, the Municipal Gas Authority of Georgia, calculated that its 243,000 customers paid an extra $18 million in the 2006-07 winter season because of Amaranth. More than half of American homes are heated by natural gas.
The CFTC filed a civil suit this summer accusing Hunter, who is still trading natural gas, of attempting to manipulate natural gas prices in 2006. Hunter, through his spokesman, denied the charge and said he would prove his innocence in court.
"It is worth asking whether the CFTC's sudden decision to file a headline-grabbing action against Brian Hunter was politically-motivated," Brian Maddox, Hunter's spokesman, wrote in an e-mail. "The CFTC's action came after several days of hearings conducted by the [Senate] criticizing the CFTC for ineffective regulation of natural gas."
Lawmakers and even some in the industry say more oversight of commodities is needed. ICE, the unregulated exchange that hosted the debacle, has begun to share some trading information with the CFTC. But there is little agreement on how far a new law should go, or whether commodity trading can be effectively monitored.
That's in part because a significant percentage of commodity trading doesn't happen on any organized exchanges, regulated or not. They take place in private, as over-the-counter trades. It is difficult to know how many of these are occurring.
Commodities markets also have become complex with many trading futures contracts as well as financial tools called derivatives and swaps, whose value is based on the risk of futures contracts. Gathering data on these products has been a challenge for the CFTC.
The evolution of the markets has led to some tension between the CFTC and the Federal Energy Regulatory Commission, the agency that oversees the commercial use of energy resources, which is directly impacted by commodity trading. The two agencies have both gone after unscrupulous traders.
For now lawmakers are focusing on increasing the authority of the CFTC, which has a stronger relationship with the commodity exchanges.
Levin's bill would require unregulated exchanges to comply with some of the same standards that the CFTC requires of a regulated body such as Nymex. For instance, unregulated markets would have to set limits on trader positions and share trading information with the CFTC. Levin's proposal would not seek to regulate trades that occur in private. Levin hopes to attach the measure to a farm bill currently moving through the Senate.
Exchanges are wary of these moves, warning of unintended consequences. Jeff Sprecher, the chairman and chief executive of ICE, said active unregulated exchanges serve an important function in helping determine the price of a commodity. Over-regulating them could squash that activity and encourage traders to flee to the less transparent venue of over-the-counter trading.
"No one could have imagined that you would have a [commodity] energy market develop the way it did," added James Newsome, chief executive of Nymex. "The markets are changing so quickly that there is no way you could keep up with the changes from a rules standpoint."
But Dan Berkovitz, a top Levin aide, said traders "hesitate when somebody's watching. And when nobody's watching, traders will go wild."