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Let me make the bald statement that I believe hedge funds impact energy prices and cause them to behave in a manner differently than they would without their participation. I base that response on three beliefs:
- First, hedge funds are not in the market to lose money;
- Second, most hedge funds that trade outright price exposures are trend traders;
- Third, those that don’t trend trade are likely to trade volatility (options based trading);
- Fourth, funds will tend to trade individual trades in significant portions of their capital.
These four beliefs act together lead me to my prior conclusions. And the NYMEX report seems to disagree with some of these. The NYMEX report states” To illustrate this point, if increases in Hedge Funds open interest were to cause increases in volatility, logically, it would be because purchases increase price (from what it would otherwise be) and sales decrease price (from what it would otherwise be). To be profitable with such dynamics, it would need to be the case that, somehow,. Otherwise, it would not be profitable.
For this to succeed, Hedge Funds, in effect, must rely on someone else to trade unprofitably, but who is it that would fall into this category? There are three other fundamental classes of market participant to consider in asking this question: commercial natural gas industry participants; non-commercial participants that specialize in providing liquidity; and other non-commercial participants (i.e., Hedge Funds or entities with similar trading orientations to Hedge Funds). Below, each of these groups is considered.
1. Commercial Participants: In fact, they would be expected to be the best informed of any group as to supply and demand of natural gas, cash-market prices and OTC transaction prices. It is not reasonable to argue that the best informed class of market participant would consistently trade so naively.”
(NYMEX A REVIEW OF RECENT HEDGE FUND PARTICIPATION IN NYMEX NATURAL GAS AND CRUDE OIL FUTURES MARKETS March 1, 2005, pages 10-11)
Unfortunately, this appears to presume that hedge funds are not anticipating making money in this market. I would suggest that “Hedge Funds’ purchases are followed by purchases by others that result in prices increasing even more (from what they otherwise would be) and then selling at the higher price; and vice versa with respect to sales” is exactly the expectation hedge funds have. In addition, I have from personal experience in consulting with large consumers and utilities observed that the commercial participants look to the non-commercial traders for understanding the market. Why would institutions that run educational seminars promote large locals and fund traders as keynote speaker on “insights” into the market? Because the commercial traders believe the non-commercials know more than they do.
The NYMEX report also notes that “Hedge Funds hold their positions a significantly longer period of time than other market participants as a whole. Similar to crude oil, this means their participation, in spite of being larger, results in non-disruptive supply of liquidity to the market.”
(NYMEX A REVIEW OF RECENT HEDGE FUND PARTICIPATION IN NYMEX NATURAL GAS AND CRUDE OIL FUTURES MARKETS March 1, 2005, page 8)
Hedge funds do not ride losing trades. This means that they only hold winning trades for a long period. For them to hold trades longer than commercials whom, I presume, are hedging against budgeted consumption or production means:
- Commercials have fairly high volatility of consumption and production (i.e., something is making their business process unstable); or
- Commercials are moving in and out of hedges (formerly called “hedgulating” – now called a major Sarbox risk); or
- Hedge funds are getting their trades right a lot of the time.
What does it mean if the hedge funds are calling the trend right? This means that hedge funds are buying at the bottom of a down trend or reinforcing an up trend or they are selling the top of an up trend or reinforcing a downtrend. The market (read commercials) would not be concerned unless they are the ones getting squeezed. Now, trending markets are actually a market of decreasing volatility – smooth directional movements are a lower volatility regime than a market that wildly whipsaws around a central price. Therefore, if hedge funds reinforce a trend and make it last longer they are decreasing volatility. Unfortunately, this also means that the market will move to higher highs and lower lows than they would without the hedge funds. I am not sure, therefore, that decreased volatility means the same thing to all people.
Second, hedge funds that trade volatility (frequently called “gamma” trading). Come from a differing point of view. They may not care what direction prices move; they just want a lot of movement. If you buy an option, gamma trading is a mechanistic structure for obtaining value back from the market. It is actually “risk free” except for the premium paid. The bet is that the “expected” amount of price movement the market is charging you for is less than the actual movement the market exhibits. And this is not the movement on end of day closing prices. This is the movement of every tick of the market if the market price is relatively near the strike price of your option. I have had clients transform their operating assets (be they electric generation plants, gas processing plants or other energy intensive processes) into exactly these option structures. Their variable output becomes an option to trade with no “speculative” risk. Hedge funds do the same thing.
Finally, hedge funds – I have observed – can tend to trade in large blocks. An aphorism I use (and paraphrased from a book by a speculative fiction author called Dean Ing) is that if you share the jungle path with the elephant, it doesn’t matter if you stumble or the elephant stumbles, you lose. If you are an industrial customer hedging 10 lots of June natural gas consumption and a hedge fund comes in to buy 500 lots of June gas at the same time, you will end up paying more than you would without them. Large trades can be the black hole of liquidity. I describe market liquidity as a “sweet spot”: a combination of volume – not to big, not to small – and price – somewhere in the bid offer spread – where trades can be consummated without significant price movement. It is the total volume of bids and offers that define the “sweet spot”. If a significant number of the hedge funds trade similar technical models, then their trade orders are going to be of roughly similar frequency and timing. Any engineer can tell you what happens if a lot of little waves have the same frequency and timing – they amplify each other. They become less random (and therefore less “volatile” mathematically) but no less forceful.
The conclusion I draw is that hedge funds do have an impact on market prices that would not be present without their presence. That impact is not necessarily “wrong” but it may lead to an environment where consumers pay more for the commodity while producers receive less and the difference is the hedge funds profits. Commodity markets work that way, speculators have always been present and profited in exactly that manner. My sense it is the scale of the profit and its implications on other industries that is the issue now.
