Commodity Hedge Funds Ending In Tears

We always hear about gold trades "ending in tears" due to the rapid swings of the yellow metal. As some are finding out, apparently gold is not the only commodity with a volatile price (see WSJ article). Declining prices recently have some commodity-specific hedge funds deep into negative territory. As an example, the Ospraie Fund has suffered from bad trades on energy and natural resources stocks, resulting in a loss of roughly $1 billion from a fund that had peaked near $3.8 billion in assets late last year. The fund declined more than 13% in July alone. Back in 2006 the fund lost almost 20% from bad trades attempting to guess the direction of copper prices. Yet before 2006 the fund had returned annual gains of around 18% since 1999. Just yet another reason that asset or fund returns should be compared against some type of reward-to-variability ratio, such as the Sharpe ratio or Treynor ratio, among others, to help determine if you and your portfolio can stomach the swings.

Soros And Crude Oil

As reported at Bloomberg.com, George Soros purchased an $811 million stake in Petroleo Brasileiro SA (better known as Petrobras) in Q2. The Brazilian oil company is now the largest holding in his fund, amounting to 22 percent of the total $3.68 billion of stocks and American depositary receipts held by Soros Fund Management LLC. Of course, crude oil has taken a dive in the last month, helping to push Petrobras down 28 percent since his purchase and costing Soros's $235 million. I guess we would all like to be in a position to lose nearly a quarter billion dollars and still be "OK". Then again, if Soros holds tight, he could end up doing well.

While the timing for Soros may not be perfect for this trade, a number of other people are also betting on Petrobras. As quoted by Ricardo Kobayashi from UBS Pactual SA: "Petrobras has something that other oil companies don't have: oil - lots of it and they're going to find more. If you can buy now and hang on, if you have the staying power, it's great.'' As written in a previous post , estimates have the Tupi-area fields in Brazil costing between $200-$240 billion to develop, in part due to deepwater rigs causing $600,000 a day to rent, forcing Petrobras to look for capital. Yet the cost might eventually be worth it given that the offshore fields are expected to hold up to 50 billion barrels. Petrobras has already leased approximately 80% of the deepest-drilling offshore rigs (see post). They are also buying new rigs and production platforms. If oil prices stabilize, companies to consider would be Transocean (RIG), Nobel (NE), and Nabors (NBR), each of which have sold off with lower crude prices, but each of which are also near some key support levels. For longer-term investment, some capital-intensive E&P oil companies such as Exxon Mobil (XOM) should do well, even without direct investment. Of course, this all requires crude oil to stabilize, probably stay over $100 a barrel, and potentially continue its march higher. If not, you may be experiencing the short-term returns of Soro, and not necessarily the longer-term ones.

Traveling For a Few Days

As you have probably noticed, there has not been any new posts for the last couple of days. I have been traveling and involved in activities keeping me away from the computer. Posts may be absent or lite until probably Saturday or Sunday. Looking forward to writing soon, and hope to do so this weekend. In the mean time, check out greenfaucet.com for some good articles.

Hunter Having A Nice Return, Literally And Figuratively

Former hedge-fund trader Brian Hunter, now advising and working with Paul Touradji and Renee Haugerud, made 24 percent in July, and are up 230 percent this year in their Peak Ridge Commodity Volatility Fund (see Bloomberg article). As you may recall, Hunter is the former Amaranth Advisors energy trader who helped lose $6.6 billion in 2006 from disastrous natural gas trades. As for evaluating the fund's performance, Aoifinn Devitt, founder of Clontarf Capital said it best: "They timed their trades well when everybody else missed the beginning of the correction, and this correction is increasingly looking like it's got legs.'' Definitely correct on the first point, and probably right on the second. Whether the correction is long lasting or not is yet to be seen. You also have to love the opportunistic nature of the fund itself: commodity volatility. Timing truly is everything. A little foresight does not hurt either.

Its Worse This Time - Says Former LTCM Partner

Hans Hufschmid, former partner at Long-Term Capital Management, is stressing how this time around it is much worse than it was in 1998 when LTCM went under (see Bloomberg article). The main reason? This time it affects everyone. Given that hedge funds benefit and even survive on credit and leverage, current liquidity issues are forcing many to take less exotic and esoteric positions, essentially reducing flexibility and opportunity. Of course, it is easy to forget that it was not exactly a picnic for everyone after the LTCM collapse, but intervention by the Fed did soften the impact. As mentioned in a previous post, July has been a bad month for hedge funds, with data from Hedge Fund Research showing that on average funds fell 2.4 percent in July and are down 3.5 percent year-to-date. Furthermore, daily net asset value estimates are down 2.8 percent in the month. As a result, fewer funds are starting up, and some smaller funds are closing down, crowded out by larger players with better liquidity and capital, although emerging hedge funds may be outperforming (see previous posts here and here).

New Option Volatility Fund Offered - Quantum Physics To The Rescue?

David Ko, a quantum physicist who was formally with Long-Term Capital Management, has a new hedge fund out of London focused on profiting from volatile markets (see WSJ article). The fund, called Kurtosis Capital Partners is in partnership with Stephen Cain, a former global head of currency trading at Deutsche Asset Management. The global macro fund hopes to initially raise between $100 to $250 million. As quoted by Cain, "Our strategy is to buy options when we think a market is going to become volatile. The closer to the dislocation, the better. Then, at the moment of highest volatility, sell." Buy low and sell high. Sounds like a good strategy to me. Certainly not complicated on the surface, but it would be interesting to see what types of models they are coming up with to forecast volatility, especially if Ko plans to use his background in quantum physics. Something tells me it is a little more complicated than GARCH. Cain also mentions that the fund will not use leverage, but will limit risk to the option purchase price. Another good lesson, and one learned the hard way at LTCM.

Institutional Investor Fear

As reported at the Financial Times, 60 percent of US and European institutional investors surveyed expect that another big financial firm will collapse within the next 6 months. Another 15 percent think it will happen in 6-12 months. Of interest is that 55 percent of those surveyed have also stopped using one or more financial institutions, other than Bear Stearns, as a counterparty on credit trades due to concerns regarding solvency. This has caused many to cut back their use of credit default swaps and other credit derivatives. US firms in particular were most worried, with 85 percent stating counterparty risk as a serious threat. It appears that many market participants are waiting for another shoe to drop, and at least one more washout and possible testing of the lows before the markets move higher.

Commodity Bear Market

Commodities have fallen into Bear Market territory, down 21 percent as measured by the S&P GSCI Index (see Bloomberg article). Amazing, the bear market defined 20 percent or more move down has occurred since the July 3rd highs for the index, just a little over a month ago. Specifically, gold is off 22 percent from its recent highs, silver is down 33 percent, platinum is down 36 percent, and crude oil has fallen 23 percent. The move is certainly what you would call a serious short-term correction, and starts to make you wonder when and if a snap-back is going to occur, even if the move is just temporary. Nonetheless, the weak reaction of crude oil to the recent military issues in Georgia certainly makes one suspect that crude oil wants to go down further. It will be interesting to see how this plays out. The $110 and $100 prices should be the next interesting decision points for crude.

Sovereign Wealth Fund Speculation

The Washington Post is reporting that sovereign wealth funds are becoming some of the largest commodity speculators. While the CFTC recently told Congress that its internal monitoring did not show influence by SWFs, it is believed by some that the CFTC may not be detecting their influence since the SWFs are working through swap dealers, which are often unregulated and operate through investment banks such as Goldman Sachs, Morgan Stanley, and Lehman Brothers. Officials have requested additional data from swap dealers, with these finding expected in September. It is believed that many of the foreign funds are coming from countries less familiar to SWF investing, such as Norway, Singapore, Kuwait, Australia, Russia, Libya, and even Iran. Estimates believe such funds represented 12 percent or more of investment bank commodity activity. The collective value of such funds is estimated at more than $2 trillion and is expected to increase 5-fold by 2012.

Private Equity Increasing Investments In Leveraged Loans

As discussed a few days ago, private equity firms are looking to take advantage of the recent sell-off in the banking sector by investing in beaten down banks trading at cheap valuations (see previous post). These same firms are also looking for ways around regulatory requirements that limit how large their stake can be in these banks. Now the Financial Times is reporting that private equity firms are also increasing their exposure to leveraged buy-out debt, purchasing the debt at discount rates. It is normal for these firms to take on leveraged debt as they purchase companies, but the recent credit issues have made it difficult to borrow enough using traditionally means in order to do such deals. As an alternative, firms are now buying loans at prices near 80 cents on the dollar and using the debt to help finance current deals. While the private equity industry as a whole may not be picking a bottom in the banks, recent moves indicate that they certainly appear to like current valuations and the discounts they are receiving.

An American Export: Credit Cards

As reported at the International Herald Tribune, the use of credit cards is increasing overseas. Thirty years ago Turkey had fewer than 10,000 credit cards, yet today it has more than 38 million, resulting in outstanding card debt of nearly $18 billion. Across Asia, Latin America, and Central Europe the number of card transactions is up 20 to 30 percent a year, more than twice the growth in the United States.

The increased use of cards has been somewhat of a double edged sword. Increased transactions have spurred an increase in consumer spending, but of course, bills eventually come due. Countries such as South Korea have seen defaults surge, and other rapidly growing credit markets, such as Turkey and China, also have analysts worried. But for now the global demand for cards is still increasing, and subsequently helping Visa and MasterCard report record revenues, not to mention offering their shareholders some positive returns.

Increases In Natural Gas Production, But Maybe Not Company Stock Prices

As a result of high prices, new reserve finds, and better technology, natural gas production in the US is up 8% this year, with growth expected to continue as new wells come on-line in Texas, Oklahoma, and Louisiana, and new reserves are scheduled to be taped in Appalachia and Canada (see WSJ article). Unfortunately for the natural gas companies, demand is not growing as fast, up only 5.5% - the Pickens Plan notwithstanding. US LGN import have already been down given the higher prices paid in Asia and Europe which have caused shipments to be diverted (see previous post). As long as production in the US stays high, with reduced avenues for exports and steady demand at home, prices will be pressured to fall. Then again, we may be getting near a tipping point as prices approach $8 per million BTU, a point that analysts believe producers will cut production, with the tighter supply driving prices back up in a form of a self-correcting mechanism.

Even with short-term corrections, longer-term price pressure will most likely come from new discoveries of shale, the dense rock formations that have been known to hold natural gas, but for which production had been impractical due to the rock not being porous enough for gas flow. However, technology came to the rescue in the form of using pressurized water to crack the shale and release the gas. The technique is working in the Barnett Shale in Texas and can be used in the Haynesville Shale in Louisiana and Texas, as well as the Marcellus Shale in Appalachia. Altogether, US shale could hold as much as 840 trillion cubic feet of natural gas. Astonishingly, this estimate is equivalent to 140 billion barrels of oil, or more than half the proven reserves of Saudi Arabia. While none of this natural gas will be coming on-line overnight, it certainly seems promising for helping supply some of the clean energy needs of the US going forward. Unfortunately, unless the natural gas companies, T. Boone Pickens, and others can convince Congress of this benefit, it may be a while before demand catches up to production. As a result, Chesapeake Energy (CHK), XTO Energy (XTO), and EOG Resouces (EOG) may have to wait for real price appreciation, or to see the benefits of the massive investments each has been making to tap into the shale reserves.

A-Rod, Eat Your Heart Out

It looks like you no longer need to hit over .300, drive in 100+ runs, and hit 50+ home runs to get a big payday in New York. Fortress Investment Group has just given a $300 million (31 million share) grant to on one of its top traders, Adam Levinson (see WSJ story). Given the recent poor performance of the stock, it may not stay at $300 million for long. On the other hand, over the long-term the deal has the potential to make even A-Rod jealous.

CSI On Bear Stearns: Follow The Puts

There is an interesting Bloomberg article today giving a postmortem on the Bear Stearns stock decline. In particular, the purchase of deep out-of-the-money puts are investigated. As quoted in the article, "On CSI Wall Street, the options are the DNA." As it turn out, trade data shows that 5.7 million puts traded on March 11 of this year at the $30 strike price, along with 1,649 that traded at $25, worth in total about $1.7 million. The kicker, and why this is raising eyebrows, is that when purchased these puts were over 50% below the March 11 closing price of $62.97, and also only had about a week and a half until expiration. As far as the investigators are concerned, the traders either were buying a lottery ticket, knew something was going to happen, or were in the process of making something happen. Rumors of insolvency and investor concern filled the airwaves for the rest of the week putting further pressure on the stock until it was trading around $30 by the end of trading on Friday the 14th. On that same day, with the stock opening around $54.24, the CBOE starting listing eight new put option contracts with strikes going down from $22.50 to $5, each with an expiration of only one week. That same evening Treasury Secretary Paulson called CEO Schwartz stressing the need to find a buyer to avoid the appearance of a Government bailout. And as they say, the rest is history. Even more suspect is that on Friday March 14, a total of 6,303 of the $5 strike puts traded, above the $2 initial purchase price, but well below the Friday closing price. I am sure those individuals have been receiving some calls, as well as making a few call themselves.

Fed Asking For Wall Street Bank Stress Tests

As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.

Emerging Hedge Funds Outperforming?

Data from HedgeFund.net appears to show that emerging hedge fund managers, defined as those with a track record of less than three years and fewer than $300 million in assets under management, are doing better than their more established colleagues by generating returns that are 3% to 4% higher per year. Beside being more flexible in volatile markets due to their smaller capital structure, another possible reason for emerging fund out-performance appears to be that institutional investors are increasing their allocations to newer and smaller hedge funds, according to a report from the hedge fund group Infiniti Capital. This appears to be in contrast to previous reports (see Economist article, and previous post) that smaller hedge funds were having trouble raising capital and were subsequently being pruned from the industry as institutional investors and pension funds looked for the safety of larger, more established funds and managers. Either the data and analysis are incorrect, or a shift is occurring as institutions come to the realization that bigger is not always better, especially for those institutions investing in fund-of-funds which are more likely to generate returns closer to the market averages, while at the same time providing another layer of management fees.

The Cost Of Low Interest Rates

There is a interesting short paper written by Ryan Faulkner that is available for download at Faulkner Capital or at Barclay Hedge (registration required). In the paper, Faulkner discusses the cost and consequences of the FOMC's decision late last year to lower interest rates and keep them low. While Faulkner recognizes that lower rates have provided short-term relief for the financial markets in the wake of recent credit problems, he argues that the consequences of price instability will present consequences for the markets that may have longer lasting negative effects.

Faulkner provides a comparison to the problems of the mid-1970s (I know, the stagflation comparisons are everywhere, but hang in there). At this time the real federal funds rate was negative. During, and shortly after this period, commodity prices increased rapidly. Now fast forward to 2001 and a similar trend was developing - the real federal funds rate was also negative, and commodity prices began their assent upward to the point that in June of 2004, commodity prices were rising on average 13.5% over the previous 12 months.

As rate increases took the fed funds rate from 1.0% to 5.25%, prices for commodities began to decelerate, but the move was short-lived as the Federal Reserve began drastically cutting rates in September of 2007. Not surprising, commodity prices once again took off, with real prices rising 31.9% from May 2007 to May 2008. In fact, while numerous reasons are often given for higher commodity prices, empirical studies looking at the data show that commodity prices can be modeled as a monetary phenomena (see Barsky and Kilian, 2000). Often the rise in commodity prices were either directly or indirectly driven by monetary expansion.

Of interest is that during economic expansions, it is normal that demand for commodities will increase, with commodity prices following suit. Yet if monetary policy is such that it continues to encourage growth beyond what is normal for the economic environment, then markets run the risk of entering bubble territory, such that demand and prices continue to rise, even when not justified by current economic activity. We certainly appear to be entering, or are in the midst of such a reaction to low interest rates. How do we get out of this cycle? Two scenarios come to mind and are mentioned by Faulkner. For one, the Fed could begin raising rates, but the impact on the credit markets, and subsequent fallout for the entire economy, is difficult to predict and something the Fed appears to believe is not the best course of action, or simply something they are unwilling to risk. As an alternative, the Fed could continue to keep rates low, but this scenario is likely to cause the markets to take matters into their own hands, such as selling Treasuries in mass as inflation continues to rise.

Given recent Fed moves, it is likely that the markets will need to take matters into their own hands. Regardless, the impact and repercussions may be long lasting and are likely to repeat themselves if the Fed continues to give the impression of being more interested in managing quarterly GDP numbers, and less on controlling inflation and supporting the dollar for fear of occasional lower growth. Granted, the current Fed has its hands tied somewhat, so current motivations may be based more on walking the credit tightrope, and less on any long-term bias. Only until the current credit issues are behind us (or at least manageable), and commodity prices are somewhat controlled (it is too soon to tell if the current correction will continue and last), will we get to see whether the current Fed chairman is of the Alan Greenspan or Paul Volcker mold, or some hybrid in between. In the mean time we have to wait and hope that no rate move is the right move.

Reference:
Barsky, R. B., and L. Kilian, "A Monetary Explanation of the Great
Stagflation of the 1970s," NBER Working paper, 7547 (http://www.nber.org/papers/w7547), 2000.