Energy as an Asset Class for Hedge Fund Diversification

Fusaro and Vasey were the first to undertake comprehensive research & analysis in to hedge funds in the energy industry culminating in their August 2004 report "Hedge Funds Enter the Energy Trading Space". Based at Global Change Associates and UtiliPoint International, two of the most respected energy industry analyst and consulting firms in the world, the pair have continued to build on that original report and continue to be in heavy demand to speak and write on energy hedge funds around the world. This latest report provides a comprehensive analysis of the energy hedge fund world.

Today, there are more than 8,100 hedge funds with at least $820 billion at work. This is double the number of funds over 1999. The flat or sideways trading of global equity markets for the past year has not shown the rates of return that investors have become accustomed to. Meanwhile, the energy complex is volatile. It is capital intensive. The energy industry is just plain interesting. You can't put down the paper today without every angle of the energy complex being under intense scrutiny and interest.

What has occurred is the merger of big money and big energy together. This is no longer a game for small companies, including electric and gas utility companies. This is investment banking, asset-backed trading, pure commodity trading, and most importantly that of financial balance sheets that assume "capital at risk." The combined ongoing research of Global Change Associates and UtiliPoint International has revealed that there are over 250 energy hedge funds and perhaps as many as 400 with new funds emerging on a daily basis. We classify 'energy' hedge funds as those active in the following financial sectors of the energy world:

Energy equities;
Energy debt;
Distressed assets (such as power stations);
Oil & gas commodity futures trading;
Over-the-Counter (OTC) energy derivatives trading in crude oil, petroleum products, natural gas, electric power, and coal.

Energy hedge funds are also now investing in oil and gas reserves in the ground particularly in North America. Continued oil market price volatility in 2004 has been the catalyst for the hedge funds. Frankly, the daily news reports in all media of energy market price volatility are driving the attention of funds to trade energy commodities. This has been the opening to the transformation of financial energy markets as the funds provide liquidity and exacerbate price volatility. Their presence has escalated intra-price volatility and increased trading volumes and open interest in oil futures contracts. They also became more active in North American gas futures trading in 2004. We are also seeing increased hedge fund formation in Europe, especially around oil trading and this is a trend that we expect to continue and sharpen during 2005.

CONTENTS 1
1.0 EXECUTIVE SUMMARY 5
2.0 WHAT ARE HEDGE FUNDS AND WHO FUNDS THEM? 7
2.1 Alternative Investments 9
2.2 The Basics of Hedge Fund Investing 11
2.3 Capacity issues are important 12
2.4 The New Fund Play in the Energy Patch 13
2.4.1 Weather Risk Management 14
2.4.2 Green Hedge Funds 14
2.5 Size of Funds 14
2.6 Types of funds 15
2.6.1 Hedge Fund Strategies 15
2.6.2 What is a Fund of Hedge Funds? 16
2.7 Why Now and Why Energy? 17
3.0 OPPORTUNITIES FOR HEDGE FUNDS AND OTHER SPECULATORS IN THE ENERGY INDUSTRY 20<
3.1 OPPORTUNITIES IN OIL TRADING 20
3.1.1 China 20
3.1.2 North America and the U.S.A. 21
3.1.3 OPEC 21
3.1.4 Oil Majors Not Increasing Production Spending 22
3.1.5 Socioeconomic Impacts 24
3.1.6 Supply Situation 25
3.1.7 Russian Oil Production 25
3.1.8 Hedge Funds and Speculation 26
3.1.9 The U.S. Dollar 27
3.1.10 Outlook 27
3.2 Energy vs. Equities 28
3.3 Power Trading Opportunities 28
3.3.1 Power Trading and Asset Ownership 31
3.4 Midstream Assets Also in Play 34
4.0 HEDGE FUND BUSINESS STRATEGY 36
4.1 Managed Futures & Commodity Pools 36
4.2 Diversification of Risk & Hedge Fund Composition 36
4.3 Quick Global Assessment 37
4.4 What Do the Funds Do? 38
4.4.1 Technical Analysis & Its Role in Trading 38
4.4.2 Commodity Trading Indices 39
4.4.3 Indices' Relationship to Hedge Fund Trading 50
4.5 Various Hedge Fund Oil Trading Strategies 52
4.5.1 The Commitments of Traders Report 52
4.5.2. Other CFTC Reports and Market Surveillance 54
4.5.3 Reportable Positions 55
5.0 IMPACT OF HEDGE FUNDS ON ENERGY TRADING 60
5.1 New York Mercantile Exchange (NYMEX) 60
5.2 The International Petroleum Exchange (IPE) 62
5.3 NYMEX's Clearport: Positioned for the Fund Business 65
5.4 Intercontinental Exchange and Trading 66
6.0 THE ANATOMY OF AN ENERGY HEDGE FUND 68
Example 1: European Oil Fund 68
Example 2: US Energy Hedge Fund 69
7.0 WHAT'S ON THE TRADING HORIZON FOR 2005 70