How Risky Are Energy Hedge Funds?

Summary: Energy hedge funds appear to be very high risk investments from the outside. Is this really the case?

As is often the way in life, the most famous energy hedge fund is one that has crashed and burned rather spectacularly. The fund was very active in the energy markets, including natural gas. In 2006, it all went wrong and the fund lost somewhere in the region of US$5 billion in one week!

You can read about what went wrong here and here.

It would seem as though there were a number of things that went wrong, but the recognition of the risks appears to be high on the list.

To be fair, in every sector and industry, there are a number of factors that are unknown and out of the control of a trader. However, in the world of energy, there do appear to be many more of the unknown factors.

For example ... the weather! Energy production, transportation or use can be greatly impacted by the weather. In this case, Hurricane Katrina was the problem, hitting the oil and gas producing areas in the Gulf of Mexico amongst many other things.

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There are also a number of geopolitical issues that can come into play. Much of the world's oil and gas reserves are located in countries that are not always the most stable, democratic, friendly or cooperative. Countries like Venezuela, Iran, Iraq and Russia enjoy wielding the power that their reserves provide them with. This story provides an excellent example.

Then of course there are cartel matters. OPEC does it's best to keep prices of oil in a range of it's liking by playing with the amount of production from member countries.

There are other supply concerns. For example, just how much oil exists? No study seems able to provide a clear answer to that question, meaning that the estimates provided by governments and companies could be wildly inaccurate. This story from 2004 suggests how possible this scenario really is.

Whether such inaccurate numbers are deliberate or accidental is impossible to know, though there does appear to be a lot of potential money in a stock price if a company has far larger reserves rathan smaller.

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There are also issues relating to strategic reserves and indices. For obvious reasons, most developed nations, and lots of developing nations, maintain a reserve of oil and gas in case supply is cut. This provides several days or weeks of supply in case of emergency. These reserves are based usually on either the possible needs of the country, or a relevant index that monitors prices.

´╗┐Did we mention currency rates as an issue? Or the potential for wild swings in the stock market? It would seem reasonable that a number of energy hedge funds will trade in the stocks of the major oil and gas producers. This adds yet more risk...

While we recognise that this article is not at all balanced, we do wonder why an investor might want to invest in a vehicle that uses high levels of borrowing to make trades in markets that have so many potential risk factors. Energy hedge funds do seem to be much riskier than many other types of potential investment, including many other types of hedge fund. Caveat emptor.

To read more, please follow these links:

How Do You Define A Hedge Fund?

What Are The Best Hedge Funds?

How Do You Conduct Hedge Fund Due Diligence?

Is There Any Regulation Of Hedge Funds?

Why Invest In A Hedge Fund Of Funds?

What Do Forex Hedge Funds Do?

How Do Real Estate Hedge Funds Work?

How Can You Learn About Offshore Hedge Funds?

What Can Commodity Hedge Funds Trade?