In September, 2006, a large-sized hedge fund named Amaranth Advisors LLC lost $4. 942 billion in natural gas futures trading and was forced to close their hedge fund. Although Amaranth Advisors was not exclusively an energy trading fund, the energy portion of their portfolio had slowly grown to represent 80% of the performance attribution of the fund. Their collapse was not entirely unforeseeable or unavoidable.
Amaranth had amassed very large positions on both the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) in natural gas futures, swaps, and options. The trades consisted mainly of buying and selling natural gas futures contracts with a variety of maturity dates. Their trades were very risky from both a market risk perspective and a liquidity perspective. Background: Amaranth Advisors LLC: Amaranth was a multi-strategy hedge fund headquartered in Greenwich, Connecticut. Nicholas Maounis, a former convertible bond trader, founded Amaranth in September 2000.
Amaranth’s initial assets under management of $600 million had grown to between $7. 2 billion and $7. 5 billion by the end of 2005, which translated to an average annual return of 15%, almost double the average return of other multi-strategy funds over the same period. The Primary strategies employed by the fund included convertible arbitrage, statistical arbitrage, energy trading, merger arbitrage, long/short trading and credit arbitrage. DAAS Capital Advisors: DAAS was a multi-strategy hedge fund, headquartered in the heart of Manhattan.
It was founded in 2002 by Ali Armstrong, after he had spent several years as managing director at a major Wall Street investment bank. DAAS had achieved an average annual return of 18. 2% since its inception and had grown its assets under management to approximately $2billion. The fund’s 2006 year-to-date return was approximately 16%. This positive performance was largely attributed to investments in the automobile and uranium sectors, but was partially offset by the investment in Amaranth which was $80 million investment.
Amaranth’s success in 2005 and early 2006: It was due to its energy (primarily natural gas) trades. Amaranth’s main energy trader was Brian Hunter, a 32-year-old Canadian and the former head of Deutsche Bank’s natural gas trading desk. In September 2005, Amaranth made more than $1 billion when Hurricanes Katrina and Rita hit the U. S Gulf Coast. These Hurricanes disrupted the supply of natural gas, and gas prices soared to record highs, just as Hunter had predicted. The rise in natural gas prices drove Amaranth’s 15% return for 2005, as the rest of the portfolio performed poorly.
Why Natural Gas market was unique relative to other commodities: It is because of gaseous form of natural gas made transportation difficult. Although natural gas could be liquefied and exported overseas, this process was both expensive and potentially hazardous. Strategy used by the natural gas traders: One common strategy is to bet on the price of futures for the winter contract months. Many factors can influence the price of winter contracts, for e. g. , a strong hurricane season that disrupts supplies just before winter.
Traders who believe either a cold winter or a strong hurricane season will occur will take a long position in winter future contracts. The Collapse: In September 2006, things took a turn for the worse for Amaranth. Hunter’s natural gas bets began to backfire, and the fund quickly started to lose money. By September 20,it was reported that Amaranth had lost more than $6 billion and it was in the process of liquidating its positions. By September 30, Amaranth had liquidated the majority of its equity and public debt positions.
It was rumored that Amaranth had taken a substantial long position in the winter-summer spread in September, with a particularly large position in the March-April “widow-maker” spread. Several news reports indicated that Amaranth had also held outright long positions in winter contract months. Both these positions were betting on a rise in natural gas prices during the winter of 2007. Early in September 2006, weather forecasts predicted a meek hurricane season and with a milder than usual winter.
This news coupled with surging inventories, led to a major decline in natural gas prices and caused the spread between winter and summer months to narrow substantially, hurting Hunter’s trades. Conclusion: The collapse of the hedge fund Amaranth Advisors in September of 2006 drew a flurry of attention. There are several reasons why this hedge fund failure attracted such widespread media attention. First, the size and speed at which Amaranth made losses. In less than 14 days, from September 7, 2006 to September 21, 2006, they had lost almost $4 billion. Second, their losses occurred in the natural gas markets.
There is some evidence that Amaranth’s trading activities in the natural gas markets distorted market prices and ultimately hurt consumers of natural gas. For instance, the Municipal Gas Authority of Georgia (MGAG) complained that its hedging costs with abnormally high winter natural gas prices caused its consumers losses of $18 million during the winter of 2006-2007. Third, the failure raised new concerns about risk management and leverage. In particular, it raised questions about how large a position and influence an individual entity should have over a financial market, like the natural gas futures market.