Ken Silverstein EnergyBiz Insider Editor-in-Chief

The last five years have been dull and much of the money was sidelined. Now, investment banks and hedge funds are focused on the energy sector and getting into power and gas trading. And if the market functions properly, the benefits could trickle down to end users who benefit from more market transparency.

Trading organizations will always have a place in energy markets. As long as wholesale markets for both power and gas are open, companies will still need to mitigate risks and there will always be a need to match buyers and sellers. Some entity will be required to aggregate the energy and schedule its delivery. While the traders in the 1990s were typically part of an unregulated utility operation, the dominant ones today are the investment banks with the hedge funds right on their heels.

Now, there are literally hundreds of hedge funds. And while many made huge returns just a few years ago, the results are much tamer now at around 5 percent, overall. Still, those funds are pumping billions into commodities. And that has to affect the prices that consumers are paying. But, some studies have concluded that their participation is a limited fraction of all futures trades and therefore cannot be blamed for record-high oil and gas prices in recent months.

All freshman economics students learn that when demand goes up, supply must also rise if prices are to be kept in check. If that doesn't happen and supplies remain steady, prices will increase. Indeed, that's much of what has been happening. In the case of natural gas -- and as many already know -- the generators constructed in the 1990s largely ran on the commodity. But, producers have not been able to access gas-rich regions. And, even if they could, it would be years before that gas hit the market.

It's a hard position to explain. All consumers know is that they have been paying huge winter heating bills and $3 a gallon for gasoline. While the oil companies have earned hundreds of millions in revenues, no evidence exists that they have toyed with markets. "If the price of a commodity is going to rise, profits will react accordingly, says Rick Davis, with Stanton Chase International in Dallas.

"But, if or when those prices go down, the opposite will happen, adds Davis. "I didn't see government or various policy groups calling the oil companies in the 1980s when the industry was in the dumpster to see if they could help out." Specifically, he notes that Exxon, BP and Shell produce 13 percent of the 84 million barrels of oil consumed each day -- not enough to cause huge spikes.

Better Reflection

The financial trading sector could potentially be a profitable one in the $400 billion a year electricity and natural gas industry. For their part, the banks are looking to make up for reduced trading revenues in their equity and bond businesses.

Moreover, volatility in the oil and natural gas businesses provides opportunities. Barclays, Citibank, Deutsche Bank, Goldman Sachs, Merrill Lynch and Morgan Stanley are among those that are working to diversify their commodities positions and to sell electricity products to their institutional and industrial clients.

At the same time, hedge funds that typically trade over-the-counter in private deals have lots of cash and are participating in this segment at ever increasing rates. Such hedge funds are unregulated private investment funds and are comprised of sophisticated investors that range from wealthy individuals to institutional investors such as pension funds. Investment banks oftentimes finance them. In essence, such funds seek to find "arbitrage" opportunities whereby they might buy power for a low price in one part of the country and sell it for a higher price in another region.

The New York Mercantile Exchange (NYMEX) says that the current price volatility is tied to the underlying market fundamentals. Hedge funds, it adds, account for a modest share of futures markets and they are unable to cause large movements in price. Specifically, hedge funds represented about 9 percent of the natural gas futures trading volume while they comprised less than 3 percent of the light sweet crude oil futures markets.

At least that's the conclusion the trading exchange drew after looking at the results of such trades in the first eight months of 2004. The added liquidity, however, helped to contribute to a more vigorous and more translucent market that actually put downward pressure on prices.

"The findings of the study are consistent with our belief that hedge funds do not negatively impact our markets," says James Newsome, president of the exchange. "They generally hold positions significantly longer than other market participants, which supports the conclusion that hedge funds are a nondisruptive source of liquidity ... "

Critics of NYMEX's conclusion maintain that the time period it considered was relatively calm and note that it also has the incentive to encourage participation in futures markets to keep them vibrant. Peter Fusaro, head of Global Change Associates, says that hedge funds do in fact affect market prices. Their trades are so large, he adds, that the funds act to reinforce upward or downward trends in prices -- and profit accordingly.

But, the added involvement in the sector creates more liquidity and transparencies that would otherwise be lacking. Investment banks and hedge funds are the catalysts. And while they try to profit from price volatility, they are responsible for product innovation and the formation of a robust market. That, in turn, creates efficiencies and prices are eventually a truer reflection of supply and demand.

For far more extensive news on the energy/power visit:  http://www.energycentral.com .

Copyright © 1996-2005 by CyberTech, Inc. All rights reserved.