London 16 July 2010

Natural gas hedge funds -- huge money makers just two years ago -- are struggling as an oversupply of gas has nearly killed price volatility, and big profits from sharp price swings look unlikely for now. Fund managers have had trouble predicting how nearby U.S. natural gas futures would perform relative to longdated contracts, making it difficult to position themselves on the right side of a curve and exploit the resulting spreads. Steep peaks and valleys in gas prices have all but vanished since July 2008, replaced by a steady downtrend through August 2009 and a little choppy trading since -- hardly exciting stuff for traders used to stomach-churning rides in gas.

"People are lacking strong conviction that there's great value in where the curve in natural gas is right now," said Michael Zenker, head of American power and gas research at Barclays Capital, referring to the spreads between the spot contract of natural gas on the New York Mercantile Exchange and contracts that extend into 2011/2012.

Fraser McKenzie, head of research at 47 Degrees North Capital Management in Pfaeffikon, Switzerland, which has about $250 million invested in hedge funds, said few have been able to read the market correctly.

"Twice in the last two years, funds have tried to build positions in natural gas on the back of good fundamentals. Each time, they've got into trouble," he said.

Funds made some of their biggest money in U.S. natural gas between late 2005 and mid 2006 as prices hit all-time highs after Hurricane Katrina and other storms destroyed a chunk of the energy infrastructure in the U.S. Gulf of Mexico, shutting in supplies and causing billions of dollars in damages.

Funds long in gas also did well in the first half of 2008 as record highs in oil prices pulled almost all energy markets higher before the financial crisis ended the run.

Dismal Year

This year has so far been dismal for natural gas funds, which have either lost money or eked out marginal gains. Gas prices held in a range before suddenly rebounding in May and June, tripping up funds that did not anticipate the shift.

SandRidge Capital Management, which manages just under $1 billion, lost about 7 percent in June, extending May's drop of around 15 percent, according to a hedge fund tracker.

Velite Capital, another gas fund, also lost about 7 percent last month, an investor said. Even Centaurus Energy, led by billionaire trader John Arnold, fell more than 3 percent in May and was "down slightly" in June, one investor said.

Centaurus made nearly $1 billion in late 2006, betting correctly on lower prices. Amaranth Advisors, another hedge fund, bet the opposite, lost $6 billion and later collapsed.

"It's been a rough time lately for most people" in natural gas, said Ernest Scalamandre, founder of AC Investment Management, a fund of funds in New York that has about $1 billion invested mainly in energy funds. The start of a new Atlantic hurricane season has sparked speculation on the impact of storms on gas supply and prices.

But analysts say there are fewer worries about gas supplies now than there were five years ago. They point to the abundant resources available from onshore shale rock and fortified offshore platforms that can better withstand storms. One sign of oversupply is the U.S. gas rig count, now at 964 according to oil services firm Baker Hughes in Houston. A rig count of 875 indicates zero year-on-year growth in supply, and "anything above is bearish," said Mike Guido, associate director of hedge funds at Macquarie Bank in New York.

The rig count is one reason funds are not placing "big bets based on a tropical (weather) event risk alone," Guido said. The supply glut has narrowed the spreads, or differential, between key gas futures contracts on NYMEX, limiting the potential for profit.

The spread between the 2011 March and April contracts in NYMEX gas -- a popular trade representing the end of winter and start of warmer weather -- stood at 16.5 cents per million British thermal units (MMBtu) at Wednesday's close. In early December 2005, just months after Hurricane Katrina, the spread for March-April 2006 was almost $4 per MMBtu, as traders feared supply would fall short of demand.

Funds " Strangle" to Make Money

Another damper on gas trading has been position limits placed by both the CME Group Inc , which owns NYMEX, and the Intercontinental Exchange , the electronic trading platform for commodities. The limits are intended to prevent market manipulation.

In a bid to eke out some money, fund managers have resorted to selling options in natural gas, using a strategy known as a "strangle." Used successfully in flat markets, it involves selling a put at $4.00, for example, to place a bottom on the price, and a call at $4.80 to cap the upside. Assuming that gas continues trading at $4.30-$4.40/MMBtu, the trade is covered on either end and the fund never has to pay out on the option. It is worthless at expiration and the fund pockets a premium on the sale.

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