Today, the most amazing thing about the energy industry is the lack of accurate, experienced analytical support offered to investors from its Wall Street and City of London energy analysts.
By and large, they have been out of touch painting an inaccurate picture of what is happening in the global energy sector. Frankly, they have been plain wrong, expecting prices to revert to historical means. With oil well over historical prices per barrel, there is a continued lack of recognition that the energy sector may go still higher. Something has changed this time.
Today, the sector is in focus because many changes and factors have combined to make energy very different this time around. These cannot be distilled into a sound bite for TV news and that complexity has scared off investors who should actually be looking at energy as an asset class for investment diversification and one that they should be more heavily weighted in. But it’s not too late.
The energy bull market in oil, gas, power and coal will continue for the next two years. After that, all bets are off, but the sector may get an unexpected uplift from the nascent and surging global environmental financial markets. Already, the Emissions Trading Scheme (ETS) in the EU has caused a stampede of investment into carbon hedge funds and emissions trading. Energy is not the dotcom bubble and bust of several years ago. It is real and driven by market fundamentals.
The tremendous global under-investment in the oil and gas and electric power industries, and transportation sectors coupled with rising global demand for energy driven by industrialisation and globalization trends throughout the world are at the root cause.
New commodity price moves continue to accelerate with no ‘conservation effect’ to speak of this year to date. Energy in current dollars is cheap and this has resulted in continuously higher consumption with little economic braking due to price. Indeed, price has so far been almost irrelevant, having little impact on the US economy and for that matter the global economy.
While China and now India are continually blamed for this higher consumption, the reality is that the US economy consumes more than 20m barrels of oil per day, or over 20% of global oil demand, and that has eaten up all the energy efficiency gains of the past three decades. The 1990s saw relatively low, stable and not very volatile energy prices encouraging Americans to buy larger and less energy efficient cars and homes.
Capacity is increasingly constrained, global refining capacity is tight,especially after Hurricane Katrina and transportation markets are also tight as exhibited by higher-than-normal tanker rates. Overlaying all these energy concerns are rising environmental cost factors. The industry, which is mature and has a high cost base, has also brought with it higher price volatility due to globalisation of markets, a declining US dollar and endemic geopolitical risk in many oil producing countries.
In addition, speculators in the form of both hedge funds and investment banks have increased their trading activity. This additional price volatility has laid the groundwork for trading liquidity; the adage “liquidity begets liquidity” is very true. We are in the middle of a demand-driven bull market in energy commodities like we have never seen before. The reality is that the energy sector now is a tremendous investment opportunity for investors, and the question becomes how do investors play this sector?
The traditional play for investors is to invest in energy is through equities and mutual funds. Recently, most financial advisers have asked fund managers to double up on their energy holdings. Investors can buy energy stocks which continue to show great prospective returns as oil and gas price continue to rise.
Other ways for investors to: play the energy sector is through Master Limited Partnerships for oil and gas reserves; buy and sell energy debt; buy distressed energy assets; and invest through energy hedge funds. This focus is attuned more to high net worth individuals who may need both tax deferral benefits and asset diversification into energy stocks, bonds, oil trusts (which are quite popular in Canada).
Another strategy is to enter into energy options trading. If energy volatility continues to rise, these options could become even more valuable. Options give investors more leverage on higher energy prices and, of course, bring with them the attendant risks.
We anticipate that more investible indexes will also come into the market so that retail investors will have access to them through their banking relationships.
More sophisticated financial traders can trade or invest in the energy commodities. Thus, we have seen as many as 110 energy hedge funds trading energy commodities. Here the play is either through exchange-traded futures contracts or over-the-counter price swaps or options. These markets are even more risky but investment banks can manage the price risk for high net worth investors.
Several institutional investors such as college endowments and pension funds are evaluating whether to invest in this sector as well. The new energy hedge funds also do not meet the traditional financial metrics of having one, three or five-year track records. The better play is to invest in the less-risky fund of funds. A fund of funds is an investment of a hedge fund into other hedge funds that actually do the trading. The volatility is lower in fund of funds. In our universe of energy fund of funds, we have counted over 20 fund of funds, with more to be launched in Europe, Canada, the US and maybe Asia.
More speculative investors can invest in all types of energy hedge funds. While many are diversifying into energy commodity trading, they are also investing in long/short energy equities, equity/commodity funds, physical oil and gas reserves in the ground, energy industry debt, distressed assets, coal assets and commodities, both physical and financial electric power, and renewable energy and emissions trading including carbon dioxide. These strategies are not all the same, and their risk tolerance varies.
What has been the hardest obstacle for many energy analysts and investors to comprehend is that it is different this time. Most energy companies and governments have continued to look backward and wait for an expected mean price reversion to lower energy prices. It has not occurred and will not this time. There is no surplus supply cushion this time in these demand-driven markets.
As the third quarter 2005 ends, the profit picture should brighten substantially higher for energy companies, and the perception may change into one of the greatest energy bull market of all time. Each sell-off is actually a buying opportunity or, as one European fund manager told us, “the lows get higher”. Global energy demand continues to rise and global refining surpluses are almost exhausted, leading to a summer of higher highs due to capacity tightness. While it may be buyer beware, savvy investors know a good thing when they see one. Energy is that new asset class.
Peter C Fusaro is author of ‘What went wrong at Enron’, and co-founder of the Energy Hedge Fund Center (www.energyhedge-funds.com), of which he is a co-principal with Gary M Vasey. Together they advise energy and environmental hedge funds and publish the ‘Directory of Energy Hedge Funds’ and Energy Hedge, an energy financial newsletter

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