Amaranth’s Effect On The Markets
By Dr. Richard S. Appel
www.financialinsights.org.
October 2, 2006
September 29, 2006 – The natural gas market has provided a roller coaster ride of profits and losses for those investing or speculating in it. It began 2005 below $6.00 an mcf (million cubic feet). By December, the combination of an increasingly tight inventory, a rising oil market, and the devastation produced by hurricane Katrina made it soar and set a $15.75 all-time price record.
Natural gas conceived its Bull Market in September 2001, when it arose from its $1.76 base. It is an emotional market. This can be attested to by its February 2003 temporary spike above $10.00 an mcf with its following collapse to under $4.50 several months later. Similarly, in the weeks leading up to hurricane Katrina’s unleashing her fury, it was trading in the $8.00 range. This all changed when Katrina’s winds began to build and she approached the Gulf of Mexico’s prolific oil and gas fields, and the numerous onshore storage and processing facilities that she was destined to damage or destroy.
The spot price for natural gas approached $4.00 an mcf earlier this week. By so doing it broke below its $4.39 and $4.52 lows it posted in September 2003 and September 2004 respectively. How could gas trade at nearly $16.00 an mcf as recently as nine months ago, and then fall 75% in price? I believe that the surfacing of the Amaranth hedge fund collapse sheds some light on this issue.
Amaranth had earlier success in the natural gas market. They correctly anticipated its direction and accordingly positioned themselves in a bullish fashion. To their detriment, when the market reversed course they continued to maintain their existing posture and, I’ve read, they even increased their exposure. Finally, after suffering substantial losses, they attempted to sell their enormous hedged long positions in order to survive.
To their misfortune the apparent size of their position was known by various large traders who “smelled blood in the water”. They watched while Amaranth worked in vain to exit their positions, and they likely increased their shorts which drove the market still lower. Amaranth’s plight was further exacerbated due to their need to meet forced margin calls. These latter developments increased the downward pressure on the gas market and caused Amaranth’s losses to swell. I believe that the depth to which natural gas plunged was a direct result of the unfolding of these events.
Finally, the banks and financial institutions that financed Amaranth called their loans. This forced Amaranth to sell their energy book. Interestingly, it was reportedly purchased by J.P. Morgan Chase and the Citadel Investment Group. I suspect that they were two of if not the largest shorts in the market.
With the signing of the agreement and transfer of their positions to Morgan and Citadel, Amaranth took a reported loss approaching $6 billion. Simultaneously, J.P. Morgan and Citadel were gracefully allowed to offset their enormous short positions and bank untold profits. In effect, Morgan Chase and the Citadel Group were likely let off the hook of having to repurchase their huge short positions! Further, they likely did it at a steep discount to the market. If Amaranth had not been forced into liquidating their contracts, the buying by J.P. Morgan and Citadel to close out their futures contracts would otherwise have forced the market significantly higher.
In my opinion, Citadel and J.P. Morgan Chase played the game brilliantly. They garnered huge profits while Amaranth’s investors suffered incredible losses. What is interesting is that natural gas continued to substantially decline after the reported September 20 sale of Amaranth’s holdings.
The saga is not yet over. It remains to be seen if another distressed hedge fund or entity will surface and take the natural gas market further lower. In fact, that might be the impetus behind its continuing decline.
I believe that natural gas is in a major, secular Bull Market. As early as June 2003, when it was trading at $6.31, none other than the venerable Alan Greenspan stated, “Today's tight natural gas markets have been a long time in coming, and futures prices suggest that we are not apt to return to earlier periods of relative abundance and low prices anytime soon”.
I heartedly agree. Despite its temporary oversupply, if anything the U.S. supply vs. demand equation for the commodity has become more bullish since Greenspan uttered this quote. Further, I see no indication that significant additional supplies will be available in the next few years at a minimum.
In my opinion, when this price decline ends it will set the stage for what will likely be an incredible entry point. Additionally, I believe that natural gas and the companies that produce or explore for it are already enormously oversold and are preparing to resume their Bull Markets.
I feel that the natural gas price grossly overshot its downside target when it entered this correction. This was to a large degree the result of Amaranth’s misjudgement of the direction of the market, and the “sharks” that astutely recognized Amaranth’s plight and capitalized on it. Remember, J.P. Morgan and Citadel were sufficiently happy to book their profits when it was trading in the $5.00 range
Of great importance to myself and other investors is my belief that the gas complex shares should perform far better in their next upleg. When natural gas soared on three earlier occasions in its Bull Market, the gas shares did not perform as one would expect. True, many of them multiplied in price. However, to my thinking, gas stock investors were unwilling to use in their decision making, any price near the $10 or $16 peak prices that the hydrocarbon posted. I doubt if more than a few people valued these companies using more than about a $6 mcf price.
This is understandable because investors and other interested parties did not believe that those prices had staying power. They had been through too many wide swings in its price, and didn’t want to overpay and expose themselves to serious losses as they had done in the past.
If I am correct, this mind-set will be softened when natural gas resumes its Bull Market. If it can surpass and remain above the $10 or so level for a number of months, I believe that more and more investors will begin to realize that it is truly in a secular Bull Market. In this event, they will begin to attribute substantially higher gas prices when they evaluate a company’s worth.
I sense that many natural gas stocks have posted or are approaching their lows, and that their risk vs. reward levels are now exceptional. It may require a time before gas stabilizes and resumes its Bull Market. Few markets can sustain this sharp a free-fall and immediately reverse course and move sharply higher. Yet, given the fact that the likes of J.P. Morgan Chase was satisfied to cover when it was at higher levels, natural gas is likely either at its nadir or within shooting distance of it. In any event, given the beating that the gas exploration and producing companies have suffered, and the likelihood that gas prices will be far higher in the foreseeable future, I view staged entry into their shares an excellent opportunity.
By Dr. Richard S. Appel
www.financialinsights.org.
October 2, 2006
AI
