The energy-trading high wire

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Sky-high prices have made energy trading look like easy money. Look again.

In recent months, Credit Suisse Group and Lehman Brothers Holdings Inc. have piled into the business, witnessing the billions of dollars that competitors at Goldman Sachs Group Inc. and Morgan Stanley have made as Wall Street's two top commodities players.

Numerous hedge funds -- including the $2 billion-plus Old Lane LP being launched by former Morgan Stanley executives Vikram Pandit and John Havens -- also are joining the fray on behalf of wealthy clients trying to profit from swings in the prices of crude oil, natural gas, electricity and even pollution-emissions credits.

The activity is reinvigorating some markets that dried up in 2002 after energy-trading behemoth Enron Corp. collapsed. Competition to hire traders away from power utilities and oil-trading desks is intense.

Some of the new investments have resulted in home-run profits, but painful strikeouts show that energy trading is as tricky as it is popular.

A few months after hiring some high-profile Morgan Stanley gas and electricity traders to expand its commodities business, J.P. Morgan Chase & Co. said in January that bad energy bets helped clip fourth-quarter earnings. J.P. Morgan also has been a large buyer, either for itself or for clients, of pollution-emissions credits, the prices of which plunged earlier this year. Hedging strategies may have mitigated losses. Chief Executive Jamie Dimon has said that its energy business last year still made three times what was expected.

The Barclays Capital unit of Barclays PLC, a fast-growing commodities operation, in recent months parted ways with two crude-oil traders over how they had valued how much they had at risk in options, traders familiar with the episode say. A Barclays spokeswoman declined to discuss the departures.

A steeper-than-expected dive in natural-gas prices since December has rattled traders already licking wounds from autumn's jagged market. Gas and electricity bets that went sour in the days before and after Hurricane Katrina cost hedge funds Citadel Investment Group about $150 million and Ritchie Capital $100 million, people familiar with the firms say. Citadel has more than $12 billion under management; Ritchie has about $2.8 billion. The two Chicago-area funds have since hired new energy-trading heads and gained back some of their losses, these people say. A Citadel spokesman says last year's hurricane season was one of the few times the firm's energy business wasn't profitable.

Energy trading is alluring for the same reason it is so risky: volatility. Unpredictable factors like weather and geopolitical unrest always have driven the cost of energy. But prices of energy futures -- contracts to deliver commodities for a set price at a later date -- are bouncing around like never before, multiplying the opportunities and risks as volatility in other markets falls.

Crude-oil prices rose from the mid-$40s a barrel last May on the New York Mercantile Exchange to $68 in January and closed Monday at $60.42.

Swings in natural-gas prices have some traders calling that market "Gas Vegas." Natural gas roughly doubled from its summer price after Hurricane Katrina to $14.33 per million British thermal units on Oct. 25, then fell before peaking Dec. 13 at $15.38. It has been on a nearly relentless free fall since, hovering near $6.50 much of this month before a rebound. Monday the price stood at $6.835.

"That's like the Dow going from 10000 to 25000 and back to 10000," says Foster Smith, head of U.S. gas and power trading at Deutsche Bank AG. "We've had a colossal round trip in about a 10-month time span."

Being on the correct side of that whipsaw is intoxicating. Amaranth LLC, a $7 billion hedge-fund firm in Greenwich, Conn., made several hundred million dollars trading natural-gas futures and fared well during the decline, people familiar with its activities say. A significant portion of the fund's approximately 18 percent return last year was because of energy bets, one of its investors says.

Houston-based Centaurus Energy LP, a $1 billion fund founded by Enron alumnus John Arnold, turned a nail-biting December into a blockbuster with a correct bet on natural gas's downhill slide, Wall Street trading officials say. According to SparkSpread.com, a Web site that tracks energy trading, his fund was up 160 percent for 2005, giving investors a 100 percent return after fees. Mr. Arnold declines to discuss returns.

"No one wanted to be an energy trader 20 years ago -- it was the least sexy thing in the world," says John D'Agostino, a former executive with the Nymex, the world's main energy-trading market. "Fast forward to today: Investors are lining up at the door. (But) if you're going to invest in energy, you'd better be comfortable with volatility."

In early 2005, Mr. D'Agostino founded energy hedge-fund MotherRock LP with former Nymex President J. Robert "Bo" Collins and former Nymex trader Conrad Goerl. The fund returned 23 percent in 2005, according to SparkSpread.com.

A big factor in the volatility is soaring demand from developing countries like China and India at a time when production isn't rising as much as it had been and when finding big untapped energy deposits is getting harder. Unrest in energy-rich Nigeria and worries about Iran's nuclear ambitions also play their parts.

Another factor is the surge in investor speculation. Hedge funds are taking ever-larger bets in a futures market that is smaller than the stock or bond markets, and the funds are using borrowed money to maximize their bets, magnifying the impact on prices. They are also trading heavily in short-term futures that call for delivery in just a few months rather than a year or more, a practice that also can push prices around.

Natural gas is especially tricky. Economic growth and the commodity's environmental benefits over coal have caused demand to climb in recent years. The blue vapor, shipped via pipelines, is a main fuel for electricity generation -- especially in times of high demand -- and for plastics and fertilizer production. Moreover, nearly 60 percent of U.S. homes use it for heat. That makes its price especially sensitive to weather.

Gas and electricity traders often bet on the difference in power prices in regions of a country that use different levels of coal and gas. Many bets are based on long-term seasonal trends, but energy experts say last year's hurricanes disrupted these trends. Gas and power prices initially spiked because supply from the energy-rich region was disrupted. But industrial plants in the area were damaged by the storm and stopped operating temporarily, while New Orleans effectively shut down -- driving down demand.

"A lot of hedge funds trade the historics," says Peter Fusaro, co-founder of the Energy Hedge Fund Center, a research and risk-management consulting firm. In 2005, "these financial models were not predictable models."



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