Political Skullduggery

The Bear Stearns CDO Hedge Fund exigency is reminding some people of another recent low liquidity event.

After a nine-month investigation, a bipartisan Senate subcommittee is expected to issue a report today detailing how a single hedge fund, Amaranth Advisors, dominated the North American natural gas market last year, causing high prices and extreme volatility that ultimately led to its stunning collapse.

Amaranth, once a star hedge fund, lost more than $6.5 billion on disastrous bets in the natural gas market last summer before shutting itself down. The fund's activities are still under investigation by the Commodity Futures Trading Commission.

Investigators from the Senate Permanent Subcommittee on Investigations examined millions of trading records from the two main American energy exchanges, the New York Mercantile Exchange, or Nymex, and the Intercontinental-Exchange, known by its acronym, ICE. In a 135-page report, the investigators pieced together the events that led to Amaranth's collapse, from the start of 2006 to the fateful final weeks of last September.

The report found that Amaranth held as many as 100,000 natural gas contracts in a single month, accounting for 5 percent of the total amount of natural gas consumed in the United States last year. The position was so large that it allowed the company to dominate trading in natural gas futures and push up prices.

By the end of February 2006, for example, the fund held nearly 70 percent of the open interest in the November future contracts on Nymex and nearly 60 percent in the futures for January.

It was that size that led to its collapse: Amaranth made a huge bet that natural gas spreads — or the difference between two monthly future contracts — would rise, and it kept pumping more money into that bet. When prices fell, Amaranth found itself on the wrong side of the market and could not make up for its losses.

The investigation offers a fascinating insight into the company's doomed trading strategy, revealing both missed opportunities and what appeared to be destructive greed. The turning point came in May 2006, according to the report, when Amaranth's energy portfolio showed a loss of $1 billion.

"By the end of May, at least some of Amaranth's traders and officers were aware of the firm’s predicament — that it had accumulated larger natural gas positions than it could sell profitably," the report said. "In June and July 2006, Amaranth did not, however, pare down its spread positions; it enlarged them."

By the end of August, Amaranth was pumping in more money to hold its position, but the market had taken a different direction. After starting 2006 with $7.5 billion, the fund soared to $9.2 billion and eventually collapsed to less than $3 billion.

The investigation also faults Nymex for failing to restrain Amaranth in time. Nymex officials had known since May 2006 that Amaranth had accumulated sizable holdings in several future contracts. When Nymex finally asked Amaranth to reduce its holdings, in August, the fund simply moved its assets from Nymex to ICE, an exchange that is exempt from federal regulation.

In a hearing on Capitol Hill today, Senator Carl Levin, Democrat of Michigan, who is chairman of the subcommittee that conducted the investigation, is expected to draw attention to the lack of regulatory oversight of ICE.

Among the report's recommendations, the report urges Congress to "reinvigorate" prohibitions against excessive speculation, provide more funds to the Commodity Futures Trading Commission and close the "Enron loophole," a provision in the Commodity Exchange Act, requested by Enron in 2000, that exempts crucial energy commodities from government oversight.

"Current commodity laws are riddled with exemptions, exclusions and limitations that make it virtually impossible for regulators to police U.S. energy markets," Mr. Levin said.

Update: The reports have now been issued (PDFs).

Senate Permanent Subcommittee on Investigations Staff Report - Excessive Speculation in the Natural Gas Market

Appendix - Excessive Speculation in the Natural Gas Market