Amaranth -- When Hedge Funds Forget to Hedge

Speaking of hedge funds, on the weekend I said about oil: “...a 5% (so far) drop in September may have hedgies heading for the exits before they wipe out last year’s profits.” First hedge to cry uncle is already in, and it’s (drum roll please)... Amaranth!

On their web site Amaranth states: “Amaranth’s investment professionals deploy capital in a broad spectrum of alternative investment and trading strategies in a highly disciplined, risk-controlled manner. Our ability to effectively pursue a variety of investment strategies combined with the depth and strategic integration of our equity, credit and quantitative teams, supported by a world-class infrastructure, are some of the key strengths that distinguish and define Amaranth.”

This must be a form of highly disciplined risk control that I am unfamiliar with, as it allows a fund to lose 45% of its assets in 2 weeks. That’s 45% of $9.2B for those of you playing along at home!

This is one of the smartest funds on the planet and they got clobbered by oil’s move last week, the carnage may be indescribable as this thing continues to unwind. The CEO of Shell estimated that there is $100B of speculative plays on oil alone. When you add in gas (Amaranth’s downfall), gold and other metals, we could be looking at upwards of $500B on the wrong side of a trade!

It is easy to see the temptation; we’ve heard it ourselves from the oil bulls for 2 years now. Natural gas was $12.25 this time last year; it’s September, so gas should be $12, not $5! The problem is that this sort of logic does not take into account that, for 99 out of 100 other Septembers, natural gas was $4. The statistical aberration does not become the norm in one, two or ten years...

The premise oil and gas bulls are operating under is that for 100 years of being traded as a public company, through 2 World Wars, a Cold War and a depression, every investor, trader and analyst who ever lived undervalued Exxon by 150%. That’s right, the people buying oil stocks now think that, not only are they worth close to 2x more than at any point in history, but that here, at the high point, they remain undervalued.

Since April of 2005, Exxon has outpaced the S&P by over 100%, with half of that gain coming in the past 60 days. This is after tracking within 5% of the S&P for 100 years. How did Warren Buffet miss this one???

For the record, Mr. Buffett also seems to have missed out on the homebuilder craze as well...

Comment on this article

Comments

[CrossProfit]

As you correctly pointed out in another article of yours, Exxon Mobil’s margins and profits have increased over 50% and 120% respectively since April 2005. There is a three to six month delay for the margin phenomenon to show up in the earnings. Q2 was the second most profitable quarter in the history of XOM. Q3 is going to set a new record. Q4 earnings will come down a bit, still making 2006 the best year ever. 2007 will be better than 2006 even with lower oil prices. You have to hand it to XOM for successfully lowering their base costs during a period of rising oil prices. All competitors have higher base costs, not lower! XOM is still going to show higher than average results as long as oil doesn’t fall below $51.

Oil will remain high (see below) for the next several years, until new LOW COST production comes on line. The CVX find in the Gulf is a deep water play and is NOT a low cost site. Mexico has to replace its ‘low cost’ production with ‘high cost’ production over the next decade. When evaluating the oil giants you have to look at their production costs. It is not enough to say that there is plenty of production capacity on the planet. At any price this would be correct. The question you must ask is how much production is profitable at $45, $55 and $65. Even at $75 not every reserve field is profitable. About 68% (+/- 4%) of current global production is profitable at $17 and the operators of those fields are raking it in. Some fields are profitable at $6! The same rules apply to natural gas with the added transport/location logistics.

In other words if oil drops now – today to $45 a barrel the world will lose about 4% of production overnight. No one will continue pumping to sell at a loss. Until this is replaced with lower cost production there is no chance of oil falling below this level for any extended period of time. The supply/demand surplus is at 1.5% (on average) and not 4%.

If Iraqi oil comes on line again without disruption, then the world has continuous low cost production supply that will allow prices to fall below $45, probably as low as $28-32. Some of the Russian fields are low cost production sites. Putin is making life difficult for everyone but that is a whole different topic. The large Venezuelan reserves are medium cost production sites but the high sulfur content makes refining so expensive that whatever is saved on production is given back on refining. (Not exactly, but close enough.)

What will dictate the price of oil are not the production costs of 96% of the wells but the last 4%. We can not rely on averaging either. All it takes is one major producer to run out of low cost fields and switch to high cost fields and we are back to High Oil.

Clarification: ‘High oil’ is anything above $45 a barrel.

Disclosure: This personal comment by a CrossProfit analyst reflects the opinion of CrossProfit.com.
www.crossprofit.com

[ElyZimmerman]

This is the most concise explanation of a significant piece of the oil market dynamics I've ever come across. Defininitely "a keeper". Thank you crossprofit!

[BarryGitarts]

Buffet owns COP, so he is in the oil game.

[Philip Davis]

I stand corrected, it's interesting that COP stopped dropping right about Buffet's $59 buy price. My readers know that COP is not one of the oil companies I bet against for value reasons anyway so I agree with Mr Buffett there.

Cross, that is indeed excellent analysis! I'm adding you guys to my own reading list.

Thanks,

- Phil

[PINAKiDASGUPTA]

Just my two cents advice..In sanskrit ...i just did the word analysis of
AMARANTH..=AMAR +ANTH meaning .. Immortal(amar) End ( anth)..Had it been AMARNATH = AMAR + NATH it would mean Immortal ( AMAR)god (NATH).. just the question of N before A..
well Mr.Brian hunter ( the star trader ) of amaranth advisors did misread into natural gas hedging till 2011 ..by shorting summer and fall gas contracts and went long on winter contracts...
As they say its all in the NAME!!!!!!!!!!