Energy Traders On The Verge Of Extinction
Four Advisors Discuss The Challenges Of Trading In The Energy Complex
Copyright 2000 Barclay Trading Group, LTD.
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At year-end 1990, there were 23 CTA programs that were devoted to trading energy futures exclusively. As a group, these energy specialist investment programs were managing approximately $275 million. Today, there are only five remaining active CTA programs that trade energy only. Their combined assets under management are a meager $3.4 million. What happened?
Part of the problem is attributable to the fact that the performance of energy traders (as measured by the Barclay Energy Trader Index) has been disappointing. For the 77-month period from January 1, 1991 to May 31, 1997, the Barclay Energy Trader Index has measured a compound annual return of 0.01%, the lowest return of any of the Barclay indices. Most of the damage occurred in 1996 when the Energy Trader Index declined 17.92% while all of the other Barclay CTA indices measured profits for the year. However, even as the energy specialists were taking historically unprecedented losses, diversified traders were having good successes in wringing profits from the energy complex.
At year-end 1990, the five largest energy futures trading firms were headed by people who had all come from cash-market operations. Savvy, intelligent risk-takers, these experienced oil-patch operators seemed like a sure bet to rise to the top. Today, none of these five firms remain.
Are energy traders, who specialize in extracting profits from price changes of fossil fuels, in danger of becoming dinosaurs themselves? In order to get a clearer understanding of the issues involved, we've gathered a distinguished panel of CTAs with significant energy trading experience to help shed some light on the matter. Our panel includes:
Ralph Adams, Lora Trading Company, Inc. Mr. Adams is President of Lora Trading, a CTA firm specializing in energy trading. He has 25 years of energy market experience including oil tanker chartering, physical oil trading and brokerage. Mr. Adams began his career in managed futures at Tricon (USA) in 1987. He founded Lora Trading in 1989 while still associated with Tricon and became independent in 1992.
Douglas Bry, Northfield Trading L.P. Mr. Bry is President of Northfield Trading L.P., a Colorado based CTA managing $250 million. He has sole management authority over the day-to-day activities of Northfield and is primarily responsible for its non-discretionary, technical trading program. Mr. Bry earned a law degree in 1978 from the University of Colorado and a BA in Philosophy and Sociology from Beloit College in 1974.
Bruce Cleland, Campbell & Co. Mr. Cleland is President of Campbell & Company, an investment management firm that has been in business since 1972 and currently manages assets of $700 million. The firm applies quantitative, systematic trading strategies to diverse portfolios of global futures and currencies. Mr. Cleland has served as a member of the Board of Governors of the Comex, and is currently a member of the Managed Futures Association, where he serves on the International Committee.
Michael Schiff, Coast Energy Investments, L.P. Mr. Schiff is the Managing Partner of Coast Energy Investments which operates an energy fund, Coast Energy Partners, L.P. He is a Wharton MBA with a fundamental energy industry background. Mr. Schiff gained his experience with logistics, marketing, risk management and trading at Conoco, Cal Gas, and Amerigas before founding Coast Energy Group in 1989.
Q: From January 1, 1993 through the end of the first quarter of 1997, the Barclay Energy Traders Index was the only Barclay index to show a loss for the period. How would you explain the low rates of return in the energy complex since 1993?
Adams: I can only make an educated guess based on my own experience and observations as to why energy traders, at least as represented by your index, have performed so poorly since January, 1993.
The energy markets have always been very complex. But during the period under discussion the energy markets were hit with more serious exogenous and conflicting events than normal. Some examples would be the decimation of the NYMEX gasoline contract caused by the EPA's mandated changes in gasoline specifications, the unprecedented liquidation of crude oil inventories by the major oil companies who were incorrectly expecting the market to fall, the extraordinary number and strength of hurricanes during the autumn of 1995 and the prolonged and always imminent settlement between Iraq and the United Nations. From the middle of 1995 through the end of 1996, oil analysts and consulting boutiques were issuing bearish forecasts based on substantial increases in crude oil production due to come on stream in late 1995 and the first half of 1996. These production increases, combined with expected Iraqi exports threatened to drive prices much lower.
Bry: Without knowing the trading methods used by the managers comprising the Energy Index, it's hard to explain the loss for this sector. In looking at a chart of crude oil prices over the period from January, 1993 through March, 1997, there has certainly been enough movement to create profit potential. However, the energy markets have the characteristic of turning quickly and reversing without follow-through. For fundamental traders, this creates the possibility of being "correct" with the market not responding and, for systematic traders, it could result in a succession of false signals.
Cleland: The Barclay Energy Index is presumably dominated by fundamental, discretionary traders who by definition trade in the energy sector only. My guess is that the energy complex has generated positive total returns since 1993, but not necessarily for the subset of fundamental traders alone. If Campbell & Company's returns are any guide as to how the systematic technical trading community have fared over this period, then they have certainly been positive.
Schiff: The reasons that most energy traders have lost money since 1993 can be classified generally into two categories. First, most energy traders have a background with the cash-market hedging or speculative trading operations of the large or mid-sized oil producers and marketers. As a result, most have a strong fundamental trading bias. Being "in the business" provided them an opportunity either to arbitrage cash against futures, or at least to speculate in inefficient markets. As inexpensive information has become readily available, markets have become more efficient and traders have had to learn new ways of "reading markets".
A second reason for energy traders not having made money during this period is that just as the large hedge funds (which utilize technical trading systems) were placing more and more money into the energy markets, many of the large energy companies were abandoning speculative trading. Some had taken large losses. Others didn't want to take the chance that they might be next. With this concurrent activity came a change in the market, from one being driven by fundamental traders to one being driven by technical traders. Simultaneously, especially in 1996, the fundamental factors that drive the decisions of a fundamental trader sent numerous false signals.
As an example of this, many fundamental traders sold into the crude oil market on numerous occasions with the expectation that Iraq would be allowed to begin producing oil for the first time since the Gulf War. However, time after time, the deal with the UN was delayed and the shorts were stopped out of the market. By the time Iraq finally began producing, many traders were out of the market. Technical traders simply saw a solid up-trend and followed the trend to profitability. Extreme volatility in natural gas prices also hurt many fundamental traders, as well as some technical traders, in late 1996 and early 1997. As consumers tried to husband their supplies during the early winter, the cash market tightened. However, once it was apparent that supplies were not tight enough to justify a $4.60 price, the market plunged by more than $2.00 in six trading days. This is the equivalent to a $20 per barrel move in crude oil, or as dramatic as the price spike caused by the Iraqi invasion of Kuwait. No system, technical or fundamental, could predict the magnitude of that price swing and few could react quickly enough to take advantage of it.
Q: During 1996, the Barclay Energy Traders Index measured a loss of 17.92%. However, many diversified CTAs were able to make money in the energy markets. How would you explain this apparent contradiction?
Adams: It is very simple. I'd bet those diversified CTAs were systematic trend-following traders. Historically, trend-following systems have gotten chopped up and haven't been consistently profitable in the energy complex. It seems that once every 5 years or so there is a good trend and 1996 happened to be one. Maybe there are a few exceptions, but historically and over time, it has been the discretionary trader who has managed to make consistent profits in the energy complex.
Bry: Focusing on one sector requires you to be right all the time to produce consistent and profitable results. The obvious benefit of diversification is that you don't have to make money in all markets all the time. In fact, as a diversified trader, whether systematic or fundamental, you can be flat and waiting for an opportunity, whereas if you trade just one sector, there will probably be pressure to have a position most of the time. Diversified traders also have the benefit of developing methods that work across multiple markets and may therefore have developed trading strategies that are inherently more reliable.
Cleland: The backwardated (inverted) price structure which has prevailed in the energy complex for the last several years may encourage fundamental discretionary traders to trade from the long-side. The long-term fundamentals of the global energy markets are also strongly bullish. On the other hand, the prices of crude oil and its refined products have fallen significantly since the end of the Gulf war in 1991. Perhaps the fundamental traders have had a stubborn long-side bias over this period which has been difficult for them to shake?
From a fundamental perspective, perhaps one of the reasons why the energy market has been so difficult to read has been because of the uncertainty of the overhang of Iraqi production largely restricted since the Gulf war (theoretically at least) by U.N. sanctions.
There are times when fundamental information flows drive price in a reasonably rational and predictable manner, and during these periods, fundamental discretionary traders will tend to be successful. There are other times when the flow of fundamental information is discontinuous, inaccurate, untimely, or unreliable, causing the market to behave "irrationally", and during these periods fundamental discretionary traders will have difficulty. Global energy markets, because of their unique characteristics and their ologopolistic producer structure, have exhibited some of these characteristics over the past 5 years which has made it extremely difficult for fundamental discretionary energy traders to trade successfully.
Diversified technical traders on the other hand just "go with the flow", and were able to benefit from the lineal price movement that occurred in the energy sector during 1996, irrespective of the underlying or fundamental rationale.
Also, much of the diversified technical traders' return from the energy sector during 1996 may have come from trading natural gas futures, rather than from trading crude oil, heating oil and gasoline. On the other hand most fundamental discretionary traders probably trade crude oil and its refined products more often than they trade natural gas.
Schiff: Pure energy traders take signals from the industry fundamentals of supplies, demand and inventories. The diversified traders generally are technical traders. The technical traders now dominate, and therefore the diversified traders made money in 1996. However, the diversified traders, as technicians, still have to deal with a market that is often thinly traded. Fundamental traders can go through delivery and not be concerned with getting caught in a NYMEX squeeze. Additionally, diversified traders still have to deal with the extreme volatility of the energy complex.
Q: At present, it seems that investors prefer to gain exposure to the energy complex via diversified traders rather than through energy-only specialists. Is this a desirable trend? Do you feel that this trend will continue? What might happen to turn it around?
Adams: I think it is an unfortunate but understandable trend. The energy sector has always had a difficult time competing for funds because it hasn't trended as well as many other markets. Add to this a period of poor sector performance and funds then flow out of the sector. There are scenarios where the energy sector could become more attractive to investors, such as if stock market returns go sour or if there is a single European currency. A serious and chronic problem for energy specialists as a group has been the difficulty of raising enough money to achieve the critical financial mass necessary to allow them to operate their businesses properly. Energy specialists are starved for cash to invest in their businesses. Few have ever had the funds to adequately invest in research and infrastructure. But they still have to perform all the same functions as their larger competitors.
The foregoing notwithstanding, there is presently a vacuum in the energy sector which the big trend following diversified CTA firms cannot fill. Energy is a large commodity market and generally not correlated with other markets. I think I see an opportunity for a few energy specialists.
Bry: Unless investors have a particular need for energy exposure, the bottom line is going to be the returns regardless of what is being traded. In many cases, investors think they are getting exposure to certain markets or sectors when in fact, their exposure is more to the trading skill and methods of the manager. There is definitely a trend towards selecting diversified traders because they have more capacity, are better able to control risk, and are more likely to produce profitable and consistent results than are strictly sector traders. One sector that may lend itself more to being traded in isolation is the agricultural where fundamental information, in particular weather data, can be analyzed by experts to provide a trading edge. Of course, weather also impacts the energy markets and investors might be more inclined to seek out energy-only specialists during periods of extreme weather, unrest in the Gulf region, or if inflation increases.
Cleland: A well informed, rational investor will seek the highest quality of return at all times, and everything else being equal, should not have any inherent bias towards or against specialist (fundamental) or diversified (technical) traders. Risk-adjusted performance should prevail in the investor's allocation decisions, and since energy specialists have been unable to perform as well as diversified technical traders over recent years, rational investor equity will tend to gravitate towards the stronger performing group.
That said, I believe that many investors still have an intuitive preference for "specialists", (particularly when our industry is so dominated by diversified technical traders) and it probably wouldn't take much positive relative performance for this trend to begin to shift.
The trade-off between being specialized and being diversified is an interesting one, but on balance, I believe diversification wins the race. The trade-off is between the relative benefits of fundamental information flow and market sensitivity which the specialist clearly has, and the diversity of opportunity and consistency of approach which a diversified technical trader clearly has. I believe that if quality of return rather than absolute return is the goal, (and I believe it is), that over time the diversified technical trader will win the race.
Schiff: Of course investors prefer to gain exposure to the energy complex via diversified traders, rather than through energy-only specialists, because that is where the money has been made the past few years. The dollars simply chase returns. Is this a desirable trend? As long as the diversified traders make money, it is desirable for the investors and those traders. For the energy purists, obviously not. This trend will continue as long as the diversified traders make money and the purists do not. If the purists make money, then a share of capital will flow their way. No one says that a purist cannot also become a technician!
Copyright 2000 Barclay Trading Group, LTD.