Many Speculators on High Oil Prices Bailed Too Soon

Many Speculators
On High Oil Prices
Bailed Too Soon

By PETER A. MCKAY and HENNY SENDER
Staff Reporters of THE WALL STREET JOURNAL
September 2, 2005; Page C1

Hurricane Katrina struck just as Wall Street's latest bout of bullishness on energy prices was waning, with some speculators having recently exited from trades that would have been profitable and at least some booking losses, according to government data and interviews with money managers.

Plenty of big-money investors have spent much of this year betting on the trajectory of the price of oil and other power sources -- and often getting it wrong, which is why relatively few speculators were in the energy markets when Katrina came ashore.

"The traders who fought the tape capitulated well before the storm," says the head of oil trading at one investment bank.

While the general sentiment regarding energy was still bullish, it was less so than before. Evidence of that can be seen in weekly data from the Commodity Futures Trading Commission that tracks the activity of energy-markets speculators and funds. In the week ended Aug. 23, these traders reduced their net holdings of bullish, exchange-traded contracts for delivery of crude oil by about 60%, heating oil by 15% and gasoline by nearly 5%, the data show. Traders also said that some market players who were betting on continued price increases before Katrina were waiting for another spike so that they could book profits, a typical strategy in late-summer markets, where trading volumes normally drop and trading becomes more difficult.

With the energy markets now being driven more by fundamental analysis than by the twin forces of speculation and momentum, many traders remain on the sidelines.

"Quite a few hedge funds took positions off because of the potential volatility and uncertainty," says Jonathan Taylor, head of commodities sales for Barclays Capital in New York. Given the increased volatility after the hurricane, traders are paying higher initial amounts on margin trades, Mr, Taylor adds.

However, the rally in oil futures and other energy products -- up as much as 25% since the storm -- suggests that some of the same players have rushed back in as buyers, analysts say. Likewise, the majority of hedge funds and trading desks that bet on oil in less direct ways -- for instance, by buying shares in oil-producing companies -- seem to have been emboldened all over again by the catastrophe.

"Katrina is a catalyst to accelerate what had been our market view coming into the year," says David P. Prokupek, chief executive of Geronimo Partners, a hedge fund and money-management firm. "To me, the hurricane is just one of the many factors that will keep energy prices moving higher for some time."

Although gasoline, natural gas and heating oil are all trading busily in the aftermath of the storm, the price of oil continues to be a catalyst for all other energy products, including lesser-known investments such as contracts based on freight transportation.

"Everyone is trying to figure out how much demand destruction there will be," says Thomas Leaver of RAB Commodity/Energy Fund in London, using a term of art that describes the point at which energy prices climb so high that consumers cut back their purchases. "This is all new territory. Nobody knows what the intrinsic value of oil is."

Indeed, there are other signs that the summer doldrums departed early because of Katrina-induced trading.

The Chicago Mercantile Exchange recorded its busiest day ever Wednesday, with total trading volume of nearly 10 million contracts. That news, in turn, boosted shares of the CME, which lists futures on stock indexes and interest rates. And the Chicago Board of Trade, where Treasury bond futures trade, reported record electronic volume Wednesday of almost four million contracts. While energy products don't trade at either of these exchanges, dealings there reflected bets on the direction of the economy, including the Katrina effect and whether the Federal Reserve will slow the pace of interest-rate increases to help consumers facing higher energy prices.

Mr. Prokupek says his firm, which handles about $500 million in client money, had been holding its energy weighting steady before Katrina, around 12%. But since the storm, Geronimo has ratcheted that up to 15% by buying shares in diversified energy companies such as BP PLC and Exxon Mobil Corp., as well as exchange-traded funds that represent ownership in baskets of energy stocks.

For him to become bearish on energy, Mr. Prokupek says, crude prices will have to dip below $45 a barrel -- a level that hasn't been hit since early February and that would represent a decline of around 35% from current levels near $70 on the New York Mercantile Exchange.

Some hedge funds have engaged in so-called relative-value trades in which they owned refined products -- where the squeeze on supplies has been especially sharp -- while adopting bearish positions on crude oil itself. Others going into the hurricane owned short-term contracts on both oil and gas but had bearish bets on longer-dated contracts, with a view that prices would decline in coming months. Many preferred to trade in options that gave them the right but not the obligation to buy or sell in coming months.

Analysts say it is too early to know whether any hedge funds had massive losses. One risk: In volatile markets, players whose trades have gone wrong may be reluctant to close out positions and take the losses, and will instead roll over those losing bets or even double them.

Meanwhile, the spillover of the volatility in energy markets continued to spook other markets. Metals companies were hit by fears that spiraling energy costs and slower economic growth would erode profits, while others argued that rebuilding would feed demand, particularly for copper. Those twin fears also put downward pressure on heavily indebted companies and the dollar.

And, of course, traders are debating bets on whether the refinery outages -- more than 10% of the country's refining gets done in the Gulf -- will create a crunch that will drive retail gasoline prices to the point that consumers cut back their demand.

Forecasters this week have theorized about $4 or even $5 a gallon as the price point at which consumers might finally hit their limit. People who actually make bets on the market have been less likely to endorse such a view -- but not because they see it as too bullish.

"No one really knows what the elasticity of demand is for crude or gas -- it's never really been tested," said one executive at a small hedge fund.

Write to Peter A. McKay at peter.mckay@wsj.com¹ and Henny Sender at henny.sender@wsj.com²