Amaranth: Tip of the Iceberg

Includes: BP, C, COP, CS, CVX, DB, GS, JPM, LNG, MS, RDS.A, SRE, XOM
by: Philip Davis

Amaranth lives! Quote of the day: “We lost a lot of our own money this month, we lost more of your money. We feel bad about losing our own money. We feel worse about losing your money.”

Only the money that was “their own” used to be yours too as the fund charged fees of 1.4% of the assets ($126M) plus 20% of the profits against the $9b dollar fund. But wait, there’s more...

According to Business Week: "In 2003, for instance, Amaranth Advisors of Greenwich, Conn., logged charges on its Amaranth Partners fund of about 1.4% of net assets for "bonus compensation to designated traders" and about 2.3% for "operating expenses." Although Amaranth does not have a traditional management fee, the filing reveals that when an investor's account shows a net profit over the previous 12 months, the manager is entitled to a "management allocation of income" of up to 1.5% of each member's account balance per year. The manager also receives a 20% cut of each investor's net profits. This 20% is reduced by the amount paid to the traders, as well as by the amount of the operating expenses. If the fund is losing money, investors remain on the hook -- certainly for the operating expenses and possibly for any trader bonuses, too. Amaranth declined to comment.”

I think a hedge fund should be run more like a corporation. My 1.5% should be a salary, perhaps another .5% for expenses, and the rest is paid out in stock bonuses which I can only redeem 1:1 with my shareholders. So when I make 20%, for the fund, you make 16% and I hold 4% in restricted stock. When I lose 20% for the fund, I lose 20% of my stock right along with you. When I overspend on a Christmas party, 20% of that money is mine too!

Think that would make me think twice about betting half the assets on red?

Another domino that may suffer some fallout from the Amaranth scandal is the ICE, where many hedge funds trade. As I mentioned at the beginning of the month, the unregulated trading that runs rampant at this "UK rules" exchange allows for shenanigans that would never be tolerated, even under a Republican SEC!

Dominoes lined up to date include (according to NYTimes DealBook): Morgan Stanley (NYSE:MS), Goldman Sachs Group Inc. (NYSE:GS), Credit Suisse Group (NYSE:CSR) and Deutsche Bank AG (NYSE:DB), who had direct investments in Amaranth, as well as Citigroup Inc. (NYSE:C) (who are rumored to be attempting to take over what’s left of the fund), JPMorgan & Chase Co. (NYSE:JPM), and Citadel.

If you think this is over -– you must read this. Really, you must! I usually quote things, but Heather Timmons is my new journalistic hero for coming up with an article where I want to quote 75% of the lines! So really, go read this – I’ll wait...

OK just a couple of major points:

“Traders in the natural gas market referred to Mr. Hunter of Amaranth as a “bully,’’ not in reference to his personality but to his ability to move the price of natural gas artificially, because of the huge positions he was taking.” So when I say “they” are manipulating the markets -– now we’ve got one name!

“What younger traders often lack is a strategy to unwind their trades if the market goes against them.”

“Still, energy trading will always entail “significant risk," he said, “because storage and transportation are limited and demand is stochastic and highly inelastic."

“When the market retreats, it is vicious.”

My only criticism is that the $60b estimate of money invested in energy by hedge funds is clearly a gross understatement as there are 7,000 funds and just one, Amaranth lost a $6b bet in natural gas alone! You can toss and turn all night, but you still can’t worry enough to cover this potential disaster.

First of all, understand that Amaranth tried to cover up their losses, doubled down, lost and doubled down again and lost. Even as recently as Wednesday, the fund was claiming that they “only” lost 35% of their assets when, in fact, it was closer to 65% of what they reported on-hand as of 8/31.

Worse than that (yes it is worse), CNBC and most of the financial press is clinging to a fantasy that there are “winners and losers” in these trades so it all balances out in the great game of market Karma, and they are telling you there will be limited overall impact. Not true, not true, NOT TRUE! Yes there are winners, but they’re probably no one you know.

How does oil get to $70 in the first place?

1) You poke a stick in the ground and oil pops out. This tends to cost $8-$20 a barrel. Let’s call it a worst-case $20.

2) It is then priced on the open market which is driven by speculators who take a premium to guarantee delivery on a certain date, a form of insurance. While those speculators do buy and sell to each other (the zero-sum game), their actions inch (or recently yard) up the price paid to the producers. Just like us options traders, we may jack up the price of a stock with frenzied buying and selling, but all we trade are contracts to buy the stock; the actual stocks are purchased by other people.

3) The producer is paid the spot price, the price at which the speculators generally settle on, of $65 a barrel or $1.54 per gallon. The money is exchanged for black liquid and leaves the country (trade deficit) FOR GOOD!!!

When the price of oil goes down, they don’t load up tankers with $100 bills to send your money back! I was going to get into refining distribution tax etc., but I don’t want to cloud the issue. You work to make money which you give to the gas station guy, who gives it to the refiner, who gives it to the tanker company, who gives it to the producer. That money, about 60% of the cost of each gallon of gas, NEVER COMES BACK, EVER!

So when a bunch of out-of-control traders drive the cost of a barrel of oil from $25 to $65 – it constitutes an extra $189,000,000,000 a year that goes from you to OPEC and other non-US producers. When it turns out that those traders overpaid for 3 months worth of oil by $20 a barrel, that’s $23b that isn’t coming back anywhere, it just goes up in smoke as the prices fall.

Very, very simply: The trader paid $77 for a barrel of oil and sent the cash (the cash that Amaranth feels very bad about losing) to Saudi Arabia in exchange for a barrel of oil. Now he finds that he can only sell it for $60. That is a real, actual, irreversible (because someone is going to consume it) loss of $17. There is no “winner” on the other side of the trade; just a nation full of suckers (oops -- I meant to say voters) who let things get so out of hand.

Sounds a lot like the Savings-and-Loan scandal doesn’t it?

The S&L scandal was also caused by changes in regulations allowing out of control brokers (that time it was mortgage and loan brokers) to run wild, lending to their pals and overcharging U.S. citizens hundreds of billions in order to pocket tens of billions in commissions for themselves.

The S&L scandal started out with one, then another institution being on the wrong side of interest and real estate bets, which snowballed as webs of interconnected institutions began falling-in upon each other. The actual crisis played out over years and was originally expected to be a $10-$20b loss due to a few bad apples. I’m sure, at the time, there were plenty of analysts telling people there would be winners and losers and it would all "even out."

In the end, the savings and loan scandal amounted to 2,600 out of 4,000 banks either closing or consolidating (much like Citibank is looking to consolidate Amaranth), with $300b in losses, costing the U.S. economy $1.4 trillion, all so a few well-connected people and their friends could skim a little off the top. How many of the 7,000 registered hedge funds will “consolidate” and what will it cost the American people?

How will we look back in history and see where the great Hedge Scandal of 2006 began?

Amaranth is just the tip of the iceberg, with $6b in losses in 2 weeks. According to some of the articles cited above, it seems that they were controlling 20% of the natural gas contracts. 20%? Who controlled the other 80%? Logic would dictate that those funds lost $24b dollars -– they just haven’t told anyone yet. $30b is starting to sound like some money isn’t it?

That’s just natural gas contracts; very small potatoes compared to oil! Although gas fell from $12 to $5 over the course of this year, oil may be just getting started falling from $77 to $60 in the course of 42 days (so far).

"It's been going straight down. We can't be surprised by a rally," said Man Financial broker Andrew Lebow. That wouldn’t be the same Man Financial that is heavily invested in Amaranth would it?

Does Man Financial have a double down on oil going up before they have to report their quarter? That would be one mighty big domino!

So that let’s call it $60b that is likely to go up in smoke in the oil and gas complex, money that there is no “other side” to, it will just be gone and someone, maybe you, will just be $60b poorer. But wait, there’s so much more!

Oil companies, like ExxonMobil Corp. (NYSE:XOM), ConocoPhillips (NYSE:COP), Chevron Corp. (NYSE:CVX), BP PLC (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.A) for example, have a combined market cap (just these 5) of $1 trillion -– that’s $1,000,000,000,000. Very nice if you own them…

Unfortunately, much like oil itself, the money that flows out of your cash and into your portfolio has also been pumped and manipulated by brokers until the same set of companies that were worth just $400b in 2003, have been sold to you – yes you, they guy who bought the oil company in the past 2 years – for $500b more than they would have been worth if they were any other stock on the S&P over the same time:

So now you have a piece of paper that you paid $70 for in August that says you are the proud owner of a share of XOM, a company that will sell oil for $70 a barrel and make $10b a quarter. Nice deal right? Forgetting the fact that you only own 1/6,000,000,000th of the company, it’s a great stock that earns $6 a share. Very nice!

But isn’t this is the same company that was earning $3 a share in 2003? Yes. What changed? Did they increase market share? No. Did they increase efficiency? No. Cut costs? Heavens no! So what did they do? They raised prices (whether you want to say it was directly or not -– it still ends up in their sales and profits) 130%. Raised prices 130%. Brilliant!

As we discussed last week, this sharp bit of business acumen, known as passing on costs plus a little somethin’ for the boys, has netted XOM, for example, an extra $20b a year in profits; perhaps an extra $50b annually for our group of 5 majors alone. That’s over $100b in “excess” profits for the EOG sector this year. Brilliant!

Now a prudent investor may worry that this may not, like the Energizer Bunny, keep going and going. And if oil prices head back down, then how much is your piece of paper really worth? $60? $45? $35? It’s hard to say because runaway revenues have obscured runaway costs for many companies.

Should our group of five pull back just 20% in value, $200b additional dollars will disappear from the accounts of ordinary investors. On a sector level, we could very easily eclipse the $1.4t that was lost in the Reagan/Bush era during our last national financial scandal.

And even if you may not have bought XOM or COP or Suncor Energy Inc. (NYSE:SU) directly, it may be in your mutual fund or index fund or just a large holding of your broker. You won’t know, just like the millions of S&L victims didn’t know, that your institution is in trouble until well after the damage is done.


On another front:

I didn’t know about this when I called for shorts on Sempra Energy (NYSE:SRE) and Cheniere Energy Inc. (NYSEMKT:LNG), but what a disaster this might be for them! It turns out the gas they are looking to report may be a nightmare for our existing infrastructure as it is fundamentally different from our domestic natural gas. After spending tens of billions of dollars, this is just coming up now?

Don’t worry though, our government is working very hard to remove the regulations that are in place to prevent the problem.

So I was only shorting them because I felt they were spending far too much of other people’s month to build something that may not be needed at prices no one will pay. The fact that it is shaping up to be a potential practical and environmental disaster is just a bonus!
The LNG Jan $30 puts are just $3.20 (up 10%), while SRE $50 puts are holding $1.50, and the Jan $45 puts are still .60.


Disclaimer -- As of this posting, I do hold puts in MS, XOM and GS for reasons that are obvious!

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here