On March 27, 2007, the United Kingdom-based Financial Services Authority (FSA) issued a report in which they warn about the increasing risks in commodity investing1. To briefly summarize their findings, the FSA warns that there is insufficient energy experience at many investment firms and that the existing experience is overstretched. Furthermore, they say that increased volatility in many commodity markets raises the "cost of trading and the risk of financial failure" and promote the concept of proper risk management including "thorough testing and modeling for algorithmic trading systems." But they go further in recognizing that many investment firms are now investing in commodities through physical assets (i.e., holding and trading physical position) such that their portfolios are "significantly altered and risk management systems must be appropriate and senior management must fully appreciate the risks they are assuming." Lastly, the FSA states that "consumers risk being exposed to unsuitable investments that they do not fully understand."

It's also interesting to take note of two other studies recently published. The first by Deloitte2 looks at risk management in hedge funds and makes very intriguing and frightening reading. To quote the company's press announcement "the nine areas identified as red flags include lack of position limits; tracking liquidity without stress testing and correlation testing; measuring off-balance sheet leverage without stress testing and correlation testing; lack of industry concentration limits for nonsector funds; not tracking liquidity; use of Value at Risk (VaR) without back-testing; using leverage without tracking on-balance sheet leverage; use of VaR, or other models, without stress testing and correlation testing; and holding assets with embedded leverage without measuring off balance sheet leverage." Their survey found that less than half of all hedge funds actually utilize stress testing on their portfolios. The second study is by HedgeFund.Net which looks at investment levels in hedge funds and finds that total assets in energy sector-focused hedge funds increased 52 percent to US$79.3 billion in 2006, including new allocations of US$18.2 billion.

Plainly, there are many danger signs for investors when the findings of these three reports are put together. Back in August 2006, myself and colleague Peter C. Fusaro via the Energy Hedge Fund Center website3 issued a statement regarding inceasing investor risks in energy hedge funds. The statement said, in part, "energy trading markets have changed with more intraday price volatility caused by speed fund trading. Trying to use older trading strategies have failed some funds, we expect more blowups to come as many energy traders have not adapted to the new trading reality“ and “to some extent, due diligence has become mechanistic following pre-prepared questionnaires that were designed for more traditional investments. This mechanistic approach also speaks to a lack of understanding on the part of the majority of investors as to the underlying additional risks inherent in the energy industry. Energy is the hot asset class for investing but investors be warned, energy expertise is required to perform proper due diligence and to insure that effective risk mitigation is in place."

Since then, we have observed the collapse of Amaranth and other hedge funds in energy and yet, the trader responsible for Amaranth's huge losses is back in the news again as it appears he has already raised $1 billion of investor money to start his own fund! There truly is one born every minute.

As I have written many times in the past, for example, in our recent book4, energy is a complex and physical business. But, it is worth examining some of the issues one more time in the light of the three reports mentioned above.

1. There has been a 15 to 20-year lack of interest and investment in energy. This came to an abrupt halt in 2004 as essentially demand began to reach, and even exceed in some instances, supply. What this means however is that energy just wasn't a great career choice for the nation's best and brightest. I mean why join an industry that for 12+ years had been laying off talent and seeking to retire people early? A forthcoming report from UtiliPoint on aging workforce and assets in the utility industry5 shows just how significant an issue expertise in energy and utilities truly is. The FSA is entirely correct to point to lack of energy expertise as a problem in today's investment world. The best and most knowledgeable energy trading talent was picked off early in this cycle and unfortunately this expertise was always thin. It is a serious issue that many investors are totally unaware of this lack of experience and more importantly perhaps, would not know what energy experience is if they saw it on display because they don't really understand what they are investing in!

2. Are investment firms "overstretched" when it comes to energy expertise? The answer to this question has to be an overwhelming yes. Almost every investment bank has opened energy trading operations or expanded existing operations, new hedge funds are being created at a rapid rate and institutional investors are pouring money into energy investments. Given statement one above then it is certain that many of the firms investing money in energy are doing so with a thin veneer of energy expertise. And I am not just talking about energy trading here, I am talking about the entire range of investment strategies including equity and debt. To invest in energy companies, you have to understand the business, its processes and complexities and not just use standard metrics.

3. Its not just investment firms that lack energy expertise—it's investors too! People who can barely spell "seismic" are pouring money into energy without ever truly understanding what it is they are investing in and what risks they are exposing themselves to. Even supposedly sophisticated hedge fund investors seeking good returns are doing this. They think they are doing proper due diligence but they are NOT. In many instances, they don't have enough knowledge of energy to frame the right due diligence questions in the first place and many use standard, template due diligence questionnaires available from organizations such as the FSA. These due diligence questionnaires were never designed with energy investing in mind and they are flawed!

4. Energy and commodities in general are "hot" today and all investors want to increase their exposure to this asset class. What has happened almost simultaneously is that energy is becoming easier to invest in! The barrier to entry has lowered significantly via the increasing availability of exchange-based instruments, exchange clearing for OTC contracts, emergence of numerous electronically traded Funds (ETFs) and indexes. Almost every week another electronic contract or ETF is launched that has some aspect of energy in mind. While this is a good development and is helping energy financial markets mature, it also means that anyone can invest in energy including those who should not as the FSA rightly point out. Its not just professional investment firms that are investing in energy but Mr. Average through his IRA who is buying oil futures through ETFs.

5. Finally, let's look at some of these investment firms without the benefit of rose colored spectacles. Let's take hedge funds for example. They are often referred to as "sophisticated private investment vehicles for the wealthy" by the media but given the evidence outlined above and my own personal experience, many times they are anything but "sophisticated." It is true that there are hedge funds out there that are sophisticated, run by smart people who understand what they are doing and are rigorous in their approach but for every one of those there are many more that are not. The thin veneer of sophistication is easily smashed by asking the right questions but these questions are rarely, if ever, asked because investors do not understand energy! What is obvious and apparent to me (I have done due diligence on more than 70 hedge funds) is that many of these funds are simply small businesses that rely on one individual's talent to make money and do a poor job of managing their risks.

Let's consider one final aspect of the FSA report—that of volatility. Volatilities, particularly intra-day volatilities, are large in many commodities and energy commodities specifically, perhaps not in absolute percentage terms since five percent volatility in a commodity priced at $1 (+ or - $.05) versus five percent volatility in a commodity priced at $100 (+ or - $5) is really what we are observing much of the time. The issue here is that risk management needs to be performed properly and that means using the right risk analytics in the first place. Risk analytics used for foreign exchange (FX) and other asset classes do not readily work in energy partly due to volatility and party due to the nature of the energy commodity itself. This is one of my greatest concerns—simply—even if there is a systematic approach to managing risk, the wrong risk analytics are being used!

What the FSA did not say is this. Historical trends in energy and other commodities have broken down at times and this has a serious impact on risk management too. Risk metrics that use a historical pricing method are therefore flawed and one is left needing to perform more stochastic-based risk management including stress testing. According to Deloitte, his simply isn't happening.

In my opinion, the FSA is entirely correct in its assertions and their report could not have been issued soon enough. I am not saying that investing in energy is a bad thing for anyone concerned in fact, quite the reverse. I am simply beginning to get increasingly worried that something bad and ugly is about to happen in the investment world around energy. All the warning signs are in place and they are growing in magnitude. I am not looking for increased regulation but increased oversight. I am not looking to stop people investing in energy but I am looking for firms involved in the industry to start advising investors properly about the risks that they face. Education is required but unfortunately, those overseeing and advising the industry need to be educated about energy too.

1 Growth in Commodity Investment: risks and challenges for commodity market participants, Financial Services Authority, March 2007
2 Precautions That Pay Off: Risk Management and Valuation Practices in the Hedge Fund Industry, Deloitte Services, LP, March 2007
3 www.energyhedgefunds.com news release, August 20, 2006
4 Energy & Environmental Hedge Funds: The New Investment Paradigm, Peter C. Fusaro & Gary M. Vasey, Wiley, 2006
5 Aging Workforce and Aging Assets Trends 2007– 2012, UtiliPoint report in preparation