2005: Using Long Calls to Bet on the Weather

During the five-year period from 2000 to 2004, natural gas prices spiked every winter except 2002. At the beginning of 2005, chief trader Brian Hunter wagered that natural gas prices would spike again during the coming year. To profit from this expectation, he purchased a large number of out-of-the-money calls on natural gas. For the first half year, his bet seemed likely to fail, and it looked as if Hunter’s options might remain underwater for the rest of the year. Gas stockpiles were abundant and weather forecasters were predicting subdued hurricane activity in the late summer and early fall. As a result, natural gas prices rose modestly from January to June (see Figure 8.2). When Amaranth reported its 2005 midyear performance, the results were disappointing, with losses amounting to about 1 percent.

Industry conditions changed quickly in late summer. Hurricane Katrina hit the Gulf Coast and New Orleans with a vengeance in late August 2005 and was followed, less than a month later, by Hurricane Rita. These severe storms destroyed scores of natural gas platforms and miles of pipelines, causing supply to plummet. Natural gas prices soared, and when they did, Amaranth’s out-of-the-money calls suddenly became highly valued. By year’s end, Amaranth’s profits on energy-related investments accounted for almost 98 percent of its 21 percent annual return. For his efforts, Hunter (purportedly) earned approximately $100 million.

2006: Using Futures and Spreads to Bet on the Weather

The economic effects of Hurricanes Katrina and Rita dissipated quicker than expected and were followed by relatively mild winter weather. As a result, Amaranth shifted energy strategies to benefit from these new conditions and its revised expectations. The company reasoned that a glut of natural gas would continue to put downward pressure on prices throughout the summer of 2006, but the surplus would vanish by the winter 2006/7 heating season because of anticipated weather-induced disruptions in supply, delivery bottlenecks, and cold snaps. Once the surplus was eliminated, Amaranth figured that winter prices would spike, just as they had during four of the past five years, causing winter 2006/7 natural gas prices to rise relative to prices in the summer and fall of 2006. To profit from these expectations, Amaranth made both directional and relative value bets.

Amaranth’s Directional Bets: Short Futures Positions

Expecting natural gas prices to fall during the spring, Amaranth began, in January 2006, taking short positions in the March 2006 futures contract. By the beginning of February, it held 40,000 contracts. Amaranth stood to gain considerably if natural gas prices fell below the average futures price but could incur significant losses if it rose above the average. If Amaranth’s expectations proved correct and natural gas prices fell, it intended to roll over the short March positions into April, and then April into May, May into June, and so on until either its expectations changed or the fall 2006/winter 2007 months arrived.

On February 24, 2006, when the March 2006 futures contract matured,257 Amaranth was short 20,000 March 2006 futures contracts. Assume the average price of the contracts in Amaranth’s portfolio was $9.80/MMBtu. To roll over this position, the company would purchase 20,000 March 2006 futures contracts, offsetting its short position. Simultaneously, it would roll the position ahead one month by selling April 2006 futures.258 On February 24, 2006, the average price of the expiring March 2006 futures contract was about $7.10/MMBtu, and the average price of an April 2006 futures contract was $7.30/MMBtu. Therefore, the fund earned, on average, $2.70/MMBtu (i.e., $9.80/MMBtu – $7.10/MMBtu) on each of its 20,000 March 2006 futures contracts (see Figure 8.3). At 10,000 MMBtu per standardized futures contract, Amaranth’s return would have been $540 million.259 Because Amaranth wanted to increase its exposures, the company rolled over its short March 2006 position (20,000 contracts) and established an even larger April 2006 position (i.e., about 25,000 contracts) at a futures price of $7.30/MMBtu.

Even though many of the storm-damaged natural gas platforms remained nonoperational in spring 2006, the discovery of new wells returned production to pre-hurricane levels. Stored reserves of natural gas began to rise, and the prospect for increased supply, combined with reduced demand, caused natural gas futures prices to fall. As long as they did, Amaranth earned profits at each rollover date, and by rolling its investments, the company set the stage to earn even more profits in the next month. Except for some brief periods when futures prices followed a rollercoaster pattern (see Figure 8.4), Amaranth’s strategy was profitable during the January to August 2006 period. What was troublesome about Amaranth’s directional bets was their size. By August 29, Amaranth’s short September 2006 futures position had increased to 105,000 contracts!260 (See Risk Notepad 8.1.)

Amaranth’s Relative Value Bets: Long Spread Positions

In January 2006, Amaranth made two major calendar-spread bets that proved to be fatal. Calendar spreads are on the same underlying asset but with different maturities. Expecting winter 2007 prices to rise relative to fall 2006 prices, Amaranth purchased natural gas futures contracts expiring in winter 2007 (January) and sold contracts maturing in fall 2006 (October and November).261 Its second gamble was based on the March/April 2007 price spread. Expecting the price of natural gas in the last month of the winter season (i.e., March) to increase relative to the first month of the spring season (i.e., April), Amaranth bought the March 2007 futures contract and simultaneously sold the April 2007 contract.

Figure 8.5 summarizes the Amaranth’s calendar spreads and the direction it expected them to move. Risk Notepad 8.2: Primer on Spread Trades provides an explanation of how traders can end up with profits or losses on calendar spread trades, regardless of whether spot prices rise, fall, or stay the same.

Inadequate Risk Management Practices

If you focus only on the change in Amaranth’s net asset value and profits from January to August 2006, it would be easy to believe this hedge fund had a solid, well-reasoned natural gas strategy. With the exception of May and July, Amaranth’s net asset value increased each month during this eight-month period. At the end of August 2006, Amaranth’s net asset value stood at approximately $10.2 billion, its highest month-end balance ever and an increase of $1.3 billion from January 2006 (see Table 8.1). Profitability was also strong, with net accumulated earnings between January and August 2006 of $2.5 billion (see Table 8.1) and a year-to-date compounded return of more than 30 percent (see Table 8.2).

Table 8.1: Amaranth: Monthly Net Asset Values, First-Day Contributions/Withdrawals, Month-End Contributions/Withdrawals, and Performance: January 2006–August 2006

* NAV is the sum of net of asset values for Amaranth LLC, Amaranth Partners LLC, and Amaranth Global Equities. These funds accounted for about 80, 15, and 5 percent, respectively, of Amaranth’s total net asset value.

Source: Amaranth’s CP Leverage Funds Due Diligence, prepared by JPMorgan Chase & Co. (Permanent Subcommittee on Investigations, PSI Report, Exhibit List: Hearing on Excessive Speculation in the Natural Gas Market, June 25 & July 9, 2007).

Table 8.2: Amaranth Monthly Returns and Weighted Average Return: January–August 2006

Source: Amaranth’s CP Leverage Funds Due Diligence, prepared by JPMorgan Chase & Co. (Permanent Subcommittee on Investigations, PSI Report, Exhibit List: Hearing on Excessive Speculation in the Natural Gas Market, June 25 & July 9, 2007

Table 8.3: Amaranth’s Investment Portfolios: September 2006

Source: Amaranth’s CP Leverage Funds Due Diligence, prepared by JPMorgan Chase & Co. (Permanent Subcommittee on Investigations, PSI Report, Exhibit List: Hearing on Excessive Speculation in the Natural Gas Market, June 25 & July 9, 2007).

Strategy should not be judged solely by return and top line growth. The risks inherent in Amaranth’s portfolio must also be considered. Despite employing twelve risk managers, who produced an avalanche of daily risk management measures, Amaranth was woefully overexposed.271 Table 8.3 shows the disproportionate weight (56%) of energy in Amaranth’s portfolio. Nick Maounis advertised Amaranth as a multi-strategy hedge fund, with the implication that its assets and strategies would be diversified. By placing more than 50 percent of the company’s assets in leveraged energy bets, the fund was not well diversified, and by building single-mindedly its long winter 2007/fall 2006 spread positions, its strategies were not multi-faceted.

Lack of Liquidity

Ultimately, Amaranth’s decision to sell its energy book and close the fund was forced by a lack of liquidity. Not only was the company desperate for funds to meet margin calls, but Amaranth also needed them to make new investments. Normally, Amaranth would react to every decrease in natural gas prices as a buying opportunity, but with enormous margin calls and a portfolio that was becoming increasingly difficult to sell, Amaranth was unable to take advantage of new deals in the market.

These liquidity problems had three sources. First, Amaranth had such large open positions in the futures markets that there were no natural counterparties to assume them at profitable prices. Second, Amaranth was the victim of large net withdrawals by investors. Third, competitors realized Amaranth’s desperate position and exploited it.

Huge Open Positions in Natural Gas Futures Contracts

At various times during 2006, Amaranth held between 46 and 81 percent of the open interest in NYMEX’s most active natural gas futures contracts (see Table 8.4). In fact, it held similarly large positions in less active futures contracts stretching out as far as 2010. Reducing these positions quickly and at profitable prices turned out to be almost impossible

Table 8.4: Amaranth’s Positions in NYMEX Natural Gas Futures Contracts (2006)

Source: PSI Report, June 25, 2007.

Net Investor Withdrawals

Table 8.1 shows that, from January through August 2006, investors’ net withdrawals from Amaranth were $709 million.272 Withdrawals were particularly large in July 2006 when they reached $567 million.273 It appears the smart money knew when to leave, and for good reason. During April, May, and June, Amaranth’s monthly profits fluctuated wildly, rising by about 10.6 percent from March to April and falling by 24.3 percent, from April to May, then rising by 17.4 percent, from May to June (see Table 8.2). What saved the company from even greater withdrawals were Amaranth’s lock-up and gating provisions.

Competitors’ Reactions to Amaranth’s Financial Crisis

Amaranth’s liquidity problems were exacerbated by market reaction to the company’s impending crisis. When competing traders got wind of Amaranth’s financial difficulties, they reacted predictably, skillfully, and immediately by adjusting their portfolios, causing market prices to move significantly against Amaranth’s positions. Between Friday, September 15 and Wednesday, September 20, Amaranth lost $800 million from deteriorating spreads. Having sold the most liquid assets from its not-so-diversified portfolio (e.g., convertible bonds and leveraged loans), the company was unable to liquidate enough other positions in time to pay its mushrooming margin calls.

Extraordinarily Large Movements in Market Prices

Value-at-Risk (VaR) analysis would have enlightened many investors to the fact that Amaranth was a risky investment. Based on monthly historic data, the company’s VaR (with a 99% confidence level) was 28 percent, which meant that for 99 months out of 100, Amaranth stood to lose 28 percent or less of its portfolio’s value, implying that for one month out of 100 months (about once every 8.3 years), it stood to lose more than 28 percent.274 Using the month-end figure for August 2006, 28 percent of Amaranth’s portfolio translated into a $2.9 billion loss; but Amaranth ended up losing more than $4.6 billion in just one week! Based on historic data, a monthly loss of this magnitude should have occurred about once every 27.4 quadrillion years.275

Christopher Fawcett of Fauchier Partners, a U.K. hedge fund with $4.3 billion under management, would have been a good representative for investors who saw Amaranth for the risky investment it was. In December 2005 (before it collapsed), Fawcett withdrew $30 million of Fauchier’s funds from Amaranth, citing at least 11 warning signals he recognized during an on-site visit.276 In his letter to investors, he stated that Fauchier was willing to pay an early redemption penalty because “Amaranth had just about every characteristic we do not look for in a hedge fund,” including the lack of an independent third-party administrator to verify the fund’s returns, insufficient risk management supervision, high leverage, poor transparency, overconfident management, overreliance on a narrow trading strategy, and loose accounting controls that allowed employees to pass company expenses to the fund. For Fawcett, Amaranth’s losses were “anything but unforeseeable.”277

Did the Futures Markets Function Effectively?

In general, the U.S. regulatory system and exchanges seemed to have functioned effectively. Even though losses on the scale of Amaranth are disconcerting, NYMEX’s concern was with JPM, an exchange clearing member, and not particularly with Amaranth. Amaranth always deposited sufficient margin with JPM, and JPM was never in jeopardy of insolvency. Federal regulators and NYMEX communicated as early as June 2006 about Amaranth and followed up in August. In the end, Amaranth was purchased. As a result, its credit facilities were not terminated, and the fund did not go bankrupt, which would have caused its collateral to be sold, en masse, on the market. There was no need for the Federal Reserve to intervene, and there was no contagion to domestic or foreign financial markets. As for Amaranth’s incredibly large losses, it is not the job of regulators or exchanges to protect traders from themselves. As long as markets are fair, function efficiently, and are free from price manipulation, fraud, and trading abuses, no more should be expected from regulators and exchanges.

Did Amaranth Dominate the Natural Gas Futures Markets?

In October 2006, barely a month after Amaranth’s crisis, the U.S. Senate Permanent Subcommittee on Investigations (PSI) started a nine-month inquiry into the causes of this financial fiasco and possible cures. The PSI Report, entitled Excessive Speculation in the Natural Gas Market, was published in June 2007. Hearings followed in late June and early July 2007. Among the conclusions of the fact-filled PSI Report were Amaranth dominated the U.S. natural gas market in 2006 and engaged in excessive speculation that distorted natural gas prices, widened price spreads, and increased volatility. The report also concluded that the regulatory structure of U.S. futures markets permitted Amaranth to evade federal rules and regulations.

PSI’s accusations of market domination were based on two pillars: the significant portion of open interest Amaranth held in the futures markets and the correlation between the fund’s positions and the price of natural gas futures contracts. Table 8.4 shows that, at various times during 2006, Amaranth held between 46 and 81 percent of open interest in NYMEX’s most active natural gas futures contracts. The fund also held large open interest positions for longer maturities. PSI was concerned that Amaranth’s large purchases and sales distorted prices away from underlying energy market fundamentals, which could cause calamitous spillover effects on consumers, as well as financial and commodity markets. Surely, if a manufacturing or primary products company controlled such a large portion of total market sales, its activities would be scrutinized by antitrust authorities for abusive practices. Wouldn’t they?

Table 8.5 shows the extremely high correlation between Amaranth’s January 2006 open interest and the price spread of the January 2007/November 2006 calendar spread. Perfect positive correlation is 1.0, and these correlations range from 0.75 and 0.93. They appear to be so large as to leave little doubt that Amaranth dominated the natural gas futures markets during 2006.

Table 8.5: Correlations Between Amaranth’s January 2007 Futures Position and the January 2007/November 2006 Price Spread

Source: PSI Report, June 25, 2007, 66.

There are problems with the arguments used by the PSI Report to connect Amaranth’s activities to market domination. For one, the link between open interest and futures market domination is different from the link between market share and product market power. Physical goods have relatively high production and distribution costs, as well as relatively long production and distribution cycles. Therefore, physical products are supplied to the market slowly because they have to be produced, transported, and sold. An individual or company can corner a physical market by purchasing a large portion of the available supply, storing it, withholding delivery, and driving up the product’s price.

By contrast, the marginal cost to create a new futures contract is almost zero, and it can be delivered instantaneously, whenever there is a demand. Futures contracts cannot be stored, with the intent to withhold them from the market. Having a large share of a contract’s open interest seems to carry almost no power to restrict supply. In fact, most individuals holding long futures positions end up reversing (i.e., selling) them before maturity.

A second problem with the PSI Report is its use of correlation analysis. Correlation is not the same as causation; therefore, the high correlation between Amaranth’s open interest and the price spread on futures contracts does not mean that one caused the other. To understand why, consider the high correlation between a child’s foot size and her vocabulary. No one would argue that foot size has anything to do with the number of words a child possesses. Foot size does not influence vocabulary, and vocabulary does not influence foot size; rather the high correlation is caused by a third variable, age, which influences both foot size and vocabulary. Table 8.6 uses the same data as Table 8.5 but removes trend as a causal factor.282 Notice how the correlations fall from a range between +0.75 and +0.93 to a much lower range between –0.15 and +0.31. These trend-adjusted figures provide ambiguous results. They indicate that the correlation between changes in Amaranth’s open interest and changes in the price spread could be negative, a relatively insignificant positive value, or even zero.283

Table 8.6: Correlations Between Amaranth’s January 2007 Futures Position and the January 2007/November 2006 Price Spread

Source: Statement of Amaranth Advisors L.L.C. Before the Senate Committee on Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations Concerning “Excessive Speculation in the Natural Gas Market”25 July 2007. Analysis by David J. Ross, Lexecon, Inc.

Finally, Amaranth was just one of many well-capitalized players in the natural gas futures market. Among the others were 200 prominent financial institutions (e.g., Goldman Sachs, Morgan Stanley, Deutsche Bank, and Lehman Brothers), hedge funds (e.g., Citadel Investment Group, D.E. Shaw, Centaurus Energy, BP Capital, and Ivy Asset Management Corp.), and energy producers (e.g., BP-Amoco, Sempra Energy, and Chevron-Texaco). Normally, these large players account for about 80 percent of the open interest on NYMEX.284 If Amaranth dominated the natural gas markets, then what prevented these other key players from exercising their financial muscle to prevent it?285

Did Amaranth Engage in Excessive Speculation?

Since its inception in 1974, the U.S. CFTC has been charged with protecting the integrity of U.S. futures and options markets for commodities by preventing excessive speculation.286 Congress believed that excessive speculation caused abnormal price fluctuations, hindering interstate commerce. The CFTC’s mandate has been to shield financial markets for commodities from “sudden or unreasonable fluctuations or unwarranted changes” in prices.287 The problem has been that Congress never defined sudden or unreasonable fluctuations or unwarranted changes in prices. As a result, there is a wide playing field of interpretations.

Congress did not make excessive speculation a per se violation of any law, such as the U.S. Commodity Exchange Act (CEA). Therefore, even if Amaranth (or any trader) engaged in excessive speculation, it was not an illegal act. Rather, this provision was written into the CFTC’s charter to assign responsibility and provide the Commission with authority to implement restraints to stop or prevent excessive speculation.

Excessive speculation may be harmful to a nation, but normal speculation is not. Speculators can contribute to healthy, dynamic economies by providing liquidity to markets that would otherwise be relatively shallow. Speculators are particularly important in the natural gas industry because the quantity of futures contracts supplied by those who produce and store natural gas and who want to protect their future revenues is normally much greater than the amount demanded by consumers who want to lock in future costs. Speculators bridge this gap.

Did Amaranth Commit Regulatory Arbitrage?

On August 8, 2006, Amaranth’s share of open interest for the September 2006 futures contract exceeded 44 percent.288 Because this contract was due to expire in three weeks, NYMEX contacted Mike Carrieri, Amaranth’s compliance officer, and requested that he reduce, in a commercially reasonable trading manner, Amaranth’s September 2006 open interest to between 30 and 40 percent. Amaranth also held a large October position; so, Carrieri was instructed not to roll Amaranth’s September positions into October 2006. Within three days of the notification, Amaranth reduced its September exposures on NYMEX to 29 percent, satisfying NYMEX’s demands. Shortly thereafter, its October position was also reduced.289

Only insiders and Amaranth’s clearing agent (JPM) knew that Amaranth reduced its September and October 2006 positions on the regulated NYMEX by switching them to the unregulated ICE (see Figure 8.7). By the end of the month, Amaranth was well within NYMEX’s position limits, but its September 2006 position on ICE was actually higher than when NYMEX warned Carrieri in early August.

Amaranth was able to avoid NYMEX regulations, due to a provision in the Commodity Futures Modernization Act of 2000 (CFMA 2000) that created a special trading unit called an exempt commercial market (ECM). An ECM is an OTC entity not required to be registered, designated, recognized, licensed, or approved by the CFTC. To qualify, the exchange had to deal in bilateral transactions between eligible commercial entities, and an eligible commercial entity was any institution or high-net-worth individual who traded either financial derivatives or exempt commodity derivatives, such as metals and energy.290

Congress reasoned that well-heeled investors who use ECMs do not need the protections and safeguards provided to smaller investors. It also understood that electronic exchanges operate in a competitive twilight zone between fully regulated exchanges and the fully unregulated OTC markets. Moreover, electronic exchanges were recognized as experimental proving grounds for new and innovative contracts, which is an area the United States needs to promote if it wants to continue playing a leadership role in global financial markets. By passing CFMA 2000, Congress statutorily removed most federal regulations and oversight from electronic trading platforms and gave legal certainty to OTC transactions.

Amaranth, therefore, was able to pull off its contract-vanishing illusion undetected because, as an unregulated exchange, ICE had no reporting obligations and was not required to impose limits on Amaranth’s positions. Amaranth’s contract-switching operation might have defied the spirit of NYMEX’s position limits, but it did not violate any law.

Did Amaranth Manipulate the Price of Natural Gas?

Within a month of the PSI Report on Excessive Speculation, the CFTC filed a civil enforcement action suit against Amaranth and Brian Hunter. The suit accused the defendants of intentionally and unlawfully attempting to manipulate the price of NYMEX natural gas futures contracts on two expiration days—February 24, 2006 and April 26, 2006.291 The day after the CFTC filed suit, the FERC issued a “Show Cause Order,”292 after making a preliminary determination that Amaranth entities,293 Brian Hunter, and Matthew Donohoe, an Amaranth trader, had manipulated prices on NYMEX and affected physical gas prices on three futures contract expiration days—February 24, 2006, March 29, 2006, and April 26, 2006.294 The suit against Amaranth was the FERC’s first prosecution of a price manipulation case under the Energy Policy Act of 2005, and the civil penalty for this offense was $1 million per day per violation. In its Show Cause Order, the FERC proposed penalties equaling $291 million.295

Suspicions about the trading activities of Amaranth, in general, and Hunter, in particular, were not new. In April 2006, the FERC’s market oversight staff noticed “anomalies” in the price of NYMEX gas futures, which might be connected to Amaranth’s trades. In early August 2006, the Compliance Department of NYMEX sent Amaranth a letter inquiring about its May 2006 natural gas trades.

CFTC versus FERC

The CFTC was created in 1974 as an independent agency with exclusive jurisdiction over accounts, agreements, and transactions involving commodity futures and options contracts that are transacted on regulated exchanges.296 By contrast, the FERC was created in 1977 to ensure fair and competitive natural gas markets in the United States. The FERC has been charged with regulating markets for physical natural gas, and the CFTC has been charged with regulating financial exchanges for natural gas (i.e., futures and options). The CFTC and FERC did not base their charges on Amaranth’s enormous open interest on NYMEX; rather they charged the fund with manipulating prices by selling extraordinarily large amounts of NYMEX futures contracts during the last 30 minutes of selected contract expiration days. The CFTC immediately claimed jurisdiction over the case because Amaranth dealt in natural gas futures and option contracts, which fell within the CFTC’s exclusive territory. The FERC also claimed jurisdiction, arguing that Amaranth affected cash market prices for physical natural gas. Even though Amaranth never traded in the cash market and never took (or made) physical delivery of natural gas on a futures contract, the settlement price for NYMEX’ natural gas futures contract was (and is) used as the basis for many cash market transactions. Therefore, the FERC argued that Amaranth’s trades increased natural gas prices to wholesale market participants, harming natural gas customers.

What is Price Manipulation?

FERC’s suit was based on the Energy Policy Act of 2005 (EPA 2005), which prohibited “the use or employment of manipulative or deceptive devices or contrivances in connection with the purchase or sale of natural gas.” The EPA 2005 standard for price manipulation came from language in the U.S. Securities Exchange Act of 1934.297 By contrast, the CFTC’s price manipulation suit was a per se violation of the U.S. Commodity Exchange Act (CEA) because it threatened two of the most fundamental functions that markets perform, which are risk management and price discovery. Specifically, CEA makes it unlawful for “[a]ny person to manipulate or attempt to (emphasis added) manipulate the price of any commodity in interstate commerce, or for future delivery on . . . any registered [exchange], or to corner or attempt to corner any such commodity.” Amaranth immediately cried foul, claiming that it was being prosecuted under two different sets of price manipulation rules.

The usual standard for price manipulation is the ability and intention to unduly influence prices. It also matters whether prices actually changed as a result of the behavior. When price manipulation occurs, it is usually because someone:

Manipulating Price Spreads by Affecting Storage Opportunities for risk-free arbitrage occur when a futures price is more than or less than the spot price plus the cost of carry. The cost of carry is the net cost to purchase an underlying asset on one date (say, on April 2) and then sell it later (say, on December 12). Therefore, it is the sum of all interest, insurance, and storage expenses to purchase, warehouse, and transport an underlying asset minus any investment returns earned from owning the underlying. As the price spread between the winter 2007/fall 2006 contract increased, why didn’t arbitragers hammer the markets to earn risk free returns? All they had to do was borrow sizeable amounts, use the funds to purchase natural gas on the spot market, store it, and then sell the fuel at futures prices that guaranteed profits. Where were the arbitragers?

In fact, they were there! But there was one big problem. Amaranth bought a huge number of futures contracts for winter delivery, bidding up the winter 2007/fall 2006 price spread. These higher winter prices encouraged natural gas storage, but as arbitragers bought increasingly more natural gas in the spot market and sold more futures contracts, the limited capacity of U.S. storage facilities was gradually exhausted. As a result, the ability of arbitragers to engage in further arbitrage reached its limits. Purportedly, Brian Hunter’s strategy was based, in part, on his expectation that higher futures prices would encourage storage and storage would be exhausted by fall 2006. Once the storage facilities were full, he expected natural gas to be dumped on the spot market, causing futures prices in autumn 2006 to drop relative to winter 2007.

Manipulating Prices by Playing One Exchange Off Another To understand the price manipulation charges against Amaranth, recognize the similarities and differences between settlement on NYMEX and ICE. These two exchanges compete vigorously against each other, and their contracts are functionally (i.e., financially) identical. On both exchanges, natural gas futures contracts expire three business days before a new month begins. One difference between the exchanges is NYMEX requires physical delivery of natural gas for all futures contracts held to maturity.299 ICE contracts are settled financially (i.e., with no obligation to deliver natural gas). Many price manipulation schemes require control of the production, transportation, and storage of physical natural gas; so, this difference matters.

Most individuals trading NYMEX futures do not intend to take physical delivery. If they wanted to purchase natural gas, they would do so on terms that suited their particular needs (e.g., delivery location) instead of NYMEX’s standardized terms. The overwhelming majority of NYMEX contracts are closed prior to maturity, nullifying the physical delivery requirement. One problem with having to close out positions on NYMEX is transactions, if large enough, can move the contract price in a disadvantageous direction. For example, a trader with a large short position would benefit if the price of the futures contract fell; but to offset a short position, the trader must purchase futures contracts, which would raise the price and reduce profits. Similarly, a long position would benefit if the price rose, but to offset a long position, the trader must sell futures contracts, which would lower the futures price and reduce profits.

Because ICE contracts are settled in cash, rather than by physical natural gas, they are called swaps, but as far as hedgers, speculators, and arbitragers are concerned, the two contracts are functionally equivalent. With no possibility for physical delivery, traders simply let their ICE contracts expire and then collect or pay the difference between the spot price of natural gas and their previously negotiated futures prices. Because there is no need to unwind these positions, traders do not engage in offsetting transactions that could move futures prices disadvantageously.

On NYMEX, the final settlement price is a weighted average of settlement prices during the final 30 minutes of trading (i.e., from 2:00 P.M. and 2:30 P.M. EST).300 Natural gas futures contracts on Atlanta-based ICE are financially settled, and the final settlement price in 2006 was taken directly from NYMEX.301

Price Manipulation on February 24, 2006? Expiration day for the March 2006 contract was February 24, 2006. The day before expiration, Amaranth was short 1,700 March 2006 contracts on NYMEX and at the same time, short 12,000 March 2006 swap contracts on ICE. If the price of natural gas fell, Amaranth stood to gain handsomely. Brian Hunter wrote text messages to colleagues saying he wanted to make a “bit of an expiriment (sic)” . . . so, “make sure we have lots of futures to sell MOC [market on close] tomorrow” . . . because we “just need [March] to get smashed on settle then [the] day is done.”

On expiration day, Hunter kept his enormous short position on ICE but reversed his short position on NYMEX, ending up with a long position equal to about 3,000 natural gas futures contracts. Then, during the last half hour of trading, when NYMEX’s settlement price was determined, he sold all 3,000 long contracts, putting downward pressure on the price of NYMEX’s March 2006 natural gas futures contract.302 Even though the lower price hurt Amaranth’s profits for the 3,000 contracts Hunter sold on NYMEX, it increased the fund’s profits on his 12,000-contract ICE position. We know this because ICE took its final settlement price directly from NYMEX.

Price Manipulation on April 26, 2006? Regulators claimed that Hunter manipulated prices in the same way on April 26, 2006, the day the May 2006 futures contract expired. In the days prior to expiration, Amaranth accumulated a net long position on NYMEX equal to 3,000 May 2006 natural gas futures contracts and, at the same time, took a short position on ICE for 19,000 May 2006 futures contracts. Of the 3,000 contracts sold on April 26, 2,527 were traded during the last 30 minutes, of which 2,517 were traded in the last four minutes, and 1,897 were traded in the last minute. During the day, the natural gas futures price for May 2006 rose from $7.15/MMBtu at 2:00 P.M. to $7.27/MMBtu at 2:22 P.M., and then plummeted to $7.10 at the close of trading.303 Amaranth’s ICE positions benefited handsomely.

Issues Relating to the Price Manipulation Charges against Amaranth

Charges of price manipulation raise a number of important economic issues. Do speculators destabilize prices? Do changes in futures prices affect the spot price of underlying assets? The CFTC and FERC accumulated a considerable body of circumstantial evidence against Amaranth, but many questioned the claims.

Do Speculators Stabilize or Destabilize Prices? If they are successful, speculators earn profits by purchasing natural gas at prices lower than they sell it. This means they buy natural gas when the market price is below where it should be and then sell it when the price rises back to or above the (steady state) equilibrium level. When speculators purchase natural gas, their actions raise the price, and when they sell, their actions lower it. If they are profitable, over time, speculators should reduce natural gas price volatility and not increase it because they are buying when the price is too low and selling when it is too high.304

In a 2005 study, the CFTC’s Office of Economic Analysis concluded that managed market traders (MMT), such as hedge funds, do not change their positions as frequently as hedgers do.305 Reinforcing these conclusions, a March 2005 study by NYMEX found that hedge funds tend to hold positions significantly longer than the average market participant and actually reduced market volatility rather than increased it.306 These studies supported the view that speculators tend to dampen volatility and not increase it.

Does Futures Speculation Affect the Underlying’s Price? Futures contracts are supposed to derive their value from the underlying—hence the name derivative. As the spot price of an underlying changes, the futures price should change in tandem, and the difference between them should equal the cost of carry (and convenience yield). If this were not the case, opportunities for risk-free arbitrage should arise. Options on commodities also derive their value from the spot price of the underlying, but these values are influenced by four other variables: strike price, maturity, volatility, and risk-free interest rate. Causation is supposed to run from the cash market to the derivative market and not the other way.

The International Swap Dealers Association (ISDA) responded forcefully to the CFTC’s and FERC’s attempt to regulate electronic exchanges. It claimed there is no hard proof that privately negotiated derivative contracts adversely affect consumers. The CFTC’s Office of Economic Analysis concluded that changes in the positions of MMTs were reactions to commodity price changes and not the cause of these price changes. Moreover, the analysis found that MMTs shifted their positions in reaction to and inversely with changes in the positions of other large hedge funds, supplying the market with needed liquidity.307

In his appearance during the Senate Subcommittee hearings, the CFTC’s chief economist said, “The [PSI] analysis failed to conclude that Amaranth’s trading was responsible for the price spread level observed during 2006.”308 Rather, the CFTC interpreted the evidence as showing two-way causality, with Amaranth influencing the market price and the market price influencing Amaranth.309 The chief economist went on to say that “[a]ll the data are consistent with the hypothesis that the March/April 2007 spread, and similar winter/summer spreads, declined due to changes in the perception of market fundamentals.”310 The CFTC’s Acting Chairman, Walt Lukken, agreed and testified that Amaranth did not have any effect on prices in the natural gas market.

Did Amaranth’s Large Open Interest Affect Futures Prices? Futures markets are not bidding arenas for a fixed number of contracts. The marginal cost of transacting a new deal is virtually zero and delivery is instantaneous. Two counterparties can create a new contract even if a third party holds 100 percent of the existing open interest. Therefore, holding a large portion of the open interest in a futures contract is not a barrier to entry because the price is determined by the flow of supply and demand transactions and not by the stock of existing positions.

Other Doubts about the Price Manipulation Cases against Amaranth Other doubts surfaced about the price manipulation charges against Amaranth. First, there was a timing issue. Amaranth began building its March/April 2007 positions in the spring of 2006, but price spreads for this contract were already wide in 2005, due to Hurricanes Katrina and Rita. This means that the spread increased and remained high for months before Amaranth took its large positions. Second, Amaranth’s demise caused its demand for and supply of futures contracts to fall to zero. If Amaranth were such a large portion of the market, you would expect its departure to reduce open interest on NYMEX, but it did not. Instead, open interest “remained fairly stable at record levels.”311 Finally, when Amaranth exited the market, it should have substantially reduced the demand for NYMEX’s January 2007 natural gas futures contract, lowering the January 2007 futures price; but the price of this contract rose with Amaranth’s departure. Independent studies came to the same conclusion, indicating that Amaranth simply made a bad bet on the weather and paid a hefty price for its reckless gambling.312

What Happened to the CFTC and FERC Suits?

It took until September 2014 for all the out-of-court settlements, court hearings, and appeals to be finalized. Both the process and eventual results played out like a Hollywood movie script.