Hedge Funds Forecast Windfall in Europe's Growing Power Market

Date: Monday, June 18, 2007
Author: Lars Paulsson, Bloomberg

June 15 (Bloomberg) -- Hedge fund manager Marcel Melis ignores stock charts, commodities reports and bond prices as he sips his morning coffee. All his attention is focused on one thing: the weather.

Melis analyzes forecasts for areas from the snowcapped mountains of Norway to the beaches of Spain's Costa del Sol to predict changes in demand for power and gas. The founder of Energy Capital Management BV, which has raised $60 million and started trading in October, targets returns of 25 to 30 percent.

``If you don't know what the weather is doing you have no chance making money trading energy,'' Melis, 38, says in his ninth-floor office overlooking Amsterdam's biggest power plant.

The number of hedge funds with more than a quarter of their capital in European energy jumped fivefold to 50 last year as German utilities began releasing data on plant outages, helping traders forecast supply in the region's largest market, according to Energy Hedge Fund Center LLC. The value of derivatives traded on the European Energy Exchange in Germany more than doubled to 58.75 billion euros ($78.08 billion).

European power prices are on the rise after falling to records following the mildest winter in more than 100 years.

Germany's third-quarter power contract has been the focus of traders ever since April 11, when the U.K.'s Met Office said the summer in northwest Europe would probably be hotter than average, boosting demand for power and increasing the risk of price spikes.

The contract rose as high as 49.30 euros a megawatt hour on May 18, after dropping to 36.40 in February. It closed at 44.25 euros on June 14.

Price Controls

Government interference may threaten the development of European markets. Price controls in France, Spain and Italy deter investors, said Peter Styles, chairman of the European Federation of Energy Traders' electricity committee.

``At worst, price caps could not only distort the market but also destroy it,'' Styles said.

Traded power volume in France, Europe's second-biggest market, is about the same as consumption, compared with six times demand in Germany, said Peter Krembel, head of continental power trading at RWE AG's trading unit.

Hedge funds gained a toehold in Europe's power markets in 2001, when Norway's Interkraft Capital Management ASA began trading in the Nordic region. It was joined by U.S. firms D.E Shaw & Co., Tudor Investment Corp. and Amaranth Advisors Inc., which collapsed in September under $6.6 billion of energy-trading losses. D.E. Shaw and Tudor declined to comment for this article.

Hedge funds are mostly private and unregulated pools of capital where managers can buy or sell any assets, participating substantially in the profits of the money invested.

Investors are turning to Germany after generators began releasing aggregated power supply data last year. In addition, E.ON AG, the country's largest utility, now publishes planned outages. RWE AG, the second biggest, says it will do the same.

German Power

Germany's size and increasing liquidity may boost profits, said Daniel Dahlin, chief investment officer at Bermuda-based Electris Energy Fund Ltd., which has raised $25 million. Electris returned 7.3 percent in its first 12 months of trading on Nord Pool, Europe's biggest power exchange, and plans to expand into Germany this year.

``If you're active in more than one market you have the possibility of higher returns with a lower risk,'' said Dahlin, 36, the former head of Nordic power trading at Vattenfall AB, Sweden's state-owned utility.

Banks are also competing for a slice of the market. Citigroup Inc., the biggest U.S. bank, plans to add 10 traders for the European power and gas and carbon allowance markets.

``When you're looking to get established, it's important to hire key traders with experience that you can build a team around,'' said Paul Mead, Citigroup's managing director for power, gas and emissions in London.

Traders in Demand

Competition for experienced traders is driving up salaries.

Compensation for European power traders started rising about three years ago and top performers now receive $4 million to $5 million a year, recruiters said.

``Bonuses of 300 percent are not limited to the banking community any longer as we are seeing similar deals adopted by the energy companies,'' said Jakob Bloch, managing director of Hampshire, England-based Commodity Appointments Ltd.

Commodities hedge funds returned 13 percent to 23 percent last year, based on 100 funds tracked by London-based NewFinance Capital LLP. The Standard & Poor's Goldman Sachs Commodity Index of 24 futures prices fell 15 percent last year.

Melis's MMT Energy Fund seeks to profit on the difference between energy prices in various markets and time periods.

``We're doing well,'' he says, declining further comment on whether the fund is meeting its target for annual returns.

Amsterdam Garages

Melis got his start in the Amsterdam real estate market, where he's been buying and selling houses and garages since the mid-1990s. He developed his energy trading skills at BP Plc, Statkraft SF, Reliant Energy Inc. and Delta Energy NV.

That experience helps him oversee the MMT fund's positions in German, Dutch and Belgian power and U.K. and Dutch natural gas as well as European carbon allowances and coal contracts.

Melis and his four colleagues spend their days in an office decorated with maps of the European power and gas distribution networks, along with charts showing generation capacity and fuel sources used in countries throughout the region.

At a communal work table, weather reports and prices for energy contracts stream across banks of metal-edged, flat-panel screens. Melis plans to add French, Nordic and U.K. power, along with Brent crude and gasoil to the fund's portfolio this year.

``The nice thing about energy is that it's very complex, difficult to understand and very volatile,'' Melis said. ``That's what makes it interesting.''

Long, Hot Summer

Melis and energy trader Olaf Ter Bille make deals on the exchanges and in the over-the-counter markets, where brokers such as Icap Plc and GFI Group Inc. match buyers and sellers.

Over-the-counter trades still account for more than 75 percent of the volume in the seven biggest electricity markets, according to Prospex Research Ltd.

``Europe's power markets are beginning to mature, but are still relatively untapped by hedge fund traders and they are growing rapidly,'' said Gary Vasey, co-principal at Energy Hedge Fund Center in New York.

For now, traders are focusing on how the weather will affect prices in the next few months.

``Everyone's afraid of a hot summer,'' Melis says.

To contact the reporter on this story: Lars Paulsson in London at lpaulsson@bloomberg.net